Enron and Newspapers

Another thought on Enron, following on my New Yorker piece.

One of the big points made by Jonathan Macey and others is that the Enron scandal is an example of “receiver failure” as well as “transmitter failure”: that is, that it wasn’t just the case that the company sent misleading signals. It was also the case that those who were supposed to be listening to and interpreting those signals didn’t do their job.

The exception, of course, were newspapers. The Enron scandal was, in large part, broken by the Wall Street Journal.

This is strange, no?

We operate with the assumption, particularly in our understanding of what makes financial markets efficient, that those with the best incentives to ferret out the truth are those who are partial—that is, are directly involved in the process—and those who are economically motivated, who have money at stake. So you’d think that hedge funds, shorts, arbs, and analysts—all of whom were massively partial and economically motivated—would have been the first to see the “real” Enron.

But they weren’t. Reporters were, a group who—at least in theory—you’d think were in the least advantageous position. They aren’t partial to the proceedings. They have no money at stake. (Compared to their Wall Street counterparts, in fact, they barely make any money at all.) They aren’t (relatively speaking) as well-trained as financial intermediaries. They have to serve a general audience, which disposes them against highly technical examination. There are real limits on how much space and time they can devote to a particular story, and their rewards for doing well are almost entirely internal and professional: good reporters are rewarded, largely, by having their status elevated among other reporters. On Wall Street, seeing truth gets you a million dollar bonus. At a newspaper, it gets you a slap on the back.

We’ve spent a lot of time, post-Enron, criticizing the flaws in the investment community’s gatekeeping activities. But I think we should also recognize what the Enron case tells us about the value of newspaper journalism. Maybe, in other words, we have underestimated the value of impartial, professionally-motivated, under-paid and overworked generalists in tackling the kind of information-rich, analysis-dependent “mysteries” that the modern world throws at us.

All of which, of course, points out the irony of what’s happening in the newspaper business right now. We are dismantling the institution of newspaper journalism precisely at the moment when it seems to be of greatest social value.

Comments

[Matt Welch]

The Houston Business Journal was writing critically and repeatedly about Enron long before the national press got around to noticing.

If we are to lament the effects that the unbundling of the general-interest newspaper is having on our knowledge of events, let's not forget to also note where said newspapers failed to even read, let alone follow up on, good journalism performed by organisms on the lower end of the profession's totem pole.

[Eric Pennington]

Great insights! Greed (on the part of those close to the action)accounts for why Wall Street doesn't keep itself in check. This doesn't imply that everyone on the "street" is evil incarnate, but it just illustrates the opiate that is greed.

Why did the journalists get it on the Enron thing? Probably the motivation for justice and a great story. Throw in a little self righteousness and you have all the fuel you need.

[Victor Appleton]

Re: Why did the journalists get it on the Enron thing?

The journalists "got it" not just because of "motivation for justice and a great story [and] a little self righteousness". As Mr. Gladwell would posit in his "Tipping Point", context matters. In this case, it may be one of the most important matters leading to the debacle.

There have been numerous ominous or bearish articles written by financial journalists which have proved false positives for various reasons. What made the following companies falure so sudden: Enron, Barings, Drexel, Kidder, Hutton, etc. or even LTCM and Amaranth and the S&Ls ca. 1990?

Each of them borrowed heavily and were dependent on the kindness of strangers (i.e. creditors, trading counterparties or the Feds) to continue operating. If the confidence of these creditors and / or regulators ebb it can quickly lead to a downward spiral.

Many of the red flags Mr. Gladwell quotes academics and journalists of stating were said of Enron were also said of the Coca Cola Co. Unusual transactions, strange accounting with its bottling affiliates, governance issues—you name it. But it never depended on creditors or the Feds for its livelihood (and its bottlers are contractually captive). The detractors, journalists among them, were right as Coke's common stock is less than it was a decade ago (indeed, more than 10 years).

Score 1 for the journalists who stay on top of these matters but note that their false positives are forgotten and that, given in a certain context, their hunches, analysis and articles will look prescient.

[Bob V]

The apparent paradox is simple to understand if you think of newspapers a little differently. In addition to being places where investigative journalism happens, they are also places to bring leaks.

