Article

Note:The Enron meltdown contained important implications for the LC industry, revealing the weakness of a competitive product, suretyship undertakings issued by insurers issued to cover defaults in gas and oil deliveries.

Under a contractual arrangement with Enron, two companies, Mahonia Limited and Mahonia Natural Gas Limited ("Mahonia") paid Enron US$1.1 billion in advance for subsequent deliveries of oil and gas. To assure performance, Mahonia obtained contractual guarantees and six suretyship bonds.

The bonds provided that:

"The obligations of each Surety hereunder are absolute and unconditional, irrespective of the value, validity or enforceability of the obligations of [Mahonia] under the [corresponding Contract] or Enron under [its separate guarantees] or any other agreement or instrument referred to therein and, to the fullest extent permitted by applicable law, irrespective of any other circumstance whatsoever that might otherwise constitute a legal or equitable discharge or defense of a surety in its capacity as such."

The bonds were issued by the following insurers: Liberty Mutual Insurance Company; Travelers Casualty and Surety Company; St. Paul Fire and Marine Insurance Company; Continental Casualty Company; National Fire Insurance Company of Hartford; Fireman's Fund Insurance Company; Safeco Insurance Company of America; The Travelers Indemnity Company; Federal Insurance Company; Hartford Fire Insurance Company; and Lumbermen's Mutual Casualty Company.

When Enron defaulted, JP Morgan Chase, acting on behalf of Mahonia, demanded payment of US$1.1 billion on the bonds but the insurers refused. Accordingly, JP Morgan Chase sued the insurers in the U.S. District Court for the Southern District of New York, and moved for summary judgment. Rakoff, J., denied the motion, (189 F.Supp. 2d 24 (S.D.N.Y. 2002)).

As explained in the opinion, the insurers alleged that:

"unbeknownst to the Sureties at the time they issued the Bonds, the Contracts between Mahonia and Enron were part of a fraudulent arrangement by which simple loans to Enron by plaintiff's predecessor, the Chase Manhattan Bank ("Chase"), were disguised as sales of assets. Specifically, they allege that Chase lent Mahonia the money used to pay Enron on the Contracts, and that, at the very time Enron was contracting to sell to Mahonia future deliveries of gas and oil, Enron was secretly contracting to repurchase the very same gas and oil from one or more entities commonly controlled with Mahonia, at a price equal to what was owed by Mahonia to Chase on the loan. The net effect was simply a series of loans from Chase to Enron; but by disguising them as sales of assets, Enron could book them as revenue while Chase and Mahonia could, among other things, induce the Sureties to issue Bonds that would effectively guarantee repayment of the loans " something the Sureties were otherwise forbidden to do under applicable New York law (which here governs). See §§ N.Y. Ins. Law 1102, 1113(16)(E); 6901(a)(1)(A) (McKinney 2000). In short, defendants allege that the Bonds were the product of fraudulent inducement and fraudulent concealment by the plaintiff."

The court considered whether the defense of fraudulent inducement and concealment were available given the terms of the bonds. It stated that "New York law does not permit a contracting party to lightly evade its contractual obligations by simply crying 'fraud.' ... Also, of particular relevance here, New York law will not permit a sophisticated party that, in negotiating a contract, has expressly disclaimed reliance on specific oral representations extrinsic to the contract to thereafter claim that the fraudulence of these representations is a defense to contractual performance."

It noted:

"[I]n Citibank, N.A. v. Plapinger, 66 N.Y.2d 90, 495 N.Y.S.2d 309, 485 N.E.2d 974 (1985), ... the [New York Court of Appeals] held that corporate officers who had signed guarantees of corporate debt containing such language could not escape payment by arguing that they had been fraudulently induced to sign the guarantees in reliance on the lenders' unfulfilled oral promises to extend a further line of credit to the corporation."

The court, however, also observed that the New York cases did not reach the result that "a general sweeping disclaimer can serve to disclaim any and all extrinsic fraud between sophisticated parties."

