Has the Department of Justice started hiring people based on their political affilation?  It's long been rumored, now the department's inspector general and office of professional responsibility have made their report:

We found that all 7 applicants [in 2002] who indicated that they were American Constitution Society members were deselected by the Screening Committee for interviews, while 2 of the 29 applicants who indicated that they were members of the Federalist Society were deselected
[snip]
The proportion of Democratic Party affiliated applicants deselected by the Screening Committee was significantly higher (70 percent, or 43 out of 61) than the proportion of Republican Party affiliated applicants (11 percent, or 5 of 46) or the proportion of neutral affiliated applicants (32 percent, or 259 out of 804) deselected by the Committee.

Goodness.  That's quite a change for an outfit that always claimed not to hire politically, but maybe those in charge felt that there had been years of invidious ideological discrimination that by golly would be rectified by reforming the hiring process in 2002.

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. . . ain't the hazard it used to be, at least not if you want to run Coca-Cola.  Coke just appointed Muhtar Kent as its president and COO, making him the No. 2 behind CEO Neville Isdell, as well as Isdell's likely successor.  Almost ten years have passed since Kent was fired from a senior position with Coca-Cola Amatil--a regional bottler based in Sydney--for shorting 100,000 of his own company's shares just hours before the company issued a serious profit warning that caused a drop of $2.5BB in the company's market cap, almost a 30% loss.  Kent had been managing director of the bottler's European division.  He apparently made about $324,000 from the sale.  After an investigation by the Austrialian Securities Commission, Kent coughed up the profits and another $30,000 to cover the costs of the investigation. 

This past October, Kent denied prior knowledge of the impending profit warning, calling it all a "bad coincidence."  The current official story from Coke is of the "dog ate my homework" variety:

Mr Kent was advised by his financial adviser to diversify his financial portfolio, which at the time consisted solely of KO stock and CCA stock options. . . . He accepted the proposal and left it to the financial adviser to execute. In doing so, he did not fully understand that it would involve a short sale or the elements of a short sale. As a result, he also did not know the specific timing of the transaction.

So he didn't know about the impending profit warning.   And he didn't know about the impending short.  Hmmm . . .  Sorta sounds like Martha Stewart's oral stop loss order.  I'm also not sure how short-selling diversifies his portfolio.  And why was he shorting his own company anyway??  When Kent was made president of Coca-Cola international in January, less than a year after rejoining Coca-Cola, it made Colin Barr's The Five Dumbest Things on Wall Street This Week at TheStreet.com.  Or you can watch the video.

In any event, CEO Isdell (declining to be interviewed) recently issued a written statement:  "Without doubt, Muhtar is a man of the highest integrity and deepest skills."

When Coke sneezes, Emory catches a cold.  So we tend to follow our local benefactor quite closely.

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Today we covered “puffery” in my Securities Regulation class, which is the notion that statements of corporate optimism in the face of a corporation’s seeming financial distress are not viewed as actionable misstatements because investors expect actors to be overly optimistic and “look on the bright side.”

I have always been troubled by this doctrine, and what it implies about the trustworthiness of corporate executives and directors. Intuitively it makes sense that you would expect officers and directors to project an image of confidence and optimism, particularly when the company may not be doing well. Indeed, studies suggest that officers of major corporations tend to be overly optimistic—it is one of the traits that apparently makes them successful.

My concern is that such a doctrine encourages investors to continually second-guess corporate statements, thereby encouraging a climate of distrust between investors and corporate actors. Thus, when I asked my students what they felt about the doctrine, most of them seemed to accept the puffery doctrine because it confirmed their impression that “executives lie.” To that end, the puffery doctrine facilitates a (growing) distrust of corporate executives.

I am also concerned about its impact on executives. Executives already tend to be overly optimistic. And at the very least, that optimism could lead them to turn a blind eye to the truth—we certainly see threads of this notion in the recent corporate scandals. The problem is that there is a fine balance. We certainly want executives to exude confidence, but we also want them to be able to provide a truthful and realistic assessment of their corporate environment. It is not clear that the puffery doctrine facilities the right balance.

In the end, I always tell my students that the puffery doctrine is like a used car salesman defense—that is, executive statements of optimism should be considered in the same light as statements made by used car salesmen. And who actually believes what a used car salesman has to say? Indeed, several surveys have suggested that used car salesmen represent the least trusted profession. If this analogy is accurate, the puffery doctrine suggests that corporate executives merit the same level of trust as used care salesmen. I find that troubling.