The question then becomes, why not leak to your investors or peers rather than journalists? A much easier question to answer.

[Bob Walsh]

I believe if you look at the Enron gas-fired power plant in India, the accounting for construction work in progress and the financial impact of the failure of the plant to come on line when forecast you might find a link with Enron needing to come up with some financial ledgerdemain.

By the way, enjoyed the article tremendously.

Bob Walsh

[Christopher Horn]

Malcolm,

I take a somewhat different position cf your conclusion to the New Yorker article (that there needs to be a class of professionals to interpret complex financial statements).

Your semi-defense of Enron is predicated on the idea that Enron was "transparent enough", perhaps transparent enough assuming such a class of experts existed to interpret Enron's communications, or lacking that maybe a few intreprid gumshoeing undergrads at Cornell.

Your semi-defense (implicitly, at least) therefore assumes that the relationship between Skilling/Lay and the readers of their disclosures is adversarial, or at least arm's length. Skilling/Lay can be "defended" to the extent that they actually fulfilled their obligations.

As it turns out, those being misled by Enron's communications were in fact Skilling and Lay's ... bosses.

Imagine, then, other employer-employee relationships managed the way that Skilling/Lay managed their relationship with their "bosses". Would any of us go to work tomorrow morning, embezzle thousands of dollars from our managers, and conclude it was "okay" because we left a Post-It note describing what we were doing in an "arguably visible" spot? Of course not. And yet, this hypothetical bears much similarity to what Skilling and Lay actually did.

Still, I believe that the punishment facing Skilling seems harsh. I suggest a more compelling 'semi-defense' might be predicated on the growing obsession from Wall Street that companies NEVER miss their earnings guidance, for any reason whatsoever.

Twenty years ago, a company like Enron could probably go through a period of fallow earnings without suffering too much in their stock price (and the senior executives not losing their jobs).

In the 21st century, companies miss thier earnings estimates on fear of great peril. It seems to this non-expert that Enron was offering up successively lower quality earnings - perhaps an unfortunate outcome of the unprecedented, extraordinary contemporary pressure on companies to hit their number - every single time.

[Victor Appleton]

Mr. Horn,

Your comment "As it turns out, those being misled by Enron's communications were in fact Skilling and Lay's ... bosses." indicates that a public company's shareholders as a group is the CEO's boss is a bit off.

It is a common misconception that senior managers of public companies are beholden to their shareholders or even their boards of directors. The reality is that they are not. Many of them feel it's unfair that they have to endure the daily grind of pounding the pavement, risking divorce among other social drawbacks while shareholders sit back and enjoy the fruits of the managers' hard work.

The classic book on this topic is Berle & Means's "The Modern Corporation and Private Property" written ~ 1933 and still relevant. The advent of the professional manager in the last century and a dispersed shareholder base has created this dynamic leading to separation of ownership and control. Note that in Germany, Japan or the UK that either their respective corporate cultures lack professional managers from outside (i.e. agents hopping from one CEO gig to another) or wide shareholder bases or both.

Twenty years ago we witnessed other sensational, sudden corporate flameouts; I mentioned one above, EF Hutton, which occurred almost exactly two decades ago. The difference here is that Enron's fiasco has become so sensationalized with even fingers pointing to the White House (remember the letter addressed to "Kenny Boy").

The point I tried to make in my earlier above post is that Enron, like Refco, suffered an immediate loss of confidence in a marketplace (the financial markets) it was dependent upon. Arthur Andersen provides another example of a loss of confidence in another marketplace once it was indicted. The best known story about these occurrences on Wall Street is Equity Funding's collapse in 1973.

If Enron had done the same deeds it committed and been, say, a packaged foods manufacturer without reliance on bankers (contrast with Parmalat) or the story didn't come to light until today after energy prices have significantly appreciated and Enron conceivably benefited, this whole discussion and the accolades being given to some, however deserving they are for other issues, would be moot.

[Joah]

I know you've been talking about sports a lot lately, but I hope you relate your Enron piece back to baseball and Mark McGwire since it's looking like he won't get in the HoF even though steroids, HGH and other "drugs" weren't illegal at the time.

