Banks have to stay on one side of the law in order not to run afoul of "anti-tying" provisions. But some allege that banks have been crossing over. Why isn't there more proof?

These days, architect Glenn Storek plies his trade freelancing. It's a far cry from the time when he and his brother Richard ran a firm specializing in the restoration of old buildings in the San Francisco Bay Area, fulfilling a dream they had while students at the Berkeley School of Architecture during the 1960s.

That dream was shattered four years ago, when Citicorp foreclosed on their grandest project to date, the Old Oakland Development--two solid blocks of buildings dating from the 1860s and 1870s that had survived more than a century of urban development, decay and earthquakes. Now the Storeks are suing Citi to regain control of the project and $288.6 million in damages, alleging that the giant New York bank used an abusive practice called a "credit tie-in" to force them into a default and then seize control of the restoration project.

Among the properties that Glenn Storek lost were the Victorian-style home he renovated and lived in for 20 years with his wife and three daughters. "If you can imagine what it's like to see your life's work wiped out, to see your home wiped out--it's the worst thing you can go through next to death," he says.

The Storek brothers face some pretty tough odds in their case against Citicorp. The first federal court to hear the case dismissed their complaint on the grounds that the Storeks failed to adequately state their claim. Now it's up to a three-judge panel from the U.S. Court of Appeals for the Ninth Circuit, which will hear arguments next month. A ruling may be handed down as soon as this coming January.

For its part, Citicorp all but refuses to discuss the matter. Public relations executives there would only release a terse statement saying that Citi does not break the law, and that its "customers wouldn't stand for" tie-ins.

Whatever the court decides, the charges against Citicorp underscore an issue that could have far more impact than the fate of a foreclosed renovation on the West Coast. The Storeks' suit is actually Exhibit A in a broader case against the industry and the abusive practice of credit tie-ins. Their charges coincide with similar ones made by certain securities firms that commercial banks violate the 1970 amendments to the Bank Holding Company Act by extending credit to some business borrowers only if they also use the bank's underwriting services.

It's a controversy that has been bubbling beneath the surface in some distant comers of the securities markets for several years now, and more recently in Washington, DC. But the Citibank suit could become the setting for much more than just one more round of unwelcome publicity. It's no coincidence that the case will be heard at roughly the same time that hearings on tie-ins will be held before the House Energy and Commerce Committee chaired by Rep. John Dingell (D-MI).

Scheduled to take place shortly after Election Day, the hearings were initiated in part by the Storeks' charges, and also by a letter from a NationsBank Corp. officer to a prospective client. Dated Jan. 19, 1994, the letter is signed by J.W. Davis, a senior vice president with NationsBank's Greenwood, SC, office and addressed to John L. Anthony, vice president for Anthony Forest Products of El Dorado, AR. It states in part that the "proposal for a letter of credit...must encompass the placement business for the marketing of (the company's) bonds. We would not be in a position to offer a stand-alone letter of credit."

Anthony did not return phone messages left for him, and the chief NationsBank lending officer in Greenwood referred all questions to the corporate public relations staff, who conceded that the letter was in violation of the bank's policies. A spokesman, Ellison Clary, could not say if any internal disciplinary action would be taken against Davis, or what, if anything, the bank learned in its own investigation. So far, regulators have not viewed that letter as conclusive proof that NationsBank engaged in a tie-in, although an investigation into the incident was still on in October.

Assault on Glass-Steagall

At the very least, the tie-in controversy could be revived just as the banking industry prepares for another attack on the Glass-Steagall Act, which separates commercial and investment banking. It could be as early as next year that banking lobbyists make a concerted push for repeal, says Edward Yingling, the American Bankers Association executive director for government affairs.

But the industry's efforts to overthrow Glass-Steagall could falter if credit tie-ins develop into a scandal. Tie-ins raise "one of the longstanding concerns over the repeal of Glass-Steagall," says a staff member on Dingell's committee--namely that banks will misuse their traditional lending powers to muscle into the securities business.

As banking scandals along the Potomac go, credit tie-ins are admittedly a far cry from a Whitewater or a BCCI. Nonetheless, the House hearings will likely include testimony from some of the people who have been arguing that credit tie-ins, bank disclaimers notwithstanding, are a serious problem.

