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November 30, 2007

The real NatWest Three deal

Natwest Three.jpgI gave up hope long ago that the mainstream media would ever provide particularly accurate reports regarding the Enron-related criminal prosecutions. However, the mainstream media news reports on the plea bargain hearing earlier this week in the Enron-related NatWest Three case (see NY Times, WSJ, Chronicle) are particularly devoid of any meaningful perspective of what really happened in the case (a copy of one of the plea agreements, which is the same as the other two, is here). The real story of the plea bargain can easily be distilled from the pleadings that are on file in the case. It's a substantially more nuanced story than what you are hearing from the mainstream media.

The prosecution in the NatWest Three case alleged that the three bankers defrauded NatWest, their former employer, by conspiring with former Enron CFO Andrew Fastow and his sidekick, Michael Kopper, to underpay NatWest for its interest in an entity named Swap Sub, which was an affiliate of one of Enron's special purpose entities (LJM1) that Fastow and Kopper ran.

Swap Sub was involved in one of LJM1's primary transactions, which was to hedge Enron's valuable but highly volatile interest in a technology company called Rhythms NetConnections, Inc ("Rhythms"). The NatWest Three were responsible for overseeing the banking relationship between Enron and NatWest, including NatWest's interest in Swap Sub. Another investor in Swap Sub was Credit Suisse First Boston ("CSFB"), which owned the same percentage interest in Swap Sub as NatWest.

In early 2000, Fastow and Kopper offered to buy NatWest's interest in Swap Sub for $1 million. NatWest evaluated its interest in Swap Sub in response to the offer and concluded that its interest was worth zero. At the time, NatWest was in the process of being taken over by Royal Bank of Scotland and, thus, was amenable to disposing of the Swap Sub interest. So, NatWest agreed to accept Fastow's $1 million offer, Fastow and Kopper created an entity called Southampton specifically to buy NatWest's interest in Swap Sub, and the deal closed on March 17, 2000.

After NatWest had agreed to accept Fastow's offer to buy the bank's Swap Sub interest, Fastow offered to sell a portion of that interest to the three bankers personally for $250,000 upon Southampton's completion of the purchase of the interest from NatWest. The NatWest Three still worked for NatWest at the time of Fastow's offer, but they were all contemplating leaving the bank because of the impending takeover by the Royal Bank of Scotland. Inasmuch as acceptance of Fastow's offer while they were still working for NatWest might run afoul of the bank's conflict of interest rules, the NatWest Three took an option to acquire the Swap Sub interest rather than buy it outright.

Subsequently, one of the bankers (David Bermingham) resigned from NatWest, exercised the option in late April, 2000 and paid Southampton $250,000 for the interest. At the time that Southampton bought NatWest's interest in Swap Sub, the NatWest Three did not disclose to NatWest that they had bought the option to acquire a portion of that interest through Southampton. That non-disclosure ultimately became an important fact in the plea bargain of the NatWest Three.

Shortly after Fastow offered to buy NatWest's interest in Swap Sub for $1 million, Fastow and Kopper -- unbeknownst to NatWest or the NatWest Three -- offered CSFB $10 million for its interest in Swap Sub. CSFB, like Natwest, also evaluated its interest in Swap Sub at the time of the offer and concluded -- as did NatWest -- that the interest had zero value.

Inasmuch as Fastow and Kopper didn't have $10 million to buy CSFB's Swap Sub interest, they reached an agreement with Enron on March 22, 2000 to unwind the Enron-LJM1 hedge transaction on the Rhythms stock, the result of which was that Enron would buy a large chunk of Enron stock from Swap Sub for $30 million. Inasmuch as the unwind transaction would not close until the end of April, Fastow borrowed $10 million from Enron on March 22nd to pay CSFB for its Swap Sub interest. Neither NatWest nor the NatWest Three knew anything about these developments.

Subsequently, in late April, 2000, Fastow arranged with former Enron chief accountant Richard Causey to close the unwind transaction between LJM1 and Enron on the Rhythms stock. The transaction has since been subject of a substantial amount of scrutiny in the various investigations and litigation relating to Enron and it appears reasonably probable that Enron should not have paid a dime (much less $30 million) to LJM1 for agreeing to unwind the hedge. The best explanation that I have heard is that Fastow and Kopper pulled a fast one on Causey, who received nothing from the unwind transaction.

After receiving the $30 million in connection with the unwind transaction, Fastow used $10 million to repay the loan from Enron that he had used to pay CSFB for its interest in Swap Sub and paid the NatWest Three $7.3 million for their interest in Swap Sub. Fastow spread the balance of the money around to some of his underlings, including Enron treasurer Ben Glisan, who received about $1 million. Glisan's failure to disclose his receipt of that $1 million eventually led to his termination in early November, 2001 as Enron's treasurer. It also formed the basis of the criminal case against him.

