Coyote Blog

A prior version of this article was published accidentally before it was complete.

I know I swore not to write about Tesla here and to confine myself to talking about Tesla on Twitter, but I can't help myself.  This is the company that is going to spawn a thousand business school case studies.  It is Enron but in the Internet Age with more transparency (or at least less sophistication in hiding their problems).

Over the weekend I re-read "The Smartest Guys in the Room" about the collapse of Enron.  I will admit I was an Enron fanboy at the time -- I drank the Kool-Aid and totally overlooked the problems.  I knew Jeff Skilling a little and worked for him on Enron when we were at McKinsey.  I believed he was brilliant and was doing what he said he was doing.  The crash of Enron took me years to accept, and only on my recent second reading of that book did I have the distance and objectivity to really understand it.  And I realized something else -- I was the same guy back then that I criticize today.  Skeptics of Tesla (including me) make fun of Tesla fanboys and their cult of Elon Musk and their belief of everything he says and their certainty he is the smartest guy in the room.  I understand them because I was that guy with Enron and Skilling.  Maybe Tesla is my chance to correct my past gullibility.

Anyway, just when I thought the story couldn't get any more dramatic (or weird), Elon Musk raises the bar.  Apparently Tesla is now only tangentially and largely irrelevantly an automobile manufacturer.  Instead, it is an autonomous ride-sharing company:

Citigroup and Goldman Sachs, who are underwriting Tesla’s latest effort to raise $2 billion in new funds, held a “broad investor call” on Thursday, where CEO Elon Musk and CFO Zach Kirkhorn answered brokers’ questions about their plans for the electric vehicle maker.

According to two invitees who attended the call, CEO Elon Musk talked up Tesla’s self-driving strategy right off the bat, expanding what he and other execs said at a recent event for investors that the company dubbed “Autonomy Day. ”

Musk confidently told investors on the call that autonomous driving will transform Tesla into a company with a $500 billion market cap, these people said. Its current market cap stands around $42 billion. He also said that existing Teslas will increase in value as self-driving capabilities are added via software, and will be worth up to $250,000 within three years.

This call was in the context of Tesla's offering this week of about $2 billion in new stock and convertible bonds.  The really interesting thing about the call:  Virtually 100% of the discussion on the call was about ride-sharing and autonomy, while neither word was even mentioned in the official written prospectus for the offering.

Before we can understand what the hell is going on here, and why Tesla is going all-in on a business it was barely talking about 60 days ago, we need to do some review.  I want to review where Tesla was last time I wrote about them, and also discuss new Tesla news and actions over the last 3-4 months.  From there, we will try to dissect what Elon Musk is doing.  TL;DR: I believe Musk is doing exactly what Jeff Skilling did at Enron, chasing new business strategies based on what stories he thinks will most likely goose the stock in the short term, rather than which strategies make the most sense in the long-term for his investors.

Where I was on Tesla at year end 2018

I had a lot of criticisms about Tesla's strategy towards the end of last year (here and here, for example).  But let me summarize some of the key points

• Tesla has taken what was already a risky entry into a capital-intensive industry and has made it even more expensive and risky by choosing to own both the dealer network and fueling networks for its cars -- this means it has to invest not only in auto manufacturing capacity but also in a world-wide network of sales and service centers and in a global network of charging stations
• Inexplicably, just as its production volume began ramping up in mid-2018 with the introduction of the mid-priced model 3, Tesla ramped down on its capital spending, R&D, and SG&A spending.  By the first quarter of this year, capital spending was no longer even keeping up with maintenance needs.  This was absolutely inexplicable for a growth company that has promised many new products in the near future (new coupe, semi truck, model Y crossover), all of which will need a plant and equipment to produce.  Further, Tesla slowed investment in its sales, service, and charging networks at the exact time its fleet size exploded, leading to a lot of customer dissatisfaction
• The decrease in these expenditures was likely tied to Tesla's hard to fathom (I seem to be searching for a lot of synonyms for "inexplicable")  decision not to raise capital last year.  Its stock was over $350 a share and it had huge momentum from its first two profitable and cash flow positive quarters.  By almost everyone's analysis, they should have raised $5 billion or more, which might have only created 10% dilution.  (Instead they waited until this week after a terrible quarter and after the stock had fallen to about $235 to raise just $2 billion, barely enough even to fill their accounts payable hole).
• Tesla and Musk claimed that the growth and performance of the 3rd and 4th quarters of 2018 were harbingers of the future and he extrapolated hockey sticks from these data points.  Skeptics like myself believe that this was merely a one-time bulge, that Tesla had sold through 2-3 years of demand in their order book in just 2 quarters, and that the first quarter would be a disaster now that the tank was dry.  In addition, Tesla has culled its order book of all the highest margin variants where it could actually make money, leaving what remained of the unfilled orders as low-margin variants it was barely worth selling.  [By the way, I figured none of this out on my own, and owe a lot to the great folks at $TSLAQ on Twitter, who bring a lot of free research to bear that made it easy to see these patterns].
• My admiration for Musk as having really shown the automobile world that electric cars can sell at high price points (and not as little sh*tboxes) and for his space entrepreneurship really ended with the SolarCity deal.  In that deal, Tesla shareholders overpaid for a failing business simply to bail out Musk and his family from a sinking ship.  The acquisition made absolutely no strategic sense and Tesla has done zero to try to develop it, and in fact has been slowly shutting it down from the moment it was purchased.
• Elon Musk has steadily lost any credibility he might have had by initiating product launches of products he claims are nearly ready for sale but never get introduced.  Tesla got a higher level of subsidy from California based on a single suspicious battery swap demo that has never been repeated or even discussed since.  Musk sold SolarCity to Tesla in part based on a flashy reveal of a solar shingle product that still has not seen the light of day.  Musk had a big reveal of the Tesla semi and started taking customer deposits but there are still no clear plans for its production.

