I was initially afraid to post this question because, for the love of God, I did not want to take my reputation down a notch, but I'm feeling spunky today:

Assuming the facts are exactly as Tom indicates, what was Enron's point in executing this sale (assuming it is a true sale) IN THE WAY that they did and WHEN they did? Please use seventh-grader language to be sure all can understand.

Good question. In tax, there is a business purpose requirement, which seems to be the sort of thing you are getting at. But I am not so sure about accounting rules. Is it unethical to conduct a transaction that has no (or little) economic substance simply to improve the income statement? Or was there some other business purpose?

I didn't see any details on this in the briefs, but Tom knows the facts better than I do, so maybe he or someone else knows and will comment.

Whoops. I realize I did not use 7th grade language. I'm not sure 7th grade language will get the job done. I will try, though: Enron wanted to improve the way its financial statements looked so that it could borrow money from the banks and the public at a lower interest rate.

Regarding a business purpose, what about transfering Nigerian risk while those barges along with others were repackaged for profitable sale to AES, and obtaining working capital in the meantime, to name a couple? And about pretty financial statements, would $12 million of revenue really have mattered to a company with some $40 billion of revenue for the year?

Good point. If, as Elizabeth asks, we assume that the facts are as Tom K presents them, then Preston is right.

From an academic perspective, tho, I guess I still have trouble understanding the business motivation. It seems odd, expensive, and inefficient to allocate political risk to an investment bank. ML presumably had to then turn around and hedge the political risk itself or seek a premium for the deal. And as for seeking working capital, it seems like an expensive way to borrow money.

Vic, your question. "Is it unethical to conduct a transaction that has no (or little) economic substance simply to improve the income statement?" seems to have little relevance to a discussion of criminal behavior. Is it illegal? - is more on point.

Secondly, in your response to Tom you mention “…unenforceable. This does create some economic risk.” Is it the level of risk that defines legality?

You also commented... “But the more substantial (i.e. more likely) economic risk is a decline in value, not a complete loss.” I believe you have this backward. If the barges sank or the political uncertainty was realized in a worst case the loss would be total. These were the more important and possibly the more probable risks not a general decline in value. These risks were far more likely to cause ML a loss than Enron being able to deliver a third party buyer.

Lastly, if the transactions were not common why did Canadian Imperial Bank of Commerce agreed to pay $2.4, J.P. Morgan Chase & Co. $2.2 billion and Citigroup $2 billion. I suggest they too were structuring off balance sheet transactions.

Tom Kirkendall makes a reasonable case. So does Vic Fleischer. Without looking into this more, I can't decide whether the Merrill defendants committed a wrong. But unless Tom is totally misrepresenting something, I have my doubts. And I think they're reasonable. Whether you have a reasonable doubt about the guilt of the defendant(s) is all that matters in criminal law.

For many prospective jurors, I would bet that before an Enron-related trial begins, they believe the defendant is guilty. That is wrong. I bet most prospective jurors, however, would say that they don't know whether the Enron defendant is guilty because they have not heard or seen the evidence. That is wrong too. A criminal defendant is innocent until the evidence is presented to prove him guilty. I worry that we forget this.

Sal noted:
"Vic, your question. 'Is it unethical to conduct a transaction that has no (or little) economic substance simply to improve the income statement?' seems to have little relevance to a discussion of criminal behavior."

I took Vic's question to mean "is it fraudulent to book an otherwise useless transaction solely to make it LOOK LIKE the books are stronger than they really are (in order to convince investors/bankers/analysts that the business being misrepresented is worth investing in, financing, or holding equity in)?"

The answer "yes," right? I mean, that is fraud: Trying to get folks to give up their cash for stuff that is not really the stuff they are being marketed. (Credit to Prof. Korman, I think, for roughly that definition of fraud. I'm likely mis-quoting, but the language was equally user-friendly.)

The "prettying up the balance sheet" mea culpa does not hold water. Enron incurred huge transaction costs and used a needlessly cumbersome transaction structure for the sole purpose of getting a favorable accounting treatment. All this financial engineering altered the underlying economics of the deal not one whit. For recommended reading on the subject, see the report issued by the SEC in mid-June on off-balance sheet financing arrangements. It is posted on the SEC website. And yes, the factors that go into determining the ownership of property, and whether a sale has occurred, for tax purposes largely mirror the factors that accountants use when presenting a company's financial statements.