Interestingly, the first time that the NatWest Three had any indication that the $7.3 million that they had received for their interest in Swap Sub may have resulted from a Fastow fraud on Enron was when they heard that Glisan had been fired in early November, 2001 over his failure to disclose his receipt of $1 million from Southampton. As a result, the NatWest Three immediately and voluntarily reported everything to the UK Financial Services Authority (the UK equivalent of the Securities and Exchange Commission) -- their involvement in the sale of NatWest's interest in Swap Sub to Southampton, their purchase of the option from Fastow to acquire a portion of that Swap Sub interest, their non-disclosure to NatWest of the option at the time, their exercise of the option and purchase of the Swap Sub interest from Southampton, and their eventual receipt of $7.3 million for that interest.

The UK authorities passed along that information to the SEC and, the next thing you know, the NatWest Three had become the subjects of a criminal complaint filed on June 27, 2002 in Houston (that really encourages voluntary disclosure of information, now doesn't it?). No US investigator ever contacted the NatWest Three to get their side of the story before filing the criminal complaint against them. UK criminal authorities never pursued any charges against the them.

The Enron Task Force originally alleged that the NatWest Three knew at the time they took the option to acquire a portion of NatWest's interest in the Swap Sub that Fastow and Kopper were going to unwind the hedge on the Rhythms stock. Thus, the Task Force asserted that the NatWest Three knew that the unwind transaction would make NatWest's interest in Swap Sub worth far more than either the zero value that NatWest placed on it at the time or the $1 million that Southampton eventually paid NatWest for it. In that connection, the Task Force contended that the $10 million that Fastow arranged to pay CSFB for its interest in Swap Sub and the $7.3 million that the NatWest Three eventually received for their interest in Swap Sub was conclusive proof that the bankers had defrauded NatWest of the true value of its interest in Swap Sub.

Alas, the government's theory of the case appears largely to have fallen apart over the past year and a half. NatWest and CSFB's zero valuations of their respective interests in Swap Sub at the time Fastow offered to buy them proved to be valid and accurate. Given those valuations, the $250,000 that the NatWest Three agreed to pay at the same time to buy a portion of NatWest's Swap Sub interest was clearly a speculative bet that placed the three bankers at considerable risk of loss of their entire investment.

Similarly, it also turns out that Fastow had a good reason to pay CSFB more for its interest in Sub Swab (i.e., $10 million rather than the $1 million paid to NatWest). At the time, CSFB was providing a myriad of other financial services on Enron-related deals for Fastow. Thus, buying the Swap Sub interest for $10 million was a convenient vehicle for Fastow to curry favor with CSFB. It did not mean that CSFB's Swap Sub interest was worth anything close to $10 million.

Finally, considerable evidence emerged during the case that confirmed that the NatWest Three knew nothing about Fastow and Kopper's plan to unwind the Rhythms hedge with Enron when they bought a portion of NatWest's former interest in Swap Sub. Importantly, that lack of knowledge is consistent with the story that the NatWest Three told to UK Financial Services Authority in November, 2001 immediately after learning of Fastow's possible fraud on Enron as a result of Glisan's resignation.

So, after years of litigation, the NatWest Three pled guilty to a single count of wire fraud. The basis of the guilty plea is that the three bankers failed to disclose to NatWest the option that they had taken from Fastow to purchase a portion of NatWest's interest in Swap Sub at the time that NatWest sold that interest to Southampton. Importantly, the basis of the plea deal is not that the NatWest Three knew and didn't tell NatWest that the value of the bank's Swap Sub interest was going to skyrocket soon after Southampton bought it as a result of Fastow completing the unwind transaction with Enron.

Subject to court approval, the plea bargain provides that the defendants will serve 37 months in prison, that they will pay restitution of $7.3 million to the Royal Bank of Scotland (NatWest's successor) and that the prosecution will support the defendants' request that they be allowed to serve their prison sentence in the UK. Under UK rules pertaining to prison sentences of white collar criminals, it is expected that the three former bankers would be released from their UK prisons after serving approximately half of their sentence.

As noted earlier here and as the Financial Times' Martin Wolf observes here, this plea deal appears to be the product of the draconian trial penalty that the three bankers faced if they availed themselves of their right to a trial and lost. Under those circumstances, the defendants were facing possible sentences of 35 years each, although the sentences would likely have been considerably less than that. Nevertheless, the sentences after a trial probably would have been greater than 37 months and, had the NatWest Three defended themselves at trial and lost, the prosecution almost certainly would never have agreed to support a request to serve their prison sentences in the UK.

Thus, on one hand, the defendants could risk a trial in a virulent anti-Enron environment (see also here) that could result in a long prison sentence that would have to be served in the US prison system thousands of miles away from their families. Or, on the other hand, they could enter into a plea deal that gives them the hope of being able to serve a considerable amount of a definite sentence in the UK prison system near their families.

Given those choices, my sense is that the NatWest Three's choice was a rational and reasonable decision. It's simply not a choice that they should have been forced to make.

Posted by Tom at November 30, 2007 11:00 AM |

Comments

Tom K., many thanks for providing this analysis. This amounts to yet more shameful behavior by the federal prosecutors in an Enron-related case. In their apparent desperation to show "results" in the Enron prosecutions, the federal prosecutors have abused their power in ways that are much more frightening than any of the alleged misdeeds of the various defendants. What a tragedy that the mainstream media has let us down on their coverage --let's hope that he full story of this witch hunt eventually becomes widely known by the public.