What has happened at Tesla this year

• The first quarter of 2019 was a disaster, with deliveries down despite initiation of Model 3 sales in Europe.  Worse, since the Model 3 seems to be cannibalizing Model S and X sales, Tesla was not only selling fewer cars but its mix shifted to lower priced less profitable cars.  It lost an enormous amount of money, and only after the conference call with analysts about first quarter results did Tesla reveal that this loss would have been far worse without a huge sale of government EV credits
• Tesla burned a staggering amount of cash in the first quarter, and was forced to pay off nearly a billion dollars in debt when the stock price did not remain high enough for the debt to convert.  While Tesla's cash balance at the end of the quarter looked OK, there were two huge red flags. First, the cash barely covered a huge hole Tesla had in its net working capital.  Second, given the large number of vehicles Tesla sold in its end of quarter push in the last 2 weeks of the quarter, it appears that Tesla was nearly out of cash in Mid-March and perhaps days away from a default (analysis below).
• The Tesla financial statements still include a number of unexplained oddities, including a billion dollars of accounts receivable, or about 20% of quarterly revenues.  How does a company that demands payment in advance before delivery have 20% of its quarterly revenues tied up in receivables?
• Tesla announced, out of the blue, that it was closing all its retail stores and going online only.  Given the drop in demand for the quarter, it was a head-scratcher as to why eliminating the sales force was going to help.  The decision seemed to be almost off the cuff, as Tesla seemed surprised that they would still have to continue paying their expensive long-term mall leases.  After this was revealed, Tesla partially reversed the closure decision, but no one -- including their own retail folks -- seems to know what the plan is now.
• Tesla constantly fiddled with its prices and model lineup.  It cut prices several times, but also announced a small raise as well.  It eliminated certain options for cars, added new ones, and then reintroduced eliminated ones.  Even long-time Tesla watchers are confused about the model lineup today.
• Tesla continued to see an outflow of executive talent, including the exit of their very well-respected new General Counsel after just over one month on the job  (Mr. Buttswinkas returned to his old law firm and purged Tesla from his resume).  This seemed to parallel the rapid exit of an outside chief accounting officer last year who gave up millions of dollars to exit in just 60 days.
• April car deliveries stayed on the same pace as the first quarter -- ie, way worse than Tesla's guidance
• Elon Musk continued to get in trouble with the SEC, firing off production and sales guidance on Twitter that was different from Tesla's official published guidance.  Mr. Musk and Tesla are still guiding to a total delivery number for the next year that is well in excess of what most anyone else looking at the first four months believes is possible
• Tesla announced a reveal of their Model Y crossover that will not go on sale until at least the end of 2020.  Unlike past Tesla reveals, this one seemed hastily set up and the prototypes shown were weird.  They looked more like the existing Model 3 with a few modifications than a promised crossover that could incorporate a third row of seats.  Tesla asked customers to start making deposits (skeptics will argue that the whole point of the reveal was just to get some free financing from Tesla fanboys) but unlike past reveals, this one fell flat.  There was apparently little interest in making deposits, though Tesla (unlike with past products) has not revealed the deposit numbers.
• Lyft went public for over $20 billion and Uber is planning a $70+ billion IPO, despite having a history of negative earnings and promising investors they may not make money for 10 years (more on this in a minute)
• After the Model Y went nowhere, Tesla set up what they called "investor autonomy day."  Tesla outlined their strategy for creating a fleet of self-driving cars, and promised fully autonomous cars by the end of 2020.  With these fully autonomous cars, Musk promised that Teslas would become an appreciating asset in that they earned income for their owners as autonomous taxis when the owners were sleeping.  He also said Tesla would own a fleet of taxis itself, using off-lease model 3's for this purpose.
• As described at the top of the article, Tesla raised over $2 billion on verbal promises by Tesla (not echoed in the deal prospectus) that Tesla was soon to be a $500 billion autonomous taxi company

So what is Tesla doing?

Having written all of the above, I realize I have left so much out -- the product quality problems, the worker lawsuits, the autonomous driving deaths, the spontaneous car fires -- but I only have so much time.  If you are interested, @teslacharts on Twitter is a good place to follow Tesla from the skeptic side.  But given all this, what the hell is going on?  The following is my theory.

I think in the 3rd quarter last year, Elon Musk honestly believed that the huge ramp in sales and profits at Tesla represented Tesla permanently turning the corner.  He extrapolated from that growth and believed it would continue for years -- he did not see it as simply the one time working through of years of pent-up orders and demand.  As a result, he put off the capital raise he should have been doing, and instead had dreams of taking the company private and getting away from all the scrutiny by analysts and shorts that seem to irritate him.  Thus was launched the ill-considered "420" tweet when he claimed he had funding secured for a go-private transaction at $420 a share, when in fact this was an outright lie.  Once the SEC stepped in to investigate, a new funding round was almost impossible.

Then, in the first quarter, reality hit Tesla in the face.  For all their public optimism, Musk had to see that the demand he expected was not there and Tesla was likely running low on cash.  I think Musk had convinced himself the convertible bonds due in the first quarter would surely convert (and would have at the third quarter stock price) but now Tesla was doing the opposite of raising capital, it had to pay off debt.  Cash was going out the door and demand was weak.  What to do?

Musk has a demonstrated pattern that whenever he needs the stock price to be higher, or he needs to sell stock, or he needs some other kind of favorable financial outcome, he will do a new product demo. It worked for battery swap and the solar shingle and the model 3 and the semi, so it would work again.  The model 3 reveal had collected hundreds of millions of dollars of cash in the form of deposits.  That's what he needed now.  The problem is, they didn't have a prototype to show.  I believe Musk had the company hastily create a Model Y prototype built on top of a model 3.  It did not really have to work, it just had to be something he could talk about.  Interestingly, his VP of engineering quit at exactly this time, for reasons unknown -- was their some internal dissention about this Y prototype?

