I really enjoy taking depositions. (I’m prepping for depositions now, so indulge me, I’ll get to the point.) The preparation, the strategy, the fluid interaction, the battle of wits; depositions are one of the better parts of the job. And, nothing beats deposing smug liars.

In the litigation over Enron’s collapse, I deposed plenty of investment bankers, relationship managers, credit risk managers, etc., in connection with Wall Street’s role in the Enron fraud. (There is a list here.) I couldn’t swing the proverbial dead cat without hitting a smug liar.

As I wrote in my last blog piece, I believe there were a lot of Wall Street bankers responsible (in part) for the collapse of Enron (see here). Given their sins and/or incompetence, one would think these specific bankers would be run out of town never to be trusted again. Au contraire, it seems Wall Street is imminently tolerant.

The point of this blog is that Enron’s collapse exposed Wall Street’s tolerance of — perhaps encouragement of — risk management procedures that turned a blind eye to wrongdoing and rewarded those whose incompetence and/or improper behavior would have caused them be fired in any other line of work.

Why should you care? As discussed in my last blog, the collapse of the entire global economy in 2007-2008 was partly the result of a housing bubble enabled and encouraged by Wall Street. In several ways, Wall Street’s sins in the housing bubble mirrored Wall Street’s enabling and encouraging of Enron’s fraud. As I wrote previously, structured finance played a large role in both. Had “we” as a society held persons on Wall Street responsible for their conduct in relation to Enron, perhaps “we” would have avoided the predicament “we” now find ourselves in.

While a “Where are they now?” documentary of the lives of Enron’s aiders-and-abettors is beyond my capacities here (I’m interested if anybody wants to write it), a case study is illustrative of the point I’m trying to make.

In March 2005, I had the distinct pleasure of deposing David Bushnell. Mr. Bushnell testified before the Senate Permanent Subcommittee on Investigations in 2002 concerning Citigroup’s role in Enron’s fraud (opening remarks here), so let’s let him describe his job responsibilities:

My name is David Bushnell. I am a Managing Director at Citigroup’s Global Corporate & Investment Bank and its head of Global Risk Management, which functions as an independent control over our business units and is responsible for monitoring market and credit risk.

* * *

At Citigroup, I oversee a sophisticated and comprehensive process for reviewing structured finance transactions.

Bushnell was the man with the power to stop Citigroup’s much maligned structured finance transactions for Enron. Citigroup’s structured finance deals for Enron caused the Company a great deal of bad press and damage to its reputation. Moreover, and more concrete to the bottom line, Citigroup’s structured finance deals cost the Company a great deal of money, including (i) a $2 billion civil liability settlement with Enron investors in the securities class action (here); (ii) the $1.66 billion settlement paid to Enron’s creditors in bankruptcy court (here), and (iii) a $120 million settlement with United States Securities and Exchange Commission (here) (which also included settlement related to the Dynegy structured finance deal that landed some Dynegy executives in jail). Citigroup’s structured finance deals with Enron cost Citigroup approximately $4 billion in litigation costs alone, not including the substantial, confidential settlements of private actions related to Enron’s collapse.

While there is some evidence that Mr. Bushnell tried to stop one of the criticized structured financings for Enron (see here), labeling the accounting “aggressive” and the deal a “franchise risk,” he ultimately did not do so.

In my opinion, David Bushnell failed to perform his duties as Citigroup’s head of risk management. But, rather than lose his job, Bushnell remained atop Citigroup’s executive structure as the Company’s Chief Risk Officer.

Unfortunately for all of us, in 2007-2008 the problems with Citigroup’s risk management processes were exposed when Citigroup collapsed under the weight of billions of dollars in toxic mortgage backed securities. Mr. Bushnell was replaced as Citigroup’s chief risk officer in November 2007, and a new group of risk management advisors was empowered to deal with Citigroup’s MBS mess. (See here.)

In November 2008, The New York Times published an expose highly critical of Citigroup’s risk management unit that allowed Citigroup to build up such a massive amount of subprime exposure, and David Bushnell in particular was singled out. According to sources within Citigroup, risk management “wasn’t independent at Citigroup” and Mr. Bushnell suffered from conflicts of interest due to his relationships with other Citigroup executives. Indeed, according to the November 2008 story in The New York Times:

Earlier this year, Federal Reserve examiners quietly presented the bank with a scathing review of its risk-management practices, according to people briefed on the situation.

Citigroup executives responded with a 25-page single-spaced memo outlining a sweeping overhaul of the bank’s risk management.

