Enron

My semi-defense of Enron is now out, in this weeks’ New Yorker.
   
And here is the link  to Jonathan Macey’s wonderful law review article on the Enron case, which was my inspiration for the piece.

I also have a minor challenge for aficionados of the Enron case.

Years ago, when I was at the Washington Post, one of my colleagues on the science desk—Bill Booth—called up a dozen or so Nobel Laureates in physics and asked them to explain, in plain language, the nature and significance of the Higgs Boson atomic particle. None of them could. This was at a time, mind you, when the physics community was arguing passionately for the construction of a multi-billion dollar particle accelerator to look for things like the Higgs Boson.  So it wasn’t for lack of interest. They were gung-ho for nailing the Higgs Boson. They just couldn’t explain the Higgs Boson.

Can anyone explain—in plain language—what it is Jeff Skilling and Co. did wrong?

I’m not asking for an explanation for what they did wrong as businessmen. That’s plain. They did a mountain of stupid and arrogant things. Nor is this about what Skilling and company did that was unethical or in bad faith. There’s a mountain of evidence on that too. The question is strictly a legal one: according to the way the accounting rules were written at the time, what specific transgressions were Skilling guilty of that merited twenty-four years in prison? For the sake of argument, let’s stipulate that summaries must be three sentences or less.

When I was reporting the piece, I tried to get someone to answer this question. But everything ended up very Higgs Bosonian.

Comments

[Ernie Fazio]

Fastow had set up a series of partnerships that ran afoul of SEC regulations and served to prop up the value of Enron stock while masking the huge losses. Fastow testified that Skilling had knowledge of and authorized these transactions. Enron energy traders during the summer of 2000 encouraged producers of energy to go off line, to go into maintenance, to generally cease to provide needed energy to the grid thus escalating prices and forcing purchasers to purchase at greatly inflated prices. The collusion between trader and producer defrauded the public and caused the state of California to lose billions of dollars in order to forstall a crisis. This fabricated energy crisis was criminal. Skilling either authorized it or supported and encouraged it. The link between Enron and the deregulated bill that passed in CA was clear. Enough or do I not understand the question?

[Malcolm Gladwell]

Hmmm. In response to Fazio: let's just take your phrase "that ran afoul of SEC regulations and served to prop up the value of Enron stock while masking the huge losses." My understanding is that a) its not entirely clear how those outside partnerships ran afoul of SEC rules, except in the matter of the 3 percent outside equity interest and b) that using partnerships to prop up the value of your stock and mask losses may be ethically dubious but wasn't--at the time, anyway--illegal. But then again, I may be wrong. The point is that even that simple phrase is arguable and complex and not nearly as straightforward as it sounds. Plus, you went over three sentences. (Just kidding)

[Paul Lightfoot]

Treating debt as revenue violates GAAP accounting rules (puts stuff in the revenue line of the income statement, when it really belongs in the cash flow and balance sheet statements). That's what I believe the partnerships were doing essentially. They kept borrowing money and treating it like revenue. That's the illegal and unethical act. It constituted fraud.

The damage occurred because wall street values companies based on their revenues, so the stock price ran up based on the fraud. They profited from the run up.

I can't remember the exact part of the '33 or '34 act (been a long time since law school), but I'm pretty sure the SEC properly gets excited when people run up a stock with fraud and make money at the same time.

[David Jacobs]

Here's two sentences:

They were operating as if they were a trading company or an investment bake, while enjoying the accounting benefits/tax loopholes of an energy company. Additionally, the trades and investments they were making were done so fraudulently.

[Paul Lightfoot]

There is nothing illegal about using special purpose entities (early in my career I was a lawyer at a big wall street firm and did lots of deals w/ SPEs). You can put debt on SPEs in many instances in ways that the rating companies, lenders and my mother think would be fine (check out the asset-backed securities market or commercial paper market for lots of examples that do our economy good and are wholesome). Don't get hung up on the SPE angle, which was just a vehicle for the bad stuff.