Anyway, the Model Y reveal was essentially a flop, and likely garnered few deposits.  Certainly not enough to fill in Tesla's growing cash hole.  And by Mid-March, Tesla may have been almost out of cash.  Tesla says it delivered half its vehicles for the quarter in the last 10 days of March, so about 31,500 were delivered in those hectic days.  At an average price of $50,000 each that would mean Tesla brought in nearly $1.6 billion in cash those last 10 days (this is conservative, may have been more if the average price was higher).  But they only had $2.2 billion at the end of the quarter, meaning Tesla was scraping bottom in mid-March, particularly since hundreds of millions of that cash is restricted and not supposed to be spent.

Somewhere in this period of March-April, after his usual product reveal trick with the Y did not work, I think Musk came to the conclusion that the Tesla car business as currently defined was not going to work.  Or, more accurately, it was never going to make enough money to support its sky-high stock valuation.  I have always said that Tesla would make a fine $10 billion niche car company, but nothing about it justifies a $50 or $60 billion valuation.  But at this point Musk can't accept a $10 billion company, even though that would ostensibly still leave him a very rich man.  But like Ken Lay at Enron, Musk has borrowed against at least half his Tesla stock and a falling stock price could lead to financial death by margin call (Musk, for some reason, also mortgaged all his multi-million dollar homes last December). His other investments are also struggling -- SpaceX has been unable to attract the capital it needs of late and Musk has poured a lot of money into the Boring company, an absolute embarrassment of a company that helps refute, in my mind, his "smartest guy in the world" rep.

As Musk looked around for a way to save the stock valuation, the Lyft and Uber IPO's must have had an influence.  Uber is losing as much money as Tesla and folks are talking about it IPO-ing at a market cap of $70 billion.  What if Tesla could call itself a ride-sharing company, only better.  Wouldn't that garner Tesla an even higher valuation?

So I see investor autonomy day and Musk's autonomy soliloquy on the capital raise call the other day as evidence that Musk has, in his mind, capitulated on auto manufacturing and has decided the way to keep Tesla's stock price up is to promise it will -- in just 20 months -- sell fully autonomous vehicles and be making tons of money selling taxi rides.  In other words, it is a robotaxi company that happens to be backward integrated into manufacturing the taxis.

I am skeptical for a number of reasons.

• This reeks of desperation and capitulation.  If Dell says they are going to reinvent themselves as a search engine, it's time to sell the company
• There is no evidence that Tesla can achieve full autonomy by end of next year and a lot of reasons to think they can't.  Most experts think full autonomy is decades away, and when they rank companies on their progress on autonomy, Tesla is usually near the bottom (e.g here).  Waymo and GM, the leaders, often go thousands of miles between driver interventions.  Tesla is hundreds of times worse.   Even over the short course at Investor Autonomy Day (where Tesla likely trained and practiced in advance) investors reported a driver intervention was needed.  Now imagine the same car with no driver.  In snow with the road markings obscured.  Driving through construction where new routes are confusingly marked off with cones.
• The basic business numbers Musk throws around are absurd.  Just as one example, he extrapolates from current ride-share prices and assumes Tesla will make a ton of money because they will get the same price but not pay the driver.  But this is crazy.  If Tesla suddenly throws a million taxis into the rideshare supply equation, rates are going to fall.  Already, since 2012, Uber reports its average fare per mile has been reduced by over half.  If everyday folks are having their cars drive autonomously at night to earn extra money, the fee per mile is going to be competed down close to the cost per mile of operating the vehicle (or even lower, since most folks underestimate their all-in cost per mile on their vehicle).  Musk is basically proposing to commoditize the market but still reap premium margins.  Not going to happen.

Warning

Note that this article is simply my analysis and in some cases my guesses.  I think the story holds together but I can be wrong.  I am short TSLA via put options but note that this is a modest investment that is a small percentage of my portfolio.  Tesla is a dangerous stock to short.  Right through the bad news, individual investors at RobinHood have been loading up on the theory they are buying the dip.  20,000 people added TSLA to their portfolio at RobinHood just AFTER the horrible first quarter report.  Be very careful

Bonus -- Tesla's Largest Mistakes

No matter what happens, Tesla will always be remembered as the company that brought EV's mainstream.  But like any tragedy, they have made some fatal mistakes.  This is my attempt to get out ahead of future business school cases and rank their largest mistakes:

1. The Model 3.  Tesla could have been a profitable luxury car maker but with the Model 3 tried to go for the low to mid end of the market.  But it does not have the manufacturing expertise or cost position (it assembles in California, for God sakes) to pull it off.  The quality problems it encountered have reduced its brand luster, and the volumes of cars have overwhelmed its service and charging networks.  Investments in the Model 3 have distracted it from real refreshes of its S and X and in fact the Model 3 has cannibalized those more profitable cars.  A higher end crossover would have been a better choice
2. No third party dealers.  Tesla chose to bring the sales and service function in house.  This was a mistake.  Not only did it eat up capital, but it robbed it of valuable marketing partners such as Penske that could have really helped its sales ramp.
3. No 2018 capital raise.  Rather than tweeting 420, Musk should have been raising capital based on its third quarter results.  The money was there to be had and Tesla needed it.  $5billion at least could have been raised with little dilution effect
4. SolarCity Purchase.  This was a complete sham to bail out the Musk family and friends.  Did absolutely nothing for Tesla except drain billions of valuable capital
5. In-house Manufacturing.  Musk often says he wants to be like Apple, but Apple is a design company.  It does not manufacture and for quite a while did not do its own retail.  Tesla would have been better off finding a manufacturing partner rather than manufacturing itself in the highest cost location in the country
6. No Charging Partner. I think Tesla had to build out its charging network at first to eliminate one of the greatest consumer barriers to purchasing an EV.  But they should be partnering to share the costs.  Instead, Tesla still thinks of its charging stations as a competitive moat.  But as other car makers form consortia for charging networks based on faster charging technologies, Tesla is stuck with an expensive network that needs upgrading.  Its more of an anchor now than a moat