Where general disclaimers were given effect, the court concluded that the disclaiming party has "knowingly disclaimed reliance on the specific representations that form the basis of the fraud claim."

"Here, by contrast, even if one assumes arguendo that the disclaimers in paragraph 7 of the Bonds preclude reliance on the representations in the underlying Contracts of which the Sureties knew or were on notice, there is no suggestion that the Sureties knew or were on notice of the allegedly circular arrangements between Mahonia, Enron, and other entities that transformed what purported to be insurable sales contracts into disguised loans that the Sureties were prohibited by law from insuring."

In addition, the court noted that any fraudulent misrepresentations in the bonds themselves were actionable. As stated by the court, "Here, each of the Bonds is expressly premised on Mahonia's having entered with Enron into a gas or oil "Inventory Forward Sale Contract" and expressly recites that once all the contracted-for gas or oil 'is fully delivered' the Sureties' obligations will cease. ... Plainly implicit in these representations is the assertion that the Sureties are being asked to insure the sale and future delivery of a commodity, rather than being asked to insure, unlawfully, a disguised loan transaction."

"In short, nothing in the broad disclaimer language of the Bonds excludes the defense " whether characterized as a defense of fraudulent inducement or fraudulent concealment " that the insured arrangements were a total sham whose reality was totally concealed from the Sureties."

JP Morgan Chase called the court's attention to a provision in New York insurance law to the effect that "a surety that illegally guarantees repayment of a loan is still obligated to make good on that surety. See N.Y. Ins. Law § 1303."

The court, however, noted that:

"[T]here is no reason to believe that the statute applies to an innocent, unknowing insurer who is fraudulently induced to illegally insure loans that the insurer has no reason to believe were loans at all. To put it another way, there is nothing to suggest that the statute was intended to change prior law and preclude an insurer from raising a fraud-in-the-inducement defense " a radical change that, absent legislative history, the legislature can not be supposed to have intended."

In response to JP Morgan Chase's characterization of the insurers' defense of fraud as "speculative and unsupported by admissible evidence", the court noted that the insurers:

"[H]ave managed to obtain some important evidence that, taken most favorably to them (as it must be for purposes of this motion), inferentially but materially supports their theory. For example, with respect to the last of the six underlying Contracts here in question, which was entered into between Enron and Mahonia on December 28, 2000, defendants have obtained evidence that, on that very same day, Enron entered into an agreement with an entity called Stoneville Aegean Limited ('Stoneville') to purchase from Stoneville the identical quantities of gas that Enron was that same day agreeing to sell to Mahonia, to be delivered to Enron on the very same future dates as Enron was supposed to deliver the same quantities of gas to Mahonia. ... The fact that Enron would be simultaneously buying from Stoneville the very gas it was selling to Mahonia becomes even more suspicious when considered in light of the further evidence adduced by defendants to the effect that both Mahonia and Stoneville " offshore corporations set up by the same company, Mourant & Company " have the same director, Ian James, and the same shareholders. ... What, finally, turns suspicion to reasonable inference is defendants' further evidence that, whereas Mahonia agreed in its Contract with Enron to pay Enron $ 330 million for the gas at the moment of contracting (December 28, 2000), Enron, in its agreement with Stoneville, agreed to pay Stoneville $ 394 million to buy back the same quantities of gas on the same delivery schedule " but with the $ 394 million to be paid at specified future dates."

In denying summary judgment to the bank, the court stated: "Taken together, then, these arrangements now appear to be nothing but a disguised loan " or at least have sufficient indicia thereof that the Court could not possibly grant judgment to plaintiff."

Citing the large amount of money at stake in the dispute, the court ordered discovery to continue.

