The Conflicts of Interests in Financial Services

(This article was contributed to Corporate Compliance Insights by Mr. James Bone, formerly the Chief Compliance Officer for Fidelity Investments. Mr. Bone can be contacted via email.)

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The “Conflicts of Interests” in Financial Services

No doubt, there will be many articles and commentary on the both the cause and the cure of the current financial crisis. These articles will explore the root cause from many angles and take the perspective of the author’s view based on their insights and participation in the solutions applied.

The purpose of this article is to take a step back and look at the current financial problems as a physician would a patient to diagnose the events as symptoms that led to the eventual financial health failures. What did the patient present as possible leading indicators to the catastrophic event?

Conflicts of Interests

First, the title, Conflicts of Interests, is a play on words. It is intended to be a little provocative and explain how the current problems in the economy can be traced back to separate and subtle symptoms of conflicts of interests that were either not addressed or ignored by Congress, regulators, boards of trustees, shareholders, external auditors, investment bankers, and senior management.

I will trace back to the early 1990’s and use one business case that encapsulates the historical symptoms presented by the patient, in this case Enron.

Enron and its Financial Conflicts of Interests

During the early 1990’s the American economy was enjoying one of the longest economic booms in history. Enron was billed by Fortune magazine as “America’s Most Innovative Company” for six straight years from 1996 to 2001. Then, in 2001 Enron became one of the largest corporate bankruptcies in U.S. history! What went wrong?

Enron’s entire financial structure became the road map or the “playbook” for many of the financial issues that have surfaced at the forefront of the financial money center banks today. While today’s new products and issues are different, the similarities are striking as examples of the systemic risks reverberating across markets today. Here are but a few examples:

1 – By the late 1990’s Enron effectively controlled almost 25% of all electricity and natural gas contracts traded worldwide through the use of derivatives and other forward contracts. This massive concentration of control was a huge red flag!

2 – Special Purpose Entities (SPE’s) – SPE’s are legitimate structures when set up properly and independently of the parent company to limit risk. Enron effectively maintained control and used these vehicles to hide massive debt that eventually had to be brought onto the parent company’s financial statements. Second red flag!

3 – Deregulation – Energy production in the US was a government-sanctioned monopoly until the late 1980’s. The government regulated power plant construction, the rates to be charged for power, and ultimately the earnings of energy companies. Deregulation required the market to replace the role of government in production, long-range transmission, and local distribution. Enron stepped into this void and created the intermediation activity that led to their dominance of the industry. Poor oversight was the 3rd red flag!

4 – Opaque financial disclosure was a 4th red flag! The off-balance sheet transactions represented huge risks and debt. The failure to follow generally accepted accounting principles led to the formation of the Public Company Accounting Oversight Board and ultimately the collapse of Arthur Andersen.

5 – Financial engineering – In 1993, Goldman Sachs & Co. invented a security that was treated like a debt or equity security to cut Enron’s federal tax bill. The Monthly Income Preferred Stock, or “MIPS” as the shares were called, were treated as both a fixed income and equity security. Enron set up an offshore subsidiary that sold the preferred shares through Goldman Sachs. The subsidiary then lent the proceeds to the parent, Enron, to be paid back over 50 years or more. Enron deducted the interest payments from its taxable earnings with the IRS. However, to shareholders Enron described the obligation as “preferred stock in subsidiary companies”. The Treasury department tried repeatedly to stop this practice to no avail by enlisting the SEC to intervene. This product became a very popular financing tool on Wall Street and gained support in Congress, according to John D. McKinnon and Greg Hitt of the Wall Street Journal.

6 – Easy credit – Enron sued and is currently settling with as many as 175 banks that financed their operations with easy credit. Enron settled with Goldman Sachs, Royal Bank of Scotland, Royal Bank of Canada, Canadian Imperial Bank of Commerce, JPMorgan Chase, Toronto-Dominion Bank, Merrill Lynch 7 Co., Fleet Bank (now owned by BankAmerica), Barclays Plc, and Deutsche Bank Ag to name a few. Much of the lending centered around commercial paper on unsecured, short-term loans issued by Enron.

If these red flags resonate with the problems in today’s market crisis, they should. Even with the advent of Sarbanes-Oxley, the Public Company Accounting Oversight Board, and the Investment Company Act and Investment Advisers Act of 1940 (206-4(7) and 38a-1) the patient is still on life-support.

The Disease of Conflicts of Interests Must be Cured

In retrospect, we should have seen this coming. The failure to act as checks and balances on this behavior by outside auditors, internal corporate oversight, experts in federal government, senior management, financial analysts, boards of trustees, or investors serves to warn us of the tremendous pressure to remain silent when the rewards are large for all those who participate.

Like the doctor who prescribes a cure that is untenable to the patient, the “conflicts of the collective interests” were too powerful to stop the unfolding financial collapse. The medical prognosis is that the patient will live, however her quality of life will be diminished unless a more measured approach is taken.

This should be a warning to the market. Enlightened self-interest operating unchecked can lead to disastrous results unless tempered by a concern for the health of the entire economy.

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James Bone has spent the last 15 years with Fidelity Investments advising senior management at the enterprise and business unit level on developing, implementing and enhancing operational risk and compliance programs across Fidelity’s Broker-Dealer, Institutional, Retirement, and Investment Operations divisions, domestically and internationally.

Tags: Enron, financial services, Goldman Sachs