2nd Bonus -- Another Musk parallel if you are tired of Enron comparisons

Even more than Skilling and Enron, the person Musk most reminds me of is Ferdinand de Lesseps, whose attempt at building a French canal in Panama ended in spectacular failure.  I highly recommend the book "Path Between the Seas" for folks who want the whole story.  When I have time, I may post on the parallels. I presume Tesla critic @ElonBachman would agree since he uses de Lesseps' picture as his twitter icon but I have never seen him discuss it.

Jeff Skilling was convicted of fraud and fined $50 million dollars and given 20+ years in jail.  Elizabeth Holmes -- for fraud that is way more obvious and for which she is clearly directly accountable -- will get no jail time, a fine of a half million dollars, loss of some voting shares in the company, and a ten year moratorium on being a director or officer of a public company.  From the SEC press release:

The complaints allege that Theranos, Holmes, and Balwani made numerous false and misleading statements in investor presentations, product demonstrations, and media articles by which they deceived investors into believing that its key product – a portable blood analyzer – could conduct comprehensive blood tests from finger drops of blood, revolutionizing the blood testing industry.  In truth, according to the SEC’s complaint, Theranos’ proprietary analyzer could complete only a small number of tests, and the company conducted the vast majority of patient tests on modified and industry-standard commercial analyzers manufactured by others.

The complaints further charge that Theranos, Holmes, and Balwani claimed that Theranos’ products were deployed by the U.S. Department of Defense on the battlefield in Afghanistan and on medevac helicopters and that the company would generate more than $100 million in revenue in 2014.  In truth, Theranos’ technology was never deployed by the U.S. Department of Defense and generated a little more than $100,000 in revenue from operations in 2014.

These are only the highlights of the many, many repeated knowingly grossly fraudulent statements made by Holmes over a span of several years, and this does not even include her harassment of whistle blowers who tried to go public with the fraud.  This isn't a case of creating an offshore JV that shifted some debt off the balance sheet -- its the case of lying blatantly about the company's technology and financials for years and years.

Update:  6/15/2018 Holmes criminally indicted for fraud.  I should have listened to Ken White at Popehat -- he always says that the wheels of justice in the US Attorney's office grind slowly, but they do eventually make progress.

Whether crimes were involved in the failures of Enron, Lehman, & Bear Stearns is still being debated.  All three essentially died in the same way (borrowing short and investing long, with a liquidity crisis emerging when questions about the quality of their long-term investments caused them not to be able to roll over their short term debt).  Just making bad business decisions isn't illegal (or shouldn't be), but there are questions at all three whether management lied to (essentially defrauded) investors by hiding emerging problems and risks.

All that being said, MF Global strikes me as an order of magnitude worse.  They had roughly the same problem - they were unable to make what can be thought of as margin calls on leveraged investments that were going bad.  However, before they went bankrupt, it is pretty clear that they stole over a billion dollars of their customers' money.  Now, in criticizing Wall Street, people are pretty sloppy in over-using the word "stole."  But in this case it applies.  Everyone agrees that customer brokerage accounts are sacrosanct.  No matter what other fraud was or was not committed in these other cases, nothing remotely similar occurred in these other bankruptcies.

A few folks are talking civil actions against MF Global, but why isn't anyone up for criminal charges?  Someone, probably Corzine, committed a crime far worse than anything Jeff Skilling or Ken Lay were even accused of, much less convicted.   This happens time and again in the financial system.  People whine that we don't have enough regulations, but the most fundamental laws we have in place already are not enforced.

California voters -- unskeptical, unrealistic, and gullible -- nevertheless trusted their elected and unelected technocrats in Sacramento to be telling them the truth when they agreed to a $9.95 billion bond issue for high speed rail.  It turns out, even according the HSR's most fervent supporters, that the numbers that were used to sell the bond issue were total crap, and they knew it at the time

In September, I was one of several journalists who interviewed top officials with the California High Speed Rail Authority. Here is board member Lynn Schenk’s response to my question about accountability:

Q: In 2008, this project was sold to voters with the claim that when it was done there would be 117 million annual riders, which is more than four times what Amtrak now has, and it operates in 46 states. It was sold with claims of a $100 round-trip ticket and many other claims that no one believes anymore. If we had known then what we know now, it might not have passed. So when do we get accountability?

SCHENK: This deserves as much of a direct answer as I can maybe possibly give. And that is about the first business plan and those early studies. These gentlemen were not there at the time. I was there. We had one professional and two half-professionals, who were constantly being furloughed because of the state budget issue. That first plan, much to the regret of many of us, was pulled together with Scotch tape and hairpins because we had to get something to the Legislature, but we didn’t have the money, the resources, the people to pull together, so there were a lot of errors. You’re right. But there were also things in there that still stand true today. And we have new studies, a new business plan coming out. The ridership study that we had it is not as bad as the opponents would say. But there are tweaks. And there are things that need to be adjusted and we are looking to do that.

Because the last thing a bureaucratic is ever going to say is "we don't know."   So they told they public the rail line would have 117 million annual riders, when even an estimate of 5 million is probably high.  Jeff Skilling is in jail for a far less substantial exaggeration of his business prospects.

Of course voters were idiots to accept these numbers, when 5 minutes of research would have shown them absurd (the media did nothing to help, of course).  One relevent factoid:

The current air passenger traffic between LAX and SFO is 2.7 million a year

But we are going to have tens of millions of rail customers.  Right.

