Coyote Blog

I have already read several commenters who have wondered how Skilling could be convicted of fraud (in the form of obscuring Enron's true financial health) but acquitted of most charges of insider trading.  Larry Ribstein (via Professor Bainbridge) asks

"Does this mean that the jury thought he didn't know enough about what
was happening to bar him from trading, but that he did know enough to
go to jail for fraud?"

Here is how I reconcile it:  The jury decided that Skilling committed fraud, but that it was not for personal gain in his stock.  How can that be?  What other incentive might he have?  Here is my explanation, based on some personal knowledge of Skilling and the Enron business model.

Enron's business model was Skilling's brainchild.  It was nearly 100% his baby.  He invented it at McKinsey and then moved to Enron to make it reality.  The trading model Enron adopted reflected Skilling's ability to handle a lot of complexity and his facility for numbers.  The failure of Enron would be a direct personal failure of Skilling's, perhaps the first and certainly the largest of his life.  Even without holding a single share of stock, Skilling had every incentive to want Enron to survive and in fact thrive.  Enron's failure would be a repudiation of his vision, a forceful proof that maybe he was not as smart as everyone thought he was.

Like nearly every new financial trading business, Enron at first enjoyed large margins on their trading deals.  This has happened throughout history, as the first traders who discover an arbitrage opportunity make lots of money.  However, over time, competition and general knowledge of the arbitrage opportunity tends to erode margins.  Eroding margins are a problem in every business, but particularly in trading.  Here's why:

Trading businesses typically make their money by executing huge transactions at thin margins.  These transactions require a lot of capital, and since margins are narrow, trading companies need to maintain a very low cost of capital.  For a company like Enron, this means maintaining a high stock price and platinum level credit to minimize borrowing costs.

The trap Enron fell into was not a new one.  As trading margins inevitably eroded (as described above) the company had to do more and more volume to maintain profits (it takes twice the volume of transactions when margins are halved to maintain profits at an even level).  But remember, Enron needed a high and growing stock price to keep its cost of capital as low as possible.  So it needed to show ever growing profits, which means in an environment of falling margins, trading volumes had to go up almost exponentially.  But, increasing trading volumes means more capital, much of it in the form of debt.  Borrowing more increased cash demands and put pressure on ratings agencies to downgrade their debt, which would have disastrously increased borrowing costs.  At the same time, falling margins and rising debt meant falling coverage ratios.    Old line trading firms like Goldman Sachs and Soloman Brothers have mostly avoided this trap by carefully husbanding and building their capital over decades.  But Enron tried to build the trading business too fast.

So you see the tiger Enron management was riding.  Any blip in their cost of capital, whether it be a fall in stock price or a downgrading of their debt, would crash the whole company.  But falling margins and a growing need for debt nearly guaranteed that their cost of capital was going to go up.  At first, management sought new growth avenues (e.g. broadband) or windfalls (e.g. California energy crisis) to make ends meet.  Eventually, management appears to have fibbed to bond and equity markets, in the form of false statements and burying the bad stuff in SPE's, trying to keep things from crashing.  Eventually, outsiders figured out what was going on, the commercial paper market dried up, and Enron faced a liquidity crisis that brought the whole thing down rapidly.

In this context, Lay and Skilling's obfuscation of the underlying financial health of the company makes sense.  Enron had reached a point where bad news about the business would do more than just depress the stock price - it could start a chain reaction that would bring the whole company to bankruptcy.  Knowing this, Lay and Skilling apparently sought to hide the true condition of the company, to try to buy time to find some way out.  Skilling, much much smarter than Lay, at some point probably realized that the crash could not be avoided and that's why he suddenly quit.  The tragedy (self-induced, of course) for these men is that nothing was going to prevent the eventual crisis, and Lay and Skilling bought a few months delay in Enron's downfall at the cost of what will probably be their freedom for the next several decades.

So, was Skilling a robber baron intent on nothing more than enriching himself at the expense of shareholders?  Or was he a visionary entrepreneur, who just couldn't accept that his dream and creation of over a decade's work was dying?  I don't really know, even having known the man personally, but the jury's verdict seems to point as much to the latter than the former.  And if it is the latter, has there ever been a visionary who was not the last person to admit his vision was a failure?  I can't tell you how many entrepreneurs I knew in the Internet bubble who were convinced their company was going to be successful almost right up to the day of bankruptcy.  Are we really better off as a society putting all these failed visionaries in jail?

I guess I end up with mixed feelings about the legacy of the case.  I certainly am worried about the prosecutorial abuse.  And cooking the books of a public company is bad and should result in jail time. Having worked once long ago with Skilling, I know for a fact that the man is brilliant and totally detail oriented.  There was no way he could not know about the SPE shenanigans, and for that alone he should face jail time.  My concern is that the other message, beyond just accounting fraud, of this case will be that we are criminalizing CEO's being overly optimistic about their company. And that strikes me as nuts.

