NORTH CAROLINA BANKING INSTITUTE Volume 8 | Issue 1 Article 12 2004 The itC igroup and J.P. Morgan Chase Enron Settlements: The mpI act on the Financial Industry Vaughn K. Reynolds Follow this and additional works at: http://scholarship.law.unc.edu/ncbi Part of the Banking and Finance Law Commons Recommended Citation Vaughn K. Reynolds, The Citigroup and J.P. Morgan Chase Enron Settlements: The Impact on the Financial Industry, 8 N.C. Banking Inst. 247 (2004). Available at: http://scholarship.law.unc.edu/ncbi/vol8/iss1/12 This Notes is brought to you for free and open access by Carolina Law Scholarship Repository. It has been accepted for inclusion in North Carolina Banking Institute by an authorized administrator of Carolina Law Scholarship Repository. For more information, please contact [email protected]. The Citigroup and J.P. Morgan Chase Enron Settlements: The Impact on the Financial Services Industry I. INTRODUCTION Corporate executives at financial institutions must increase their awareness of their companies' transactions because corporate governance is a vital issue in today's financial industry.1 Since the establishment of the Corporate Fraud Task Force in July 2002,2 federal prosecutors have charged more than 354 defendants with some type of corporate fraud and have convicted or obtained guilty pleas in more than 250 corporate fraud cases, including some related to the Enron debacle.3 In the wake of the Enron scandal, over 5,600 jobs have been lost, 28,000 employees' pensions have been drained, and Arthur Anderson has collapsed.4 Accountants and investment bankers have been held criminally responsible for their actions, while civil lawsuits have been filed against two law firms that participated in the Enron fraud.5 As the Enron scandal continues to unravel, the financial institutions primarily involved with Enron, Citigroup, Inc.6 (Citigroup) and J.P. Morgan Chase7 (J.P. Morgan), are now being held accountable for their actions.8 1. See David R. Francis, Year of Reform puts Corporations on Notice, THE CHRISTIAN SCIENCE MONITOR, Aug. 13, 2003, at 2-3. 2. President Bush's Corporate Fraud Task Force focuses on increasing the criminal enforcement activities within the U.S. Department of Justice on corporate fraud. The Task Force was established to increase the federal law enforcement on corporate officials' actions and to restore the integrity of the marketplace. First Year Report to the President-Corporate Fraud Task Force, available at http://www.usdoj.gov/dag/cftf/first-year-report.pdf, at 8. 3. Francis, supra note 1, at 2. 4. Jeff St. Onge, Top Executives Blamed for Enron Collapse, SUNDAY BUSINESS POST, Sept. 28, 2003, available at http://archives.tcm.ie/businesspost/2003/09/28/ story536028656.asp (last visited Feb. 7, 2004). 5. See Dan Ackman, Enron Probe Widens on the Two Fronts, Forbes, Apr. 4, 2002, at http://www.forbes.com/2002/04/04/0404topnews.html; see also Ari Weinberg, The DOJ"s De Facto Investment Bank, Forbes, Sept. 17, 2003, at http://www.forbes.com/2003/09/17/cx aw_0917mer-print.html. 6. See generally http://www.citigroup.com (last visited Feb. 7, 2004). 7. See generally http://www.jpmorgan.com (last visited Feb. 7, 2004). 8. See Ben White & Peter Behr, Citigroup, J.P. Morgan Settle Over Enron Deals, WASH. POST, July 29, 2003, at Al. 248 NORTH CAROLINA BANKING INSTITUTE [Vol. 8 Both Citigroup and J.P. Morgan, two financial giants, financed transactions for Enron that allowed Enron's management to present misleading financial results to shareholders, analysts, and the marketplace.9 Citigroup and J.P. Morgan primarily used "prepay" transactions that allowed Enron to disguise loans as commodities transactions.' ° "Prepay" transactions involve triangular deals where an original company (Enron) enters into a transaction with another company (a shell corporation) which enters into a transaction with the financial institution, which enters into a transaction with the original company." "The net effect of these deals [is that the original company ends up] being the shipper and receiver of the same commodity, due at the same price on the same day."' 2 Under these transactions, all the multiple deals cancel each other out, except the original company who receives a large amount of cash, which must be paid back to the financial institutions with interest. 3 The results of these deals are merely loans to the original corporation disguised as commodities transactions. 4 Through several prepays, Citigroup and J.P. Morgan lent Enron $6.4 billion dollars. 5 These transactions enabled Enron to report non-existent earnings and conceal the discrepancy between actual and reported earnings from financial analysts and investors. 16 Citigroup and Enron also entered into special purposes entities (SPEs) 1' transactions in which Enron converted cash 9. Id. 10. Kurt Eichenwald & Riva D. Atlas, 2 Banks Settle Accusations They Aided in Enron Fraud,N.Y. TIMES, July 29, 2003, at Al. 11. Id. 12. Id. 13. Id. 14. Id. 15. Eichenwald & Atlas, supra note 10. 