I had not realized that some Federal employees did not have to participate in Social Security.  Intriguingly, this fact was raised by people who were defending government pay as not being excessive -- they said something like, "well, some workers don't even get Social Security."  Via Bryan Caplan

Some government employees don't participate in Social Security. How does that change the benefits picture?

[T]hat's irrelevant because they're neither paying nor receiving benefits. If you follow Social Security, you know it pays a low rate of return... [N]ot to participate in Social Security is actually a benefit, because they're keeping more.

I agree. Not participating in Social Security is a huge benefit.  The implicit return on "premiums" paid by you and your employer is typically below zero.  In other words, if you took your social security taxes and stuffed them in a mattress, you would get a better return.  As I wrote in the link above

as a retirement program, [social security] is a really, really big RIPOFF.  Ever worker in this country is being raped by this retirement plan.  In fact, it is the worst retirement program in the whole country:

• As we see above, it pays a negative rate of return
• It is not optional "“ you go to prison if you choose not to participate
• Unlike a private annuity contract, the government can rewrite your benefits level any time, and you have to take it.  In fact, my statement says "Your estimated benefits are based on current law.  Congress has made changes to the law in the past and can do so at any time.  The law governing benefit amounts may change because, by 2040, the payroll taxes collected will be enough to pay only about 74 percent of scheduled benefits."
• There are no assets backing this annuity!!  An insurance company that wrote annuities without any invested assets backing them would be thrown in jail faster than Jeff Skilling.  The government has been doing it for decades.

CEO's of companies struggling on the brink of failure often make happy, confident public statements that all is well.  Is that a crime?

Well, it depends on how you look at it.  It comes down to a CEO's fiduciary responsibility to the company's investors, and how that is regulated for public companies.  We think of fibbing to inflate the company stock poorly serves investors, but what about when the company is facing a liquidity crisis?  Isn't public optimism in a liquidity crisis exactly what is needed to serve shareholder's interests?  Consider Treasury Secretary Paulson, and his near criminal declaration of a financial crisis, and the effect these ill-considered statements have had on the economy.

It is hard for me nowadays not to think about Jeff Skilling, who sits in jail for making what the jury thought to be overly optimistic public statements about the company's financial health  (I know you are thinking that he was put in jail for all that off balance sheet accounting and gimmickry, but in fact the prosecution never chose to bring these charges in the trial).  Even Skilling's jury, which was pretty clearly predisposed to convict, seemed to acknowledge that he did not make these statements for personal gain.

So why is Skilling in jail and not, say GM CEO Rick Wagoner?  Wagoner was making a lot of happy-face statements just a few months before his company acknowledged they were facing chapter 11 if Congress did not bail him out.  For extra credit, Wagoner told Congress $15 billion would be enough of a bailout, when he had to have been pretty confident it was not going to come close to cover the hole he faced.

Tom Kirkendall asks some of  the same questions, and looking at the cases he cites, it seems fairly clear that the difference between prosecuted and un-prosecuted CEO's has more to do with their like-ability, celebrity status, and general PR position than their specific actions.

Postscript: I have actually been thinking about the Enron bankruptcy a bit lately for another reason.  Remember that massive natural gas shortage we had when Enron went bankrupt?  Neither do I.  That's because chapter 11 is a pretty well-oiled process in this country.  Enron shareholders, bondholders, and management lost most their investment (and their jobs) but Enron's productive assets and skilled employees didn't disappear.  Enron's assets were bought by other companies who hopefully will employ them more profitably and productively than Enron had.

The same goes for GM.  We have a well-understood and proven process for taking a company like GM through bankruptcy.  However, we are instead replacing this well-understood and practiced process with a new process, called something like "Congressionally-managed restructuring funded with taxpayer dollars."  Does anyone really think this new process is better than the one we have?  Its only advantage, at least to some, is that it may preserve some management jobs, and shareholder and bondholder value, at the expense of taxpayers and any real effort for long-term reform of how GM's assets are managed.

Saul Hansell at the NY Times has an interesting article about why risk assessment programs in investment banks were not sounding the alarm coming into the recent turmoil.  The article contains this gem:

Ms. Rahl said that it was now clear that the computers needed to
assume extra risk in owning a newfangled security that had never been
seen before.

"New products, by definition, carry more risk," she said. The models
should penalize investments that are complex, hard to understand and
infrequently traded, she said. They didn't.

I continue to see parallels between recent problems and the meltdown at Enron.  In fact, in many ways events in the natural gas trading market were a dry run for events in the mortgage market.   One filmmaker coined the phrase "Smartest Guys in the Room" to describe the hubris of the guys who ran Enron.  To some extent the phrase was absolutely true - I knew Jeff Skilling at McKinsey and he was indeed the smartest guy in the room.  But everyone can be wrong, and sometimes the smartest guys can be spectacularly wrong as they overestimate their ability to predict and control complex events.  I think this is a fair description of what went on in Wall Street over the past several years.

I was thinking a bit about Jeff Skilling (former Enron CEO) today.  What must he be thinking as a series of large firms that were supposedly far more stable than Enron go down one after the other to liquidity crises much like that of Enron?  Bear Stearns and Lehman, two firms that should have been rock solid, go down in the blink of an eye in a credit crunch, and all we hear from the media is how the firms fell victim to larger forces beyond their control.  At least at Enron they were up-front with the market about their taking on large risks.  Now, the government is running around in the background trying to match-make these failing companies and helping to save at least a squidge of shareholder equity.  The only thing the government did in the Enron collapse was hound Skilling and others into jail.   