[Christopher Horn]

Victor,

You have made more than one excellent contribution to this discussion - so what follows will probably come off sounding more confrontational than it should (as everything in the blogosphere inevitably does).

Caveats aside, we could certainly go back and forth at great length about the extent to which corporate managers do or do not act in accord with their fiduciary responsibility to their "managers", i.e. the (dispersed) shareholder base. No doubt you raise valid concerns about the effectiveness of that relationship.

However, to the extent that we conclude that the manager/shareholder relationship is broken, that necessarily leads to concerns about the effectiveness of the corporate governance model in Western companies.

Which is a separate, potentially fascinating (and impactful) thread.

[MCP]

The article claims the problem was that Enron did not disclose *enough* information about the SPEs, among other things, thereby creating a mystery for investors. But, that's violation of securities law in and of itself. The legal standard is that one breaks the law by failing "to state a material fact necessary in order to make statements made, in light of the circumstances under which they were made, not misleading." That is, the disclosure fails to reveal *enough* relevant, illuminating information (intentionally or negligently withheld) to make it true and accurate. This broad definition of culpable misrepresentations reflects Congressional intent, which is the measure of public policy (market integrity, deterring false or materially incomplete disclosures) here. Your thoughtful article repeatedly describes unlawful acts despite claiming not to opine on the legality of Skilling & Co.'s conduct.

[Adam Isler]

I think the notion that the press are not as "interested" as others in the Enron game may be wrong. Their interest in knowing and exposing the facts is a financial interest - it just depends on different outcomes - that is to say, they may not have been invested in Enron but they are invested in news that sells. And while the scale of the numbers may be different, the news sales numbers are their numbers, so of very great interest to them.

In fact, your analysis of why it's so odd that the press got it right and others didn't could be extended to just about any story the press reports on: they know less about other subjects and they have less at stake in other subjects - but still we have the press to thank for uncovering lots of stories - simply because that's their job and their interests are aligned with breaking important stories, particularly where they would otherwise have remained hidden.

[George Burger]

First I want to say your article in The New Yorker was terrific...thoughtful, entertaining(the connections to Bin Laden and Nazi Germany are so symbol and political-cultural rich that they make a complex deconstruction painlessly comprehensible) and in my view dead-on. I am no fan of Skilling, Lay, or Ebbers et al, but in my view they were sacrificed to appease a profoundly wronged public. As you write, much of what they were convicted of hiding was in fact in plain sight. But the reason I write is to ask for help in understanding the classifications as puzzles and mysteries. In my view the terms should be reversed, or perhaps a different one chosen for the first category. To me a puzzle is a state of unknowingness which can be resolved by using your wits and skills to assess the clues in front of you. A jigsaw puzzle for example...when you dump the pieces on your table, the final image is right in front of you...you just have to piece it together yourself. To me, especially in the Enron example, all the pieces were there to see, you just needed to know how to put them together. In a traditional puzzle, you don't need a Deep Throat to help you solve it. So I think "puzzle" can replace "mystery". However, I am not sure "mystery" should replace "puzzle". I think "mystery" also can be solved with the proper application of skills.I think the better analogy might be "black box", where you can only determine its contents if someone provides you with a key. But this is a minor quibble. The analysis was excellent, regardless how you classify the categories. Best regards!

[Victor Appleton]

Mr. Horn,

No offense is taken. To be clear, I'm not concerned about "the extent to which corporate managers do or do not act in accord with their fiduciary responsibility to their 'managers', i.e. the (dispersed) shareholder base". This may come as a shock to many, especially former Enron shareholders and even institutional investors, but senior corporate executives with employment contracts often have explicit "duties of loyalty" to the company—not to shareholders—in their employment agreements. While the difference appears trivial and hair-splitting to the layman, it isn't as an employment lawyer would explain.

This “shareholder loyalty” clause is excluded partly because it's nearly impossible for a senior executive to express "loyalty" to a disperse group of mostly anonymous shareholders with many interests, time horizons and motives. A senior manager's covenant of loyalty to shareholders of a publicly traded company is bound to be breached in some shareholders’ eyes.

