Enron suit: A new tempest for Citi?

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(Fortune Magazine) -- "When Enron blows up, will it be worse than Long-Term Capital?"

So wrote one Citigroup banker to another in April 2001, some seven months before Enron's bankruptcy. That e-mail is, of course, a vivid reminder of two big blowups that rocked the capital markets. But -- surprise! -- it's not just a remembrance of things past.

The e-mail is also part of a series of lawsuits filed against Citi after Enron's bankruptcy, one of which is supposed to go to trial this spring, in which Enron -- or what remains of it -- is seeking more than $20 billion from Citi. In the inflated numbers, the aggressive posturing, and the mind-numbing complexity, the lawsuit itself is totally Enronesque. The funny thing, though, is that this time around it's not clear which actor is playing Enron.

Let's get this out of the way first: Yes, Enron still exists! But it's called Enron Creditors Recovery Corp., it has just 36 employees, and it exists for one reason: to pay creditors. To date, those creditors have gotten 36 cents on the dollar, double the original estimate, which Enron has paid by selling assets such as pipelines and power plants -- and extracting money from Wall Street banks that, like Citi, helped Enron fool the world.

This campaign against Wall Street began in 2003, when Enron filed a suit that it aptly called Mega Claims against 11 banks, alleging that they helped manufacture its financial statements. Nine of the 11 settled, paying what Enron says is $1.7 billion in cash (some of this was payment for claims the banks took back) and giving up almost $1 billion more in claims. A small case remains against Deutsche Bank -- and a big one remains against Citi. "We believe the suit is without merit, and we intend to defend against it vigorously through the courts," says Citi.

The Mega Claims case is separate from the lawsuit by Enron's shareholders that Citi settled in 2005 for $2 billion to "put a difficult chapter in our history behind us," as then-CEO Chuck Prince put it. Oops. It appears that Citi may have settled the wrong case, because last spring an appeals court sidelined the shareholders' suit. It is currently awaiting a relevant Supreme Court decision.

But Enron itself has a shot against Citi, thanks partly to provisions in bankruptcy law. Mega Claims has its genesis in the 4,235 pages of analysis produced by the Enron bankruptcy examiner, who concluded that Citi helped Enron "produce materially misleading financial statements."

For instance, Citi, which averaged a stunning deal a month with Enron from 1997 through the company's bankruptcy, helped Enron improperly record more than $5 billion in cash flow from operations and understate its debt by billions. As a result, Enron alleges that Citi knew the company's real condition ("When Enron blows up ...").

And so Enron argues that Citi should return what it says were $3 billion of payments from Enron to Citi in the years before Enron's bankruptcy. Enron also argues that Citi should have to fill the $18 billion gap between what other innocent creditors are being paid and what they are owed. (This number is obviously out of whack with what the other banks paid.)

The most Enronesque part of the lawsuit has to do with the billions that Citi lent Enron. In the late 1990s, Citi began to get nervous about its exposure to Enron. So Citi crafted some fiendish structures under which, in the event of an Enron bankruptcy, third-party investors -- who believed such a thing was highly unlikely -- would step into its shoes as Enron's creditors.

Not only did those investors end up with Enron's debt, but they wound up with Enron debt that may be worthless because of a concept known as "equitable subordination," under which a bankruptcy court can penalize a creditor's misconduct by making sure that the creditor is paid last.

It appears that Citi knew that was a possibility. A few days before Enron's bankruptcy, one Citi executive wrote, "Remember the risk is equitable subordination.... Think 'jammed to the bottom of the pile.'"

Today Enron argues that what it says are $5 billion of original Citigroup claims can indeed be jammed to the bottom of the pile. Citi says that because third parties now hold the claims, those claims have been cleansed of any bad acts that may have occurred. (Call it claims laundering.) But Citi still has to care, because it's also being sued by those third parties, who want to force Citi to pay if Enron doesn't.

This issue is at the cutting edge of bankruptcy law. Judge Arthur Gonzalez, who is overseeing Enron's bankruptcy, ruled that the claims should be subordinated. Citigroup and a current holder of a small claim appealed Gonzalez's decision to the district court, and in August, in a closely watched decision, Judge Shira Scheindlin ruled that claims were subject to different sorts of treatment based on how the holders acquired them. It's still unclear what her decision means for the bulk of the original Citi claims.

Of course, all this couldn't come at a worse time for Citi (Charts, Fortune 500). Maybe the real question is, Could there be such a thing as karma, even on Wall Street?