On 13 September 2002, the court denied JP Morgan Chase's discovery motions requiring insurers to identify a witness who could identify facts learned after issuance of the bonds that led insurers to claim that the bonds were disguised loans. The court stated that "what each defendant knew at the time it issued its bonds is highly relevant; but what it may have learned since then is entirely irrelevant. This is because the parties' respective obligations and liabilities are a function of what they knew, and what they disclosed or failed to disclose, at the time they entered their contractual relationships, not thereafter." 209 F.R.D. 361 (S.D.N.Y. 2002).

On 13 September 2002, the court also granted the insurers' motion to dismiss fraud claims by JP Morgan Chase of fraud. Responding to an amended complaint by JP Morgan Chase, the court issued a 2 December 2002 memorandum which explained its dismissal of two of the claims advanced by JP Morgan Chase, (2002 U.S. Dist. LEXIS 23016).

JP Morgan Chase had contended that the insurers fraudulently induced it to lend to Mahonia, arguing that the insurers had sufficient knowledge to doubt the insurability of the gas and oil sales contracts but nonetheless gave opinions through counsel without qualification regarding the legality of the bonds, thus inducing the loan by JP Morgan Chase. The court rejected this contention on the ground that the opinion letters expressly precluded reliance by JP Morgan Chase issued by insurers to Mahonia.

JP Morgan Chase also argued that the insurers fraudulently represented to it that the bonds would be "the functional equivalent of letters of credit" and, as such, payable on demand. JP Morgan Chase charged "in fact [insurers] secretly intended in the event of default to pursue 'claims adjustment' and otherwise avoid the automatic repayment characteristic of letters of credit." The court denied this claim:

"the mere allegation that 'a defendant did not intend to perform a contract with a plaintiff when he made it' generally fails to state a claim for fraud ... [citations omitted]. Yet there are entirely missing from the instant pleadings the kinds of additional allegations that might transform the instant contention from a breach of contract claim into one sounding in fraud under New York law."

Insurers in turn asserted they were defrauded by JP Morgan Chase into issuing the bonds and are therefore not liable. They claimed that the bank:

"[P]urposely misled them into believing that the underlying contracts, known as 'pre-pays,' were ordinary arrangements by which Mahonia, a purported merchandiser of oil and natural gas, paid present cash to Enron in return for future deliveries of natural gas and oil, whereas in fact the contracts were simply camouflage for a disguised, 'off-the-books' loan from Chase to Enron, the repayment of which the defendants were probibited from insuring by New York law. According to defendants, they were tricked into insuring the bonds by Chase's concealing from them a series of contractual arrangements, entered into simultaneously with the pre-pay contracts between Enron and Mahonia, pursuant to which (i) Chase purchased from Mahonia the future deliveries Mahonia purchased from Enron, (ii) Chase sold the future deliveries to another Chase vehicle called Stoneville Aegean Ltd. ('Stoneville'), (iii) Stoneville sold the future deliveries back to Enron, and (iv) the various participants entered into a series of swaps and hedging arrangements that eliminated the effect of market fluctuations."

To prove these allegations, insurers sought to introduce a series internal JP Morgan Chase e-mail communications. JP Morgan Chase moved to exclude the e-mail records and the motion was denied by the court. (2002 U.S. Dist. LEXIS 24518).

The court stated: "To avoid liability, [insurers] must prove every element of the alleged fraud by clear and convincing evidence. This includes proving, among other things, that [JP Morgan] Chase knew that the underlying arrangements were disguised loans. As part of such proof, [an insurer] seeks to introduce a series of internal [JP Morgan] Chase email communications from May, 1999 (after three of the bonds had issued and before the other three had issued) in which a senior Chase officer ... repeatedly described aspects of the bank's derivatives and prepaid commodities transactions as 'disguised loans.' Shortly prior to trial, [JP Morgan Chase] ... sought to exclude this proof across-the-board, arguing that 'it is clear from the deposition testimony in this case that the so-called 'disguised loans' referred to are the prepaid forward sale contracts themselves " the transactions which [insurers] knowingly bonded and concede are legitimate.' ... But since the references to 'disguised loans' in the emails themselves are not so clearly limited, and since, in any event, it is hard to see why a prepaid commodity purchase, pure and simple, would be characterized as a 'disguised loan' for any purpose, the Court, on the first day of trial, denied the motion, without prejudice to more particularized objections that might be raised before the proof was offered."