For example, in Enron's employment agreements (before amendments) with Messrs. Lay and Skilling (http://www.sec.gov/Archives/edgar/data/72859/0000072859-97-000009.txt), they respectively agree to a duty of loyalty "to act at all times in the best interests of the Employer [Enron Corp.]" or "to act at all times in the best interests of Company [Enron Corp.]". This is standard / boilerplate language in these agreements. Nowhere do they refer to creditors’, counterparties’, employees’ regulators’ or even shareholders’ interests or claims.

Hence, the manager / shareholder fiduciary relationship you refer to seldom, if at all, exists in the US public capital markets.

This leads back to Mr. Gladwell’s The New Yorker article. Enron’s irate shareholders, creditors and employees had every reason to be and explaining to them a posteriori that the senior managers were operating without a duty to them but to the company as a whole is cold comfort and, to the employees, probably cruel. Nonetheless, this information, like the related party transactions involving SPEs Mr. Gladwell points out, was readily available to nearly anyone.

That’s the limited legal perspective and clearly other factors impact the spirit and modus operandi of senior managers.

[Christopher Horn]

Mr. Appleton,

As you properly note, the interests of a diverse set of shareholders will no doubt differ due to their varied individual interests.

Perhaps you like more risk (higher beta), and I like less, though the senior managers of the company we commonly own must select a specific level of risk, and consequently they will make (at least) one or the other of us unhappy.

Even to non-lawyers such as myself, it is therefore quite understandable that senior management not be specifically beholden to either you or me; indeed our management must do what's best for the company, which may involve a risk profile neither you nor I prefer, among other things.

But this doesn't mean that senior managers don't "work" for us. Assuming the company we own doesn't have convoluted poison pill provisions, in fact those managers serve (and earn) at our collective pleasure.

Again, without getting into legalisms (that are beyond my scope), you and I may disagree on risk, investment policy, or other particulars, but surely we would agree on "effective stewardship".

Enron's failure of fiduciary responsibility therefore goes WAY beyond the fact that they might have managed to a beta which was unpalatable to a cohort of their investors, for example.

[Victor Appleton]

Mr. Horn,

We seem to share similar expectations of senior managers behavior when we invest in public companies.

I agree that the senior managers OUGHT to work for us as shareholders. Under the US corporate structure of especially large going-concern public companies, the senior managers “work for us” VIA the board of directors which, comprised of representatives, usually has a legal fiduciary responsibility of loyalty to a company and its shareholders as a group. This however does not mean we can ask Mr. Ballmer to “have that report prepared for Monday morning” because we own a few round lots of shares of Microsoft or any senior manager of a small public company. The reality is that there is a long distance between owning shares and exercising powers of control or, to borrow the phrase, being the boss.

An analog is our relationship with our police or fire department, mayor or other elected representatives. Yes, we pay income, sales, property and other taxes and could consider ourselves their bosses and say that each works for us. I don’t mean this to sound tongue-in-cheek but if almost any of us attempt to call or meet most of them and explain that we’re their boss or simply inform them that they work for us, we’re likely not to like the response.

Let me also clarify that I’m not a lawyer but it’s difficult to discuss this without diving into semantics and legal definitions, which I may be ill equipped to handle, so I’ll make this my last point.

Let me segue back to the New Yorker article. As I wrote my last post to you, I began asking the same or similar question Mr. Gladwell posed: did the senior managers at Enron do anything wrong? They took certain actions that personally benefited them, such as the said related party transactions, but these transactions also contributed to the company by having it appear more solvent. As board members they may have failed to exhibit loyalty to their shareholders but if these transactions were properly disclosed and approved by the board, which they likely were since they were disclosed in financial footnotes, it’s not likely they can be held accountable as senior managers and, perhaps, board directors.

I haven’t read the defense arguments and didn’t closely follow the cases. If Mr. Gladwell was proposing the use of Enron’s former senior managers criminal cases as the corporate equivalent of 12 Angry Men where the eye of the beholder (i.e. transmitter or receiver as referred in the article) determines his prejudice, he’s picked a good case. It isn’t as open-and-shut as many would believe which I trust is Mr. Gladwell’s point.