Posted by: Evan Author Profile Page at November 30, 2007 2:25 PM

If the Three are innocent as you suggest, how do you explain the emails seized by prosecutors saying things like "Problem is that it is too obvious (to both Enron and LPs) what is happening (ie, robbery of LPs), so probably not attractive. Also no certainty of making money ..."

Included in the federal indictment at http://www.usdoj.gov/dag/cftf/chargingdocs/berminghamindictment.pdf

Posted by: dnwake Author Profile Page at December 1, 2007 12:26 PM

Mr. Wake, the short answer is that the salacious emails pertained to a presentation regarding an earlier proposed transaction that never took place. The prosecution took them out of context in using them in the indictment.

The Statement of Facts that is attached to the plea agreement (see hyperlink in the first paragraph of the above post) is sufficiently detailed to show that the prosecution has clearly conceded that the original theory of the indictment (i.e., that the NatWest Three knew there was value in the Swap Sub interest and set out to steal it from their employer) was false, which was what the NatWest Three had said from the beginning.

The e-mails related to a presentation of a Feb 22, 2000 that the NatWest Three made to Fastow proposing a series of transaction to build value in Swap Sub. Fastow rejected the NatWest Three approach, and the emails do not indicate any knowledge by the NatWest Three of the unwind transaction that Fastow ultimately undertook to create value in the Swap Sub interests. In that regard, the Statement of Facts reflects that the prosecution is no longer suggesting that the February 22 presentation had anything to do with any fraud, which indicates to me that the prosecution has accepted that there is an explanation for the e-mails.

Frankly, I was suspicious about the emails from the beginning. I mean, really. How likely is it that that three bankers would plot an inside robbery of their bank on their own bank's office e-mail, using expressions like this? Perhaps the best evidence that the emails don't pertain to any fraud is that, after six years and wide publication of the emails, NatWest/RBS declined to sue or otherwise accuse the NatWest Three of any wrongdoing. In fact, it's my understanding that RBS continues to provide banking services to the three defendants to this day.

Posted by: Tom K. Author Profile Page at December 1, 2007 4:58 PM

Tom K., your last post demonstrates that a useful thing for people to realize is that an indictment is nothing more than the prosecutors' "spin" on the case. An indictment is always unbalanced, usually misleading, and often downright inaccurate -- even "background" information in an indictment cannot be trusted without investigation. Unfortunately, the mainstream media often quote the information in an indictment as fact without any attempt at analysis.

Posted by: Evan Author Profile Page at December 2, 2007 8:33 AM

Evan, you make a good point about the danger of hindsight bias that permeates business prosecutions of merely questionable business deals. In this particular case, the prosecution's case was essentially that the NatWest Three's purchase of the interest in Swap Sub violated the "too good to be true rule" -- in other words, it was too good to be true that a $250,000 investment could generate a $7 million return in such a short period of time.

However, the truth is that the underlying securities for the hedge that LJM1 provided to Enron were highly volatile, so there were huge swings in the value of the Swap Sub interests even before the point at which Fastow bought them from NatWest and CSFB. Given Fastow's dual role at Enron and LJM1, the NatWest Three (as well as everyone else who did business with Fastow) knew that he was highly motivated to generate value for the Swap Sub interest. There is certainly nothing illegal about such knowledge. So, the NatWest Three took a flier on buying a portion of NatWest's Swap Sub interest and thought that they had simply hit it right by taking advantage of Fastow's dual position with LJM1 and Enron (a CFO of a Fortune 7 company wouldn't be a crook, now would he?).

For his part, Fastow probably wanted the NatWest Three in the deal so that he could point to independent investors whose interests he had to protect in pursuing the $30 million payment in the negotiations with Causey over the unwinding of the hedge.

Thus, my speculation of what probably happened was that Fastow manipulated his position at Enron to persuade Causey that unwinding the hedge at the time generated a substantial amount of earnings for Enron in that particular quarter. For his part, Causey probably didn't care much about the $30 million payment that Enron made to effectuate the unwind transaction so long as he could book the big earnings for Enron in that quarter. My understanding is that Fastow persuaded Causey to have one of Causey's accounting staff review the unwind transaction rather than Enron's risk assessment division (Rick Buy and Vince Kaminski's bunch), which reviewed the hedge transaction in the first place. Fastow knew that if Enron's risk assessment division reviewed the unwind transaction, then there is no way that they would have ever approved Enron paying a dime to unwind the hedge, much less the $30 million that Fastow persuaded Causey to approve.

But as it relates to the NatWest Three, no evidence was generated over almost 7 years of investigation and litigation that they knew anything about what Fastow was doing with Enron in connection with the unwind transaction. Thus, the prosecution concedes in the plea deal that the non-disclosure of the option that they took, and not misrepresentation of the Swap Sub interest's true value, was the basis of their guilty plea. A prosecution that began with a bang went out with a whimper.

Posted by: Tom K. Author Profile Page at December 2, 2007 11:27 AM

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