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

[Christopher Horn]

The question should *not* be "What did Enron's managers do wrong?" To accounting professionals this is undoubtedly obvious, as several have explained in some detail above.

The more pertinent question might be "Why must the mass media trivialize the descriptions of Enron crimes?"

The GAAP implications are a bit complex sure, and the whole sordid story is somewhat similar in a way to how Oliver Wendell Holmes described pornography ("I know it when I see it").

Still, the fact that one has to dive into the complexities of accounting regulations in no way mitigates the severe nature of Enron senior managers' actions.

If a dumbed-down description of their misdeeds doesn't inspire appropriate indignation, you may wish to consider what you're reading, as opposed to what you're reading about.

[Martin]

David: Your original phrasing would rule out every possible other analogy, as very few individuals are convicted of 29 criminal counts of fraud and conspiracy. By that logic, every analogy is bad, there are just differing degrees of badness. Since I assume you don't believe that, then you can't be ruling out my analogy on the basis of T.O. not having been convicted of 29 criminal counts of fraud and conspiracy.

Sean: Shockey has ripped his coach publicly (and later apologized) and is often shown on the field waving his arms around impatiently in implicit criticism of his teammates, coaches. I am sure you are right that he has not ripped Manning, so point for you. I think my overall gist is sound, though. If an alien had visited Philadelphia during October 2005 or so and asked what this horrible person T.O. had done, he would have been surprised at how trifling the actual acts were.

But I've made that point several times. Nothing I've said makes either Enron or T.O. to be moral paradigms, just that in each case the attempt to explain the bad acts is more challenging than one would expect.

[Ernunnos]

I just wanted to note the irony of a demand for plain language...

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

...followed by a whole paragraph used to clarify the meaning of "wrong", when we already have a perfectly good single word for legal, rather than moral, or ethical transgressions.

"Crime".

You want plain talk, use plain talk.

[rone]

It can be easily argued that not all crimes are wrong. But at this point, we're going to drift into semantics sumo.

[David]

Martin: It's only false analogies like yours that are bad, not all analogies.

Can't you see that no matter how much you "prove" that T.O. was judged too harshly, it adds nothing to the question of whether Skilling was?

[Annonymous]

Mr. Gladwell hasn’t dug himself a hole. What he appears to be trying to do is extract himself from the one dug by those who rushed to judgment without ever having bothered much with the facts. I suggest that everyone, not just Mr. Gladwell – who appears already to be doing so – go back to the trial record.

Thus, regarding the alleged use of SPEs to mistreat debt as revenue, at Skilling’s trial only two tiny 1999 transactions – the $11.3 million purchase by LJM1 of an interest in the Cuiaba power project and the $7 million purchase by Merrill Lynch of an interest in three power barges in Nigeria – were challenged by the DOJ as not having satisfied the risk-transfer test set forth by Mr. Jennings previously. The basis for that challenge was testimony by Fastow that he had gotten “bear hugs” from Skilling that LJM wouldn’t lose money (i.e. wouldn’t be at risk), but Fastow conceded that even if actually given such hugs they would have been unenforceable.

And about the significance of the SPE issue at Skilling’s trial in general, the real mud the DOJ threw around was the allegation that Enron was hiding huge amounts of earnings, not manufacturing them. Try reconciling that with the overwhelming nature of the above responses to Mr. Gladwell’s query. Moreover, Mr. Weil and his progeny’s criticism of Enron’s use of MTM accounting is flawed as among other things it doesn’t take in to consideration the significance of Enron having kept its trading portfolio essentially in balance. Prof. Fleischer’s superficial tax analysis and his hypothesis, made all the way back in February 2002, that Enron “didn’t have any income” haven’t survived scrutiny and certainly weren’t issues at trial. The “fake” trading floor was the invention of now discredited Dow Jones reporter Jason Leopold, and again was not raised at trial. Nor was the allegation that Enron “fabricated” an energy crisis in California an issue there.

I could go on and on, but have exceeded my three sentences.

[Paul Lightfoot]

An additional thought: Companies with good businesses generally don't spend a lot of time defending complicated accounting. Ask Warren Buffet if any of his businesses have complicated accounting issues that nobody understands and I think he'll say no. When my managers start talking about accounting in response to a question about performance, I know that the real problem isn't accounting, it is that they are having a hard time and are looking to dodge accountability. Real companies sell stuff and get paid for it. The accounting merely "accounts for" the actions of selling and getting paid. If you run across a company whose "secret sauce" is in complicated accounting, run from it.