Treating debt as revenue, or anything that is not revenue as revenue, is accounting fraud. If nobody gets hurt, it doesn't perhaps matter. If it runs up the stock, you should go to jail.

Plain example: If I own two companies, and CO1 loans money to CO2, and CO2 treats the cash infusion as revenue, that's a mis-characterization, even if both CO1 and CO2 are legal businesses engaged in otherwise legal activities.

The debt they treated as revenue, by the way, was pretty obviously not revenue. Fails the smell test.

Lock them up.

[Petey]

Just because you can't explain something to a layman in three sentences or less doesn't mean it's not real.

[Silverbrow]

I don't understand how no-one, not even the research analysts, noted that the enormous revenues didn't tally with the tax - or lack thereof - that the company was paying. It seems an astounding oversight.

[Max Roswell]

They constructed financial schemes so flawed as to be criminal and passed them off to their investors as legitimate and profitable. People invested based on that representation, and when it fell apart, those investors suffered devastating losses while the executives in question made a few million bucks.

That's my understanding, anyway. There's probably a few thousand former Enron employees with busted bank accounts, futures and relationships that would probably be willing to explain it in more detail.

[Will]

Right on Petey. Just because there's some esoteric accounting involved doesn't make what Skilling & Co. did any less criminal... I'm thinking of the scene from "The Smartest Guys in the Room" when Skilling goes up to the podium and advises everyone in the company to buy Enron stock with their 401ks even as he, Lay and Fastow were selling their positions. Shouldn't there be an expectation of adherence to the spirit of, rather than just the letter of the law? I'd say whatever accounting rules they might or might not have broken, they certainly weren't acting in good faith or in the spirit of the law.

[Tanya]

Why it's fraud:
They made fake trades and called it profit. They took in capital and called it profit. They hid their liabilities in "other" organizations.

That's my three sentences; I guess I'm done. : )

If you want to know why it had the emotional outrage associated with it, that's a whole other question.

[Rick James]

What crime did they commit that warranted such time? I'll boil it to three words:

They were born.

[JK]

Wouldn't the way to find the answer be to check out the court documents? I'm not sure what you expect to gain from a necessarily-vague three sentences.

You're a reporter -- dig through the docs!

[Aidan Kehoe]

> Just because you can't explain something to a layman in three sentences or less doesn't mean it's not real.

No-one gave the impression they believed such a thing. It seems to be Malcolm’s experience—it is mine—that superfically obscure things can be explained clearly and accurately if someone sufficiently articulate does it. Paul Lightfoot’s second comment works for me as such an explanation.

[harryh]

I think it's also important to note that anyone that had their retirement savings destroyed when Enron collapsed was clearly guilty of mismanaging their own funds. Anyone who has their savings tied up in a single company is clearly behaving foolishly.

[Christopher]

Departing a bit from the ENRON topic, but keeping with the puzzle v. mystery spirit of the rest of the piece, I'm curious as to what K-Street mystery-solvers we have examining the 'propoganda' that Al-Qaeda releases every so often in their tapes. Are there any noticable trends or signs that we are missing? (My suspicion is that there probably are)
I'm sure that there are hundreds or thousands of people scrutinizing each message as it comes out. In what ways is identifying a super-threat by Bin laden and co. different from identifying the super-weapon that the German's claimed to have in 1943? I'm sure that there are plenty of differences - far less frequent messages, varying sources, etc. - but what they're up to remains a mystery...

[Malcolm Gladwell]

Re Petey's comment. I'm not at all denying that crimes might have taken place at Enron. I'm just curious--along the lines of the argument laid out out in my article--how simply the case against Enron can be represented. (I like Lightfoot's attempt. But I'm guessing that there are a lot of accountants who would insist it is too simplistic). It strikes me that we're not very good at dealing with problems that do not permit straightforward explanation. Ask the physicists who tried to get funding for the particle accelerator.

