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

[sean]

Investor fraud. Their financial statements did not accurately reflect the financial position of their company. It is illegal for a publicly traded company to deceive the public regarding the financial position of the company. How can you defend these guys?

[sean]

Terrell Owens publicly criticized his teammates and screamed at players and coaches on the sidelines. Is that not bad enough for you? Should people like him for that?

[Martin]

Sean, my point was that he was treated roughly as if he had punched a ref during a game. He was front-page news for weeks and weeks. I agree the guy's a horse's ass, but the ratio of furor to actual badness of acts was not reasonable.

[David]

But Terrell Owens was never convicted of 29 criminal counts of fraud and conspiracy, so I don't see why you "always think of" him when you think of Enron.

[Dan]

He ruined the lives of several hundred Enron employess by lying. There, only one sentence. He deserves everything he gets and more.

[R. Williams]

Malcolm, in your article you write of the SPEs:

"The company would make the deals work . . . by guaranteeing that, if whatever they had to sell declined in value, Enron would make up the difference with its own stock."

This is (and was) illegal. Enron was capitalizing the SPEs with its own stock, and using that to generate income. That's illegal. The fact that a number of the SPEs did not have 3% outside ownership, and that Enron controlled the disposition of the SPEs' assets, was also illegal. Not "legally questionable," but illegal.

And to the point of your article, this was not information that was disclosed to the public. In fact, the non-existence of the outside investors and the promises that Skilling and Causey made to Fastow guaranteeing the SPEs against loss were very carefully hidden from investors. That's why it was fraud. And it's why Enron was not a mystery, but a puzzle.

[Dan]

PS. The Higgs Boson is a theoretical elementary particle, one of the tiny parts of subatomic particles. The proof of it's existence would explain some of the phenomena of quantum physics and could lead to new discoveries in chemistry and nuclear physics.

[Martin]

To sean: Jeremy Shockey does those things all the time as well. I don't see any comparable outcry. Also, the previous season T.O. had performed very well in the Super Bowl despite being seriously injured -- why doesn't that count?

To David: I "always" think of T.O. when I think of emotional public overreaction to things. (Is that okay with you?) And yes, he wasn't convicted etc., but if the Eagles had acted to void his contract at that moment, the NFL fan base would have supported the act, probably.

Either the T.O. example serves to clarify what's at stake in Malcolm's piece, or it doesn't. If you reject the analogy, fine -- I don't. Indeed, I think one of the reasons people got so mad at T.O. was that he *hadn't* really broken any rules -- if he had, he would have been punished more conventionally and people would have been calmer about it. Similarly, perhaps the problem with Enron isn't so much that they broke the rules but that they followed the rules for the most part (and still did so much damage). But that's just me spitballing (is that okay?).

[Dan]

David said,
"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."

I said,
"He ruined the lives of several hundred Enron employess by lying."

I like the way I put it better, but David, you have summed it up nice and succinct.

[David]

Martin: No problem buddy. I might just keep pointing out that your T.O. story is totally irrelevant unless you already accept the original premise, which means it's not an analogy. (Is that okay?)

[David]

Dan: Actually that was Paul Lightfoot you quoted.

[John]

Along with Fastow he put millions of dollars of Enron money in outside partnerships that he controlled and from which he made millions of dollars while Enron lost. He had a legal fiduciary responsibility to Enron. He took steps to conceal his involvement in these partnerships. Doesn't that meet the basic definition of Fraud?

[sean]

1) I have never seen footage of Jeremy Shockey screaming at coach on the sidelines.

2) I have never read a public statement from Jeremy Shockey criticizing Eli Manning.

3) Jeremy Shockey has never demanded a trade and then dictated which team he was traded to.

4) Jeremy Shockey is not on ESPN 2 hours a day and is not a publicity hound like TO.

It is not the same at all. And it is not the same with Enron either. Are you saying that people shouldn't have been outraged by the Enron scandal? That is wasn't that big of a deal?

[Brad DeLong]

RE: '[T]he crimes of Skilling & Co. go beyond just "falsified accounts." Posted by: David'

You're right, of course.

[Andrew Lark]

They invented revenue where there was none against the specific and legal definition of what revenue is. The lied about their business performance, hiding failings and inventing success. They then deliberately destroyed the evidence.

[Brad DeLong]

*Sigh*

RE: "I'm not convinced! As I understand it, the accounting rules--at the time--allowed companies to 'hide' debt in special purpose entities. Only the IRS considered those transactions as loans. And Enron's use of mark to market accounting was specifically approved by the SEC, back in the early 1990's."

Malcolm, you've gotten yourself into a hole and you are digging yourself in deeper. I'd recommend that you'd stop.

