January 02, 2007
Was Enron a Puzzle or a Mystery?
Posted by Victor Fleischer

In this week's New Yorker Malcolm Gladwell writes on Enron, intelligence, and the perils of too much information.  Gladwell makes the argument that the problem wasn't that Enron was a puzzle (where you need more clues to solve it).  Rather, Enron was a mystery - where the observer is overwhelmed by information.  Solving the mystery depends on judgment and skill in analysis.  Gladwell explains:

A puzzle grows simpler with the addition of each new piece of information: if I tell you that Osama bin Laden is hiding in Peshawar, I make the problem of finding him an order of magnitude easier, and if I add that he’s hiding in a neighborhood in the northwest corner of the city, the problem becomes simpler still. But here the rules seem different. According to the Powers report, many on Enron’s board of directors failed to understand “the economic rationale, the consequences, and the risks” of their company’s S.P.E. deals—and the directors sat in meetings where those deals were discussed in detail. In “Conspiracy of Fools,” Eichenwald convincingly argues that Andrew Fastow, Enron’s chief financial officer, didn’t understand the full economic implications of the deals, either, and he was the one who put them together.

I agree with Gladwell that Enron was more a mystery than a puzzle, and that Wall Street didn't process the information as well as it should have. 

Still, I'm not sure I'd go so far as to say, as Gladwell suggests, that the disclosure paradigm is broken.  If Enron had made all its SPE deal documentation available, hardly an analyst would have cared.  Enron was a faith stock.  But maybe an enterprising hedge fund manager would have dug in, and Enron's market price might have corrected sooner, say in 2000 instead of 2001.  Moreover, as Mike Guttentag has reminded me, disclosure tends to deter fraud not just by transmitting information to an outsider, but by changing the group dynamics inside the firm.  In any event, as always, Gladwell is provocative, interesting, and quite possibly right. 

I'm quoted towards the end of the piece, where I argue that Enron's failure to pay income taxes was a red flag.  I note, however, that while the fact of the book-tax gap was easily observable, the cause of the gap was not easily observable.  I then offer the profound comment, "The tax code requires special training." (My soundbyte skills still need work.)

I expanded on this idea in Enron's Dirty Little Secret.

What do we think of Gladwell's argument?  Is the disclosure paradigm broken?  Was Enron a puzzle or a mystery?

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