As I prepare to teach Deals again this fall, I have been reading Eichenwald's account of the Enron meltdown, Conspiracy of Fools. It's a very good read if you find Enron endlessly intriguing. I do. For the more casual reader, I suspect Eichenwald's tendency to include what seems like every source and every memo might become a little tiresome. But for a scholar, it's great.
One theme I find challenging to teach in my deals course is the ethics of financial engineering. Where should we draw the line between ethical and unethical, criminal and legal? Should there be two lines or one? Why?
One argument for having a clear line between criminal and non-criminal conduct is that a fuzzy line may deter socially productive behavior as well as socially undesirable behavior.
But what, exactly, is socially productive about financial engineering? A fuzzy line may be okay if the legal behavior it deters doesn't create much social value.
This is a long post, so I'll summarize the key points in advance:
1. Financial engineering, unlike most deal lawyering, does not create value. It merely shifts value around.
2. A fuzzy line between legal and illegal conduct deters some legal conduct.
3. Overdeterrence is less problematic, though, if the legal conduct it deters is not socially productive.
4. Criminalizing the business purpose doctrine may be the best (only?) way to draw a line between legal and illegal financial engineering.
Financial engineering, as I use the term, refers to exploiting the gap between the economics of a transaction and its treatment for legal, regulatory or accounting purposes. While transaction-cost-engineering (the primary role of the deal lawyer) creates value by allocating risk to the party who can best bear the risk, financial engineering is typically a zero sum game. Value is shifted, not created. Improving the tax treatment of a transaction creates value for the client, but usually at the expense of the government. Improving the accounting treatment of a transaction pleases management and increases the short-term value of their stock, but usually at the expense of long-term shareholders or nonadjusting creditors.
Not all financial innovation is zero sum. Sometimes new deal structures carve up risk in a useful way that lowers the cost of capital. New financial products may improve the liquidity of markets. But where deal structures are tweaked to improve the tax, accounting or regulatory treatment without changing economic risk, there is little social utility. Lawyers are no longer shifting risk or reducing transaction costs -- they are merely reducing regulatory costs for the client at the expense of other parties (shareholders, creditors) or the public at large.
Perhaps there is some social value to financial engineering. Involving lawyers in deals usually encourages a culture of compliance. In other words, when lawyers push transactions to the line without crossing it, at least it suggests that the line matters. Blatantly fraudulent transactions may be prevented.
Also, transactions that expose badly-designed regulations (i.e. where economically identical transactions receive different legal treatment) may encourage better line-drawing by regulators.
But most financial engineering, as I've defined it, has little or no social value. A transaction that allows a company to book income on its financial reports that bears no relationship to the economic substance of the deal is not socially productive. A transaction that allows a company to avoid income on its income tax return without facing any economic consequences is not socially productive. I see nothing wrong with using the criminal law to deter such transactions IF we can do so without deterring transactions that are socially productive.
So how might we distinguish between the two? It's tough.
I am becoming resigned to the notion that the only practical way to distinguish between socially productive and socially destructive transactions is some sort of "business purpose" test similar to what is used in tax. If a transaction is motivated by a business purpose, then tweaking the structure to obtain a better legal, accounting, or regulatory treatment is okay. If, however, the transaction has no business purpose but is, instead, engineered to improve the balance sheet or reduce tax liability, then the transaction should be prohibited.
In an ideal world, we might expect the government, in advance, to craft perfectly clear regulations in tax, accounting, securities, environmental law, etc. --- which would then allow us to say that any transaction that fits within the literal four corners of the regs is perfectly legal. But this is unrealistic. Regulations are imperfect and fuzzy and always will be. Even when they are clear, lawyers and bankers will develop a new structure that suddenly makes the old rules less clear.
This leads me to the conclusion that criminalizing the business purpose doctrine (and extending it from tax to accounting) might be the right solution. In other words, where the government can prove that a transaction lacked any cognizable business purpose (in light of all the relevant facts and circumstances), then not only is the transaction unethical, it is illegal. If the transaction has some business purpose but mostly a financial engineering purpose, then the transaction might be unethical but not illegal. If the transaction primarily has a business purpose, then it is both legal and ethical.
The obvious problem is that figuring out business purpose is itself a difficult task. And it is easy for lawyers to manipulate through careful drafting of board minutes and the like. How much business purpose is enough? Not clear. Doctrine would have to develop through case law and Congressional guidance. We would also have to sort out such questions as whether improving one's credit rating is a legitimate business purpose.