[Chris]

Malcolm, if you do find out an answer, post it in your blog

[David]

Fraud. Multiple counts. The Enron/Blockbuster deal: booking revenues from a joint venture that had zero income. The fake trading floor, designed to deceive visiting analysts, with employees pretending to execute energy trades.

The flaw in the question is the implication that only violations of accounting rules should be considered at sentencing.

[Chad Helton]

Just in response to your Higgs Boson part of the article.
It's so important because we *don't* know exactly what it is.
We wouldn't have any modern technology from penicillin to computers if someone didn't ask the question "why"?

[Paul Lightfoot]

Particle accelerators got funded. Lay is dead and Skilling is in jail.

People found a way to express those complicated conepts in a sufficiently simple way.

One of my favorite quotes about the value of simplicity (from Enstein):

"Everything should be made as simple as possible, but not simpler."

One of my favorite quotes about accounting (from Warren Buffet):

"Managers thinking about accounting issues should never forget one of Abraham Lincoln's favorite riddles: "How many legs does a dog have if you call his tail a leg?" The answer: `Four, because calling a tail a leg does not make it a leg'."

[Oran Kelley]

Have you read much on Enron?

Someone here spells the crimes out for you, you write "I am not convinced."

What do you need to be convinced of exactly. Your initial question has been answered, as far as I can see. If you think not, you should hone your question, because I can't see what it is you are unconvinced of.

A lot of times the inability of experts to come up with answers is a function of others' inability to come up with actual questions.

[Brad DeLong]

Jeff Skilling and his co-conspirators falsified the accounts of ENRON for 1998, 1999, 2000, and 2001 in order to persuade investors it was a well-run, profitable company and so boost its stock price.

[David]

I can't beat Prof. DeLong's concision, but the point I tried to make above is that the crimes of Skilling & Co. go beyond just "falsified accounts."

[Paul Lightfoot]

This topic is killing my productivity for the afternoon. I'm going to get back to work after this post, BUT...

I just skimmed the New Yorker article and see that you and I saw some of the big picture of the story differently.

First, the data was there, but NOT WHERE IT WAS SUPPOSED TO BE. The income statement had bad data in it. Just because someone could figure it out by spending a month talking to professors and running spreadsheets doesn't mean that "all the information was there." Some of the information was obscured by fraud in the income statement and the balance sheet. The dudes didn't get on a plane to Dallas to tell the whole truth to Weil; instead they went and mislead Weil. Fraud!

Second, the use of SPEs wasn't really the smoking gun. SPEs are not prima facie evidence of wrongdoing. It was what the SPEs DID that was wrong. They called things revenue that were not revenue. Who cares about SPEs. We need to go the GAAP definition of revenue and compare their activities to that definition.

You state: "But you can’t blame Enron for covering up the existence of its side deals. It didn’t; it disclosed them." I disagree; I CAN blame them because they DID not disclose the actual stuff that mattered. Sure, they disclosed the SPEs, but they disclosed REVENUE from the SPEs, when they weren't getting revenue. That's not disclosure, that's fraud. We didn't need Enron to tell us about all the SPEs, we needed them to tell us whether or not certain transactions were revenue.

This might actually be a puzzle after all. Share with us the new piece information regarding what wasn't revenue that shows up on the income statement as revenue, and this whole things looks a lot more clear.

I'm also not sure I believe that SPEs are by their nature difficult. I'm going to have a banker friend post his thoughts on that matter next.

[Martin]

I always think of Terrell Owens. Last year when he was on the Eagles, there was about three weeks where almost every NFL fan was ready to have him excommunicated from the league -- or worse. I would ask people, "Tell me his crimes, what did he actually do?" And they would give me a rather paltry list about his being a bad influence in the clubhouse and disrespecting the coach. Not good things, certainly, but not exactly on the level of, say, shaving points or flagrant late hits or something. But T.O. had that magic capacity of pissing everyone off that it didn't matter what he had actually done.