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Peter Henning has a post today about Larry Sonsini's spring-loaded options that he received while director and counsel for certain companies, including Novell.  Peter notes that the ABA issued an opinion in 2000 that taking equity in a client is not a per se violation of the ethical rules.  Certain other states, including New York, took this same position.  Wilson Sonsini has never been hesitant to take equity in a client.  In the 1990s, WS took equity in many start-up clients that they took to IPO.  In 1999, WS partners received $230 million in IPO shares.  The day that WS took VA Linux public in December 1999, the firm saw its 102,584 shares rise to a market value of $24.5 million.  (Compare that with a piddly "hours billed" fee for taking a startup to IPO!)  With Webvan, earlier that year, WS held $51 million by the end of the first day in trading.  Even in 2000, WS took Avanex Corp. public and saw its shares rise to $109 million one month later.  Although we don't know when the firm sold the shares, we can guess that they sold them fairly quickly after any lock-up period was over, and hopefully before the first two of these companies declared bankruptcy.

If you are interested to know more about this topic, see my article Counselor, Gatekeeper, Shareholder, Thief:  Why Atorneys Who Invest in Their Clients in a Post-Enron World Are "Selling Out," Not "Buying In.

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In the wake of new disclosures about his involvement with the investigations of fellow directors, HP CEO Mark Hurd is promising to "give as much clarity as we can to these matters" at a press conference tomorrow. The latest revelations describe a sting operation apparently approved by Hurd:

Dawn Kawamoto, a reporter for Cnet.com, wrote a fairly straightforward article on Jan. 23 outlining the firm's long-term strategy after a board retreat.

Determined to ferret out the source's identity, HP senior counsel Kevin Hunsaker, who led the HP investigation ordered by Dunn, and an HP colleague in Boston created a fictitious persona, "Jacob," who would pose as a disgruntled HP "senior level executive" and cultivate Kawamoto by saying he was "an avid reader of your columns."

The idea, evidently, was to induce Kawamoto to open an e-mail attachment with a "tracer" in it that would allow them to see who she forwarded it to. They hoped it would pinpoint board member Keyworth as her source, according to the documents.

Both Hurd and Dunn have been beating on the ethics drum to justify their investigation of the leaks. This is from Hurd:

The HP Standards of Business Conduct are our foundation of ethical leadership, and encompass the basic principles that govern our ethical and legal obligations to HP.

The leaking of company confidential information violates our Standards of Business conduct which applies to all employees and Board members.

The HP Standards of Business Conduct contains the following statements regarding privacy and employee misconduct:

HP is committed to protecting the personal information of its customers, channel partners, suppliers, other business partners and employees. Personal information includes data related to a person who can be identified or located by that data. To create an environment of trust and to comply with applicable local law, you are required to follow HP privacy policies and data protection practices in using online and offline systems, processes, products and services that involve the use, storage or transmission of any personal information....

Misconduct In general, misconduct is an illegal or harmful activity that involves or affects HP and its employees. Misconduct includes, among other things, violation of the provisions of these Standards of Business Conduct, theft, records falsification, involvement with unlawful drugs, unauthorized use of alcohol, violence, threats, harassment, possession of weapons and insubordination. If you engage in misconduct, you are subject to immediate termination of employment.

Luckily for Hurd, the privacy policy does not extend to directors or reporters.

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While browsing the Craig's List "wanted" section for Milwaukee, I noticed this very interesting posting entitled "Letter from a Marquette alumn[sic]=Free application?"

I recall hearing somewhere that with a letter from a Marquette alumnus, the application fee is waived. I am looking to apply to Marquette's MBA program and would prefer to skip the $40 application fee. Is this true? If so, can you help me out? I would gladly buy you a drink.

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A few of our blog friends have been riffing on the usury law meme and each other.  See Matt B. here, Kate at Ideoblog, ProfB starting it all and responding to Kate and Matt.  I have defended usury laws before, and Paul Gowder's comment to Kate's post explains why.  Although the law may have no interest in stopping fully informed individuals from binding themselves or their entities to a high rate of interest that compensates the lender for a particular risk, the law realizes that in many cases the borrowers aren't fully informed of their bargain.  Unfortunately, many lenders and vendors seem to have a business plan that hinges on individuals legally binding themselves to obligations they don't understand.  Because the law is not very effective at making sure that borrowers are clear on their obligations, usury laws (interest rate caps) ensure that at least those caught in sharp business practices won't be damaged too bad.  Obviously, reasonable minds differ here, but I want to discuss something else.