Update:  Tom Kirkendall, who has been all over this case, has more here.  Larry Ribstein, whose question started this post, observed:

Many people think that there was so much loss associated Enron that the
guys at the center of it must have been villains. But they weren't
villains. The jury is saying they weren't even insider traders, as if
that would have made a difference. They lost as much as anybody, and
that's what drove them to lie, if they did lie. This doesn't make them
saints, but it should make even the most hardcore antibusiness types
queasy with the denouement of this tragedy. Locking these guys up for
pretty much the rest of their adult lives for being unable to face the
fact that their dream had ended is not the way a civilized society
would deal with this case.

Technorati Tags:  Enron, Skilling

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.

Tom Kirkendall has another excellent roundup of the Lay/Skilling trial.  According to Kirkendall, the prosecution is having some trouble, and in fact have wandered pretty far afield from their original indictment (a document that the prosecution now actually has disowned).  In effect, Lay and Skilling seem to be being tried for different things than they were ostensibly brought to trial for.  Most interesting is this:

On the other hand, the Task Force's case to date has wandered away from
the SPE's, so there is a decent chance that a difficult-to-control
Fastow could end up being a not-so-important witness in the
ever-changing big scheme of this corporate criminal case of the decade.

If Kirkendall is reading the trial correctly, and the SPE's and Fastow's testimony are becoming irrelevant, then the trial has virtually nothing to do with anything we have heard about in the media about Enron.

Barrionuevo and Eichenwald, who have been following the trial for the NY Times, agrees that the government case is shifting but believe it is due to the strength of what has been presented so far.

A steady drumbeat of damaging testimony in the five-week-old criminal trial against the former chief executives, Jeffrey K. Skilling and Kenneth L. Lay,
has led legal experts to praise the government case presented so far.
That has raised questions about the risks prosecutors would run by
putting Mr. Fastow, the former chief financial officer, on the stand as
early as Tuesday.

I haven't followed the testimony in any depth, so I can't choose from these two point of views, except to say that the government tactics of essentially changing the charges mid-trial and suppressing defense witnesses by naming a record number as unindicted co-conspirators may or may not be effective, but strike me as fairly scary abuses of the justice system.

The firm of Arthur Anderson was put to death by government prosecutors.  Unlike human beings, Anderson was killed without ever receiving a trial, and was dead long before any appeal was mounted.  Many a media tear have been shed for Enron employees who lost their savings in the Enron 401-K, where they invested in Enron by choice, but I have seen few people sympathizing with the tens of thousands of people who lost their savings in the AA collapse, the vast vast majority of whom never touched the Enron account.

Mary Morrison has a nice analysis (pdf) of why Anderson was probably killed unfairly.  Her central argument is that the main fraud at Enron was perpetrated in the off-balance sheet special purpose entities, or SPE's, when third parties put up capital that the SPE called equity, but was in fact really a loan with a verbal (non-written) promise to repay by either the entity or Enron.  By disguising a loan as equity, and by by disgusing related parties as arms-length investors, Enron was able to avoid consolidation of the SPE's with its financial statements.

Ms. Morrison argues persuasively that since Anderson was not the auditor for any of these SPEs, it had no way to uncover the true nature of these sham financing agreements, since these SPEs were effectively different corporations with different auditors.  AA had to rely on signed statements by each deal's principals that the financing for the SPE was as described (which is standard practice in this type situation and is considered to represent adequate due dilligence).  Anderson had no way to know what was going on in the SPE's, and since the SPE's were separate legal entities from Enron, it had no legal right to poke around in these entities and of course no subpoena power.  It had no way to know about the hidden verbal second part of the financing agreements.  She argues AA was a victim of the fraud and of false statements by Enron and the SPE managers and investors. 

It is interesting to note that the prosecution of the Enron case is prosecuting Enron managers right at this minute for making such fraudulent statements to AA and for hiding the nature of the SPE's from AA.  In other words, the prosecution team that first gave AA the death penalty for allegedly conspiring with Enron to hide their problems is now prosecuting Enron managers on the legal theory that AA was innocent and duped by the managers, which was AA's defense before they were wiped out.

Tom Kirkendall has more on AA's martyrdom here.  He also continues his scary series of articles on prosecutorial abuse here.  The pressure brought to bear to prevent defense witnesses from testifying is particularly frightening.  When you read this, you are really left wondering how the auditors for the SPE's, which may include KPMG, escaped unscathed (in fact escaped richer, since they got their share of the now-defunct Anderson's clients) when Anderson was put to death.