[TNLNYC]

How about:

"The executives misled investors about the financial situation of the company."

This would clearly be in violation of SEC rules. If you take a look at the 2000 annual report for the company, you will find a very optimistic investor note from Skilling and Lay (I think they are claiming to be "outpacing the competition") at the front of the report.

If you look at the financials in the same report, you will notice that most of the numbers they quote in their investor note are not appearing in the financials.

Similarly, if you look at the year-on-year cashflow position of the company, you will see decreasing cash flow. You could also calculate net margins with the data they provide and notice a company that is seriously failing.

So, notwithstanding all the fraud that was exposed afterward, the financials of the company showed a company that was probably 6 to 18 months from completely going under. Yet, the executives of the company made public statements that were not in line with that picture.

Actually, an interesting thing I've heard is that many funds were visited after Enron failed because they had been shorting the company all along. The SEC suspected they had had insider information and was looking into the problem. Turns out that most of the funds actually had done their homework against the publicly available financials instead of listening to Enron executives and they saw a company that was already in shambles.

[Martin]

David: OK, so then you and I are having a disagreement about the scope of this discussion; IMO you want to restrict it to an absurd extent. If I don't agree that interest here is limited to the narrow question of Skilling's guilt (which I don't), then your objections become entirely moot. Do you deny that Malcolm is making a broader point about the way we think about guilt in our society? About scapegoats and the role of the media in assigning culpability? Why can't we address that as well?

Note also that my other interlocutor here has not agreed with my premise, so whatever else I'm doing, I'm not beating a dead horse. Sean would have written "fail to prove" there. I'm not just restating the argument to annoy you.

[Oran Kelley]

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."

You are confusing two issues here: the fact that experts may have a difficult time quickly explaining the crime here does not mean that there is a lot of gray here.

If someone points a gun at my head and tells me he is going to kill me with it, his inability to explain quickly how the gun will hurl a projectile through my head does not mean that there is any gray here regarding its potential lethality. It just means he can't make me understand how a gun works.

As far as the gray of accounting laws go, there is gray there, Enron was clearly way past the gray zone on this. They put fake deals into there quarterly reports, they set up fake entities (entities with no outside investors at risk, definitional of SPEs) and they used these entities to dress up their reports to keep their stock price up.

That stock was bought by people at what was an inflated price. Executives were rewarded on the basis of that inflated price. When that inflated price collapsed, real people, some of them plain old schmoes, lost lots of money.

Fraud. Plain and simple.

Now if you have specific questions about the accounting rules supposedly broken or whether they were broken, ask them.

[sean]

Martin: First, I don't get your analogy. I understand that you think TO was unfairly treated in relation to his "crimes." So, are you saying that if an alien dropped into Texas and I laid out the list of things that Skilling had done (lied about financials, screwed his own employees and millions of outside investors out of billions of dollars, all the while making himself rich)that this "alien" would just shrug and say "that's all?" I think you are wrong.

Sailer: you are missing the point. what malcolm is saying is that we know osama is somewhere, we just need to put the pieces together to find him, which is like a puzzle. there is a definite right answer once everything is in place. however, no one knew what would happen in iraq, people may have guessed, but no one knew for certain, there was no exact answer, so it was a mystery. there was no correct outcome like a puzzle. got it?

[Oran Kelley]

On the T.O. analogy:

It would seem to me to be incumbent on Martin to explain what he thinks went wrong last year with T.O. and the Eagles. Everything went fine in 2004, so what was the big problem?

The story the team presented was that he caused absolutely maximal disruption to the team because he wanted a new contract. None of this was "criminal" but he wasn't sent to prison, either.

If you want an explanation of TO "hoopla," well we're going to have to develop a generalized theory of hoopla to account for all the idiotic things people preoccupy themselves with.

It doesn't have anythings at all to do with Skilling. You might as well bring up the Dreyfus Affair or Sacco and Vanzetti. It just doesn't apply unless you are already a Skilling apologist.

[Ben]

PBS' Newshour had a great segment explaining this a few years back. The video, "Accounting Alchemy" is easy to follow and is available at http://www.pbs.org/newshour/bb/business/jan-june02/enron_1-22.html

[Ben]

Just to sum up: Watered stock. They artificially pumped up the value of their own stock by selling/giving shares of Enron to a shell company and then reporting the money they should've received (had it been a legit sale) as assets. They made money that didn't exist and never would magically appear. However, this was only the tip of the iceberg, though it's perhaps the easiest to understand.