Elizabeth

Companies enter into all kinds of transactions, some that are uneconomic, just to dress up their reporting. It is a common business practice. What I believe is illegal and fraud is false reporting which is what is claimed in this prosecution. The actual act being how the accounting was handled not the transaction itself.

In the barge transaction the prosecution has claimed, by way of 47 un-indicted co-conspirators, that the corporate attorneys, outside law firms, and all the accountants named knew that the reporting was improper and intended to break the law – a conspiracy.

Elizabeth, I do not know the size of the business or social circles you travel in, but the idea that a large number of professionals with records as good citizens and community leaders would intentionally (knowingly) work in support of breaking the law - this is not something I can relate to in my experiences.

Sal,

Common business practice is a non sequitur with respect to what is legal. Remember spinning? How 'bout "buying" (as it were) good research reports? QED.

I am not familiar with your business or social cirles, but I not need to be. Nor do you need to be mine. I suspect we can both agree that, indeed, good folks sometimes do bad things, either because they just DO or because they have convinced themselves that what they are doing is somehow justifiable. (e.g. Clinton, Nixon, Milken, North)

I'm sorry Richard, but the "underlying economics" included at a minimum increased working capital and less Nigerian risk, which is some serious risk. Thus, your "sole purpose" comment just doesn't hold up -- or water. Whether the fees were "huge", the transaction "needlessly" complex, etc., are matters that I suppose can be debated, but we'd need some more information. E.g. what are your points of reference here?

And whether tax versus accounting considerations largely mirror each other, try telling that to the tax and accounting folks who spend "huge" amounts of time working on the real differences between them. Perhaps all that is "needlessly" done?

Preston, I appreciate the opportunity to expand on my earlier comment. As to whether the fees were huge, please see the Joint Committee on Taxation's report on Enron's off-balance sheet machinations. As to whether the Nigerian transaction was needlessly complex, let me suggest that Enron had far more direct routes by which it could have increased working capital and mitigated Nigerian risk. The more direct routes would not have served the purpose of inflating the balance sheet, of course.

My point about tax and accounting considerations largely mirroring each other was limited to the narrow issue of identifying factors that determine whether an asset has been sold or is still owned.

I certainly agree there are real differences between tax and accounting considerations; in fact, I am one of those "folks" who has spent "huge" amounts of time working on the difference between them. The differences are not "real" in any sense, however. Contractual allocations of economic risk and reward are unaffected by how the transaction is reported to investors or the government. But when considerations of how to report a transaction to investors or the government become the overriding objective, thus distorting the optics, without improving the underlying economics of the deal, I am hard pressed to see the value.

Richard, I think we might ultimately find ourselves in significant agreement here. About the tax report, I listened to the hearing at which the results were reported and don't recall any conclusions about illegality, something that one would have expected from that clearly highly partisan bash-Enron effort had there been even the thinnest thread of an argument to base such. And about the quality of work of the government in general -- especially when it comes to Enron -- I only have to point to the irresponsible and presumably knowingly wrong take by Congress on the Enron prepays. More importantly for this conversation, perhaps, is that I detect a certain frustration in you regarding the work of these governmental folks, as it is the "unreal" differences that exist in their rules with which you appear to have to spend "huge" amounts of time dealing.

But in any event we were talking about the Nigerian barges transaction. Whether the "optics" were distorted would seem to depend, most simply, on whether risk had transferred. I trust you would agree that if risk were satisfactorily transferred than a recognition of earnings and funds flow would have been appropriate, right? You note that the tax and accounting laws are of mostly one mind on this issue. Would it concern you to know that the barges defendants tried to get in expert testimony on both the accounting and tax rules related to this issue but were thwarted by the DOJ? This seems just another disturbing example of the prosecution distorting the record considered by the jury. Then, about "needless" complexity "without improving the underlying economics," it would seem a certain level of complexity would have been necessary (1) to set things up so that risk was transferred -- a laudable goal all by itself, which was rewarded by allowing earnings and funds flow recognition -- and (2) to insure that Enron was in a position to repackage the Nigerian barges with other barges in anticipation of a further profitable deal in the future it needed Merrill to remain a passive investor. Actually, wasn't this really a very smart transaction, and one that was ultimately successful for all involved, including as mentioned Enron, Merrill, LJM, AES and Nigeria -- until of course the DOJ came along? What are the more "direct routes" to have accomplished this, or would you now have to start charging me by the hour?