16. See Citi and Morgan Chase agree to pay $289-mil. to settle charges related to Enron deals, GLOBAL POWER REPORT, July 31, 2003, at 1 [hereinafter Global Power Report]. 17. Special Purposes Entities (SPEs) operate as a trust for a company. See THE CORPORATE LIBRARY, at http://www.thecorporatelibrary.com/spotlight/accounting/ SPEs.html (last visited Feb. 7, 2004). The company creates the SPE and sells it an asset to fund a new project or product. Id. That asset is also removed from the company's balance sheet. Id. Some companies, including Enron, use these entities purposely to keep debt off the balance sheet. Id. 2004] FINANCIAL ACCOUNTING AND DERIVATIVES 249 received from financing activities to cash from operations. 18 Citigroup financed the off-balance sheet SPEs for Enron.1 9 These SPEs, such as Project Nahanni, purchased short-term government securities which were then quickly sold with "the proceeds [being] booked as cash flow from operations." 20 Although Citigroup and J.P. Morgan's transactions with Enron were arguably legal, the transactions deceived investors and forced the financial institutions to settle with bank regulators and the Securities and Exchange Commission (SEC).2 1 This Note addresses two main issues related to Citigroup's and J.P. Morgan's settlement with regulators. Part II of this Note will discuss the particular details of the settlements. Part III of this Note will discuss the implications of the settlements for these particular financial institutions as well as for the financial services industry. Part IV of this Note will discuss the possible negative effects arising from the settlements.24 II. DETAILS OF THE SETTLEMENTS Although Citigroup and J.P. Morgan were both heavily involved in the Enron scandal, they received different punishments from the SEC.25 Under these settlements, Citigroup and J.P. Morgan will pay fines of $101 million and $135 million, respectively. 26 In determining the settlements with the financial institutions, the SEC took into account how each company "[cooperated] with the [SEC's] investigation, as well as its timely 18. Global Power Report, supra note 16; see also In the Matter of Citigroup, Inc., 7 Fed. Sec. L. Rep (CCH) $ 75,482, at 63,160 to 63,173 (July 28, 2003), available at http://www.sec.gov/litigation/admin/34-48230.htm (last visited Feb. 7, 2004) [hereinafter Citigroup Enforcement Action]. 19. Eichenwald & Atlas, supra note 10. 20. Id. 21. See Floyd Norris, A Warning Shot to Banks on Role in Others' Fraud, N.Y. TIMES, July 29, 2003, at C1. 22. See infra notes 25-44 and accompanying text. 23. See infra notes 45-134 and accompanying text. 24. See infra notes 135-158 and accompanying text. 25. Norris, supra note 21. 26. Press Release, SEC, SEC Settles Enforcement Proceedings against J.P. Morgan Chase and Citigroup (July 28, 2003), available at http://www.sec.gov/ news/press/2003-87.htm (last visited Feb. 7, 2004) [hereinafter SEC Press Release]. 250 NORTH CAROLINA BANKING INSTITUTE [Vol. 8 efforts to resolve the matter., 27 Citigroup paid less in fines than J.P. Morgan because Citigroup officials were more cooperative with the SEC investigations.28 Citigroup accepted a "cease and desist" order issued by the SEC in an administrative proceeding, while JP Morgan accepted a civil injunction prohibiting it from committing future violations of Section 10(b) of the Securities and Exchange Act of 1934 and Exchange Act Rule 10b-5.29 Under a "cease and desist" order, there is no automatic contempt of court penalty for violating the order.3" However, if Citigroup refuses to comply with the order, then the administrative law judge has the discretion to impose additional civil penalties.3 According to an SEC official, the J.P. Morgan injunction was meant to "send a signal" to other organizations that are not cooperative with SEC investigations.32 If J.P. Morgan engages in more Enron-like transactions, it will have violated a court order and have committed a criminal infraction.33 The SEC warned it would be willing to file criminal charges if such an infraction occurs.3 4 The injunction against J.P. Morgan was similar to the SEC's injunction against Arthur Anderson.35 Arthur Anderson violated that injunction in its dealings with Enron, commencing the criminal case that led to the dissolution of the well-respected accounting firm.36 In addition to their settlement with the SEC, J.P. Morgan and Citigroup will each pay a combined total of $25 million to the 27. Id. 28. Norris, supra note 21. 29. Id.; see also Citigroup Enforcement Action, supra note 18; SEC v. J.P. Morgan Chase & Co., 7 Fed. Sec. L. Rep (CCH) 75,481, at 63,158 to 63,160 (July 28, 2003), availableat http://www.sec.gov/litigation/litreleases/lr18252.htm (last visited Feb.