[David]

Anonymous: Carol Elkin, a former Enron employee, was a named source in the fake trading floor story. Is she an invention too? Can you point us to any correction or retraction of the story by anyone?

Martin: I am not trying to restrict the discussion in any way. I felt you dragged a red herring across the thread and called you on it. If you'd prefer I keep these kinds of opinions to myself, well, I can't promise anything.

[Matt]

Is the purpose of the "three sentence" question/challenge really just to get me to realize that the most terrible aspect of the Enron situation is that - according to current government regulations - the Enron folks actually didn't do anything illegal?
If so, you are a wise and sneaky man - and I'm even more depressed than usual.

[Martin]

To be honest, I think that getting into the 2004 season and so on in that way is precisely what this thread shouldn't be about. The 2004 season is reason to think well of T.O., surely. The guy is a jerk, Skilling is slime, nothing I've said here suggests otherwise. Our mechanisms for policing such things are (correctly) weak. Convicting people on crimes (or infractions of league rules) is hard.

David: Believe it or not, I welcome your opinion. What I don't welcome is categorical rejections of other posts based on arbitrarily narrow criteria of your devising. You still haven't actually addressed anything about the T.O. analogy except that it "doesn't apply" etc.

[David]

Martin: You have me there. This thread should be about T.O. and not Skilling. In fact, Gladwell's article should have been about T.O. and not Skilling. Then we could both enjoy the moment when someone would post, "T.O. always reminds me of Jeff Skilling. . ."

[brad lehman]

"You still haven't actually addressed anything about the T.O. analogy except that it "doesn't apply" etc."

I'll give it a whack. You are right (to my mind) that TO's transgressions were largely trivial, or at least personal in nature. What he was publicly convicted of was being a bad guy. It was an easy story to tell, and an easy one to sell, given the celebrity-personality driven media culture. He is a particularly interesting character, so the story "had legs." Whether you think he was a bad guy on the merits or not, when you ask what he "did" you got an actual, clear answer from almost anybody. He taunts. He criticizes good quarterbacks when he doesn't feel he gets enough touches. Etc Etc.

Enron, on the other hand, was a much harder story to tell, involving GAAP, SPE's, and a host of other terms that are not in our everyday vocabulary. The public did not care one bit about any of the Enron personalities until there was a substantial material impact on the economy and the wallets of many families. But if you ask people what they did, you will get wobbly answers.

In sum:
a) TO's story is simple and personality-driven, leading to oversaturation. Most people can explain why they don't like TO (regardless of how satisfying that explanation seems to you).

b) Enron's story was complex, and not particularly personality driven to start (if Enron never tanked, no one would ever care about Skilling or Fastow). The public knows they did bad things, but have trouble explaining what those bad things were, and tend to rely more on outcomes ("people lost their savings!") rather than actions.

I'm not really seeing a lot of commonality here, let alone analogy.

[Maynard Handley]

"Ask Warren Buffet if any of his businesses have complicated accounting issues that nobody understands and I think he'll say no."

Dude, this is simply not true. Berkshire Hathaway does lots of things, but the serious money comes from insurance. I have read every one of Buffet's annual messages to investors and even in those, where he is trying to simplify things as much as possible, I usually can't figure out what he saying about the insurance business. It's certainly not as simple as "we somehow persuade people to pay us higher premiums that other insurance companies, then we scam by paying them less when things go wrong". The whole thing is based on tax laws (some I think international), shifting profits around, all this technical accounting stuff.

I stand by my earlier (long) post on this subject. The fact is that these matters are complicated, and pretending that they should be reducible to three sentences is a childish world-view that refuses to accept the realities of the modern world.

[David Lloyd-Jones]

I think maybe Malcolm is hitting the point of diminishing returns with his heretofore very successful strategy as a writer.

He's done a very good job in several books of taking a simple observation and wandering up to it with a great deal of intelligence, and a cystalline sense of simplicity, then writing what he things.

The problem with this comes when your elegant simplicity fades off into naivete, and you still try to retail it winsomely.

Enron constructed its separate entities, i.e. without the needed outside 3%. This sounds like a little thing, and this is how Gladwell tries to shrug it off, but in fact it is crucial: is is of the essence that somebody handling a very very large amount of money off the regular books, which may very well be necessary in industries like trading or intermediating, be forced to explain the deal with a straight face to somebody who is then willing to put up a large chunk of separte money, the 3%.