Respectfully yours,

Preston

Preston, the Joint Committee on Taxation's Enron report, as well as the two interim reports on Enron's financial engineering issued by Neal Batson, the court-appointed special examiner, lay out the facts more neutrally than the hearings before Congress, which not surprisingly were calculated to appease the cameras. It is hard indeed to read these extensive investigative reports and maintain a benign view of Enron.

Blame for the artificial distinctions between financial reporting rules and tax reporting rules cannot be laid fully at the government's door. Tax reporting is prescribed by Congress and the IRS. Financial reporting has for many years been regulated by the Financial Accounting Standards Board, a nongovernmental, not-for-profit organization. This has now changed, with the creation of the Public Company Accounting Oversight Board under the Sarbanes-Oxley Act. It remains to be seen whether the PCAOB can do a better job of prescribing financial reporting rules than the private sector.

I am inclined to agree that if risk were "satisfactorily" transferred in the Nigerian barge deal, then some reflection of this fact in Enron's published financial results would seem appropriate. But I am unconvinced that risk was "satisfactorily" transferred, and I doubt you and I can reach agreement on this point.

Whether the prosecutors should have brought criminal charges regarding the Nigerian barge transaction is something reasonable persons can hold different views on. I don't, however, understand your criticism of the prosecutors for out-lawyering counsel for the defendants by keeping the expert testimony on accounting and tax rules out of the record at trial. Perhaps the defendants should have hired better counsel. Perhaps the judge erred in excluding the evidence, but that is what appeals are for. It is most certainly not about "the prosecution distorting the record considered by the jury." Defense counsel doubtless would not hesitate to "distort" the record if it served their client's interests. No one is entitled to a perfect trial, only a fair trial. It remains to be seen whether the appellate courts find this a fair trial, but the prosecutors should not be criticized for doing their job skillfully in the courtroom. (Again, whether the charges should have been brought in the first place is another debate, on which I stake out no position.)

Your earlier post identified two supposed aspects of the underlying economics -- increased working capital and less Nigerian risk. Free of charge, let me suggest more direct routes of achieving these goals.

You can always increase working capital by rolling up your sleeves and running the business so as to improve operating margins and cash flow. This approach has the additional salutary benefit of fostering long-term business efficiencies, rather than transitory financial reporting advantages. Did Enron improve its working capital in truth, or merely in appearance? The latter, I am disposed to say.

"Less Nigerian risk" may be an awkward way to put it. Enron could not "lessen" Nigerian risk. At most, Enron could contractually redistribute some of that risk to other parties. By at least two more direct routes, Enron could have lessened or even eliminated its Nigerian risk without all the transactional complexity and steep transaction costs: (A) a straight cash sale, or (B) insurance. Neither route would have presented a parallel opportunity to inflate Enron's balance sheet at the expense of investors and other users of Enron's published financial statements.

Asymmetric information distorts pricing and causes market inefficiencies. Enron took asymmetrical information to new heights, duping investors out of billions of dollars. Management, with the help of talented advisors who knew fully well what they were doing, presented a different view of Enron's business to the world than the view held by management. This in turn caused investors to allocate wealth (about $60 billion) to Enron, rather than to truly productive economic activity. Economic inefficiency on a titanic scale resulted.

If you have an argument suggesting how the strategic use of asymmetric information, by the very same parties who create the asymmetric information through distorted financial reporting, promotes an efficient marketplace, I'd love to hear it.

Best regards,

Richard

Richard, seems as is the nature of life in the blogsphere this thread has winnowed down to a conversation between just you and me.