Criminalizing the business purpose doctrine might discourage some transactions that have a little bit of a business purpose and a lot of financial engineering purpose. Many securitizations and structured finance transactions, for example, would be suspect. Is that so bad? I'm not sure. If I am right that financial engineering has little social utility, then the over-deterrence problem isn't such a problem after all.
I am okay with deterring some socially productive behavior if it also discourages a lot of socially destructive behavior. Given limited resources for enforcement of ethical and legal rules, using the criminal law as a backstop (and to express our social expectations) makes a lot of sense.
Is there a better way to criminalize the business purpose doctrine without deterring socially productive behavior?
Or is relying on the purpose or intent of the deal-makers the wrong path to pursue? How else could we draw the line?
Criminalizing the business purpose doctrine has LOTS of potential problems, but I am finding it hard to find a better solution. I don't see how the status quo -- where fraudulent transactions are sometimes criminal, sometimes not, and no one knows what "fraud" is -- is better.
I should stress that my thoughts here are preliminary and not targeted at KPMG, the Nigerian barge case or anyone case in particular. My goal here is to start putting some thoughts on paper, and perhaps I will try to apply them to specific facts later. As it is, the only theory of the ethics of financial engineering that we have is the "smell test," and it has not served the country well. The smell test is the sort of test that increases the cost of doing business without actually preventing socially undesirable conduct. I certainly hope we can do better, and this post is an attempt to move my own thinking along.
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1. Posted by Preston Tucker on August 15, 2005 @ 13:22 | Permalink
I'm sorry, I know you want to avoid the details at this point, but perhaps that is putting things in the wrong order. May I ask now -- as opposed to later when I presume you will attempt to apply doctrine to the details you put off considering -- just what in Eichenwald's book sparked your blog? He simply adopts Batson, DOJ characterizations of Enron transactions, then tries to add a novelist's touch. Eichenwald starts off on the wrong foot, though apparently an entertaining one, from the get go when he gravely states that mark-to-market accounting is somehow unique in that MTM companies have to start at zero earnings ever year. Well, what company doesn't? I'm not an academic, but I think I've heard that doctrine should be grounded in reality; if one assumes something is wrong, then builds a theory to fix it, one had better pray he or she was right about the original assumption.
So, back to Eichenwald, and Enron, if I may. Where are the transactions in the "gap" you speak of, which lack a business purpose?
2. Posted by Vic Fleischer on August 15, 2005 @ 13:49 | Permalink
Preston -- you are right to ask for more concrete examples. I will try to do more of that as time permits. But staying away from Enron/Tyco/KPMG etc (as much as possible) is supposed to help us academics keep from reverse-engineering a theory to match the result we want. Theory first, then you test it.
So, anyway, I hope to get to details later. For now I will just say that without passing judgment, transactions at issue include everything from ordinary pipeline accounting to MTM accounting to LJM and LJM2 to the barge transaction to the circular forward contracts.
Obviously, lots and lots of routine transactions exploit a gap between economics and legal treatment, and many transactions share both a business purpose and a financial engineering purpose.
The universe of transactions that have no business purpose, however, is fairly small. Most tax shelters fall into this category. I suspect that some but not all of the Enron transactions that Eichenwald discusses would fall into that category, but I cannot say that with confindence until I develop more facts and test the theory. I haven't even finished the book yet.
If you have examples of socially productive transactions that you think would be deterred by my scheme, that would be helpful to me.
3. Posted by Preston Tucker on August 15, 2005 @ 14:15 | Permalink
I don't know what was wrong with the Enron transactions you listed, and certainly am no wiser after having read Eichenwald. What do you think was socially unproductive about them?
Interesting that you mention KPMG. Have you seen the anonymous memo by present and former KPMG partners and directors that has just started circulating? Peter Henning has linked the memo here. http://lawprofessors.typepad.com/whitecollarcrime_blog/2005/08/more_kpmg_dirty.html
If the memo is not a hoax – and it doesn’t appear to be – it would appear to me to be the sort of explosive document that would cause one to pause and reassess just what it is that has gone wrong. Might our efforts be better spent on questioning those who say there are witches amongst us, rather than on figuring out who the witches are?
4. Posted by Shag from Brookline on August 15, 2005 @ 14:44 | Permalink
Assuming that lawyers can locate and draw the line (or lines) between the ethical and unethical, criminal and legal, is it their duty to their client to advise and/or guide the client who wishes to do so how close to be able to get to it (them) without crossing it (them)? If so, what if the location and drawing of the line (lines) turn out to be incorrect? What kinds of fees should these lawyers expect from their client?