Skilling could not do this, for the very good reasons that a.) most Enron deals were barely profitable, even when legal, so few people would have been willing to take 3% positions with open eyes, and b.) few of he deals were legal in their own rights, as would have been clear immediately to people not blinded by the frat-house atmosphere of Enron's trading rooms.

The inability to meet such scrutiny should have stopped the deals. That is the whole point of the 3% rule.

That Gladwell does not see this is the sign that he has hit the limit of usefulness of his faux-naif style as a writer.

[Greg]

Malcolm, in that article you wrote: "This was one of the most admired companies in the United States, a firm that was then valued by the stock market as the seventh-largest corporation in the country, and there was practically no cash coming into its coffers."

Enron was never even close to being "valued by the stock market as the seventh-largest corporation in the country". At its peak, Enron had a market cap of $65 billion. By contrast, Cisco's market cap peaked around $600 billion, or nearly an order of magnitude greater than Enron's market cap.

That is like saying somebody who hits 5 homeruns a year is one of the seven greatest homerun hitters.

If somebody were talking baseball with you and claimed somebody who hits 5 runs a year is a great homerun hitter, you probably wouldn't take what they say about baseball very seriously.

Likewise, most of the people who talk about Enron have no clue about finances. I don't mean to pick on you, Malcolm, as I really enjoy your writing, but I doubt you'd have written that howler if you knew finances as well as you know sports.

What you meant to say was Enron had the seventh highest REVENUES among US corporations. This statistic itself is very suspect, because Enron's accounting for revenues was as mendacious as their accounting for profits.

But in any case, mistaking revenues for market cap is like mistaking the homerun leader for the leader in stolen bases. Again, if somebody were talking baseball and mistook homeruns for stolen bases, you would not take their baseball opinions seriously.

Most reporters and writers do not know much about financial markets. Therefore they make the most basic mistakes when discussing them. It is no surprise that they cannot explain Enron to the public since they don't even know the difference between revenues and market cap.

If you want a simple explanation, look at Wikipedia: "[Enron] achieved infamy at the end of 2001, when it was revealed that its reported financial condition was sustained mostly by institutionalized, systematic, and creatively planned accounting fraud."

As for the specific things for which Skilling was convicted: "...Skilling was found guilty of 19 out of 28 counts against him, including one count of conspiracy, one count of insider trading (although he was acquitted of the other nine counts of this particular charge), five counts of making false statements to auditors, and twelve counts of securities fraud. Each conviction carries a maximum sentence of 5 to 10 years in prison."

[Angelo]

I like the simple explanation about reporting loans from one part of a company to another as overall profit. (Mr. Gladwell, that explanation is more than just a good attempt. It pretty much answers your question.) Hiding debt to boost stock prices is illegal.

Also, consider me crazy, but if persuading power suppliers in California to turn off power for periods of time in order to boost energy stock prices (as illustrated in the documentary "The Smartest Men in the Room") is legal, then the whole system by which these rules are put in place (through legalized bribery of congressmen) is messed up. But I don't think it is legal. That's price manipulation. (The invisible guiding hand of the free market isn't so invisible, it seems.)

Frankly, I'm fed up with this whole system that skews in favor of "corporate entities" over the rights of everyday people. I've been screwed by these types of "laws" to the tune of $9,000 back in 2002 when I was told that the corporate entity no longer exists while the owners of the company were able to "reconstitute" three week later by freeing themselves of "unsecured lenders" like me (who worked for them for two months on a freelance contract), but now I digress.

Frankly, people like Skilling don't deserve your attempts to "semi-defend" them. It's cute, just like when you said you can't talk to an Okie pleb without talking football. . . typically condescending.

[Malcolm Gladwell]

Good grief! Those last few posts are just a little grouchy, don't you think? My question, I thought, was a simple one. I wrote about the inherent complexity of Enron's business affairs. I wondered if the criminal case against Enron was similarly complex. So I thought I would ask if anyone could come up with a parsiminous explanation. Why? Not because I think Skilling is innocent. But because I'm interested in defining the "type" of problem represented by the company. And, if you read the comments, you'll see that some of the parsimonious explanations are quite good. That's all. To those last few commenters, I hereby prescribe a chill pill.

[Jason]

As an aside:

The Higgs boson is an elementary particle that I think is the only one predicted by the standard model but not yet observed. It explains why some particles have mass and others don't. Basically, it's the piece that's missing. Think of it as a human transitional fossil. Everything says it should be there, we just haven't found it yet.