Roots run deep between Enron and CIBC

In the summer of 1991, the London brokerage arm of Canadian Imperial Bank of Commerce was one of six firms selected to underwrite a £795-million (worth $1.53-billion at the time) financing for Teesside Power Ltd., the largest independent power project to date in Britain.

The deal followed former prime minister Margaret Thatcher's transformation of Britain. During her 11-year reign ending in 1990, her Conservative government sold the telephone service, the airlines and a host of other Crown companies. The electrical utilities in England and Wales were among the last to be privatized.

The Teesside deal was a pivotal one for CIBC, which, like many banks, was still coping with the fallout from the market crash of 1987 and the meltdown in commercial real estate in the early 1990s. However, the deal's importance had nothing to do with underwriting fees, much less the bragging rights that accompany a place in any large syndicate.

The real significance, viewed in retrospect, was that it helped the bank to forge a decade-long relationship with Teesside's controlling shareholder -- burgeoning energy concern Enron Corp.

Those ties are now the source of considerable anguish for the bank, which last week was one of six financial institutions accused by the company's U.S. court-appointed examiner of "aiding and abetting" some of Enron's officers in manipulating its now-infamous financial statements. The examiner concludes that Enron could not have pulled off the fraud without the help of Citigroup Inc., J.P. Morgan Chase & Co., Barclays Bank PLC, Deutsche Bank AG, CIBC and Merrill Lynch & Co. Inc.

CIBC has denied any wrongdoing, and insists that its employees acted properly in all their dealings with the company.

Neal Batson, the examiner who wrote the more than 1,000-page report, highlights numerous transactions between CIBC and Enron -- including several whose roots extend back to the Teesside project -- that he concludes helped the energy trader to conceal billions of dollars worth of debt and dupe unsuspecting investors.

Although many of the big Canadian banks had some involvement with Enron, CIBC was the only one Mr. Batson singled out for aiding and abetting the fraud. One of the primary reasons, observers say, is culture: The bank had the people, the appetite and the ability to structure complex financings because of its aggressive move into the U.S. investment banking scene in the mid-1990s.

It was CIBC chairman John Hunkin who changed the mindset of the bank. The career banker was appointed to the helm of CIBC World Markets Inc. in 1990, shortly after the bank bought Wood Gundy.

"He became enamoured of Wood Gundy," said a former executive at the firm.

Mr. Hunkin, who became CIBC's chairman in 1999, led the push into the United States as part of a plan to reinvent CIBC World Markets as a leading North American investment banking house, one that could play in the same sandbox with the most powerful names on Wall Street.

CIBC began to develop a derivatives team in 1994, after poaching a handful of notable professionals from Lehman Brothers Inc. The next year, the bank purchased Argosy Group LP, a merchant banking outfit that helped the bank and many of its employees to earn a fortune on Global Crossing Ltd., the now-insolvent Bermuda fibre-optics company. The acquisitions allowed CIBC to dabble in some of the more exotic lines of business that were fast gaining popularity in the United States.

"It was all about financial engineering, and fancy off-balance-sheet transactions," said a former CIBC official who was there at the time.

Enron appeared to be a tailor-made client. Here was a company well on its way to becoming the world's biggest energy trader, with a stellar reputation and an unquenchable thirst for investment banking services, some of which were amazingly complex. The relationship was in lock step with CIBC's strategy to use corporate lending as a carrot to land more lucrative investment banking business.

The financial wizardry Enron applied to its balance sheet led to its collapse in December, 2001. The company, which had become renowned as one of the United States' most innovative companies on the way up, admitted that the levels of profit it claimed between 1997 and 2001 had been inflated to the tune of $600-million (U.S.).

"Clearly, Enron has highlighted that financial institutions have a higher responsibility (and added risk) if, and when, they see deals being structured that are questionable from an accounting and economic perspective," Ian de Verteuil, bank analyst at BMO Nesbitt Burns Inc., says in a research note titled Enron -- Will It Ever End?

At the same time, other observers said it would be unfair to "move the goal posts" and apply these new standards retroactively to CIBC's dealings with Enron.

"Back in the mid-nineties, I think the ethics of these things were quite different," explained a former senior executive at CIBC. "You were allowed to do these things. What the [client]was doing, as long as it wasn't overtly criminal, you didn't care why they were doing it. That didn't seem to be our issue -- that was their [the client's]issue."

Although CIBC engaged in a total of 48 transactions with Enron, ranging from commercial loans to securities offerings, the bank distinguished itself among the company's top bankers through its prolific participation in the so-called FAS 140 deals, in which Enron purportedly sold assets to "special-purpose entities," the examiner says.

Between June, 1998, and October, 2001, CIBC did at least 11 of these FAS 140 deals. The transactions were both central to the manipulation of Enron's books by certain of the energy company's officers, and one of the fundamental accounting devices used to engineer quarterly and year-end gains, the examiner adds.

Enron was able to understate more than $1-billion in debt between 1998 and 2000 and generate $585-million in profit just through the FAS 140 deals done with CIBC, Mr. Batson says.

