Infectious Greed (39 page)

The name FELINE PRIDES was a mouthful of acronym. “FELINE” stood for Flexible Equity-Linked Exchangeable Security; “PRIDES” stood for Preferred Redeemable Increased Dividend Equity Securities. The bizarre acronym had an even stranger history, one that illustrates how much financial markets had changed during recent years. The lineage of FELINE PRIDES reads like an Old Testament family tree, with a stray cat thrown into the mix. If this discussion seems esoteric, remember this: by 2002, most public companies used these types of instruments—undoubtedly companies whose stock most investors own.

In the beginning, there was equity and debt. Equity consisted of shareholders who owned a company. Debt consisted of bondholders whom the company owed. Together, equity and debt supplied all of the capital available for a company to invest. Debt was at the bottom of a firm's capital structure; equity was at the top. Bondholders received interest and were repaid their principal at maturity. Shareholders received dividends plus any other increase in the value of the company.

Then,
preferred stock
was created, a hybrid of equity and debt. Preferred stock had an infinite life, like equity, but was paid a fixed rate, like debt. Some preferred stocks could be converted into regular stock (called
common stock
) at a future date, at the option of the preferred stock-holder. Other preferred stocks had a cumulative dividend—an obligation that accumulated when it wasn't paid (unlike a common-stock dividend, which was at the company's discretion). Thus, preferred stock
sat in the middle of a company's capital structure, above debt but below equity.

The key questions about preferred stock involved legal rules. When the rules for debt and equity were different, how would preferred be treated? For example, interest on debt was tax deductible, but dividends on equity were not. Could a company deduct payments to its preferred shareholders for tax purposes? What about the rating agencies, which were always critical to the financial markets, as the first chapters demonstrated? In assigning ratings, they looked at the ratio of debt to equity. How would they assess preferred stock? And what about the all-important accounting rules? Analysts compared companies by looking at the relative amounts of equity and debt on their balance sheets. Where would preferred stock fit?

Financial engineers at investment banks were very good at answering these questions. They designed novel types of preferred stock to take advantage of tax deductions and favorable credit ratings, and to minimize the amount of debt disclosed in financial statements.

First, creative bankers noticed that common stock was really composed of two pieces: dividends, plus any change in stock price. They separated these two pieces—just as they split apart the interest and principal payments on mortgages—by putting them into a common-stock trust (one well-known 1980s version was called Americus Trust), which issued two securities: one conservative security, that received dividends plus some of any increase in the stock price; and one riskier security, that received any additional increase in stock price. Such instruments were used in the United States, Europe, and Japan.

In 1988, Morgan Stanley created a security called PERCS, based on the more conservative piece of the Americus Trust deals. PERCS stood for “Preferred Equity-Redemption Cumulative Stock,” and resembled a preferred stock, with cumulative dividends that were higher than the dividends paid on common stock (a “perk” for the investor, in case that reference wasn't obvious). The key twist was that, in three years, PERCS
automatically
converted into common stock, according to a specified schedule. For example, PERCS would convert into one share of common stock if the common stock was at $50 or lower, but convert into fewer shares if the price was above $50, so as to limit the upside of PERCS. Essentially, an investor buying PERCS committed to buy a company's stock in three years, and also sold some of the upside potential of that
stock by selling a three-year call option (similar to those Andy Krieger was trading at Bankers Trust). The company bought the three-year call option from the investor, and paid the investor a “premium” in the form of a cumulative dividend for three years.

PERCS were quite complex, and one might imagine that only the most sophisticated companies and investors would use them. But the first PERCS deal, in July 1988, was done by Avon Products, Inc.
⁶¹
Avon's common stock had fallen to around $24, but was still paying a $2 dividend. Avon wanted to cut the dividend to $1, but doing so would infuriate investors and drive down its share price even more. The brilliant solution was to offer to exchange common shares for PERCS, which would still have a $2 dividend but would convert into common shares in three years. The price cutoff for converting PERCS into common stock declined during the three years, wiping out any gain from the additional dividend—but that was much more subtle than simply slashing the dividend by $1. Investors didn't complain. If Avon's common stock were below $32 in three years, the PERCS would each receive one share of common stock; otherwise, they would get less.
⁶²
The company received some favorable regulatory treatment: the rating agencies treated PERCS as equity, as did Avon's accountants, although the dividends on PERCS were not tax deductible.