I wanted to specifically respond to Kate's point, which seems to be that "usurious" interest rates can't be unethical if they are market-driven.  Kate makes the point that she doesn't want an "ethics tsar" determining what interest rates are unethical.  Of course, Kate is responding to ProfB's post on the Pope's discussion of usurious lending rates as unethical.  My seminar, the Ethics of Business, discusses just this intersection of what is ethical, what is legal, and what is good business practice.  Merely because a practice is good business or the product of a free market does not mean that I have to think it is ethical.  Ethical philosophies exist beyond utilitarianism, beyond what is the greatest good for the greatest number.  One might determine what is ethical based on the incentives of the actor or the values embodied in the action.  One might also determine what is ethical based on an intuitive sense of right or wrong that may or may not come from a belief in a supernatural being.  And at some point, one's sense of ethics may deviate from the workings of the free market.

One particular point we discuss in class is sharp business practices.  I may have a legal obligation to disclose some things and not others, but my personal ethics may tell me to disclose others.  My business sense may incentivize me not to disclose anything or selective things.  My religious beliefs may tell me to refrain from activity that may be legal and that may also be rational in a free market.  A religious leader may extol followers to also refrain from an activity that may be legal and that may also be rational in a free market.  This teaching may create individual inconvenience, such as not spending money one day a week, or may create huge obstacles, such as not lending money or not lending money at a high rate of interest.

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For some reason it seems to have passed with little fanfare (at least in my rarefied circles), but recently the Electronic Frontier Foundation (EFF) announced a startling discovery:  The government, in conjunction with printer manufacturers (or is it the Rand Corporation, in conjunction with the reverse vampires?)  have for some time been tracking computer printer output.  Details are sketchy, but it looks like the government has been working with printer manufacturers to embed coded messages in every document produced on certain color laser printers (indicating the serial number of the printer and the time and date of printing) in an effort to assist enforcement against counterfeiters.  According to this article, the technology has been employed by some manufacturers for decades.

EFF does some decent work (cracking this code, for example, would have to qualify), but unfortunately it’s also a group of fear mongers — not that just because they’re paranoid there isn’t anyone following them.  It’s just that they have limited credibility when this is their take:

Even worse, it shows how the government and private industry make backroom deals to weaken our privacy by compromising everyday equipment like printers. The logical next question is: what other deals have been or are being made to ensure that our technology rats on us?

Look guys — as Posner would tell you (and so would any other economist) it’s about trade-offs.  Do you think counterfeiting is a problem?  Should the government use any resources to combat it?  Now, if so, how can you be sure that this is not, in fact, the best way to do so, even though it entails a cost?  What doesn’t?  The next logical question is hardly “how else has private industry colluded with the government to screw us over?”  The actual next logical question is, “is this the most cost-effective way to deal with the problem of counterfeiting, given the potential cost?”  Now, how hard was that?  Let’s not assume our conclusions before we even ask the questions, shall we?

By the way — here’s what I think really ought to be the next question:  “How on earth was this kept secret for so long?”  I mean — there had to be dozens if not hundreds of folks in on this, in both industry and government.  How did the secret not get out?  How is it possible that not a single programmer involved in the project at Xerox leaked the news?  Or — did they?  Was this known to the counterfeiting community long ago?  (And, of course, if so, question one — was this a good idea? -- becomes a little easier to answer).

Relatedly, what kind of protections could EFF want in the future? Disclosure? That would immediately defeat the purpose, and, again, assume the conclusion of the very question being asked. So what, realistically, should be done?

Also, I note that, according to the EFF itself, the tracking dots are used only in color laser printers. Maybe this is itself a decent compromise position. If the government really wanted secretly to monitor subversive organizations like Greenpeace and the ACLU through their printed output, wouldn't it make more sense to target the black and white printers?  Or are these organizations printing strictly in color these days?

Finally, my real beef with EFF is not that it is wary of government; there's plenty to be wary of. My real problem is that it seems not to discriminate between potential government violations of one's privacy and anonymity on the one hand, and private sector incursions on the other. This, by the way, is a problem it shares with one of the organization's intellectual godfathers, Larry Lessig (see here).