Besides the allegations against Citicorp and NationsBank, two instances involving First Union Corp. of Charlotte and National City Corp. of Cleveland have surfaced as well. Details are sketchy, with most of the information coming from anonymous tips from competitors, customers or regulators.

Only the National City case has resulted in any regulatory action, and that was two years ago. A spokesman for First Union says the bank was cleared of any wrongdoing after a bond specialist was said to have coerced Thomas R. Hopson Inc. into a tying arrangement over a $4.2-million industrial development bond (IDB) in 1992. Hopson, a Marietta, GA, manufacturer and wholesaler of building materials, was putting up a plant in Bartow County, about 30 miles northwest of Atlanta. An official with the company who requested anonymity said the IDB specialist made it clear that a letter of credit would not be available unless First Union was also the underwriter.

While the Hopson executive was unaware of other incidents of tying, he gained the impression from the First Union officer that arrangements tying letters of credit to a bank's underwriting services were common. "The way he talked; he made it seem that was just the way they did business," he said.

On the one hand, no harm seems to have been done to the Hopson firm. The company executive says he shopped around for other lenders for the letter of credit and for other underwriters, and First Union offered pricing on both sides of the deal that was lower than competing offers. On the other, as the Hopson executive later discovered, what the bank did could have been illegal. Nonetheless, no charges have been lodged, and a bank spokesman says the OCC investigated the incident and concluded in October 1993 that no laws had been broken.

"No administrative action was required, and we were pleased with the outcome," says Ronald Bryant, a vice president with First Union.

The National City Incident

Two years ago, Richard Roberts, a commissioner with the Securities and Exchange Commission, sparked a firestorm of sorts when he publicly accused commercial banks of engaging in tying. Shortly after his speech, it became apparent that Roberts was referring to an incident involving National City and a county in Georgia that was never specified (U.S. Banker, September 1992). His allegations were initiated by information that had been supplied to him by Thomas Harris, a Montgomery, AL, investment banker. At the time, an NCC attorney said the bank's policy was "not to have tied arrangements," and a spokeswoman recently read a similarly worded statement in response to questions about the matter. The National City incident may be one of the few that resulted in an actual penalty against a bank.

Roberts says today that he still believes tying exists, "but I've always had a question as to what the level is. I believe the vast majority of banks are obeying the law." Still, Roberts believes that banks have a responsibility to police themselves, and he thinks they can do much better in that regard.

"Banks have been somewhat reluctant to take up the cudgel, but if they would, they'd be better off," Roberts says. "Tying isn't good for anybody, not even the banking industry."

Despite the general lack of evidence, anecdotal accounts of tying persist. Whether their collective weight indicates an industry-wide pattern is another matter. With several, Harris, who is senior managing director of Merchant Capital Corp., is a central figure. Underwriting public debt is one of the firm's key sources of revenue, and Harris claims to have lost business to commercial banks that tie their lending products and securities services together. He alerted Roberts to the NCC incident, and he forwarded the NationsBank letter to Dingell.

Harris also has a ready-made answer for why there isn't more evidence on the record. "You don't hear about it because companies are intimidated," he says.

Companies who have been victimized by tying "are scared" to make the incidents public out of fear that they will be blacklisted and cut off from credit in the future, Harris says.

Among the people frustrated by that lack of evidence is Rep. Dingell. Dingell voiced his frustration in a September letter to Charles Bowsher, head of the General Accounting Office, in which he requested that the GAO prepare a report on the issue. The letter echoed some of Harris' sentiments, and in it Dingell wrote that "'smoking guns' are nearly impossible to find. However, it appears...that much of the regulatory energy...is spent searching for such smoking guns and, when they are not found, the conclusion seems to be drawn that tying has not occurred."

In actuality, there could be smoking guns aplenty. The missing links are the injured customers--without whom regulators just aren't going to act, explained one regulatory expert who is familiar with the banking agencies' interpretation of the BHCA amendments. As long as regulators see the injuries being inflicted on no one other than the investment banks who compete with commercial banks for underwriting business, they aren't going to punish banks. His account was confirmed by a staff attorney at the Federal Reserve, who asked not to be named.

Virginia Stafford, a spokeswoman for the American Bankers Association, says the trade group believes that if customers were actually being harmed, more would be heard about tie-ins in Washington.