The following excerpt from the Opinion illustrates the scope of the emails:

"Thereafter, in appreciation of the potential impact of this proof, the Court continued to entertain further discussion of the issue, culminating in voir dire examination of [JP Morgan Chase officer] taken outside the hearing of the jury, as well as extensive oral argument and additional letter briefing. Having fully considered these submissions, the Court now rules finally and adheres to its prior ruling to permit introduction of this evidence over objections premised on irrelevancy, prejudice, confusion, or the like.

In his voir dire testimony, [JP Morgan Chase officer] disclaimed more than superficial knowledge of the particular transactions here at issue and stated that all he was trying to convey in his use of the term 'disguised loans' was that equity derivatives and prepaid commodities transactions involved loan-like cash advances that were not being subjected to the same internal controls and comparisons that Chase utilized with respect to loans, a defect he sought to fix. [JP Morgan Chase officer] was an impressive witness, and his testimony helped focus the Court on various statements in his emails that could be read as corroborative of his interpretation. But on cross-examination, as well as in oral argument, defense counsel drew the Court to an alternative interpretation"highly relevant to the issues in this case"that a reasonable juror unpersuaded by [JP Morgan Chase officer's] testimony might adopt.

Specifically, on November 24, 1998, [JP Morgan Chase officer] received an email (JD 99) requesting approval of a prepay (not one of those here at issue) in which Chase would take delivery of pre-sold crude oil. In his email response later that day (also part of JD [*8] 99), [JP Morgan Chase officer] noted that, given the fact the oil to be purchased had already been pre-sold, 'This is as much a loan as a commodity transaction.' He also asked: 'Is it now legal/ okay for us to take physical (delivery of a commodity) in this way?"

In answer to his question, [JP Morgan Chase officer] received a lengthy email (JD 101), dated December 2, 1998, in which the transactions involved in the instant case were explained in some detail (except, notably, for the resale to Enron). Thus, the email explained that Chase had been doing these deals since 1993, that 80% were with Enron, that a Chase vehicle named Mahonia was used as an intermediary even though no longer legally required, that Enron's performance was previously guaranteed by letters of credit but was now guaranteed by surety bonds, and, most importantly, that even though the overall 'transaction is priced as if it is a loan,' nevertheless, 'the prepaids are not booked as loans.' Carefully read, this email supports defendants' contention that, even without reference to the resales to Enron, Chase internally understood, in ways that would not be apparent to outsiders without fuller disclosure, that these transactions functioned economically as loans and were understood by Chase as such but were nonetheless booked and recorded as if they were not loans.

So far as [JP Morgan Chase officer] was concerned, however, the matter apparently lay fallow until the following May, when he sent another email (JD 112) to his subordinates, in which, under the heading 'Prepaid Oil Swap,' he indicated that he had recently encountered another such transaction, that it was just one more example of a 'hidden loan,' and that, while he understood that the credit risk 'has been laid off with insurance companies,' he wondered whether this kind of transaction 'could not eventually make its way off balance sheet in some sort of SPV (i.e., special purpose vehicle, like Mahonia) or whatever.'

This was followed, in turn, by the exchange of emails with which we are here principally concerned (all of which are included in JD 114). [JP Morgan Chase officer] led off, on May 12, 1999, with an email bearing the heading 'Subject: Disguised Loans,' in which he announced that 'We are making disguised loans, usually buried in commodities or equities derivatives (and I'm sure in other areas). With a few exceptions, they are understood to be disguised loans and approved as such. But I am quesy about the process:' This was followed by a series of questions to subordinates.

