Published By: Maxwell S. Kennerly, Esquire

In law school, financial fraud is so simple — Gollum tells Frodo something that isn’t true, Frodo relies on the false statement, then Gollum steals the precious and runs away.

The reality is a little more complicated. Take, for example, what New Line Cinema did to Peter Jackson for the Lord of the Rings trilogy, prompting Jackson to sue:

The suit charges that the company used pre-emptive bidding (meaning a process closed to external parties) rather than open bidding for subsidiary rights to such things as "Lord of the Rings" books, DVD’s and merchandise. Therefore, New Line received far less than market value for these rights, the suit says.

Most of those rights went to other companies in the New Line family or under the Time Warner corporate umbrella, like Warner Brothers International, Warner Records and Warner Books. So while the deals would not hurt Time Warner’s bottom line, they would lower the overall gross revenues related to the film, which is the figure Mr. Jackson’s percentage is based on.

According to people on both sides of Mr. Jackson’s lawsuit, the claim strikes at the heart of the modern vertically integrated media company. One of the apparent – though largely unproven – benefits of media integration is the ability of conglomerates like the Walt Disney Company, Time Warner, the News Corporation, Viacom, Sony and General Electric to sell subsidiary rights to the many divisions within the company.

After 408 docket entries, including such fun as a $125,000 sanction order for defendant’s refusal to comply with discovery, the case was settled.

In my own practice, these types of unfair insider deals with alter-ego entities comprise the bulk of financial fraud amongst members of a partnership, limited liability company (LLC), or corporation. The method of the fraud is dependent upon the target. If a partner wants to defraud another partner, they will set up a sham alter-ego entity and then engage in blatantly unfair transactions with it. If a partner or group of partners want to defraud an outside auditor or shareholders, they will set up a sham alter-ego entity and then unload assets or liabilities onto that entity.

That’s what Enron and AIG both did to hide the fact that both were taking on liabilities and debt far greater than they could hope to repay if the market went south: they created baloney entities and deals that masked the source and destination of funds, assets and liabilities.

Given the frequency of this fraud, and Wall Street’s evident skill in utilizing it, I was none too pleased to see Geithner’s WSJ Op-Ed and this announcement:

  • The Process for Purchasing Assets Through The Legacy Loans Program: Purchasing assets in the Legacy Loans Program will occur through the following process:
    • Banks Identify the Assets They Wish to Sell: To start the process, banks will decide which assets – usually a pool of loans – they would like to sell. The FDIC will conduct an analysis to determine the amount of funding it is willing to guarantee. Leverage will not exceed a 6-to-1 debt-to-equity ratio. Assets eligible for purchase will be determined by the participating banks, their primary regulators, the FDIC and Treasury. Financial institutions of all sizes will be eligible to sell assets.
    • Pools Are Auctioned Off to the Highest Bidder: The FDIC will conduct an auction for these pools of loans. The highest bidder will have access to the Public-Private Investment Program to fund 50 percent of the equity requirement of their purchase.
    • Financing Is Provided Through FDIC Guarantee: If the seller accepts the purchase price, the buyer would receive financing by issuing debt guaranteed by the FDIC. The FDIC-guaranteed debt would be collateralized by the purchased assets and the FDIC would receive a fee in return for its guarantee.
    • Private Sector Partners Manage the Assets:Once the assets have been sold, private fund managers will control and manage the assets until final liquidation, subject to strict FDIC oversight.

Liberal economists like Paul Krugman are on balance opposed, with the notable exception of Brad Delong.

But let’s put aside economics and look at it from the perspective of a Wall Street banker.

Wall Street Banker

Considering the Treasury’s stubborn refusal to even identify the recipients of existing bailout funds (with rare exceptions, like the partial list of AIG counterparties) and penchant for creating its own slew of vehicles (for example, the Term Auction Facility, the Term Securities Lending Facility, the Primary Dealer Credit Facility, the Commercial Paper Funding Facility, the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Money Market Investor Funding Facility, and Maiden Lane I, II and III), I have little doubt the new process will be as transparent as a chunk of coal.

Wall Street and their lawyers — one of whom almost got a top spot at Treasury — will have little trouble creating a slew of Special Purpose Vehicles / Entities (or repurposing existing, loss-laden hedge funds) for the sole purpose of bidding the price even higher than the expected value and unleashing that huge, 85% no-recourse Federal loan guarantee.

That makes the whole thing a win-win for Wall Street: it’s like setting up "Toxic Assets LLC" then using an >85% government subsidy to "buy" everything at your own garage sale at inflated prices.

If your junk is worthless, it doesn’t matter, since you set a price more than high enough to make a profit when you first sold it, taking into consideration the modest capital you put into Toxic Assets LLC.

I’m sure Treasury will put together a handful of half-hearted competitive bidding limitations that will say the exact same company that owns the assets can’t bid on them, and I’m sure Wall Street will have no trouble finding its way around these limitations. I then expect to see these "legacy assets" go for sale at impressive, expectation-shattering levels, which will be hailed as a success.

A few months or years later, totally unexpected, the entities that bought these "legacy assets" will go bankrupt, pleading that they did the best they could to help the American taxpayer, and, gee whiz, we lost some money, too.