The area most frequently cited as the hot spot for the abusive practice is in the financing and underwriting of industrial development bonds, a class of municipal security sometimes used to finance projects in which private businesses enlist the backing of local governments. These bonds' proceeds are often used to build factories, hospitals or other projects that will produce jobs and tax revenue for the state or county.

IDBs often require a letter of credit from commercial banks to attract investors, says Harris. Issuers are typically small and lack a credit rating, and the letters of credit guarantee that investors will recover their investment in the event of a default.

A tie-in occurs when the commercial bank tells the borrower that the letter of credit is available only if the borrower uses the bank, or another affiliate of the bank's holding company, as the bonds' underwriter or placement agent. Since many of these bonds are private placement issues, there is often no filing with the Securities and Exchange Commission. Also, these issues are legally subject to a $10 million ceiling, so for the most part they are small enough to escape scrutiny. For these reasons, the tie-ins are virtually undetectable, says Harris.

Some Tie-ins Legal

In actuality, many forms of tie-ins exist, and tie-ins between letters of credit and underwriting are only one form. Some types are perfectly legal, according to the 1970 amendments to the BHCA. For example, banks are permitted to give discounts for traditional loan, deposit or trust services to customers who have multiple relationships. These were intended to help banks hold on to their competitive position against other financial service providers. The tying arrangements declared illegal are for non-traditional services, such as securities underwriting, which is where the current controversy--of which the Storeks are only a small part--comes in.

A bank doesn't even have to go so far as pressuring the customer or making the provision of one product conditional upon the purchase of another, says the regulatory expert. Merely offering a discounted loan to a commercial borrower who uses the bank as a securities dealer is illegal. Says this person: "Does it happen all the time with industrial development bonds? Sure."

Still, little evidence of the practice has become public chiefly because bank examiners have given banks wide latitude in this area.

Dingell suggested as much in his letter to Bowsher, and he asked the GAO to explore the feasibility of instituting new regulatory criteria. One new guideline would require customers to "aver that coercion was absent," and another would call for "'cooling off' periods during which credit facilities could not be extended to companies whose securities are being underwritten by the bank's securities affiliate."

A Legitimate Interest

As far as the regulators are concerned, banks have a legitimate interest in performing the placement agent's role, as well as issuing the letter of credit, says the regulatory expert. In years past, banks would provide the letter of credit and rely on an investment bank to remarket the bonds. "But banks found out that agents were going back two or three years after the issue was offered and getting the investors to sell the old bonds and buy newer issues," he says. The banks were stuck because the credit was used up for bond redemptions and not construction costs.

This interpretation of the law has worked its way into examiners' practices since the Fed surveyed the IDB business in the late 1970s, the Fed lawyer says.

In one sense, by forcing borrowers to accept the letter of credit bank as the placement agent, banks were only protecting themselves. Moreover, the placement agent role is similar to the agency function commercial banks can legitimately perform when they buy and sell securities for a commercial customer. Legal experts at the regulatory agencies have in fact interpreted it as such, meaning that they view banks as merely tying in a traditional service and not breaking the law.

The Storeks' Case

Complaints over credit tie-ins had actually been fading until the Storeks' suit came along. And in an area where most of the information is so sketchy, it is a richly detailed account of an alleged tie-in violation involving a major bank. The story begins in 1983, when the Storeks first sought funding for the Old Oakland project. The site was a prime location for architects with their specialty and--given the 100-year age of the buildings involved--a rarity for the West Coast. It was also the largest project the Storeks had attempted to date, although their firm had 100 employees, and prior projects included renovation of the original i. Magnin department store into an office building in San Francisco's Union Square neighborhood, as well as a former power plant that became the Sierra Club's headquarters.

But the Old Oakland project was a different breed of cat, in part because of its size, and also because it required lots of money. The original round of financing was for $28 million. Costs ultimately exceeded $46 million.

As court documents consisting of internal Citicorp memos and correspondence between Citi executives and the Storeks show, Citi planned all along to underwrite the bonds and provide the letter of credit. Yet the Storeks go one step further and allege that Citi coerced them into a tie-in.

The Storeks and their lawyer, William Lukens, support that claim with an 11-year-old application for a letter of credit that Lukens says is a smoking gun. The application reads at one point: "Citibank's Merchant Banking Group shall be the remarketing agent for the bonds."

