www. NYLJ.com Volume 241—NO. 62 thursday, april 2, 2009 secured transactions Proliferating Challenges Lenders To Step Up Diligence

egular readers of this column will fraud was uncovered only in 2008, despite notice something missing from an unusually smooth pattern of consistent today’s byline—the name of my By gains of roughly 1 percent a month for two longtime co-columnist, Shepard W. Alan M. decades5 and notwithstanding investigations Melzer, who passed away suddenly on Christenfeld by the Securities and Exchange Commission RMarch 13. Shep was my partner, friend and (“SEC”) and other regulators that failed to advisor for nearly 20 years, and until his death expose the scheme.6 Madoff was allegedly we had collaborated in writing these articles aided and abetted by an accountant who has continuously since February 1997. An expert of funds. Accordingly, without repeating our been charged with, among other things: (i) in air and secured transactions, Shep previous articles’ substance—which remains falsely representing that Madoff’s operations was even more remarkable for his wisdom, as valid today as when it was originally were financially sound and that proper audits generosity, loyalty and good humor. He will published2—it is timely to remind lenders had been conducted; (ii) failing to confirm the be missed greatly. of the most common fraudulent schemes existence of securities that Madoff claimed to Today we revisit the topic covered in hold; (iii) avoiding peer review requirements 1 used by borrowers and to present strategies the first two articles Shep and I published for avoiding them. We will also discuss two applicable to auditors by representing that he in this space, more than a dozen years ago. distinct difficulties today’s credit crisis poses for was not engaged in audit work; (iv) failing to Those columns discussed fraud in secured lenders: assessing creditworthiness and valuing examine revenues of Madoff’s operations; and transactions, outlining the types of swindles collateral.3 (v) failing to examine a Madoff account that borrowers most commonly commit, and through which billions of dollars flowed.7 offering guidance to help lenders reduce their Common Types of Fraud Robert Stanford, the head of Stanford exposure to fraud and to address it should it Group, is accused of operating an $8 billion arise. They highlighted some of the hoaxes that Borrower fraud falls into three main fraud. Regulators claim that he lured occurred in the recession of the early 1990s categories: false information; multiple financing into buying certificates of deposit by promising and the years leading up to it. of the same collateral; and worthless, overvalued, rates of return substantially higher than those We are now experiencing a global economic non-existent or inaccessible collateral. offered by mainstream and by advertising meltdown that has blocked virtually all but the False Information. Borrowers who cannot investments in liquid securities. The SEC, most creditworthy borrowers from obtaining or obtain credit based on their true financial however, asserts that Stanford’s consistent retaining lending commitments. The current condition often resort to providing false returns—which were identical for 1995 and “credit crisis” follows a long period of cheap information to potential lenders to appear 1996—were “improbable, if not impossible,” and plentiful liquidity during which lenders more creditworthy. Manufactured references, and that a substantial portion of Stanford loosened credit standards to an unprecedented, manipulated financial statements, phony bills Group’s assets were held in illiquid real estate if not perilous, degree to win business. This of lading and other forged documents are and private equity investments.8 economic collapse presents a uniquely commonly submitted to get loans. Borrowers , a attorney and the challenging environment for lenders and may also provide fake contact information so founder of an eponymous , has been borrowers. Lenders must identify creditworthy lenders cannot reach them for payment. charged with committing a $700 million borrowers in a climate where few exist, while Several recent scandals underscore the fraud in which he allegedly misrepresented borrowers must compete for a dwindling supply dangers that false information poses to lenders his identity and that of his associate during and investors and the difficulty that lenders and meetings and conference calls.9 investors face in verifying such information. Such schemes, of course, are not limited to Alan M. Christenfeld is senior counsel at Clifford Chance US. Evan J. Cohen, a partner at Clifford Chance, Bernard Madoff recently pleaded guilty the . The chairman of Satyam, a co-authored this article, and Jonathan M. Schalit, an to having run a multi-billion dollar Ponzi major Indian computer company, admitted to associate at the firm, assisted in its preparation. scheme, beginning in the 1980s.4 The creating fictitious cash balances of more than $1 thursday, april 2, 2009 billion and to falsifying financial statements for site inspections; (3) differences between a agency’s opinion, holders of the obligations over five years.10 Two of the company’s auditors borrower’s actual operations and a lender’s so rated are as likely to be paid principal and from PricewaterhouseCoopers