In response, one of [JP Morgan Chase officer] subordinates forwarded to him an email from another Chase officer, dated May 14, 1999, in which the officer, describing one category of these 'products,' noted that 'Legal (i.e., Chase's legal staff) have requested that the Financing Component of the transaction is not represented as a loan facility internally, given the remote risk that our internal records are subpoenaed by the Court in administration.' Read favorably to defendants, this seems to be an admission (albeit not directly with respect to the precise transactions here in issue) that Chase feared that a court might view internal recording of aspects of the transactions as loans as proof that they were, indeed, loans, rather than other forms of financing.

[JP Morgan Chase officer] however, was unpersuaded. He responded, by email dated May 18, 1999, that 'Legal says don't list it as a loan. Legal does not run the bank. They didn't want us to tape phone calls in the dealing room, either!! Their obscure risk has to be weighed against other factors as well and a wise judgment made. In this case, I am not happy with the outcome. I do not wish to have a piling up of disguised loans in trading account receivables that escape efforts at distribution, which is a central tenet of how the global bank runs.' In other words, it appears that [JP Morgan Chase officer] (unaware of the special risk involving surety bonds and loans) believed the need for treating these kinds of transactions as loans internally, so as to better evaluate how to spread the bank's risk, outweighed the danger that an outsider might become aware of this treatment and seek to attack the manner in which these transactions had been booked externally. Nor, it is clear, did [JP Morgan Chase officer] limit these remarks to transactions other than those here in issue, for in the very next sentence he states: 'I have asked for a thorough review of disguised loans. I know Commodities, under the heading of 'prepaid ...' has a whole bunch.'

While there are several more emails of similar tenor, the above examples suffice to show that, notwithstanding [JP Morgan Chase officer's] testimony, a reasonable juror could find these emails highly probative of the defendants' central contention that Chase knew that the prepays here in issue, when coupled other aspects allegedly not disclosed to the defendants (but, with the exception of the fact that the resales were to Enron, disclosed to [JP Morgan Chase officer]) were really loans that were being disguised as such in the case of outsiders but should not be so disguised in terms of Chase's own internal records. Indeed, [JP Morgan Chase officer], a highly experienced banker but one only modestly familiar with the particular transactions here in issue, picked up on this right away, even though his own subordinates did not tell him the further fact that the resales went back to Enron (thus, incidentally, depriving him of the information he needed to appreciate the true magnitude of the risk of disclosure that 'Legal' seemingly appreciated fully). To be sure, [JP Morgan Chase officer], whom the plaintiff has indicated it will call as a witness if these emails are not excluded, may well convince the jury that a narrower and less damning interpretation of his emails is the correct one. But that is a jury question, and not one for this Court."

Editor's Note: On 2 January 2003, shortly before the case was due to go to jury, JP Morgan Chase and the 11 insurers announced they had reached a settlement. Under terms of the settlement, the insurers agreed to pay around 60% of the $965 million principal amount of the claims and JP Morgan Chase agreed to forgo the balance. Commenting on the settlement, counsel for JP Morgan Chase said the bank agreed to compromise the claims because of "the uncertainty of jury verdicts in complex matters".

Comment: It is understandable why JP Morgan Chase elected to settle this case. Given the amounts involved, neither party was prepared to risk all or nothing on litigation and appeals. What is significant about the case, however, for the LC community is the insight that it provides into alternative products to standby LCs.

These products, whether labeled as insurance, "credits", or the like, are touted as the functional equivalent of standby LCs. As this case illustrated, however, there is a major difference. We will not know yet what the legal basis for the claim may be since the case has settled. What we do know is that the insurers behave like insurers when claims are made: they dishonor now and litigate later. That behavior does not characterize the position of LC bankers who, assuming a complying presentation, pay now and leave matters to sort themselves out. For those who think that the mental framework of the clerks and executives who make determinations about whether or not to pay does not matter, this case stands as a significant warning. It is a decision to which the attention of all sales representatives for banks should be directed.

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