Sure, Skilling may have made some overly optimistic statements about his company as he was trying to stave off the crunch, but no more so that the happy-face statements issuing from Bear or Lehman in their final days.  Executives who find themselves in a credit crunch are in a nearly impossible position.  The best way they can serve equity holders is to downplay or even bury bad news to head off the looming crisis of confidence.  But if they do so, they face presecution for making false statements about the company, ironically under laws meant to protect equity holders.

A few days ago, I pointed to a Tom Kirkendall post where he reported that a large volume of evidence, including interview notes with star witness and Enron CFO Andy Fastow, was finally turned over to the Skilling defense team.  This is required by law to occur before the, you know, trial itself but in fact comes months and years after the trial.  Apparently, there are a lot of bombshells in the notes, including this one as described by Skilling's attorneys in a brief linked by Kirkendall: (citations omitted)

Task Force prosecutors called the "Global Galactic"  document "three pages of lies" and the "most incriminating document" in  Skilling's entire case. At trial, Fastow testified Skilling  knew about Global Galactic because Fastow "confirmed" it with him during a  spring 2001 meeting. Skilling denied knowing anything about Global Galactic.  To bolster Fastow's testimony and impeach Skilling's, the Task Force introduced a set of handwritten "talking points" that Fastow said he prepared in anticipation of his meeting with Skilling. At trial, Fastow swore he "went over" the talking points with Skilling, including the crucial point "Confirmation of Global Galactic list." Id. In closing, the Task Force relied heavily on this document to corroborate Fastow's testimony that he discussed Global Galactic with Skilling.

The raw notes of Fastow's interviews directly impeach Fastow's testimony and the Task Force's closing arguments. When shown and asked about the talking-points document in his pre-trial interview, Fastow told the Task Force he "doesn't think [he] discussed list w/ JS."

This obviously exculpatory statement was not included in the Task Force's "composite" Fastow 302s given to Skilling. Nor was it included in the "Fastow Binders" the Task Force assembled for the district court's in camera review of the raw notes. It is not possible that this omission was inadvertent. Fastow's statement is one of the most important pieces of evidence provided during all his countless hours of interviews. Moreover, in preparing both the composite 302s and Fastow binders, the Task Force extracted and included other"”relatively inconsequential"”statements from the same interview date and even the same page of notes. The Task Force's exclusion of this critical piece of evidence for over three years is inexcusable and, on its own, warrants a complete reversal of Skilling's convictions and other substantial relief.

Disclosure: I actually worked with Jeff Skilling briefly at McKinsey & Co.  From that experience, I have always thought it unlikely that this incredibly detail-oriented guy did not know about a number of these key Enron partnerships.  However, that presumption on my part in no way reduces my desire to see him get a fair trial, and I am becoming convinced that he did not.

With Eliot Spitzer going down for what shouldn't be a crime (paying for sex) rather than what should be (abuse of power), now is as good a time as ever to focus on prosecutorial abuse.  As in the case of Spitzer, the media seems to have little desire to investigate overly-aggressive prosecution tactics.  In fact, in most cities, the local media cheer-leads abusive law enforcement practices.  It makes heroes of these abusive officials, whether their abuses be against the wealthy (in the case of Spitzer) or the powerless (as is the case of our own Joe Arpaio here in Phoenix).

Tom Kirkendall continues to be on the case of the Enron prosecution team for their abuses, which have been ignored in the media during the general victory dance of putting Jeff Skilling in jail and running Arthur Anderson out of business.  But, guilty or innocent, Skilling increasingly appears to have solid grounds for a new trial.  In particular, the Enron prosecution team seems to have bent over backwards to deny the Skilling team exculpatory evidence.  One such tactic was to file charges against every possible Skilling witness, putting pressure on them not to testify for Skilling.  Another tactic was more traditional - simply refuse to turn over critical documents and destroy those that were the most problematic:

The controversy regarding what Fastow told
prosecutors and FBI agents who were investigating Enron became a big
issue in the Lay-Skilling prosecution when the prosecution took the
unusual step of providing the Lay-Skilling defense team a "composite
summary" of the Form 302 ("302's") interview reports that federal
agents prepared in connection with their interviews of Fastow. Those
composites claimed that the Fastow interviews provided no exculpatory
information for the Lay-Skilling defense, even though Fastow's later
testimony at trial indicated all sorts of inconsistencies. 

However,
I have spoken with several former federal prosecutors about this issue
and all believe that the government has a big problem in the Skilling
case on the way in which the information from the Fastow interviews was
provided to the Lay-Skilling defense team. None of these former
prosecutors ever prepared a composite 302 in one of their cases or ever
used such a composite in one of their cases. The process of taking all
the Fastow interview notes or draft 302's and creating a composite is
offensive in that it allowed the prosecution to mask inconsistencies
and changing stories that Fastow told investigators as he negotiated a
better plea deal from the prosecutors. 

Similarly,
the Enron Task Force's apparent destruction of all drafts of the
individual 302s of the Fastow interviews in connection with preparing
the final composite is equally troubling. Traditionally, federal agents
maintain their rough notes and destroy draft 302s. However, in regard
to the Fastow interviews, my sense is that the draft 302s were not
drafts in the traditional sense. They were probably finished 302's that
were deemed "drafts" when the Enron Task Force decided to prepare a
composite summary of the 302's.

Note that showing how a person's story has changed over time is a key prosecution tactic, but one that is being illegally denied to Skilling.  Apparently Skilling's team has now seen the actual interview notes, and believe they have found "a sledgehammer that destroys Fastow's testimony" against Skilling.  Stay tuned, a new trial may be on the horizon.

I have written before that the government story of the next decade will be the financial meltdown that will ensue as state and local governments are forced to face up to the enormous unfunded pension and medical liabilities they have assumed for their state employees.  Largely, these liabilities are currently well-hidden and off the books, a trick even Jeff Skilling was unable to pull off at Enron. 