I completely agree with your comments on the danger of "asymmetric information," I am just questioning whether the Enron financial statements are a good example of that. And as the first step in that questioning, we've been taking a closer look at the barges transaction, which has been sold as a quintessential example of Enron creating asymmetrical information.

Focusing again on the economics of that transaction, I don't see how the "direct routes" you mention handle the additional business goal of being in the position to ultimately repackage the barges with other barges for profitable further sale. And I don't understand your point about not being able to lessen Nigerian risk, unless you are getting philosophical. Isn't transferring 90% of the risk to a passive investor a significant lessening of that risk to Enron? More generally, might the transaction have been complex because the business purposes, which all seem laudable to me, were complex? And might all of us, who are otherwise inclined to judge harshly and too quickly, take a step back and see and appreciate just how smart and well-intentioned the deal and deal makers were?

But, alas, I see that this is where you and so many/most others become overwhelmed by the many myths and extreme prejudice that have resulted from the largely unfair demonization of Enron. I was happy to see that you were at least willing to be somewhat objective about what happened on Capital Hill, and that such was for the cameras -- and, I would add, the mob. On the non-advocacy "advocacy" of Neal Batson, I recommend you consider the August 3, 2004 decision of Justice Cooke in the UK regarding the JP Morgan Chase/Enron prepays, which soundly rejected the Batson analysis of those transactions. Then I would ask you to consider whether that might mean that other aspects of Batson's analysis should be questioned as well. Believe me, they should.

Finally, for now, I detect that you may not be completely satisfied by your "out-lawyered" explanation for the barges trial result. You shouldn't be satisfied. A careful and dispassionate review of the record should at least raise some serious questions about whether there was a miscarriage of justice there. I believe there was, and that at least one man, Dan Bayly, is sleeping in a cell tonight whereas he should be home with his family.

I have concluded you are a lawyer and see that you work for the DOJ, a presumably well-intentioned organization with immense powers, powers that I believe have been and are being abused by the Enron Task Force. An idealized view of the role of the professional prosecutor was set forth in Berger v. United States, 295 U.S. 78, 88 (1935), where the U.S. Supreme Court stated that the government’s interest in a criminal prosecution “is not that it shall win a case, but that justice shall be done” and that, therefore, it is the prosecutor’s duty “to refrain from improper methods calculated to produce a wrongful conviction [even] as it is to use every legitimate means to bring about a just one.” Given the contradiction between a mandate to seek only justice and a mandate to do so with every available means, the Berger construction is apparently rarely seen in the real world. “The admonitions to prosecutors in ethical codes and judicial opinions to ‘do justice’ in prosecuting a case has little meaningful effect, however, when the public judges prosecutors by the results of cases.” Peter J. Henning in Prosecutorial Misconduct and Constitutional Remedies, 77 Wash. U.L.Q. 713, 726 (1999).

You and I as fellow citizens and, in addition, you as a member of the DOJ have a personal interest in seeing justice done. It would seem that there is enough proof of injustice vis-a-vis the barges defendants in particular and Enron in general that you and everyone else should be concerned. This is serious stuff. This ultimately is the hard fought for, but unfortunately all too easily discarded, rule of law that is at stake.

Sincerely,

Preston

Preston, let me suggest that the multibillion dollar Enron settlements paid by Citigroup and JP Morgan, among others who touted Enron to investors, strongly imply that Enron's financial statements are a good example of asymmetric information. Wall Street investment banks don't shovel billions out the door to settle cases without good reason. (Millions, perhaps, for nuisance value, but not billions.)

For now I must leave our otherwise irreconcilable differences as they are. My posted comments reflect solely my personal views and not those of my employer.

Kind regards,

Richard

The plaintiffs in the Enron banking cases are claiming over $50 billion in damages. The district court refused to dismiss the case. A lay jury is going to be asked to evaluate a complex financial transaction by the defense and be told "Enron Enron Enron" by the plaintiffs. In that context, $2 billion seems a small extortion price to pay. It's not quite a nuisance settlement, but the settlement amount at a minimum shows the lack of faith the plaintiffs have in their own case that they're settling for less than a nickel on the dollar.