Accounting rules allowed corporations to *offload* debt and its associated risk to SPEs, not hide it in SPEs. The requirements that there be third-party investors in the SPE and that they be genuinely at risk are ways of distinguishing SPE transactions that are legitimate from those that are accounting fraud.

Mark-to-market accounting means that you are allowed to value your *tradeable* assets at the value that you could sell them to a genuine third-party buyer today. It doesn't mean that you can fraudulently misstate assets as being worth much more than any genuine third-party buyer today.

I think your basic problem is that you have discovered that there are ways of doing accounts that mislead but that are not criminal accounting fraud, and you have jumped from that to the conclusion that it is unfair to send people to jail for doing things that are criminal accounting fraud.

Yours,

Brad DeLong

P.S.: Wikipedia has a good short article on the Higgs boson that answers your other question.

[Killian Tobin]

Just had to pipe in here but not being an Enron expert here is my take:
1)Enron used their entangled shell companies to monopolize certain energy markets by faking shortages. IMO the worst of their crimes becuase of the unnecessary hardships and fake energy economy that sprung up.
2)Enron executives falsified the financial state of the company by lying to the SEC/investors/employees.

[Malcolm Gladwell]

Re: Brad deLong. Please don't misunderstand my position. I'm not saying that Skilling doesn't belong in jail. I have no idea, either way, which is why in my article I didn't address the legal particulars of the case against the companh's officers, and chose instead to focus on the disclosure paradigm. My point is simply this. That in talking to accountants and legal experts, the thing tht struck me was how difficult it was for them to characterize the precise nature of the company's malfeasance. There's an awful lot of gray here, in other words. I think that even you acknowledge that, when you say--"there are ways of doing accounts that mislead but that are not criminal accounting fraud."

It's that difficulty and ambiguity that interests me, because it strikes me as perfectly characteristic of "modern" public policy problems. That's why I chose to comnpare Enron to Watergate, which strikes me as very characteristic of the earlier, simpler paradigm of institutional wrongdong.

[Rama]

Seriously brilliant idea and a provocative post to boot.

Policy issues are rarely understood, let alone, fully envisioned by no more than a few geniuses.

The rest all is how you sell it and make people emotionally connect to it.

My 2c.

[Robert Jennings]

Malcolm:
I executed SPE's and off balance sheet loans and synthetic leases for many of the Fortune 50 for years. In every deal the accountants would ask:
1) Is the equity true third party equity?
2) Is the equity at risk?
and the good accountants would ask
3) Are there any guarantees or credit support agreements protecting the equity?
For practitioners (and Enron was a practitioner) none of this was vague or confusing or difficult to understand and if you lied to the accountants then you were committing fraud. So maybe life is more complicated and maybe the man on the street has problems with boson and quarks and SPE's but the issue about Enron is not a Higgs Boson question, it is a speed limit question and for any accountant who had the facts Enron was clearly speeding.

[R. Williams]

Malcolm, I think Robert Jennings' comment makes the point succinctly. There actually isn't "an awful lot of gray" about Enron anymore. We know that the equity in many of the SPEs was not true third-party equity, that the equity was not at risk, and that there were guarantees from Enron's management to Fastow protecting the SPEs against loss. We also know that Enron did not disclose these facts, and that therefore its management was committing fraud.

Now, the interesting thing is that we didn't know all of these things in the late 1990s or early 2000. You could read the financial statements (as the Cornell students, or Chanos, did) and figure out that something seemed not right. You could even figure out, perhaps, that Enron wasn't a good investment. But you couldn't figure out that its managers were criminals, precisely because the information you would have needed to figure that out -- that there weren't real outside investors, that the SPEs were actually controlled by Enron, and that Enron had promised to make good on any losses -- was hidden.

You argue that Enron and Watergate are radically different, and obviously in some ways they are. But if, in 2000, an Enron Deep Throat had appeared, and told a WSJ reporter that the Raptor SPE did not have any real outside investors, that the decisions about what that SPE would do were made by Enron's management, and that Jeff Skilling had made a secret promise to the head of the SPE (who happened to be Enron's CFO) that Enron would make good on any of the SPE's losses, I'm pretty sure that would have blown the whole charade to pieces, much as Deep Throat's revelations did to the Nixon White House.

[Dr. No]

Enron sold assets to investors, booking revenues and profit. The sales, however, were in truth loans, Enron having secretly promised to repurchase the assets from the investors at a future date. Thus the booking of revenues and profits from these transactions was fraudulent.

For example:
http://www.washingtonpost.com/wp-dyn/articles/A38336-2004Nov9.html

[Brad DeLong]

Dear Malcolm:

You rip my words badly out of context when you write: "There's an awful lot of gray here, in other words. I think that even you acknowledge that, when you say--'there are ways of doing accounts that mislead but that are not criminal accounting fraud'."