In May, Brian Leach, Citigroup’s new chief risk officer, told analysts that his bank had greatly improved oversight and installed several new risk managers. He said he wanted to ensure “that Citi takes the lessons learned from recent events and makes critical enhancements to its risk management frameworks. A change in culture is required at Citi.”

Sadly, the problems at Citigroup exposed by Enron were not fixed. Hopefully, true changes are being made now and Wall Street learns from its mistakes.

This morning I received a wake up call about the passage of time, and the inexplicable willingness of investors to forgive (and forget) the unforgivable.  Mark Hulbert’s commentary on MarketWatch.com, “Can you believe Wall Street?  Ten years ago, infamous Enron began to crumble,” struck a nerve.  Having poured my blood, sweat and tears into litigating on behalf of Enron investors, I was struck both by Mr. Hulbert’s cursory analysis of the question and that few financial journalists have taken up the issue.

Accordingly, Mr. Hulbert has inspired me to write about some of my own observations over the past decade since Enron’s collapse.  Consider this Part 1 of a multi-part series that I will publish as my time permits.

Structured Financing and Hiding Liabilities Off Balance Sheet:  Does the transaction really serve a legitimate purpose?

To understand anything about the Enron fraud, you have to focus on the link between Enron and Wall Street.  As the plaintiffs in the Enron litigation alleged, Enron cooked its books with the help of structured financing transactions that Wall Street banks devised.  For background stories on Wall Street’s role, see (for example) these releases by the U.S. Securities and Exchange Commission (here) and (here).

In the wake of Enron’s collapse, Wall Street promised reforms.  Citigroup publicly declared it would not sell such structured finance deals to its clients any longer.  In December 2002, Citigroup’s Charles Prince testified in front of a Congressional sub-committee that Citigroup created a new “transparency policy” to govern structured financings.  Prince went on to state:

Citigroup would execute material financing transactions for companies that were not going to be recorded as debt on their balance sheet if, but only if, that company agreed to clearly disclose the net effect of the transaction on its financial condition. We announced this net-effect rule for two reasons: first, to encourage companies to account for financing in a transparent manner, so that investors can adequately assess the net effect of the transaction on the financial condition of the company; and, second, because we simply did not wish to be a party to transactions that failed to meet a high standard of transparency.

Despite the lessons seemingly learned from Enron’s collapse, Wall Street banks continued to perform (and utilize) structured financings in a way that hides a company’s true financial condition.

Writing about the topic recently (here), Professor Frank Partnoy and former Chief Accountant of the SEC Lynn Turner commented on the common link between Enron and the financial collapse of 2008-2009:

And then, of course, there was Enron, with off-balance sheet derivatives exposure that, as one of us testified at the first Senate hearings on Enron’s collapse, “made Long-Term Capital Management look like a lemonade stand.”

The most recent financial crisis was no different. Financial institutions built up hundreds of billions of dollars of exposure to subprime mortgage markets without disclosing these assets and liabilities on their balance sheets.

Partnoy and Turner go on to specifically single out Citigroup’s use of off-balance sheet entities as particularly problematic:

Citigroup’s recent filing reports $292 billion of “significant” unconsolidated VIEs. These VIEs are the nieces and nephews of Enron’s Special Purpose Entities, or SPEs. The VIEs have debts, but – like Citigroup’s swaps and other derivatives – the VIEs are referenced only in a footnote. They are not part of Citigroup’s actual balance sheet, and Citigroup does not record its interest in or maximum exposure to these entities.

Because banks do not report these assets and liabilities in any comprehensible way, regulators and market participants cannot understand the banks’ exposure to risk. Instead, the banks’ approach to off-balance sheet liabilities has made their financial statements virtually useless.

Partnoy and Turner go on to write that Citigroup’s federal bailout was, in large part, necessitated by its off balance sheet liabilities that had not been transparently disclosed:  ”Citigroup’s losses on off-balance sheet transactions swallowed up the rest of its balance sheet.”

So what happened to Citigroup’s pledge — made in the wake of Enron’s collapse — that it would adhere to a strict code of transparency as it concerned the use of structured financing and off-balance sheet entities?

To be sure, Citigroup is not alone here.  As alleged by plaintiffs in ongoing securities actions, AIG, Lehman, Bear Stearns and many others had massive, undisclosed off-balance sheet exposure to the mortgage market that ultimately caused their collapse.

Sadly, the lessons learned from the Enron fraud — and the use of structured finance to deceive — were not heeded, and another generation of investors has suffered incredible losses as a result.