My previous prediction that the liabilities probably total over a trillion dollars now seems way low.  Just one state, Illinois, may have over $100 billion in such off-the-books liabilities, and this does not even include liabilities of local authorities like the city of Chicago:

The study puts the state's pension debt at $10 billion, its unfunded
pension costs at $46 billion, its unfunded employee health care costs
at $48 billion, and its unpaid Medicaid bills at $2 billion. The total
costs that will be pushed onto tomorrow's taxpayers without reforms is
an enormous $106 billion, or $8,800 per every person in the state of
Illinois.

Apparently Chelsea Clinton will start work soon as a McKinsey associate.  However, she doesn't seem to have had to solve eight or ten business case studies in real-time during interviews as I had to, nor am I guessing that she will spend her first year working 80-hour weeks buried in spreadsheets and charts.  As a aside, the first partner I worked with at McKinsey was Jeff Skilling, of Enron fame, one of the brightest people I ever worked with.

Tom Kirkendall has an update on the various Enron cases, starting with the Nigerian barge case where  the conviction of four Merrill Lynch executives was vacated by the Fifth Circuit.  In fact, the appeals court ruling was so damning that the DOJ has decided not to retry the executives, and the case may well be a leading indicator that other Enron-related prosecutions are in jeopardy.

Although expected, the DOJ's decision in the Nigerian Barge case
reverberates through several other pending Enron-related cases. The DOJ
can retry three of the four former Merrill Lynch executives, but that
would be petty by even the DOJ's standards given the eviscerated nature
of the original charges and the fact that each of the defendants has
already spent a year of their lives in prison based on a prosecution
that was based more on resentment than on true criminal conduct. The
Fifth Circuit's now final decision in the barge case casts doubt (see also here) on a substantial number of the charges upon which former Enron CEO Jeff Skilling was convicted, and dispositively blows away over 80% of the case against former Enron Broadband executive Kevin Howard. In addition, the re-trials of Howard's former co-defendants from the disaster that was the first Enron Broadband case are now in various states of disarray, as is the pressured plea deal of former mid-level Enron executive, Chris Calger. And don't forget the mess that is the DOJ's case against the NatWest Three (see also here).

There is no doubt that electricity markets are a mess.  Electric utilities have been regulated for so long and in so many ways, and new capacity is so hard to add, the deregulation experiments tend to fail over short time periods for any number of reasons.  In California, what was called "deregulation" never really was such, since pricing signals were never passed on to consumers and therefore never really influenced demand.  In Texas, the areas where my company operates still struggle with deregulation, and we have seen few price or customer service benefits. 

This is not that surprising when you consider other major industries that have been so thoroughly regulated.   Railroads come to mind, for example.  Deregulation occurred thirty years ago and we are only recently starting to see a renaissance in that industry.  Pre-deregulation airline incumbents (e.g. Delta, United, American) are still struggling with open markets.

Mike Gibberson links a pair of court decisions that may set back any progress made in deregulating at least the wholesale electricity markets.  In a series of suits, the State of California is seeking a mulligan, asking the court to rule that wholesale electricity contracts it entered into in 2000-2001 should be voided because the price was too high and FERC did not have the authority to allow blanket market-based rather than cost-based electricity pricing.  And the judges seem to agree:

The panel held that prices set in those bilateral transactions pursuant
to FERC's market-based program enjoyed no presumption of legality.

I don't think there is anything more depressing to a good anarcho-capitalist like myself than seeing the government rule that a price negotiated at arms length by the free will of consenting, and in this case well-informed adults enjoys "no presumption of legality."  If not, then what does?  Is that where we are heading, to a world where no voluntary actions enjoy a presumption of legality?

By the way, one has to remember that this is not a case of an impoverished high school drop-out in East St. Louis signing a high interest rate loan he didn't understand.  This is the case of highly paid electricity executives and government electricity officials signing electricity contracts.  It is as ridiculous to argue that they were somehow duped in buying the one and only item they ever buy for resale as to argue that Frito-Lay somehow shouldn't be held responsible for the price it negotiates for potatoes.  These electricity companies knew they had obligations to supply power at retail at certain rates and failed to lock up enough supply in advance.  Whether Jeff Skilling gamed the short-term spot market is irrelevant - the utility executives were at fault for finding themselves beholden to the spot market for so great a volume of electricity, and doubly at fault for taking this power at insane rates when other lower cost options were available to them (such as cutting off customers on interruptible contracts).

Ken Lay and Jeff Skilling were convicted on numerous counts of fraud but were acquitted on most counts of insider training.  Professor Bainbridge has some quickie analysis.

I worked for Jeff Skilling for a brief period of time at McKinsey & Co.  Jeff was easily one of the smartest men I ever met, as well as the most detail-oriented.  It was this latter quality that forced me to concede that he was probably lying to Congress back when he said "I didn't know any of this stuff was going on in my organization."  Whatever else they did, Lay and Skilling will never be forgiven by my family for sucking in a couple of our family friends who were not business people (doctors and such) onto the Enron board, perhaps as dupes who had no hope of crying foul at the complex business machinations that were taken place.  Whatever the reason, our friends will spend the rest of their lives dealing with Enron lawsuits.

My only regret in this case is that I hate seeing some pretty scary prosecution practices get rewarded.  The guilt of Lay and Skilling does not change the fact that we need to start reigning in heavy-handed prosecutors, and disavowing the Thompson memo would be a good start. Update: Tom Kirkendall has much more on prosecutorial abuse in this case and possible appeal points.

In the next few weeks, Enron leaders Lay and Skilling will or will not be found guilty of various fraud-related charges (betting is that they will be).  You, in turn, may or may not agree with the verdict. (Disclosure:  I used to work with Skilling at McKinsey.  From my knowledge of his brilliant mind and his attention to detail, I thought that his Congressional testimony that he was unaware of the shenanigans in the SPE's was unconvincing, and so thought at the beginning of the trial he would be found guilty.  However, the prosecution's case has had surprisingly little to do with the SPE's and was weaker than I expected, so I am less sure now).