are alleged to perception thereof; (4) inconsistencies in the interest on time as holders of U.S. Treasuries. have been complicit in the fraud and have borrower’s records; (5) secret operations; (6) The recent widespread inaccuracy of the ratings been arrested by Indian authorities.11 trying to avoid direct contact with lenders; (7) of many traded obligations has cast doubt on Multiple Financing of Collateral. Certain attempting to short-circuit customary credit the rating agencies’ ability to assess accurately lenders require that borrowers grant liens on approval processes; (8) attempting to secure borrowers’ likelihood of being able to service specific assets as a condition to extending financing in an extremely short period of time; their debt. Lenders thus should view borrowers’ credit. Such assets are supposed to be pledged (9) using a firm of accountants that is far too credit ratings with an appropriate degree of to only one lender. To obtain financing from small to audit an account of the borrower’s skepticism and as only one component of a multiple lenders, however, dishonest borrowers size; and (10) having retained many different comprehensive credit analysis. may resort to assigning the same collateral to to represent it on similar transactions or Valuation in the Wake of the Credit Crisis. different lenders while representing to each having had lawyers disclaim their past opinions “Mark-to-market” and “mark-to-model” are two lender that the collateral is theirs alone. or work product. accounting methods that have forced lenders Duplicative financing of the same collateral recently to recognize multi-billion dollar losses. weakens each creditor’s ability to recoup its Due Diligence Under these methods, lenders must periodically losses in the event that the borrower does not In the face of potential borrower fraud, write down the value of assets to reflect either repay the loan. lenders are well advised to perform rigorous the amount they would be worth upon sale, in Worthless, Overvalued, Non-Existent or diligence, verify independently all information the case of mark-to-market, or that a proprietary Inaccessible Collateral. Worthless, overvalued, provided by or on behalf of borrowers, and, mathematical model imputes to them, in the non-existent or inaccessible collateral is a where information cannot be verified, case of mark-to-model. major concern for lenders. Intangible assets are require more stringent debt service coverage Lenders have criticized mark-to-market especially prone to manipulation by borrowers. ratios and/or more collateral. The same accounting vociferously, charging that it forces Unscrupulous borrowers often intentionally recommendations hold true where collateral financial institutions to recognize losses on still- 18 overstate the value of receivables, re-date stale values cannot be readily ascertained. valuable assets. Underlying this complaint receivables and create fake invoices, among Compounding these challenges, the credit is the fact that the market for particular other things. crisis presents new difficulties in measuring assets in a distressed economy can set values Thomas Petters, the former CEO of Petters borrowers’ creditworthiness and in valuing that, although valid for a limited time, could Group Worldwide, the corporate parent of collateral, both of which we address below. become inaccurate quite quickly. Although it Polaroid, is alleged to have committed a multi- Furthermore, although the types of deception is useful to understand the value of collateral billion dollar fraud in which he obtained loans in which borrowers engage have not changed at any particular time, lenders must plan for secured by non-existent goods and fake accounts fundamentally since we last wrote on the fluctuating collateral values. Notably, the price receivable. The complaint against Petters subject, the well-publicized recent scandals that mark-to-market accounting produces in accuses him of creating false documentation, suggest that today’s affect more victims today’s economy is skewed by depressed global including purchase orders, invoices, bills of and have a broader geographic impact than demand for goods and services and is considered sale, wire transfer confirmations, shipping their predecessors. by many to be a “fire sale” price. documents and financial statements, to trick Measuring Creditworthiness in the Wake of Mark-to-model accounting has been attacked 12 lenders into providing funds. Petters’ alleged the Credit Crisis. In addition to the information on the grounds that “in-house mathematical fraud led, in large part, to Polaroid’s filing for that can be gleaned from borrowers’ financial models are, in the phrase coined by Warren 13 in December 2008. statements, lenders historically have relied on Buffett, ‘mark to myth’” and that “even without The Uzan family of , former owners of credit ratings provided by Moody’s, Standard market prices, banks still are expected to look to the Turkish wireless carrier Telsim, were ordered & Poor’s and Fitch (the “rating agencies”) the market for any other data available to serve 19 to pay more than $3 billion in compensatory to borrowers’ creditworthiness. These as inputs into their valuation models.” and punitive damages to Motorola and Nokia ratings are intended to gauge the likelihood