5. Posted by save_the_rustbelt on August 15, 2005 @ 16:58 | Permalink
Shag:
lawyers generally expect to be paid regardless
whether they deserve to be paid is the more interesting question
6. Posted by Ron Groeber on August 16, 2005 @ 17:13 | Permalink
I have read Eichenwald's "Conspiracy of Fools." I can see why your interest in transactions/deals draws you to it. But you should note it takes a lot of liberty in dealing with the actions of Ken Lay. In Eichenwald's book, we are told what Lay is thinking. How did he know that Lay was admiring Sheila Watkins for her courage when she was whistleblowing. I suppose he is taking Ken's word for it. For this reason I have read the book but won't quote it. I don't know if I can trust a journalist who would proceed in such a way.
7. Posted by Peter on August 16, 2005 @ 21:37 | Permalink
Your definition of financial engineering differs from a definition that exists & is accepted to be standard among financial engineers, finance professors, & applied mathematicians. See e.g., A Normative Analysis of New Financially Engineered Derivatives, 73 S. Cal. L. Rev. 471 (2000), reprinted in 33 Securities L. Rev. 637 (2001) and excerpted and reprinted in 1(12) Derivatives Report 13 (2000)
8. Posted by Vic Fleischer on August 17, 2005 @ 7:36 | Permalink
Peter -- yes, that is true. I was careful in my post to distinguish what I was talking about from financial innovation, which is often socially productive.
I am not sure a phrase exists to describe the lawyer's role in managing or exploting the gap between economics and legal treatment. Regulatory arbitrage is close but not quite right. Regulatory cost engineering, perhaps? I use financial engineering because it is a useful way to get the general idea across, but maybe I should stay away from it to avoid confusion with financial product engineering.
9. Posted by Peter on August 17, 2005 @ 9:39 | Permalink
Vic, your care to distinguish your definition from a traditional definition is commendable. But, other legal scholars might neither be aware of, nor make such a distinction. The word engineering in the phrase financial engineering might have originated from the fact much financial engineering theory is based upon stochastic calculus & financial engineering done by invetsment banks or hedge funds involves numerical methods, e.g. Monte Carlo simulations. The same mathematical heritage does not apply to Gilson's choice of phrase transactions costs engineering. The liberal usage of the word engineering probably culminated in the euphemism sanitation engineers for garbage collectors. Frank Partnoy has already established the precedent of using the phrase regulatory arbitrage in legal writings. Your suggested phrase of regulatory cost arbitrage nicely parallels Gilson's phrase & avoids possible confusion. Finally, the phrase financial engineering describes a proper subset of the phrase financial innovation. For example, credit cards are usually not viewed as financial engineering but are ususally thought of having been a financial innovation for a method of payment. Just hoping to prevent confusion & disagreements over terminology.
10. Posted by Vic Fleischer on August 17, 2005 @ 10:47 | Permalink
Thanks Peter, this is helpful. You are spot on that financial innovation is broader than financial engineering.
I will think about the proper phrasing more as I move forward with the project. I am partial to the word engineering as it is more consistent with Gilson's original phrase and conveys a more active role for the lawyer. Whether that characterization is accurate depends in part on what we think lawyers do, or ought to do.
11. Posted by Peter on August 17, 2005 @ 20:46 | Permalink
You're welcome, Vic. Just somew final thoughts. Regulatory cost engineering (not the typo in my last post of regulatory cost arbitrage) does evoke Gilson's phrase & images of active lawyers. But, arbitrage also depicts activity. The juxtaposition of lawyers & engineering just seems ironic because most lawyers suffer from math anxiety if not math phobia, except for JD/MBAs, some IP lawyers, & former undergrad math/physics/engineering majors. Also, engineering something sounds technocratic & socially neutral, if not desirable.
12. Posted by Nancy Friedman on October 19, 2005 @ 6:23 | Permalink
I have been interested in the ethics of
Financial Engineering and these comments
have helped me figure the whole thing out.
Espcially engineering vs innovation.
I read a past edition of FEN (Financial Engineering News) which had a whole bunch
of visionaries and "experts" in the field
discussing similiar issues and it touched
upon a lot if this. I believe the next issue (Nov-Dec) will be addressing this, too. It's worth checking out.
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