I'm not looking to get into a drawn out debate over Enron, but Tom Kirkendall has posted a long, thoughtful reply to my post that deserves a response, which I supply below the fold.
For reference, Tom's original post is here, my post is here, Larry R's response and my comment here, and Tom's reply here.
1. Is Enron Evil? Quite simply, I agree with Tom that the answer is no. Enron is not evil. Its managers are not evil. Even Fastow is not evil. Tom is mistaken if he thinks I am allowing prejudice against unpopular people to overcome the rule of law. I, too, was disappointed in the Enron documentary. I was originally trained as a tax lawyer, so I have more than a bit of empathy and sympathy for financial engineers. As much as Tom would like to attribute my feelings to some sort of personal animus, it simply isn't the case. Now, there may indeed be many folks in Houston who are furious at anything or anyone who had anything to do with Enron and are blinded by animus. I am not one of them.
Why, then, do I take such offense at bringing the fine personal and professional reputations of the defendants into the conversation? Why do I bristle at the reference to a Man For All Seasons? Making it personal undermines the sort of neutral principles that we normally rely on in legal analysis. We should be able to determine whether a transaction was legitimate or fraudulent without considering whether the principals were decent men or heroic or greedy bastards. Such matters are relevant for sentencing, and perhaps even for prosecutorial discretion, but they don't make the deal smell like a rose.
2. The Deal. Tom is right that I have not looked at the underlying papers. I understand that Enron did not literally sell the barges, but rather "sold" a company that held the barges as an asset. (Sold is in quotations because I do not concede that the sale was a true sale. As I read the evidence as summarized in the briefs, Merrill did not take on any economic risk.)
Tom does not explain the significance of this fact. It is, of course, quite common to transfer subsidiaries rather than assets. But I find it useful when explaining deals in the classroom, in scholarly papers, or in blog posts, to simplify the facts where appropriate. Does the fact that the barges were held by a sub that was owned by a parent company change the deal in a significant way? If it does, I hope Tom will let me know.
3. Economic Risk. Tom's argument is somewhat stronger than what I read in the briefs. Tom argues that in fact Merrill was taking on economic risk, but was willing to do so to secure future business. Perhaps there is good evidence or testimony on that point, I don't know. The defense briefs do little to undermine my initial impression that Merrill didn't take on economic risk, because wink wink nudge nudge it was going to be taken out in six months, max. This is the key factual question, and Tom and I seem to interpret the evidence differently.
Tom points out that Fastow's promise may have been legally unenforceable. This does create some economic risk. But the more substantial (i.e. more likely) economic risk is a decline in value, not a complete loss. And again, although Fastow's promise was likely to be legally unenforceable, it made the deal suspect. It is simply not clear to me that ML bore (most of) the risk of economic loss or enjoyed the opportunity for gain. Nor did ML appear to control the bargers/companies after the transaction closed. These are indicia of ownership under the tax law, and I am assuming that similar factors govern the accounting treatment.
Perhaps I'm getting the law or the facts or the accounting treatment wrong. If so, just let me know.
How much economic risk is enough? Hard to know. What seems clear to me is that ML did not take on as much economic risk as the public would have thought they did had they relied on Enron's financial statements. That's what the case is about.
4. LJM2. Is LJM2 a third party? Not in a meaningful way. But this may be clearer in hindsight than it was at the time. At the time, relying on the legal fiction that LJM2 was separate and independent may have seemed more sensible than it does now. I would need to dive in to the papers to really have an opinion on whether ML's beliefs were reasonable at the time.
5. Fraud. Is the deal ordinary finance, or is it fraud? I have a hard time viewing it as finance because it wasn't really a finance deal. Merrill took ownership of the barges (okay, the company that owned the barges) for a short while so Enron could book some artificial income. Tom says that this is "absolutely" a typical transaction. I was only in practice a brief while (3 years), so maybe I have a skewed data set. But this deal is very different than the bit of structured finance I worked on, or the securitizations that I have studied in my research. Conceptually, it resembles a tax shelter, except that the goal is to book an artificial accounting gain instead of an artifical tax loss. Just because a tax shelter is common does not make it legal. The same is true here.
There is something to what Tom is saying. In tax practice, people sometimes refer to the Wall Street rule, which (in this context -- there are other "Wall Street Rules") means that when over $x million dollars of a new financial product have been issued, the transaction is automatically blessed and is unlikely to be challenged by the IRS. So a shady transaction becomes less shady the more that it is done.
If earnings management was so widespread during this period that it was perceived as legitimate and perfectly legal, then there is reason to think that the Merrill defendants lacked criminal intent. Still, there is some evidence --- seeking assurances that could not be written down, for example --- that is more consistent with ... well, I won't say criminal intent, but fraudulent intent.
6. Literary references. I stand by my accusation that Tom was casting the Merrill defendants in the role of martyr, both in his post generally and specifically by referring to A Man For All Seasons. AMFAS is one of those references that is invoked too frequently, much like people like to roll out the "First they came for the Jews ..." reference. I understand that Tom did not literally compare the defendants to More. It was a literary reference, and I assumed it was chosen for a reason.
But no one is denying the Merrill defendants the rule of law. They were convicted by a jury in front of a sympathetic judge, represented by expensive and talented lawyers, under the watchful eye of the public and the press and the blogs. And now they are getting an appeal. And it is quite possible that they will win, despite the fact that they are criminal defendants in the 5th Circuit, because they are businessmen instead of crack dealers.
The prosecution of the barge case may be weak, but it is not an inquisition, it is not the Holocaust, and it is not even a witch hunt.
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1. Posted by Elizabeth on August 4, 2005 @ 10:27 | Permalink
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.
2. Posted by Vic Fleischer on August 4, 2005 @ 10:34 | Permalink
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.
3. Posted by Vic Fleischer on August 4, 2005 @ 10:40 | Permalink
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.
4. Posted by Preston Tucker on August 4, 2005 @ 14:36 | Permalink
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?
5. Posted by Vic Fleischer on August 4, 2005 @ 14:53 | Permalink
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.
6. Posted by Sal on August 4, 2005 @ 15:06 | Permalink
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.
7. Posted by Chris on August 4, 2005 @ 17:01 | Permalink
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.
8. Posted by Elizabeth on August 5, 2005 @ 1:42 | Permalink
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.)
9. Posted by Richard on August 5, 2005 @ 6:10 | Permalink
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.
10. Posted by Sal on August 5, 2005 @ 7:40 | Permalink
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.
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