Reckless banks still to pay

Judicial opinions highlight fresh risks to financial sectors’ profits

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Among the most interesting developments in the wake of the credit meltdown are a few recent judicial rulings that come as creditors of companies in bankruptcy protection fight over corporate carcasses that by definition don’t have enough value to go around.

Two recent judicial opinions rebuking the banks offer a window into the lending practices that fuelled the boom and the tactics that banks resorted to in a belated attempt to cut their losses. These cases highlight just how reckless the banks have been and how that recklessness may come back to haunt them – and their bottom lines.

Even as credit markets rally and the prices of the loans they carry on their books improve, the banks may yet have to give back some of the gains they have already booked – a warning for investors who think most banks offer considerable upside now that the worst of the downturn is over.

These cases are receiving widespread attention because the issue of excessive debt prior to bankruptcy filings is an issue that is beginning to be litigated widely. The cases include Charter Communications, as well as LyondellBasell and Tribune Co. where the outcome hasn’t yet been decided.

The first ruling involves Tousa, a Florida homebuilder, where a bankruptcy judge ruled that Citigroup and other banks made fraudulent transfers when they lent Tousa about $500m in 2007. The loan was made less than 6 months before Tousa’s bankruptcy protection filing in January, 2008. The loan went to refinance an earlier loan for a disastrous acquisition in 2005 and to repay some lenders on the 2005 loan.

The judge, John Olson, found that the lenders “were grossly negligent” in extending the second loan and “should have known the company was insolvent or perilously close to it,” according to the ruling.

Few of the parties involved look good, according to the judge. The banks, their advisors and the company itself all seemingly pursued a course that was both short sighted and careless. “Citi harbored significant doubts about Tousa’s solvency, but motivated by the prospect of substantial fee income, pressed forward nevertheless,” the judge states. Meanwhile, Tousa’s chief executive officer Antonio Mon “had outsized personal incentives to consummate the transaction,” the judge said, noting that Mr Mon’s bonus of $4.5m was partly contingent on the successful completion of the loan.

Before the new, 2007 loan went through, bondholders warned that the financing, which was additional, expensive debt could put Tousa close to insolvency and imperil its survival. Citigroup then asked for a solvency opinion, but the fees for that too were determined by the opinion.

Tousa retained Alix Partners, and agreed to pay $2m if Alix opined that Tousa would still be solvent after the loan but would pay only time charges and costs if it did not so opine. The banks are appealing the judgment which will cost them more than $600m if it is not overturned on appeal. A spokesman for Citigroup declined comment.

The second case involves Charter Communications, the fourth largest cable company in the US, and one of the most hotly contested battles to confirm an operational plan in the wake of a Chapter 11 filing. The judge rejected the banks’ claim that their loans were impaired, and said the banks were holding up the company’s emergence from bankruptcy protection just to change the terms of their loans and earn more interest. The adverse ruling could deprive the banks of $1bn in tax savings, a lawyer for the banks said. The banks in this case were led by JPMorgan whose spokesman declined to comment.

These rulings come at a time when the Federal Reserve is being extraordinarily generous in allowing the banks to make money by keeping interest rates low. But their previous carelessness may still cost them dearly. After all, when the banks helped Enron disguise its debts eight years ago, they were victims of the practices they acquiesced in. And while there is no fraud this time around, bad judgment can still be expensive.

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