I do not acknowledge that there is grey here. Enron did its accounts in ways that misled, and that were criminal accounting fraud. No grey about whether they were misleading. No grey about whether they were fraudulent. That there is a grey area in which accounts are misleading but not fraudulent does not mean that Enron was in that grey area. It wasn't.

Robert Jennings has it right when he writes: "For practitioners (and Enron was a practitioner) none of this was vague or confusing or difficult to understand and if you lied to the accountants then you were committing fraud."

IIRC, Skilling's defense was not that Enron did not commit fraud. It was that Fastow was the mastermind, and that he, Skilling, was an ignorant dupe.

You're in a hole. Stop digging.

[Michael Rubin]

Malcolm, you are guilty of oversimplification.

It is not the accounting methodology that was inherently illegal. It was not even the way they created over 3,000 SPEs, mostly offshore and hid a great deal of debt within the SPEs.

It is the fact that they hid the debt and presented the debt as earnings to shareholders in public statements, in employee meetings and in shareholder meetings.

In this case, the deficit is lesser than the parts...so to speak.

The information was there in the balance sheet, but the story surrounding the information was falsified. The purpose of the accounting was to hide the truth.

So you may be correct that they followed GAAP, however the GAAP was exploited and the message manipulated by the leadership (Fastow, Lay, Skilling, et al). And there lies the rub-you can't make forward looking statements that are false according to the SEC. And you can't use your books to hide debt or earnings without eventually stating them correctly and accurately.
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Also, the problem of what would happen in Iraq after the toppling of Saddam Hussein was NOT a mystery. Replay some of the Sunday morning television political pundits prior to the invasion of Iraw and MANY stated that the war itself would be short, Saddam would go into hiding, along with his retreating armies who would return and fight as civilians in a guerrilla war. No mystery there-just most people failed to listen to the predictions.

[Maynard Handley]

"My point is simply this. That in talking to accountants and legal experts, the thing tht struck me was how difficult it was for them to characterize the precise nature of the company's malfeasance. "

So your issue, then, is about language and understanding? And the answer is, essentially
(1) to explain anything, you need a prior set of ideas and words for those ideas
(2) to explain something in three sentences, the gap between those ideas and the priors you are using cannot be too large and
(3) for things that are not part of standard public discourse, the fact is that that gap is larger than three sentences.

This is simply a fact of life. The pool of world knowledge is massive, the pool of expected general knowledge a whole lot smaller.
Could you explain the internet satisfactorily in three sentences to someone from the 1950s? From the 1850s? From the 1750s?
What has changed is partially the language (you will need to use up one of your 1850 sentences describing electrical computers and networks; for 1750 you have to start off describing electricity)
but also the set of ideas we all take for granted.

You are assuming that accountancy is such a trivial occupation that what its practioners do really involves no intricate concepts beyond everyday life. You are likewise assuming the same for physicists. Both of these are clearly wrong assumptions.

Of course one can explain, at a vague level, Enron
(they claimed income where there was none) or Higgs (it explains the reason why the weak interaction is weak; which ultimately explains why certain forms of radioactivity occur as slowly as they do). But you've indicated a dissatisfaction with both of these --- you want to know the details in both cases, but you still assume those details reduce pretty simply to the pool of everyday assumed knowledge. Not a good assumption.

Or, let's take a different example. I know nothing about basketball, but you seem to be very interested in it. If Matthew Yglesias lists his fantasy basketball team and gives three sentences justifying it, there is presumably a meaningful exchange of data going on between the two of you because you are using a pool of shared words and ideas. He cannot do the same with me apart from some lame words along the lines of "you need a guy who is good at attacking, and you need two guys who are good at blocking everyone else from stopping your attacking guy" because none of the basketball vocab he wants to use mean anything to me --- I know there are people called forwards, but I've no idea what they do. I know there are multiple people in a basketball team, but I've no idea how many. I know you're supposed to get the ball into the basket, but I've no idea what the rules are that make this a difficult problem, and how the guys on the other side are allowed to stop you from doing this.

Bottom line: the world is that experts are experts for a reason --- they know all sorts of finicky details that you and I don't. Asking for a three sentence explanation is going to be unsatisfactory. Asking for a three page explanation can probably me made a lot more satisfactory, but writing such a document is very difficult, since it requires a very careful unravelling of one's tacit knowledge so as to lead the reader from the starting point to the desired endpoint, giving all the relevant concepts along the way, but not distracting him with irrrelevant side issues. The fact that most people (accountants or physicists) are incapable of providing such summaries, certainly with no notice, and frequently even after trying for a week or two to do so, tells us that most people are lousy teachers, but that's all it tells us.