The point seems obvious, but there is an enormous, qualitative difference between the threat posed by Leviathan reading your emails and that posed by your boss doing it. If you don't like your boss doing it enough, you work someplace else (or contract with your boss to stop). If you don't like it that Sony encodes intrusive DRM software on its CDs, you buy another label's CDs. If enough people share your aversion to these incursions in the private sphere, the market will induce the violators to respond and/or it will provide alternatives. But we can't say the same for Leviathan, and the democratic process is hardly a reliable system for inducing the government to respond, even to the preferences of the majority.

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Professor William Black (Texas, criminology) has posted an interesting comment on one of my prior posts, A Case Study in the Ethics of Financial Engineering.  An excerpt:

Fourth, like most white-collar criminologists I rarely use the word "evil," because it is so subjective a phrase and generally adds little value to the discussion. I wonder, however, why you were so quick to agree that the senior insiders, including Fastow, who destroyed Enron were NOT "evil." How can any of you know this? And what is your conception of "evil"? You seem to (implicitly) reject the concept that it could be banal. Fastow has confessed to actions that you know from your reading involved scores, probably hundreds, of acts of deceit in order to get even more wealthy. He betrayed everyone he had a duty to protect. He had no need to do so.

I should also add that Mitt Regan (Georgetown) has a great paper on Enron.  I will post to it when it's on-line.

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Immortal??  I don't even have tenure. 

Meanwhile, having admitted unlawful conduct, KPMG is fighting back.  My instincts are with KPMG on this one -- I find it a little hard to believe that the shelter consumers didn't know what they were buying.

Calvin Johnson's analysis of the shelters can be found through Paul Caron here.
 

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Bainbridge links to Tom K's coverage of KPMG.  Both refer to it as the "criminalization of agency costs." 

If the KPMG partners are the agents, who are the principals?  I assumed the phrase "criminalization of agency costs" (a clever turn of phrase that I believe originated with Larry Ribstein) referred to the use of the criminal law to protect shareholders -- the implication being that the protection is unnecessary and a problem for shareholders and managers to work out among themselves.  Markets, not the government, should police accounting fraud, theft of corporate assets, etc.  I disagree, but I think I understand the argument. 

At least I thought I did.  Now I'm not so sure.  Tax fraud is not an agency costs problem.  KPMG, an advisor, sold its clients tax shelters for the benefit of the clients' shareholders.  Accounting gimmicks shift value away from creditors and long-term shareholders.  Tax gimmicks shift value away from the government.  The public, not the clients' shareholders, got hurt.  How is this an agency costs problem?

Pre-cooked phrases should not substitute for thought.  "Criminalization of agency costs," once it loses its substantive meaning, becomes as useless a phrase as "witch hunt" or "inquisition" or "corporate greed."  Sloppy writing is a sin I am sure I am guilty of as well, and I hope you will call me on it too.

In any event, the KPMG memo is good reading, as is Tanina Rostain's article on KPMG. 

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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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From ContractsProfBlog,the Wisconsin Supreme Court publicly reprimanded an inactive Wisconsin attorney doing work in Colorado and ordered him to return near $400,000 in fees he had earned pursuant to his agreement with his client.  The facts go something like this: Bolte (the attorney) told the client that he was not licensed to practice, couldn't appear in court, and that she would have to hire a lawyer to pursue any legal claims.  She agreed and they signed an agreement that Bolte would: "investigate, examine, copy, analyze and interpret" documents relating to her lease.  Bolte advised the client that she had a good claim, she hired a lawyer and sued, winning nearly $ 2 million.  Bolte received $388,000 under the agreement.  The client soon thereafter demanded that he renounce all future payments or else she would report him for unauthorized practice.  He refused and she sued in Colorado claiming that their agreement was unenforceable, eventually getting the $388,000 back.  Bolte then did something that was plainly stupid: he transferred his property to a friend in an attempt to avoid the judgment.  In a grievance filed against Bolte in Wisconsin, the Wisconsin Supreme Court held that Bolte's work constituted unauthorized practice and gave him a reprimand.

I imagine the number of law profs that are not licensed in the state they teach but still do manage to do some consulting here and there is quite large.  My immediate response to this story was to find out the rules on waiving into the VA and DC bars...

