Street Unwise

by Noam Scheiber | February 25, 2002

With ten congressional committees holding hearings on Enron, it's almost impossible for any one member of Congress to distinguish himself on the issue. But that hasn't stopped Senator Jon Corzine from trying. These days the freshman New Jersey Democrat sounds more like Ralph Nader than the former investment-banking pooh-bah he is. In an interview with The Hill newspaper last week, Corzine announced, "We need accounting reform, pension reform, corporate governance reform and, obviously, campaign finance reform."

Accordingly, in the last two months, Corzine has sponsored a pension reform bill as well as legislation to ensure the independence of financial audits. He's called for consolidating financial-services regulation under the Securities and Exchange Commission (SEC) and the Federal Reserve, and for giving the SEC the resources it needs to fill that expanded role. And he's spoken out in favor of ending the conflict of interest among stock analysts whose own firms underwrite stock offerings. When it comes to the behavior of former Enron executives themselves, he's been even more outspoken. Reflecting on the investigative report recently released by a committee of Enron board members, Corzine declared that "if the facts of it are accurate, it's quite despicable and damning."

To hear Corzine tell it, his years of experience in the corporate world-- culminating in his chairmanship of Goldman Sachs from 1994 to 1999--give him special insight into how to restore confidence in the stock market, and the credibility to pull it off. But his years of experience in the corporate world also make him partly responsible for what went wrong. And it's not just the vague responsibility that would fall on anyone who'd been a major Wall Street player at a time when dubious companies were being hawked to credulous investors at an unprecedented rate. As BusinessWeek and The Wall Street Journal recently reported, Corzine's former firm directly contributed to Enron's collapse by creating and marketing a financial instrument that the failed energy trader used to hide as much as $3 billion in debt between 1993 and its collapse last year. So when Corzine talks about the "despicable" behavior that made Enron possible, he may be implicating himself. Around 1990 the major investment banks recognized they could make a killing by solving one seemingly simple analytical problem: how to design a "product" that would look like equity (i.e., stock) on a company's balance sheet but look like debt on the company's tax return. Such a product would give companies all the advantages of issuing debt (a generous tax deduction and money to finance expansion) but none of the disadvantages (a balance sheet saturated with liabilities). More importantly, it would generate huge underwriting fees for the investment bank that created it.

The problem was that the relevant U.S. tax laws were proving difficult to game. As early as September 1991, Merrill Lynch had successfully engineered a similar product for foreign firms, wherein the firm would create an offshore subsidiary, which then issued stock and loaned the proceeds back to the parent company. But if American firms tried this, the Internal Revenue Service (IRS) would levy an onerous 30 percent withholding tax--a tax so expensive that it defeated the transaction's original purpose. That is, until 1993, when a Goldman Sachs "product manager" named Christopher Hogg had an epiphany: If the subsidiary were set up as a limited liability company (LLC), it would be treated as a partnership for tax purposes, which would negate the withholding tax and leave all the benefits of the loophole intact. That spring Goldman dispatched its team at the law firm Sullivan %amp% Cromwell to the Caribbean islands of Turks and Caicos, where they apparently wrote the necessary legislation and had the local government rubberstamp it. Goldman then began aggressively marketing the product, dubbed MIPS (monthly income preferred shares), and by fall of that year the investment bank had its first takers: two oil giants by the names of Texaco and Enron, which issued $350 million and $200 million of the securities, respectively. Goldman wasn't shy about taking credit for the innovation.

