| SIENA, Italy
SIENA, Italy Monte dei Paschi struck a last-minute, secret deal with Bank of New York that allowed the Italian bank to mislead authorities and smoothed through its acquisition of rival Antonveneta, according to a report by the financial police in Italy.
A deepening fraud and bribery scandal at the country's third largest bank has caused a political outcry ahead of a parliamentary election on February 24-25, with the Bank of Italy under fire over suspected financial irregularities at the Tuscan institution.
Monte dei Paschi's (BMPS.MI) 9-billion euro purchase of Antonveneta in 2008 precipitated an eventual state bailout and prosecutors in its home city of Siena are probing whether it deliberately overpaid and whether bribery was involved.
Monte dei Paschi's current management have said they have found no evidence of bribery.
In a report by Italy's financial police provided to prosecutors for their investigation and reviewed by Reuters, the police say that Monte dei Paschi granted Bank of New York (BK.N) an indemnity in return for investor approval to change the terms of a 1-billion euro hybrid financial instrument.
It did not disclose the indemnity to the Bank of Italy.
The Bank of New York did not want to be liable for coupon payments if some of the noteholders refused to agree to the change in the terms of the notes.
There is no suggestion in the police documents of any wrongdoing on the part of Bank of New York. But the success of Monte dei Paschi's bid for Antonveneta rested partly on the deal, known as FRESH 2008, raising the money it needed to acquire Antonveneta.
Convertible into Monte dei Paschi shares, the FRESH 2008 notes were sold by U.S. bank JP Morgan (JPM.N) to a number of investors, with Bank of New York (BK.N) acting as an intermediary.
The Bank of Italy had initially raised objections about the FRESH operation, saying that in its original form it was too similar to a bond, rather than a hybrid equity instrument and could therefore not be counted as core capital, according to Bank of Italy documents seen by Reuters.
In an internal email cited in the document, Monte dei Paschi's then head of treasury and capital management, Massimo Molinari, accused Bank of New York of behaving like "pirates" and complained about having to use "innovative" constructions to help Monte dei Paschi's capital position.
"From my point of view, I assure you I can't wait for the time when this bank will have such a capital position that it does not need to resort to these innovative ‘legal/financial constructions', my blood pressure would be better off."
The Bank of Italy demanded changes to ensure that if Monte dei Paschi made no profit, it would not have to pay coupons to JP Morgan or the investors in FRESH 2008. Paying coupons in such a scenario would mean the instrument was more like a bond so that Monte dei Paschi could not count it as core capital.
The effort by Bank of New York to seek an indemnity to protect investment returns is not illegal but the internal police documents say that the secret indemnity deal violated the conditions set by the Bank of Italy by placing the financial burden of coupon payments back on Monte dei Paschi rather than JP Morgan or a third party.
If proved correct, Monte dei Paschi may not have met the Bank of Italy's capital requirements and should not have been able to buy Antonveneta.
Monte dei Paschi declined to comment.
Reuters has not seen the indemnity agreement given to Bank of New York.
In his email, Molinari said that the Bank of New York had threatened to suspend a meeting called to approve the changes to the terms of the notes unless they were given an indemnity letter relieving Bank of New York from any obligations towards the note-holders.
The financial police allege that Bank of New York made the demand after one of the FRESH 2008 investors, Swiss hedge fund Jabre Capital Partners SA, complained about the changes demanded by the Bank of Italy.
A spokesman for Bank of New York in London said: "We understand from recent media coverage that there are ongoing investigations in Italy into the role of MPS (Monte dei Paschi) in the deal. In the circumstances we believe it would be inappropriate to make any statement or comment".
Jabre Capital did not return calls or respond to emails seeking comment. Molinari referred all queries to Monte dei Paschi's press office, which declined to comment. JP Morgan declined to comment.
In a March 12, 2009 email to Raffaele Rizzi, former head of legal compliance at Monte dei Paschi, Molinari describes the indemnity as the "lesser evil" to losing the investment.
The email was included in the police report reviewed by Reuters.
"Dear Raffaele, I am forwarding for cc the indemnity that in the end I gave to BoNY (Bank of New York)," the e-mail is quoted as saying.
"I know you disagreed about the specifics, but at 13:57 with the meeting due at 14:00 and the note-holders already there, BoNY would not start the meeting if this point was not resolved."
"The necessity for indemnities was presented to us only after the Jabre complaints and not as a pre-condition to start the meeting procedure. To hold a meeting hostage seems to me the behaviour of 'pirates' rather than professionals."
Molinari continues: "I have judged ... that the ‘lesser evil' for BMPS (Monte dei Paschi) is the indemnity, given that I would have not been able to obtain the approval of the note-holders on a second occasion."
"I am convinced that giving 'cover' to the broker BoNY for those who voted no and for Jabre does not worsen the situation too much for an operation that you already think could give rise to many legal problems."
Rizzi declined to comment.
It was not clear if any investor benefited from the alleged indemnity agreement.
The Monte dei Paschi foundation, the bank's biggest shareholder, subscribed to about half of the FRESH 2008 issue, or 490 million euros, running up big debts of its own to do so.
Its 2011 accounts show that it booked a loss of 376 million euros on the FRESH operation. A source with direct knowledge of the matter said the foundation had not benefited from the indemnity agreement.
(Editing by Carmel Crimmins)