Lenders would be wise to consider over- in 2007 in connection with loans obtained that borrowers will be able to make timely collateralizing their loans, when possible, to from them in bad faith, denying access to books payments on their debts. protect themselves from inherent flaws in mark- and records, diluting the value of stock that In the current downturn, however, some to-market and mark-to-model accounting. had served as collateral and placing the stock have questioned the accuracy of credit ratings Lessons Learned under the control of a Turkish foundation, a and how much reliance should be placed in step that legally barred Motorola and Nokia them. Moody’s Investors Service reports Although investors, rather than lenders, 14 from accessing their collateral. that 101 rated corporate issuers defaulted on have been targeted by the largest recent 15 Warning Signs of Fraud $42.7 billion of commercial loans in 2008. A swindles, lenders can learn valuable lessons number of investment grade commercial loans from all of today’s frauds. Although the current credit crisis presents are currently trading well below par.16 Similarly, On-Site Inspections and Red Flags Are economic circumstances not seen since the AAA rated commercial-mortgage-backed Vital. The Madoff scandal stresses the red flags 1930s, the fundamental warning signs of securities lost 22 percent of their market value that should be raised by problematic on-site borrower deception remain consistent over the in the three months from September through inspections, inconsistencies between one party’s decades. Some of the borrower conduct that November 2008, and by the end of December expectations and another party’s operations, lenders should beware includes: (1) refusing 2008 were trading at around 73 cents.17 A secret operations and a borrower’s use of an to disclose information; (2) objecting to on- rating of AAA implies that, in the rating unusually small auditing firm. In early 2003, thursday, april 2, 2009

the French bank Société Générale visited diligence tool to measure accurately borrowers’ ••••••••••••••••••••••••••••• Madoff’s New York headquarters to perform financial condition. Discovery of such chicanery 1. A.M. Christenfeld and S.W. Melzer, “Fighting Fraud: due diligence. Société Générale’s on-site would have been difficult in Satyam’s case What Every Secured Lender Should Know,” The New York Law Journal, Feb. 6, 1997; A.M. Christenfeld and S.W. inspection led it immediately to put Madoff because its accountants were one of the “Big Melzer, “Fighting Fraud: What Lenders Should Know,” NYLJ, Investment Securities on its internal blacklist, Three” accounting firms. The same cannot be April 3, 1997. on the grounds that the red flags at Madoff’s said, however, regarding Madoff’s financials, 2. Readers who would like to review the prior columns and who cannot locate them are encouraged to contact the author firm were obvious. Madoff’s pattern of eerily which were audited by a sole practitioner who, at [email protected]. consistent results, in the bank’s opinion, was operated out of a small storefront office,22 3. Frauds allegedly perpetrated by lenders, especially indicative of a and diminished his lacked both recognized standing and, seemingly, mortgage loan originators, that have become the subject of 20 recent inquiry by Congress and various regulatory authorities legitimacy. A former Madoff client recounted the resources to audit comprehensively an are beyond the scope of this article. that sharing a communication between himself enterprise of Madoff’s supposed size; that fact 4. R. Frank, A. Efrati, A. Lucchetti and C. Bray, “Madoff and Madoff with other investors resulted in alone should have elicited suspicion. Lenders Jailed After Admitting Epic Scam,” , March 13, 2009 at A1. 21 the threat of expulsion from Madoff’s fund, should also be wary of borrowers who have 5. J. Zweig, “How Made Smart Folks Look hardly a repercussion one would expect from had multiple auditors in a short time period. Dumb,” WSJ, Dec. 13, 2008, at B1. 6. K. Scannell, “Madoff Chasers Dug for Years, to No an operation with nothing to hide. Sequential auditors, like sequential attorneys, Avail,” WSJ, Jan. 5, 2009, at C1. Lenders should thoroughly investigate are indicative of potential concerns that should 7. Complaint at 2-3, 13, 14, Securities and Exchange prospective and existing borrowers, be keenly be investigated. With the diminished value of Commission v. Friehling (S.D.N.Y. 2009) (No. 09 Cv. 2467); See also M. Hamblett, “Madoff’s Accountant Faces Multiple attuned to any signs of unscrupulous activity, credit ratings and the potentially uncertain Charges,” NYLJ, March 19, 2009. keep abreast of developing frauds through nature of financial statements, lenders need 8. C. Krauss, P. Zweig and J. Creswell, “ Firm Accused market observation, and conduct routine to make credit judgments that are truly of $8 Billion Fraud,” , Feb. 18, 2009 at A1. follow-up inspections and verifications to independent before extending financing. 