Wherever you are on guilt or innocence, you should be concerned about the increasingly aggressive tactics that prosecutors are getting away with in this and related cases.  Tom Kirkendall is all over this story, and reports:

the Enron Task Force refused Ken Lay and Jeff Skilling's request to
have the prosecution recommend to U.S. District Judge Sim Lake that
half-a-dozen former high-level Enron executives who have declined to
testify during the trial on Fifth Amendment grounds be granted immunity
from having their testimony used against them in a subsequent
prosecution.

Those witnesses -- several of whom have been mentioned prominently
in testimony during the trial -- would likely provide exculpatory
testimony for Lay and Skilling if they were to testify. The
Lay-Skilling defense team limited their immunity request to those six
witnesses even though the Task Force fingered the unprecedented number
of the Task Force identified over 100 former Enron executives
as unindicted co-conspirators in the case for the transparent purpose
of preventing the jury from hearing the full story of what happened at
Enron.

Another potential outcome may be the weakening of attorney-client privilege.

I have been following the Lay/Skilling Enron trial fairly closely, if only because in a past life I worked briefly with the principles, having worked with Jeff Skilling at McKinsey & Co. before he went to Enron.  By the way, if this causes you to assume this makes me particularly sympathetic to the gentlemen, think again.  Jeff Skilling is one of the brightest and most detail-oriented people I have ever worked with, giving me near certainty that his testimony before Congress where he imitated Sargent Shultz (I know nothing... NOTHING) was perjurous.   So I am not entirely neutral, but maybe not in the way you might imagine.

However, all that being said, Tom Kirkendall (whose blog is here and is doing a great job keeping up with the trial) has a very interesting post on the fairly scary tactics the Enron prosecution task force has brought to bear on a number of Enron and Enron-related defendants:

In an unprecedented move, the Task Force has named over 100 co-conspirators
in the case. So, the potential definitely exists for substantial
testimony about out-of-court statements going to the jury without the
defense ever having an opportunity to cross-examine the persons who
made the alleged statements. Moreover, fingering unindicted
co-conspirators is an equally effective technique for the Task Force to prevent testimony that is favorable to the defense
because persons named as unindicted co-conspirators are likely to the
assert their Fifth Amendment privilege against self-incrimination and
thus, not be defense witnesses during the trial. Thus, the Task Force's
liberal use of the co-conspirator tag has a double-whammy effect -- not
only does it allow the Task Force to use out-of-court statements
against defendants without having the declarant of the statements
subjected to cross-examination, it has also effectively prevented
previous Enron-related defendants from obtaining crucial exculpatory
testimony from alleged co-conspirators who have elected to take the
Fifth and declined to testify.

The co-conspirator tactic has had a huge impact on two of the previous Enron-related trials. During the Nigerian Barge trial,
the Task Force used out-of-court statements of co-conspirators
regarding the key factual issue in the case -- that is, what was said
during a conference call between several Merrill and Enron executives,
including former Enron CFO Andrew Fastow -- without ever having to put
a witness on the stand who actually participated in the call.
Similarly, none of the dozens of unindicted co-conspirators testified
on behalf of the defendants during that trial, so the Task Force's use
of the tactic effectively prevented the Merrill Lynch executives in
that case from providing the jury with exculpatory testimony. Not
surprisingly, the Task Force's liberal use of the co-conspirator tactic
has become a key appellate point for the Merrill executives in the appeal of their convictions.

Similarly, the importance of the co-conspirator issue on freezing
out exculpatory testimony was brought into full focus during the trial
of the Enron Broadband case last year. In a trial that, at the outset, appeared to be a sure-thing for the prosecution, the Task Force's case unraveled quickly as witnesses Lawrence Ciscon and Beth Stier
both testified to a riveted jury about how the Task Force's threats of
prosecution against them gave them second thoughts about providing the
exculpatory testimony that they gave during the trial. That trial ended
in a disastrous mix of acquittals and jury deadlock on the prosecution's charges.

The ability to face and cross-examine your accusers is a fundamental part of the American legal system.  Even well-intentioned relaxing of this principle has in the past led to innocent people going to jail.

Update:  Kirkendall writes that the same issue is being addressed on appeal in the Worldcom trial of Bernard Ebbers.

I don't know John Bolton from Michael Bolton, so I can't comment on whether he is an appropriate choice for the UN.  Nevertheless, there are a couple of things I do know:

1. Absolutely no one in the Senate gives a crap if Bolton has a temper or sometimes was tough on subordinates.  I am willing to wager about any figure you can name that many of the Senators commenting on Mr. Bolton are themselves strutting prima donnas who have blasted subordinates.  I remember that former CA Governor Gray (Grey?) Davis supposedly had some incredible temper tantrums with subordinates, but at the time that was not thought to be a disqualifier for office.  Why is it that stupid issues like this (or the immigration status of nannies) seem to dominate confirmation hearings rather than the person's qualifications and philosophy?
2. I have worked for not one but two men who have been featured on that famous "Toughest Bosses in America" list.  Compared to some of my encounters with these two, the stuff being talked about with Bolton is a joke. 
3. When you hear "the UN" when any senator is talking, substitute the word "Enron".  This is not quite appropriate, because in many ways, as referenced here, the UN scandals are much worse than Enron.  However, if this comparison is at all apt, why is it so inappropriate to send an ambassador who is openly skeptical of the UN in its current state?  When the feds sought out a prosecutor to oversee the Enron investigations, did they go looking for a person who had a high degree of respect and friendship for Ken Lay and Jeff Skilling?