Illegal Tying of Loans to Investment Banking: The Next Big Scandal?

Some dealmakers who have watched the progression of various types of scandals over the past year think that the next regulatory shoe to drop will be investigations into “tying,” or illegally linking loans to investment banking work. Certainly, investigations into hedge fund activities and pension funds could occupy regulators’ attention before they turn to tying, but experts report that enough conflicts-of-interest exist in the linkage of services to justify regulators’ interest. The National Association of Securities Dealers (NASD) sent out a notice to members requesting comment on the issue and press reports have said that the group is conducting an investigation. The NASD’s September 2002 notice cites a recent study by the Association of Financial Professionals (AFP) that found that 48% of members responding believed that “if they did not award other business to short-term lenders, the amount of short-term credit provided would be reduced, and 39% would expect no credit to be offered if they did not award other business to lenders.” While tying can come in many forms, the NASD notice states that “illegal tying arrangements may involve structuring commercial credit transactions to support investment banking activities, such as providing federally insured bridge loans to support a merger or acquisition transaction managed by the investment bank.” Other potentially interested regulatory parties could include the Federal Reserve Bank, since Section 23B of the Federal Reserve Act prohibits an insured bank from extending credit to a company if the bank would not extend credit alone but only in conjunction with investment banking services. Gray areas and porous Chinese walls To many experts, the question of when tying is illegal is a moving target. “It can be hard to say when cross-selling becomes illegal tying but there are similarities to the way accounting firms have used auditing as a loss leader to get consulting assignments,” states Jay Ritter, a finance professor at the University of Florida. Another observer, Prof. Linda Allen at Baruch College, notes that tying is legal when the information flow about a client or a particular deal goes from the commercial bank to the investment bank, but not vice versa. However, the Chinese wall that would prevent illegal information sharing is porous, she adds. “One of the less nice aspects of tying is when the m&a gig is linked to the promise or expectation of future lending. This may not be legal,” Allen says. She adds that one marker of the type of conflict that could attract regulators’ interest is when the loans are mispriced. One technology investment banker says that his understanding is that tying of capital loans to investment banking work is not allowed. But in an indication of how murky the area is, he says that some technology investment bankers realigned their strategies in the late ’90s because of the expectation that the linkage of capital and merger advisory work would shut out all but the largest players. He adds that, in retrospect, this trend didn’t become as meaningful as was expected in the technology sector. One reason for this was that the number of m&a transactions among emerging-growth companies that required capital was small; a lot of the deals were stock-for-stock. He goes on to say that tying conflicts-of-interest were especially rife in the buyouts world. “The financial “supermarket banks,” – the Citigroups, J.P. Morgans, and Goldmans of the world – will always have an advantage with LBO firms because of their debt capacities. They can ask their debt team to come in with the most aggressive position they can, and that’s the name of the game. It makes the ability to do the transactions that much harder for everybody else,” he asserts. Copyright 2003 Thomson Media Inc. All Rights Reserved. (http://www.thomsonmedia.com)