Citi's Enron Nightmare Just Got Worse

A new report shows how key the bank was to Enron's dealings

So far, Citigroup (C ) has managed to limit its direct Enron-related losses to a fraction of those incurred by the energy company's other big banker, J.P. Morgan Chase & Co. But a 2,000-page report released by Neal Batson, the Atlanta lawyer who is the court-appointed examiner in Enron Corp.'s bankruptcy, could spell much more trouble for the country's largest bank.

Batson's report, released on Mar. 5, details how integral Enron's bankers were to its massive fraud. The court document presents the most comprehensive picture to date of how Enron relied on banks to help prop it up for years, and how the banks sometimes provided the bulk of Enron's cash flow. Transactions investigated by Batson show that Citi helped Enron with more than $3.83 billion in financing. Coming on the heels of the bank's $400 million settlement with the New York Attorney General and the Securities & Exchange Commission, the report could further damage Citi's reputation. In a statement, Citi said the report "shows the scope and size of the fraud perpetrated by Enron and condemns the accounting techniques repeatedly approved by [Enron's auditors] Arthur Andersen LLP and Enron's other advisers." Citi said it "relied on Enron, its accountants, and advisers to report these transactions properly." The bank declined to be interviewed for this story.

However, Batson's report could lead to some very costly consequences for Citi. Already, its detailed description of Enron's finances and the bank's involvement in them provide factual basis that civil litigants, who are suing Citi for billions, can use in court. Worse, Batson has been asked by U.S. Bankruptcy Court Judge Arthur J. Gonzalez, who oversees Enron's bankruptcy, to determine by June 28 how much blame banks, accountants, and lawyers should bear for the company's failure.

If Batson finds that banks did commit fraud, shareholder and bondholder suits against Enron would have a better chance of recouping losses from their deep pockets. Ultimately, Morgan and Citi, still both owed millions by Enron, might have to make payouts to other creditors rather than recovering losses themselves. And individual bankers named in the report could face fraud charges. Morgan, which declined to comment on the report, added $900 million in "litigation reserves" in the fourth quarter of 2002. Citi added $1.3 billion, in part for "regulatory inquiries and private litigation related to Enron."

But civil suits and hefty payouts may be the least of bankers' worries. Justice Dept. investigators are building cases against Enron executives, lawyers, bankers, and former officials at Arthur Andersen. On Mar. 12, they arrested two Enron executives, charging them with conspiracy, securities fraud, and wire fraud for helping Enron fake earnings. If convicted, they face a maximum sentence of 15 years.

The Batson report and Justice Dept. investigation share much common ground. Earlier this month, agency investigators, worried that the document might tip their hand to potential defendants, asked Batson to delay its release. The report could prove to be a "road map for prosecutors," says John C. Coffee Jr., a law professor at Columbia University, because it shows that participants acted "intentionally, knowingly, and fraudulently."

Despite Batson's detail about Citi's close ties to Enron, proving any bank liable in the bankruptcy of a third party is a difficult and unusual step. "It will be a very tough case to make, given the regulatory oversight practiced on banks," says Richard X. Bove, an analyst at Hoefer & Arnett Inc., a San Francisco-based investment-banking boutique. A successful litigator would have to prove that a bank's oversight was so inept that the bank was able to participate knowingly in Enron's fraud.

Batson says Enron violated generally accepted accounting principles (GAAP) with the help of Citi and other banks. The banks knew that Enron was misrepresenting the deals in its own annual reports, he says. Citi bankers, in internal memos collected in Batson's report, identify some Enron transactions as a "shell corporation" or "essentially a loan." One Citi banker notes that some were created to add "oomph to revenues."

In one case, the report also accuses Citi bankers of failing to follow even the most basic of financial practices. Two off-balance-sheet deals, named "Fishtail" and "Bacchus," were hatched only to patch a hole in Enron's revenues after a joint-venture partner walked away from its pulp-and-paper business, Batson says. Completed with Citi and Morgan on successive days at the end of 2000, the two deals were "short-term interim financings done solely to allow Enron to record $112 million of income from a purported sale that never truly took place," and to "record cash flow...that was actually from a financing," Batson says. After examining Citi's internal memos on the deals, Batson finds, "no discussion of why Citibank would want to own [a pulp-and-paper business]." Further, "there is no indication that Citibank performed any due diligence on the asset."

The most lucrative bank-related financings that Batson explains are a series of deals known as "prepays." These are complex commodity contracts through which banks provided Enron with financing that didn't have to be classified as a loan, and so disguised how much debt Enron was carrying. These deals brought Enron a total of $8.6 billion in revenues from 1992 to 2001. Prepays with Citigroup and Morgan provided 100% of Enron's cash flow in 1999 and 32% of its 2000 cash flow. Citi structured and was the counterparty for prepays known as the Yosemite transactions, which brought in $2.4 billion from December, 1999, to May, 2001. William W. Brown, the Enron officer charged with responsibility for some Yosemite deals and the manager of Enron's corporate finance group, told Batson that the size of the transactions was determined by the cash flow that Enron wanted to show to rating agencies. Such an operation blunts the rating agencies' effectiveness. "Surreptitiously created cash flow doesn't give us a true picture of a company's ability to generate cash from operations," says Pamela Stumpp, managing director at Moody's Investors Service.

The deals were fundamental to Enron's survival, say financial experts. "As long as banks would structure deals that let Enron call loans 'cash flow' and keep the debt off the company's balance sheet, the whole fantasy could continue," says D. Quinn Mills, a professor at the Harvard School of Business who studied the report. "It looks like an updated Ponzi scheme -- more sophisticated than the original, but even more imaginary a business."

One deal in particular is cited for its accounting violations. In 1999, Enron and Citi developed Project Nahanni, which Batson charges was "designed solely to permit Enron to record $500 million in cash flow from operating activities" for the year. Through Nahanni, Enron borrowed $500 million, bought Treasury securities with it, sold them, recognized $500 million of operating cash flow, and repaid the loan -- all without reflecting the loan as debt on its financial statements. In a footnote, Batson says that Nahanni was one of Enron's "clearest violations of GAAP."

Citi and other banks have little choice but to wait until June to see if they're going to be cited for fraud. But if this report is any indication, they should already be calling their lawyers.

By Heather Timmons and Emily Thornton in New York, with Lorraine Woellert in Washington

— With assistance by Lorraine Woellert

    Before it's here, it's on the Bloomberg Terminal.