Without the tax benefit, PERCS lacked mass appeal. The idea was really not that new, and investors preferred to buy either common shares, which kept all of the upside, or corporate bonds, which were safer. The main advantage was that a company could “borrow” money using PERCS without increasing its debts (at least in the minds of rating agencies officials). In the early 1990s, a few debt-laden companies whose credit ratings were lower than their competitors' issued PERCS, instead of debt: Citicorp, General Motors, Kmart, RJR Nabisco, Sears, and Tenneco.
⁶³
The credit-rating agencies did not seem to care that these companies' short-term obligations were increasing, and they did not count these securities as debt in their analyses. The companies protected their credit ratings, and were willing to pay large fees for the deals. Morgan Stanley doubled its income in 1991, due in large part to the sale of about $7 billion of PERCS.

Then, in 1993, Salomon Brothers introduced DECS (for Dividend Enhanced Convertible Stock), which added a twist to PERCS, to give the investor more upside. PERCS had two payout zones: above and below a specified exercise price—below that price, the investor received one
common share for each PERC; above that value, the investor received a diluted number of shares, capping the investors' upside. DECS added a third zone, at a higher stock price, above which the investor received the upside of common stock.

For example, Salomon did a DECS deal for First Data Corp., the data-processing subsidiary of American Express. If you bought 100 DECS, your payout in three years would fall into one of three zones, divided by common stock prices of roughly $37 and $45. If the common stock were below $37 in three years, you would receive 100 common shares. Between $37 and $45, you would receive fewer shares, to maintain a constant value of $37—that meant that if the price went up to $40, you would still only receive $37 worth of shares per DECS; if the price reached $45, you would receive only 82 common shares. However, in the new third zone, when the price increased above $45, you would still receive 82 shares—no more dilution—regardless of how high the price went. This new upside was the only economic difference between PERCS and DECS.

For American Express and First Data, the regulatory benefits of the DECS were enormous. First, because American Express had agreed to pay the first three years of dividends, the credit-rating agencies gave the DECS a high rating, based on American Express, not First Data Corp.
⁶⁴
The rating agencies also treated the DECS as equity in their analyses. Second, Salomon had obtained an opinion that the three years of payments—called “dividends” for PERCS but “interest” for DECS—were tax deductible.
⁶⁵
In other words, tax lawyers were willing to call DECS “debt” for tax purposes. Third, accountants did not include DECS among the financial statement's other debts and obligations, even though everyone else was calling them debt. Salomon had created a financial chameleon that could appear to be equity or debt, depending on the regulator.
Investment Dealers' Digest
labeled the DECS for American Express “Deal of the Year” in 1993, and Salomon was paid an incredible $26 million,
⁶⁶
roughly the same fee Salomon would have received from advising Bell Atlantic on its planned $21 billion takeover of Tele-Communications Inc.—the largest announced takeover since the RJR Nabisco deal in 1989—if that deal had not collapsed in 1993.
⁶⁷

In 1994, as the Fed was raising rates and losses were spreading throughout the financial markets, every major investment bank was copying Salomon's mousetrap. Merrill Lynch had Preferred Redeemable Increased Dividend Equity Securities (PRIDES), Goldman Sachs had
Automatically Convertible Enhanced Securities (ACES), Lehman had Yield Enhanced Equity Linked Securities (YEELDS), and Bear Stearns had Common Higher Income Participation Securities (CHIPS).
⁶⁸
For a time, having a facility with acrostics became more important on Wall Street than mathematical training.

For the next two years, Wall Street made substantial fees from these deals; and companies raised billions of dollars while propping up their credit ratings, reducing their taxes, and hiding their debts. A company's financial statements would not reflect changes in its obligations on these new instruments as the companies' share prices changed, even though the value of the obligation depended on which of the three zones the company's stock was in.