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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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Josh makes a strong case that payola is efficient.  At least in terms of competition.  What he doesn't quite convincingly address is what he calls the "deception" case. 

What makes the radio different from groceries?  Our relationship with the radio feels more personal.  I have no special bond with Safeway or Ralphs.  (Whole Foods would be a tougher case.  I like my Whole Foods.  I trust Whole Foods.  Maybe because they don't take slotting fees.) 

 Listening to the radio is more than a commercial transaction.  When we listen to the radio, we are often alone in the car or at home, and the DJ and his music keep us company.  We bond with our DJs and trust them.  Or at least we used to. 

Something is lost when we dismiss such notions as naive.  Perhaps because payola dates back a few years, the scandal reminds me a bit of the fine film Quiz Show, which explores the loss of a sense of shame in American post-war society. 

(We know where Ribstein stands on this movie.  Shocker.)

What would happen today if American Idol were fixed?  Perhaps it is.  Josh might even call it efficient.

Shame has disappeared as a social norm, at least when it comes to commercial transactions.  And so we must redefine the relationship between consumers and the radio.  DJs are our agents when in comes to picking music, and we routinely require agents to disclose conflicts of interest to their principals.  I don't see why this is different.  Perhaps the radio was never pure -- payola and radio seem to go hand-in-hand -- but that does not seem like a good justification for deceiving the listener. 

So I think a disclosure scheme would help -- just a quick announcement, once an hour, about the payments-for-spins, and which songs are plugged and which are clean.  Commercial radio can have its payola, or it can have our trust, but it cannot have both.

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Arthur Andersen (AA) is appealing its criminal conviction to the Supreme Court, and oral argument is tomorrow, the last day of the current term. (I think it is only coincidental that AA settled claims relating to its audit of Worldcom yesterday.) The Supreme Court granted cert in this case to examine two issues: (1) whether the federal witness tampering statute (18 U.S.C. 1512(b)) requires something more than an intent to subvert an official proceeding; and (2) whether the government should be required to prove that Andersen intended to interfere with a particular proceeding other than SEC fact-finding. Although the resolution of these issues will have important legal consequences, the case is more important for symbolic reasons.

According to AA, the fact that this case revolves around a witness tampering statute is itself suggestive of prosecutorial overreaching. The following is from AA's Supreme Court brief (pdf):

It is plain as day that the Government did not charge Andersen with obstruction of justice for discarding documents during the relevant time period because no official proceeding of the SEC was pending. This Court has held for more than a century that “a person lacking knowledge of a pending proceeding necessarily lack[s] the
evil intent to obstruct.” United States v. Aguilar, 515 U.S. 593, 599 (1995) (citing Pettibone v. United States, 148 U.S. 197, 207 (1893)).

The United States attempted to evade that settled law by instead charging Andersen with “witness tampering,” on the remarkable theory that although it was perfectly lawful for Andersen to have a document retention policy that preserved only the final audit work papers, and perfectly lawful for Andersen’s employees and professionals to follow that policy, it was somehow a serious felony for Andersen’s in-house attorney and supervisors to remind its employees of the policy.

I think all of us were surprised at the time of AA's conviction that the case boiled down to an email from Nancy Temple to the Enron engagement team: “It might be useful to consider reminding the engagement team of our documentation and retention policy. It will be helpful to make sure that we have complied with the policy.” Whether the Supreme Court upholds AA's conviction -- and perhaps more importantly, how it does that -- may influence the debate about post-Enron reform efforts.

With respect to the merits of this case, here is the relevant text of that statute:

Whoever knowingly uses intimidation, threatens, or corruptly persuades another person, or attempts to do so, or engages in misleading conduct toward another person, with intent to ... cause or induce any person to (A) ... withhold a record, document, or other object, from an official proceeding; [or] (B) alter, destroy, mutilate, or conceal an object with intent to impair the object's integrity or availability for use in an official proceeding ... shall be fined under this title or imprisoned not more than ten years, or both.

On the first issue, AA makes a textual argument, which was rejected by the Fifth Circuit: the words "corruptly persuades" must connote something more than improper motive because the statute contains a separate intent provision. While the Fifth Circuit appears to agree with this point, the court held that the trial court had given "corruptly" a separate meaning when it defined the term as follows: "The word 'corruptly' means having an improper purpose. An improper purpose, for this case, is an intent to subvert, undermine, or impede the fact-finding ability of an official proceeding." According to the Fifth Circuit,

Acting with an intent to "subvert, undermine, or impede" an investigation narrowed the reach of the statute, insisting upon a degree of culpability beyond an intent to prevent a document from being available at a later proceeding. A routine document retention policy, for example, evidences an intent to prevent a document from being available in any proceeding. But it does not alone evidence an intent to "subvert, undermine, or impede" an official proceeding.