9. A. Frankel, “The Crack-Up,” The American , ensure that borrowers remain in compliance Lawyers’ Ethical Obligations. Practitioners Vol. XXXI, 69-73 (March 2009); See also D. Weiss, “Dreier’s Lawyer Expects Guilty Plea; Firm Lawyers at Risk with their representations, warranties and should take note of New York’s new Rules of in Bankruptcy Case,” ABA Journal, March 20, 2009. covenants. Such investigations are especially Professional Conduct for lawyers that took 10. E. Bellman and J. Range, “Satyam Probe Scrutinizes important given the geographic distance that effect yesterday. Under the rules, attorneys CFO, Audit Committee,” WSJ, Jan. 14, 2009, at B3; See also Eric Bellman and Jackie Range, “Satyam Probe Could Ensnare often separates borrowers and lenders in today’s are permitted to disclaim prior representations Others,” WSJ, Jan. 17, 2009, at B5. global markets. made in connection with clients engaged in 11. “Two Pricewaterhouse Partners Arrested,” The Hindu Confirming Identities. Marc Dreier’s alleged fraud, even if such disclaimer requires revealing Business Line, Jan. 25, 2009, http://www.thehindubusinessline. com/2009/01/25/stories/2009012551040100.htm. deception underscores the importance of confidential information. Furthermore, lawyers 12. Complaint at 3-4, United States v. Petters, 2009 U.S. verifying the identity of borrowers and their whose client attempts to defraud a court, or Dist. LEXIS 6489 (D. Minn. Jan. 28, 2009) (No. 08 Cr. 364). another agency acting in an adjudicative 13. “Polaroid Files for Bankruptcy Protection,” NYT, Dec. agents. Lenders must endeavor to ensure that 20, 2009 at B2. parties with whom they meet and/or correspond capacity, now have an affirmative duty to 14. “Court upholds $1 Billion Award to Motorola,” NYT, are the actual individuals whom they purport to prevent it from perpetrating the fraud.23 The Nov. 22, 2007 at C3; See also D. Greising, “Motorola, Turkey Chase Family for Missing Billions,” Chicago Tribune, Dec. 28, be, and that such individuals have the requisite new rules thus both permit and may oblige 2003 at C1. authority to bind the entity for which they lawyers to make a “noisy withdrawal”— 15. “Defaults, Downgrades Keep Mounting,” Credit purportedly work. precisely what Stanford’s counsel did when, Investment News, March 2, 2009. 16. For example, The Loan Syndications and Trading Verifying Information. Petters’ alleged use upon learning that its client had used investors’ Association advised the author’s colleagues via e-mail on March of false documents to obtain loans highlights money in ways contrary to their expectations, 25, 2009, that BBB+ rated term loans of TD AMERITRADE it notified the SEC that it was repudiating all Holding Corporation and HD Supply Inc. were then trading the importance of verifying all information at 93 and 79 cents on the dollar, respectively. provided by borrowers and makes the case prior oral and written representations regarding 17. S. Craig, C. Mollenkamp and S. Ng, “Goldman Faces for lenders adopting and routinely following and its affiliates.24 Loss of $2 Billion for Quarter,” WSJ, Dec. 2, 2008 at A1. 18. M.R. Crittenden, “SEC Advises No Break in ‘Mark’ rigorous collateral verification policies and Conclusion Rules,” WSJ, Dec. 31, 2008, at C6. procedures. 19. “Auditors Set to Ensure Banks Don’t Mark to Myth,” Nov. 16, 2007, CNBC, http://www.cnbc.com/id/21833872/. Ensuring Access to Collateral. Lenders When bad economic conditions occur, the 20. N.D. Schwartz, “European Banks Tally Losses Linked to must be vigilant against impediments to appearance of major frauds is sure to follow. Fraud,” NYT, Dec. 17, 2008 at B1. accessing their collateral. Whether through Dire financial straits impel to dishonesty many 21. R. Frank and T. Lauricella, “Madoff Created Air of Mystery,” WSJ, Dec. 20, 2008 at A1. complex structures, as in the Telsim fraud, people who previously were above reproach 22. W. Rashbaum, “Madoff’s Accountant Is Charged With or through other mechanisms, borrowers while their businesses were strong. They also ,” NYT, March 19, 2009, at B1. may attempt to block lenders from accessing raise the curtain on frauds, especially Ponzi 23. New York Rules of Professional Conduct R. 1.6(b)(3), 3.3(b) (2009). Whether “noisy withdrawal” should be collateral. If successful, such borrowers may schemes, that incubate during good times when required, versus merely permitted, has been hotly contested in effectively subordinate secured transactions people are flush with cash but collapse as soon the context of the Sarbanes-Oxley Act of 2002. 24 . K. Scannell, “The Stanford Affair: The Lawyer’s into unsecured ones. as the defrauded victims need their money back. Withdrawal From Stanford Case Waives a Flag,” WSJ, March Difficulty of Relying on Financial Thus, lenders now need to redevelop the credit 6, 2009 at C2. Statements or Ratings. Satyam and Madoff culture and skills that atrophied in recent years. show the difficulty that lenders face in relying Only then will they be in a position, consistent Reprinted with permission from the April 2, 2009 edition upon borrowers’ purportedly “independent” with prudent capital management, to maximize of the NEW YORK LAW JOURNAL© 2009 Incisive US financial statements. Corrupt auditors who are the availability of loans that a credit-starved Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact complicit with borrowers in forging financial nation requires while also taking appropriate 877-257-3382 or reprintscustomerservice@incisivemedia. statements deny lenders an indispensable precautions to guard against deceit. com. # 070-04-09-33