[Christopher Horn]

Mr. Appleton,

You note:

"if these transactions were properly disclosed and approved by the board"

the key term being "properly". If our standard is the undergrad Cornell finance class, perhaps. Indeed, this is one of the central questions of the Enron case: does 'properly' apply here? It would seem not. But I agree it is a moot point.

Like you, I believe that we basically share the same expectations; however, it strikes me that we might disagree somewhat with respect to enforcement.

As you note, Steve Ballmer may not be practically obliged to consider my personal views about the advisability of XBOX 720 if I am a small lot shareholder.

But this is simply a restriction based on expedience. Indeed, if my name were Warren Buffett, and I happened to own 6% of Microsoft (clearly a stretch given just about every public statement from Buffett over the past 20 years :), then beyond the fact that my best friend is the company's co-founder, you can be certain that Mr. Ballmer will listen quite closely to my views about the XBOX 720.

Our problem, as small lot shareholders, is that we are too widely dispersed to matter, NOT that the status of being a shareholder inevitably gives us poor standing with senior management.

BTW - in my community, as in many in America, any citizen has the right to request a "ride-along" with police and fire cruisers, assuming proper notice. Ownership (should) matter, even in local government.

[sean]

Note to Steve Sailer and Sean Carman: There is a difference between fame and notoriety. You are the K-Feds of the blogging world. Note to Malcolm: this blog's comments (not the blog itself) are sucking the life out of everyone. Too long, too negative, too self-serving (here's a link to my blog!). It's sad that it has turned out like this.

[Stephi]

I would say Press has always put forward cases which others have missed and for whatever reasons they work on these stories,-to be the first one to have new story or to get a pat on the back,they have exposed many companies & people.

[micky ordover]

Are you going to respond to Joe Nocera’s column? Seems to me that he’s right in suggesting that you overplayed the business students’ result "sell" just to provide a dramatic flouish.

I surely agree about the importance of investigative journalists; also their good editors and a daily newspaper.

Thanks for your work.

[fred34]

Vic and Chris,

Go get a room already.

;P

[CMJ]

I think individual writers at our media outlets need to exercise their freedoms of press so oft denied by their feudal lords (corporate bosses). Our system of checks & balances depend on it. I've seen far to much erosion in the past 6 years that the criers of "slippery slope" back then now look less crazed and more like prophetic geniuses.

[Mark Berry]

The Corporatization of Online Media...

I know we are dismantling the newspaper industry, but fret not, the effect is simply a lateral move to an "online newspaper" industry. It looks like a stop-change-start because the online newspaper landscape looks like the old newspaper industry of the 1850s (if I had to guess).

I'm not sure who maintained the role of the "newspaper industry" before the printing press was invented. It was probably just key individuals. The printing press turned those people's oral gossip into written gossip, and the printed newspaper tooks its role for 150 years. Now the "online newspaper" is similarly immature as the printing press back then (with the thousands of "start up newspapers" that were probably around). The "online newspaper" industry will eventually look exactly like today's printed newspaper... in about 150 years.

Most importantly, the industry rules may start differently, but the new industry's role in society will ultimately be the same: propagator and amplifier.

[MauriceEaston]

I read with interest the Enron article.The role of financial disclosure is NOT to obfuscate the financial condition of a company or to mislead the public. To that extent Skilling et al are guilty!
The more interesting story to me is that after the Cornell business class analyzed Enron and recommended a "sell" it took two years and a doubling of the stock price before the "puzzle" broke apart. Even if the Cornell students sold the stock short they would have lost their shirts.
Why the disconnect between the stock broker community and the reality of value? Is it momentum, greed,stupidity, pushing the latest HOT stock, or a combination of all of these factors?
Beware the story or tip to good to be true.It usually isn't. At some point the investment community will suffer if they do not try to solve these mysteries before the "puzzle" falls apart

[Peter]

On the margin, money does not motivate like pride. Who plays harder in a regular season game, pro or college player?

[de]

offtopic: FYI