Accountants at the SEC began questioning this accounting treatment in 1996, after they examined a Merrill Lynch PRIDES deal for AMBAC Inc. When they told officials at Merrill that AMBAC would need to record an ongoing expense for the PRIDES, the deal collapsed.
⁶⁹
Then Goldman Sachs invented a security called MIPS, for Monthly Income Preferred Securities, which purported to qualify as equity for accounting purposes but debt for tax purposes. Enron was a major issuer of MIPS, and even won a battle with the Internal Revenue Service in 1996 over the tax treatment of such preferred securities.

In 1997, Merrill added the FELINE twist to its PRIDES, thereby inventing a nearly perfect financial mousetrap. Instead of the company itself issuing the PRIDES securities, Merrill would create a special-purpose trust to issue securities resembling the original PRIDES. The trust would give the money it received from investors to the company in exchange for securities that matched the trust's obligations on the new securities it had issued. In other words, the trust was simply a middleman: cash would flow from investors through the trust to the company, and the obligations would flow from the company through the trust to investors. The economics of the deal were essentially the same as those of the original PRIDES, with a few bells and whistles added to target specific investor profiles, and a maturity that was extended to five years. By March 1997, Merrill had completed its first FELINE PRIDES deal for MCN Energy Group Inc., through a special-purpose entity called MCN Financing III, which was created especially for the purpose of new issue.
⁷⁰
The new hybrid securities would be tax deductible, would be treated as equity for credit-ratings purposes, and would neither be included as a liability nor dilute the common shares on a company's balance sheet.
⁷¹

On February 25, 1998, just weeks before Cendant's massive accounting scam was uncovered, Cendant announced the public offering of 26 million units of FELINE PRIDES, worth about $1 billion in aggregate. Essentially, investors would buy a preferred stock that would pay a dividend of 6.45 percent for five years and then automatically convert into Cendant common stock, according to a specified schedule. The FELINE PRIDES were tax deductible, received an investment-grade credit rating, and were not included as debt or equity on Cendant's balance sheet. Merrill Lynch—which had represented HFS in the Cendant merger—created the FELINE PRIDES and was one of the lead underwriters for the Cendant deal. This deal was Cendant's last gasp for breath, an attempt to raise money to fund its money-losing businesses without disclosing any new debt or jeopardizing its credit rating.

The fact that Cendant did a FELINE PRIDES deal just before its collapse is significant for two reasons. First, it shined a bright light on these new financial instruments. There were numerous related lawsuits, and the publicity presented an obvious opportunity for SEC accountants and, perhaps, even experts at the Internal Revenue Service and the credit rating agencies, to reexamine the impact of these new financial techniques, now that—please indulge one jab at the acronym—the cat was out of the bag.

Second, Cendant's deal made it clear that the investment bankers were facing serious conflicts of interest in their various businesses, conflicts that became more intractable as financial instruments became more complex. Merrill Lynch had advised HFS in the Cendant merger negotiations and, supposedly, had performed due diligence on CUC at that time. It also had created Cendant's FELINE PRIDES, so it should have performed due diligence at the time of that deal, too. In addition, Merrill Lynch brokers had been involved in selling Cendant stock to investors, and Merrill's analysts had recommended Cendant stock. Merrill had earned substantial fees from all of these various sources, just as it had pocketed huge fees from its role in the Orange County debacle as derivatives salesman, bond underwriter, and cleanup crew. Was it really any surprise that Merrill had not uncovered the accounting problems at Cendant?

 

 

T
he scandals in the United States during the mid-1990s raised troubling questions about the conflicted role of accountants and investment bankers, and the inability of regulators to police them. Top accounting
firms were involved in approving accounts that later turned out to be fraudulent. Top investment banks were closely advising the firms engaging in these schemes. In 1998, regulators finally began pursuing accounting fraud in a few cases, but they largely ignored the more complicated schemes, sending yet another message that complex financial crime did, indeed, pay. Meanwhile, the financial innovations of the early 1990s, having been nurtured in a warm, comforting, deregulated environment, were about to multiply and spread throughout the markets. Their next stops would be outside the United States, where no one was prepared for the consequences. Soon enough, they would return home.