Hogg told the trade publication Investment Dealer's Digest (IDD),"This is a breakthrough transaction, for a U.S. company to issue a security with many of the attributes ascribed to equity, yet to receive a tax deduction." IDD itself characterized the development as a "coup for Goldman," which it proclaimed the victor in a "frantic race" to invent the first such product. By September 1994, right around the time Corzine became its chairman, Goldman had helped 17 companies sell some $2.7 billion of the securities, and almost $4 billion in sales were in the pipeline. But Goldman's early advantage wouldn't last long. Merrill Lynch had finally gotten into the "trust-preferred securities" game itself that July, underwriting a $75 million MIPS-like issue for Goldman's old client Enron. Over the next few years the two would struggle to outdo one another, making their products progressively more attractive by skirting legal barriers ever more closely. According to one former high-ranking IRS official, "It evolved into a new offering a week; more and more instruments that had the dual character of debt and equity. They began to be refined, and if Treasury or IRS would indicate concern, it wasn't long before another instrument would pop up." Perhaps not coincidentally, it was during this same period that Corzine was rapidly restoring profitability to his firm, which had fallen on unusually tough times in the early '90s. (Charging an average commission of between 1 percent and 1.2 percent, Goldman has made tens of millions of dollars on MIPS- like issues over the last eight years.) Of course, pushing to skirt tax laws hardly makes you culpable for another company's collapse. In principle, the trust-preferred securities Goldman and others marketed could have been just as attractive to responsible companies looking to save on their tax bills while beefing up their credit ratings as they were to flame-out candidates like Enron. In practice, though, the securities were most attractive to companies that would otherwise have had a tough time raising money. As BusinessWeek points out, the interest rates on the securities and the commissions charged by firms like Goldman to set them up were far higher than what a firm would pay on ordinary debt. A firm in better shape would have been less likely to pay this premium given the ever-present risk of a change in tax law that could leave it holding the bag. Indeed, the special appeal of MIPS to cash-strapped firms was touted as early as June 1994, when an article in Petroleum Economist recommended them to companies looking for a "finance option" when "a major issuance of debt would be difficult" because of the large amounts of debt they were already carrying.

By late 1995 officials at the IRS, the Treasury Department, and the SEC had concluded that the only way to rein in the trust-preferred securities market was through legislation. The moral suasion the government had been relying on since early 1994--"information gatherings" with officials from Goldman and Merrill Lynch, IRS notices threatening "scrutiny" of the products--had failed to restrain the practice. (As the Journal reported, Wall Streeters were extremely sophisticated at playing officials against one another, telling Treasury officials that the securities were really like debt and, hence, not a tax scam--and telling SEC officials that the securities were really like equity and, hence, not a way to sanitize balance sheets.)

Meanwhile, the tax loophole MIPS had exposed had begun to cost the government hundreds of millions of dollars per year. On December 7, 1995, the day Treasury was set to unveil its proposed legislation publicly, Deputy Assistant Secretary for Tax Policy Cynthia Beerbower briefly outlined the proposals at a meeting with top executives. The executives became apoplectic. One later fumed to The Washington Post: "She was belligerent and named particular firms, saying their products were abusive of existing tax laws and that Treasury was going to do something about it." The Financial Times reported that some executives were especially hurt that one of their own, then-Treasury Secretary and former Goldman Sachs Co-Chairman Robert Rubin, had his fingerprints on the legislation. And of all the firms, Goldman Sachs and Merrill Lynch had the most to be upset about: As the market leaders in trust-preferred securities, they stood to lose a major source of revenue. Almost immediately, the firms and their industry trade group, the Bond Market Association, mobilized to thwart the legislation.

According to last Monday's Journal, which documents the effort extensively, the lobbyists they employed amounted to a virtual who's who of Washington influence-peddlers: Mark Weinberger, now assistant Treasury secretary for tax policy; Nick Calio, now the top White House lobbyist on Capitol Hill; former Bush pere IRS Commissioner Fred Goldberg; former Reagan Chief of Staff Ken Duberstein. The strategy, according to former Treasury officials, was to take advantage of the ill will toward Clinton on the Hill in the aftermath of that year's government shutdown. As one top former Treasury official puts it, "You have to put it in the context of ... the strong partisanship at the time. For folks who had friends on the GOP side of the Hill, it was great time to hook onto something. Anything the administration wanted, the Republican leadership didn't." Once the proposals had stalled on the Hill, the industry could go to the administration and say there "wasn't any constituency that wanted [the loophole] closed except Treasury," as another former Clinton administration official recalls. And that's exactly what happened.