In its Supreme Court brief, AA contends that this is not only bad law, but bad policy: "There is nothing inherently 'corrupt' or wrongful about an intent to impede future government fact-finding within the bounds of the law." Criminal law isn't my area of expertise, but AA's argument looks like a truism run amok. As noted in the Solicitor General's brief (pdf):

Notwithstanding the facts that (1) petitioner had retained outside counsel; (2) Temple had concluded that “some SEC investigation” was “highly probable”; (3) Temple had designated the Enron matter as a “government/regulatory investigation”; and (4) petitioner’s work for Enron was ongoing, Temple and others embarked on a campaign to encourage Andersen employees to destroy Enron-related documents, under the guise of complying with the document policy.

With respect to the second issue, AA makes two arguments. First, AA contends that "an official proceeding" is something other than "the fact-finding ability of law enforcement or preliminary agency investigations." While there is some precedent in support of this view, it looks like a loser to me. The more interesting argument is AA's appeal to the rule of lenity:

Whether particular conduct is criminal should never be debatable, or a surprise. The theory of this prosecution criminalized conduct commonly understood to be lawful, including the document retention policies in place at almost every American corporation or professional firm of any size. And the jury may well have rested its verdict on an email from Nancy Temple which "offered such common legal advice that the chairman of the American Corporate Counsel Association wrote in a letter to his members: 'Who amongst us has not thought: There but for the grace of God go I.'"

As you might imagine, the SG offers a much different view of AA's conduct in this case:

Petitioner was validly convicted of corruptly persuading its employees with the intent to cause them to withhold documents from, or alter documents for, an official proceeding, in violation of 18 U.S.C. 1512(b)(2)(A) and (B). Petitioner portrays its document-destruction campaign, in the face of a looming SEC investigation, as wholly legitimate conduct—as if American corporations routinely find it proper to instruct their employees to lay waste to vast troves of documents when a government investigation is viewed as highly probable.

In the end, I suspect that AA's conviction will be upheld, but this is a case worth watching for many reasons.

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A NYT article today describes new zero-tolerance policies of some investment banking firms in the area of ethics.  Similar to Boeing firing Stonecipher for having a consensual affair, other instances of unethical but not illegal behavior are getting employees fired in this new environment.  One example involves two BofA employees, Eric Corrigan and Thomas Chen, who contacted Capital One after hearing in confidence that Capital One was in merger talks with Hibernia.  Mr. Chen had a relationship with someone at Capital One, and contacted him to see about getting in on the deal.  This conduct, which historically has been expected and encouraged, got them fired by BofA, who coincidentally has paid nearly $1 billion in SEC fines this year.  Ironically, if the bankers had not acted on their knowledge just months ago, they might have reprimanded for standing still.

I have no problem with ethics.  I teach Business Ethics.  But I do have a problem with hypocrisy.  I do feel for employees like Mr. Corrigan and Mr. Chen, who operate under a set of rules that is endorsed in their industry but then get caught up in a sea change that is more PR move than enlightened ethical practice.  If everyone is aware of new rules that will be applied to everyone, then by all means lets raise the ethical bar.  However, it is not moral or ethical to use unsuspecting employees as scapegoats to cleanse your image.

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In my Ethics of Business seminar, we rarely have firm answers to the questions that are raised, but here is the answer to the question that I (and others) raised yesterday.  Should applicants to B-school who hack into a database illegally merely to find out if they had been accepted be denied for that act alone?  The Harvard Business School says yes.

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CNN is reporting today that about 100 b-school applicants hacked into an database owned by ApplyYourself to try to determine if they had been accepted into their schools of choice, including Harvard, Duke, Stanford and Dartmouth.  The schools say that they know which applicants tapped into the database, but will not comment on whether those students were accepted or rejected.  However, a spokesman for HBS says that the school is treating the incident as breaking and entering.

