News took a turn for the worse on Monday for J.P. Morgan Chase ( JPM) in its court battle with a group of insurers over the bank's role in a controversial financing deal for Enron. In a potentially pivotal court ruling, a federal judge in Manhattan will allow the insurers to introduce into evidence a series of email messages in which a J.P. Morgan executive refers to its dealings with Enron as a "disguised loan." The judge's decision is a major blow to J.P. Morgan, because the insurers' main contention has been that the bank deceived them into writing a $1 billion insurance policy for the transaction, which was the subject of a heated congressional hearing this summer. The insurers have refused to honor the policy, contending a series of so-called prepay oil and gas transactions involving J.P. Morgan, Enron and offshore company called Mahonia were really "disguised" bank loans to Enron and not actual contracts to transfer energy shipments. And the emails that U.S. District Judge Jed Rakoff is going to permit the insurers to present to the jury -- which began hearing evidence in the case two weeks ago -- would seem to be devastating to J.P. Morgan's legal position. "A reasonable juror could find these emails highly probative of the defendants' central contention that Chase knew the prepays here in issue, when coupled with other aspects allegedly not disclosed to the defendants ... were really loans that were being disguised," the judge said in a 10-page ruling, issued prior to the resumption of testimony in the trial. In one of the emails, a bank executive writes: "Legal says don't list it as a loan." In another, the financing deals with Enron are described this way: "I have asked for a thorough review of disguised loans. I know Commodities, under the heading of'prepaid' has a whole bunch." The person writing the emails was Donald Layton, a senior bank executive, who may be called to testify if the emails are introduced into evidence. If J.P. Morgan were to lose the lawsuit, it would be forced to write off the $1 billion insurance policy as a lost investment and probably take a big charge against earnings. But this legal battle is much more than a dispute over the validity of a $1 billion insurance policy.
Already in many investors' minds, the Mahonia transactions have tarnished J.P. Morgan's reputation and raised questions about the bank's risk-management strategies and corporate governance procedures. This summer, lawmakers on Capitol Hill, during a highly publicized Senate subcommittee hearing, denounced the Mahonia deals as "sham" transactions and accused J.P. Morgan of helping Enron improperly inflate its revenues. Indeed, a shareholder already has filed a lawsuit claiming J.P. Morgan's management "irreparably damaged" the bank's reputation by approving the Mahonia transactions. J.P. Morgan also is one of the leading defendants in the massive class-action suit filed by Enron's shareholders. And the bank also faces other shareholder suits stemming from the sharp drop in its stock earlier this year after the Mahonia transactions first came to light.