His report goes on to say that several of the FAS transactions that were structured to appear as asset sales were, in substance, loans from CIBC and other lenders to Enron. Enron's primary objective was simple, the examiner says: To borrow money and record the loan proceeds as cash flow from operations rather than as a debt.

In the course of its dealings with Enron, CIBC's credit committee learned that about 15 per cent of Enron's profit in the first nine months of 1998 was attributable to the FAS 140 transactions, Mr. Batson says.

He cited testimony and internal e-mails from CIBC employees to demonstrate that the bank became skeptical in mid-1998 about how Enron was reporting some of these transactions, but nevertheless continued to participate.

"Presumably [Enron's auditor Arthur Andersen LLP]is happy with the deals so far as signing annual financial statements is concerned," one CIBC official wrote to a colleague. "It does of course make one wonder how 'true' a picture these statements actually give."

In another e-mail, a managing director in the bank's credit capital markets group noted that between $150-million and $200-million of the $1-billion in operating profit reported by Enron in the first three quarters of 1998 was from accounting gains. However, he warned that "Enron has asked that we keep the following information confidential as they consider it 'very sensitive.' "

In the early 1990s, CIBC engaged in a limited number of transactions each year with Enron, including various derivatives instruments and the financing for the construction of the Teesside Power Plant.

CIBC was well familiar with the Thatcher government's public sale of several Crown companies through the bank's acquisition in 1988 of Wood Gundy, at one time the bluest of blue-chip firms on Bay Street. Wood Gundy, the dominant Canadian investment bank in London, got a piece of the action on many privatizations, including British Gas and British Aerospace.

It was in London that CIBC completed its first FAS 140 transaction with Enron in June, 1998. The arrangement, dubbed "Riverside 3," was a way for Enron's European subsidiary to monetize its interest in the Teesside project. CIBC was a co-underwriter and said it would lend half of the £154-million Enron was scheduled to pocket.

Riverside 4 followed in September, with CIBC acting as sole underwriter and committing to lend the entire £60-million. Riverside 5, the final FAS 140 deal done in CIBC's London office, closed in January, 1999.

In his report, Mr. Batson concluded that CIBC knew the Riverside deals were being done for accounting purposes. The credit application for Riverside 3, for example, noted that "the underlying purpose of the transaction is to enable Enron to book a second-quarter gain on their shareholding in Teesside Power Ltd."

As with many of the other transactions done by Enron, the FAS 140 deals consisted of "purported" asset sales that were nothing more than disguised loans, the examiner concludes.

There were numerous other FAS 140 transactions, all essentially carbon copies of each other. CIBC's Houston office did its first FAS 140 deal in December, 1998. But it was the transaction known as "Hawaii 125-0" that was the bank's most significant, the examiner says. In that deal, CIBC led two banking syndicates that provided lines of credit totalling $550-million (U.S.) to help Enron monetize its interests in 10 different assets. The name was a play on the old television show Hawaii Five-O and an accounting rule called FAS 125 that is used for off-balance-sheet transactions.

During an eight-day period in December, 1999, CIBC completed a staggering three FAS 140 deals. The pace was frenetic, but it paid off, as CIBC was elevated to one of Enron's "Tier One" banks the following June. The criteria for joining this exclusive group included a bank's ability to underwrite $1-billion in a short period; lead and/or structure complex deals; and develop strong senior management contacts and distribution capabilities.

As it turns out, that was the pinnacle of their relationship.

In the aftermath of Enron's collapse, the Teesside plant, which was eventually built in 1993 and began supplying as much as 4 per cent of the electricity requirements of England and Wales, was left stranded with a heavy debt load and a worthless $500-million electricity purchase contract with Enron. It was sold earlier this year by Enron's receivers to SembCorp Utilities of Singapore for £83-million ($187-million Canadian).

The power project remains a physical reminder of CIBC's first major dealings with Enron. Today, the legacy of that relationship is unfolding on a number of unpleasant fronts.

The bank, along with several other financial institutions, is being sued by investors in a class-action suit. Both sides have been ordered to participate in mediation talks in an effort to forge an out-of-court settlement and avoid a lengthy trial. Legal experts, however, say the banks' bargaining position could be undermined by Mr. Batson's damning report.

The examiner concludes that there are ample grounds for "equitable subordination" of the debts owed to the banks. In other words, the banks would go to the end of the line, leaving more for creditors that did not participate in the fraud.

CIBC says it has taken provisions to cover its exposure to Enron, which it says totalled $215-million (U.S.) when Enron collapsed. The examiner's report, however, pegs the bank's exposure at just under $500-million. Rob McLeod, a spokesman with the bank, said Mr. Batson's tally includes $115-million worth of undrawn loan commitments, which have since been cancelled, as well as exposure to Enron affiliates.

CIBC is also confronted with possible regulatory actions. The U.S. Securities and Exchange Commission has already reached settlements on the Enron matter with J.P. Morgan, Citigroup, and Merrill Lynch. The three firms have paid fines totalling just under $380-million, but have not admitted to any wrongdoing.

As for Mr. Hunkin, he will likely be questioned about the examiner's report by directors at the bank's monthly board meeting on Thursday.

"This is one additional challenge for Hunkin to face," said an analyst who asked not to be identified. "I certainly think he will come under pressure from the board to explain what happened."