"You can't find more of a smoking gun," says Lukens. "This is a firing gun." In fact, the application is but one of several documents dating from 1983 to 1990 submitted to the court with the Storeks' complaint. One of the most interesting things about the "application" is that it is printed on the Storeks' letterhead stationery. Lukens alleges that a Citicorp officer asked the Storeks to supply their stationery so that the document could be printed in Citi's offices. That way it would appear that the Storeks requested the tie-in in their application, rather than having it imposed upon them by the bank.

Cumulatively, Lukens alleges, the documents show a clear-cut pattern of abuse of the BHCA amendments. Besides alleging that the coercion took place, Lukens also accuses Citi of exploiting its role as the sole remarketing agent, or dealer, for secondary market trading of the bonds. He says Citi purchased all the outstanding securities in 1989 and 1990 so that it might foreclose on the Storeks without opposition from other creditors.

Citi was able to foreclose after the Storeks missed the September 1990 interest payment on the bonds. Up until that point, the Storeks had not missed any payments despite Citi having withheld more than $1 million in requests on a secondary line of credit that had been issued in 1989.

For a time, the Storeks made up the shortfall by taking out second mortgages on their other properties. But these funds quickly ran out. The foreclosure occurred at a time when the project was near completion, and, Lukens alleges, Citi spent far more--close to $28 million, in fact--buying up the bonds than it would have by merely extending the Storeks for the portion of the project that was unfinished.

Not only was Citi's action illegal, Lukens charges, but the project's denouement need not have happened the way it did. Had Citi continued funding the project and allowed the Storeks to finish their work, the loan would not have been at risk of default. Instead, Citi rushed in to solve a problem of its own making.

Citi's Defense

Citi's defense is based partly on procedural grounds. The bank's key rebuttal in its court filings is that no tying occurred because the contract drawn up for the 1989 loan includes a clause permitting the Storeks to assign another remarketing agent.

Lukens points to an earlier clause in the same agreement that assigns Citi as the remarketing agent for the bonds and prohibits the Storeks from making any changes to the agreement without Citi's approval.

It comes down to a case of dueling clauses and legal interpretations. Lukens and the Storeks argue that the earlier clause demonstrates that a tie-in existed. The reply filed by Citi's lawyers argues that the later clause gave the borrowers an out. On the first go-round, the federal judge bought Citi's argument when he dismissed the case. Citi also argues that the statute of limitations on the case has already passed.

The Citi case aside, it's difficult to argue that much blood has been spilled because of credit tie-ins. It may be because IDBs are no longer a large market.

Through the first nine months of this year, there were 287 of these issues worth a total of $1.7 billion, according to Securities Data Corp. of Newark, NJ. Of those, 115 were backed by letters of credit.

Those totals are a tiny fraction of the total municipal bond market, for which there were 10,700 issues during the same period.

Those paltry figures are a steep drop from a decade ago. Back then, the tax law encouraged IDBs, and the market was much larger. For example, in Maine alone more than 100 issues would be floated in a given year, says Tim Agnew, chief executive officer for the Finance Authority of Maine. But then came the 1986 tax reform, which removed most exemptions from IDBs, and the market never recovered.

No News of Tie-ins

Besides running the Maine agency, Agnew is also president of the Council of Development Finance Agencies, a Washington, DC, trade group for municipal bond issuers. In that role, he's one of the people who should be aware of problems with tie-ins. But he hasn't heard of any.

"I've been a member for 20 years, and I've never heard the issue come up," he says. But he also points out that issuers such as his agency aren't likely to be harmed directly by tie-ins. It's the borrowers, the private companies seeking the letters of credit to back the bonds, who are more likely to suffer.

Similarly, there's no evidence of a tying epidemic coming from The Government Finance Officers Association. Members have not brought instances of tying to the group's attention, according to Cathy Spain, the director of its federal liaison center. "It doesn't mean that it's not occurring, but no one has brought it up," she says. Still, Spain is keeping tabs on the issue, and if the situation warrants, she'll bring it before the association.

Even when bankers are careless enough to put a smoking gun in black and white, most people, including customers and regulators, are inclined to look the other way. Until somebody other than an investment banker says, "I've been shot," that isn't going to change.

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