This Wall Street Journal ($) article reports that Bank of New York Co. sued Citigroup Inc. earlier this week over the sale of financial instruments related to Enron Corp. The lawsuit could involve as much as $2.5 billion in liability for Citigroup.
The lawsuit is particularly interesting because it involves credit insurance, which has become one of the trendiest new financial products over recent years. Such insurance provides investors a hedge against the risk of insolvency for their investment, and the Bank of New York – Citigroup dispute focuses on whether banks involved in the market may have superior knowledge to other participants.
The suit alleges Citigroup knew (or presumably “should have known”) Enron’s debts were far greater than the numbers presented in its public financial statements between 1999 and when Enron went into bankruptcy in early December, 2001. The suit alleges that Citigroup just could not get enough of Enron’s business and that by 1999, Citigroup’s exposure to Enron totaled a staggering $1.7 billion, which was four times Citigroup’s internal limit on exposure to Enron. Bank of New York alleges that Citigroup’s exposure increased over the next two years as Enron entered a series of financial deals with Citigroup that enabled Enron to mask debt as cash flow on its financial statements.
In short, Bank of New York alleges that Enron was a Ponzi scheme and that Citigroup knew it. The lawsuit alleges that the only reason Citigroup did not cut Enron off from new financing was because Citigroup knew that Enron would collapse before Enron could pay it back.
So, the lawsuit alleges that Citigroup approached major institutional investors to reduce its Enron exposure by promoting an investment in “Yosemite” securities, a series of notes with a total face value of $2.4 billion that were linked to the creditworthiness of Enron. So long as Enron remained financially viable, the investors in the Yosemites would receive interest payments that were more attractive than the interest rate on Enron bonds. If Enron defaulted on any debt obligations or filed for bankruptcy protection, the lawsuit alleges that Citigroup was supposed to replace the Yosemites with Enron bonds that would likely be worth far less than 100 cents on the dollar to investors, but which would rank relatively high in claim priority in an Enron bankruptcy.
As sad stories go, this dispute was triggered because Enron and its other creditors are asserting that the investors ought should be subordinate to other creditors in Enron’s claim priority ranking because of Citigroup’s involvement in the deception that helped cause Enron’s bankruptcy. If Enron’s position is sustained and the claims of the Yosemite securities holders go to the bottom of the Enron claim totem pole, then those investors will likely get nothing on their claims.
Such a result will not make the holders of those claims happy. Most of those Yosemite securities claims are now held by distressed-debt investors — a notoriously hard-knuckled group in insolvency cases — who bought the securities from the original holders at discounted prices between 10 to 50 cents on the dollar.
Just another $2.5 billion aftershock of the Enron financial earthquake. This one should be interesting.