By the summer of 1997, all but a few of the Treasury proposals had been abandoned completely. While no one can say for sure that Enron's demise would have proved less disastrous had the Treasury proposals succeeded, there are reasons to think so. According to BusinessWeek, Enron's 2000 annual report revealed $8.5 billion in long-term debt at a time when it had as much as $3 billion more disguised as trust-preferred securities. Had Enron been forced to disclose the true size of its debt all along, the substantially higher figure could have alerted credit- rating agencies to the company's problems years before they eventually downgraded its credit rating and triggered its collapse.

A lower credit rating would have hobbled Enron's expansion and discouraged investors, which would have limited both the company's rise and the damage from its subsequent implosion. Indeed, the Financial Accounting Standards Board, the accounting industry's standard-setting body, implicitly concedes as much. It recently announced that it would dust off an old proposal forcing companies to disclose their MIPS-like securities as debt. If Corzine's only role in this episode were as the head of a company that helped Enron hide its debts, and that then lobbied heavily for the right to continue doing so, that would be bad enough. After all, you can't chide Ken Lay for claiming he didn't personally engage in any wrongdoing and then turn around and plead your innocence on similar grounds. But, particularly on the lobbying front, there's reason to believe Corzine was much more involved than he lets on.

At the very least, we know from the Journal article that Corzine joined 30- odd Wall Street executives in signing a letter to key members of Congress protesting the Treasury proposals. But Corzine wasn't just your run-of-the-mill executive, signing whatever his corporate minions happened to place in front of him. In fact, by the time he assumed the chairmanship of Goldman Sachs in 1994, he was an experienced industry lobbyist. In 1983, while a general partner at Goldman, Corzine was named to the board of directors of the Bond Market Association (known then as the Public Securities Association, or PSA). He was elected as the group's vice chairman for 1985, and the following year he became chairman. During that time he led the PSA's dogged opposition to a component of President Reagan's 1986 tax-reform plan that would have cost investment banks millions in underwriting fees by closing a tax exemption on municipal bonds. One of the PSA's tactics was to hold "seminars" in which bond traders were instructed how to persuade state and local officials to lobby Congress on their behalf. As late as 1991 Corzine was still active in the PSA, chairing the Borrowing Advisory Committee that met with Treasury officials every three months to discuss the government's debt-financing needs--and which critics suspected of giving the traders in attendance an unfair edge in subsequent bond auctions. And while Corzine became less involved in PSA once he took over at Goldman, it was at that point that he developed an even more important inside connection: his former Goldman boss, Robert Rubin, who was first a top economic adviser and then Treasury secretary to Bill Clinton. "There were those who thought that the [relationship] was a bit of a problem from time to time," recalls the former IRS official. "My sense was that [Rubin] was being lobbied heavily by his old buddies." Corzine's office insists there were "absolutely no calls" between Goldman officials and Rubin during this period.

But there clearly was some contact between the two. In 1998, for example, National Review reported that Clinton had asked Corzine, a generous campaign contributor and longtime friend of Rubin's, for help with talking the Treasury secretary out of resigning. Since the Enron scandal broke, Senator Corzine has traded on his corporate past in a different way, insisting with the authority of a former insider that Enron is not symptomatic of a larger breakdown in corporate behavior. Appearing on "Hardball" in mid-January, Corzine responded to a question about how common Enron's behavior was by insisting that "[Enron] is the exception, not the rule. " In an interview with The Hill a few weeks later, he characterized Enron as "extreme and unusual." But it's not clear what Corzine's judgment on that question is worth at this point. As the former head of a company that profited from one of the biggest accounting scandals in history, he's not exactly in a position to be offering absolution.

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