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.

By Matt Siben

As set forth here, on May 3, 2011, the SPDR® Morgan Stanley Technology ETF announced that on May 4, 2011, the fund would receive a payment as an authorized claimant from a class action settlement related to Broadcom Corp.

So what?  Why should anybody care?  Regardless of whether you have ever owned the Morgan Stanley Technology ETF, consider that the Broadcom settlement payout is symptomatic of bigger problems with our legal system’s reliance upon the class action mechanism to compensate victims of securities fraud.

Remember, victims of the alleged Broadcom securities fraud just received their pro rata share of the class action settlement. These payments were made more than a decade after the alleged fraud was revealed.  As set forth in the settlement notice (here), the Broadcom class action aims to compensate Broadcom investors that purchased securities between July 31, 2000 and February 26, 2001.

Significantly, distribution of the settlement was held up for years by the court system, objectors to the class action settlement, and a lengthy administrative process.  Indeed, the settlement was initially announced (here) by Broadcom on June 24, 2005. Nearly six years passed between the time of the settlement and the time when investors received their share of the settlement amount.

And, what did the patient members of the class receive after waiting years for justice to be done?  It is difficult to say with any certainty.  However, we know that the class action plaintiffs’ lawyers estimated that the $150 million settlement would result in an average recovery per damaged share of $0.40 — prior to deduction of attorneys fees.  (See page 2 of the Settlement Notice.) How does that $0.40 per damaged share stack up against investors’ actual damages?  Not well.  Consider that the Complaint alleges investors saw their shares decline in value by $22 (nearly 35%) in the three days after The Wall Street Journal revealed Broadcom had been granting warrants to customers that purchased its products.  (See paragraph 20 of the Complaint.)

Large institutional investors do not have to accept these types of results as the best “justice” that can be done.  Securities class actions have inherent limitations, but investors are not obligated to remain members of the class.  Indeed, under the right circumstances, we believe investors can recover a far larger percentage of their investment losses by opting out of class action cases to pursue an individual case.  Our own experience, and the empirical evidence, firmly support this belief. Moreover, in individual opt out cases, plaintiffs typically receive settlement proceeds in a matter of weeks — not years.

As illustrated by the extreme example that is the Broadcom settlement distribution, we believe the class action mechanism is failing investors.  What can be done, or will be done, to remedy the failures of the class action system remains to be seen. Nonetheless, it is difficult to muster a sense of optimism.  For these reasons, among others, we counsel our clients to consider the benefits of withdrawing from class cases all together.