So, would the incident change the status of the applicant's file?  In law school admissions, we ask very detailed "character & fitness" questions because we know that the bar asks those questions.  We treat most criminal behavior on a case-by-case basis, with different faculty members having different outlooks.  Some seriously question repeated alcohol-related offenses.  I have definite feelings about crimes involving "truth-telling," such as fraud and theft, and domestic violence.  I think I would put this offense into the "truth-telling" category, which along with its closeness in time, would force me to vote "no." 

Of course, you can see where in the movies, a b-school would applaud "initiative" like this.  I would hope that this behavior would only be acceptable in a fictional situation.

UPDATE:  Orin Kerr asks the same question.

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Many thanks to the brain trust at the Conglomerate for inviting me to muse out loud for the next two weeks, and for the nice introduction. I thought I would start with a thought or two on self interest and corporate morality. There have been several very interesting articles on these issues in the NY Times in the last several weeks. On Feb 8, 2005, in an op-ed entitled "How Wall Street Learns to Look the Other Way," Bob Shiller emphasized the role business schools play in shaping corporate culture, and worried that "the view of the world that one gets in a modern business curriculum can lead to an ethical disconnect," due to its assumption of self-interested behavior. In his "Economic Scene" column on Feb 17, 2005, Robert Frank noted that assuming that people act in self interested way has a self-fulfiling quality. My first reaction to these articles was to be glad that we are once again talking about the role of morality in business behavior. My second was to wonder how retain the benefits of consequentialist thinking without losing the focus on ethics.

Among corporate scholars, the usual suggestion -- dating back to the Berle-Dodd debate in the 1930s -- has been that managers should look beyond shareholders and profits, and take other values into account. But (as Berle pointed out), this too often ends up letting managers do whatever they want -- it gives them a way to justify any decision they make and thus diminishes accountability. Shiller suggests that recognizing the limits of markets and effect of cognitive biases might counteract the excesses of rational choice thinking. It also wouldn't hurt to alter some of the regulations that encourage excess, such as the still-privileged tax treatment of stock options.

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Outside Directors' Liability -- End or Beginning of an Era

Last night the first session of my Business Associations class met, and I began by writing the names of the 19 outside directors of Enron and WorldCom that agreed to pay around $31 million collectively out of their own pockets last weekend. I likened this to lining one of our law firm's conference rooms with the bound volumes (remember those?) from the Texaco bankruptcy -- a cautionary tale. However, I wasn't sure how to put these events in context. Did these settlements put closure on the corporate scandals of the 2000s? In a way, these settlements could give catharsis to an investing public that has already regained confidence in U.S. corporate governance and capital markets. Or, these settlements could mark the beginning of an expansionary era of director liability.

Professor Bainbridge has given his take here on the settlements and on the WSJ article analyzing the settlements. He also refers to a new article presented at the AALS conference putting outside director liability into pre-January 7, 2005 context: since Smith v. Van Gorkom, we have seen only 4 instances in which outside directors have had to reach into their own pockets in a lawsuit. The WorldCom and Enron settlements are #5 and #6. So, is this 6 in 20 years, or the beginning of an era with two or more per year?

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MBA in a Box

In glancing through one of about 15 catalogs I receive on any given day in December, I noticed this item: MBA in a Box. This intrigued me because I've always felt a little inadequate that I teach corporate law but do not have an MBA. Instead of pursuing an online degree in my spare time at home, I could just buy this item for $34.95.

MBA in a Box is actually just a large book, but what is more interesting is who wrote it.

"Written by some of the best brains in business today, this practical, jargon-free guide is a "core curriculum" for the rest of us. Contributors include bond king Michael Milken, Segway inventor Dean Kamen, and Harvard Business School dean Kim Clark."

OK, if I'm dean of HBS, why do I get third billing behind "bond king Michael Milken"? Not, "convicted criminal Michael Milken," either. I was not following the investigation of Drexel Burnham, Milken, and Boesky much at the time (as you can tell from the post below, I was practicing analogies for the SAT), so I am wondering if many in the industry or academia at the time thought Milken was a true bad apple or a scapegoat. He definitely has bounced back -- a colleague here, Eric Goldman, took a class from him at UCLA B-school. I guess there is hope for the futures of Martha and Frank Quattrone, as well. That brings me back to my original question, though. I see Martha Stewart and Frank Quattrone as scapegoats, convicted of covering up activities that probably were not crimes. I would like to know if Milken is in that category or in the bad apple category.

Anyway, I decided not to buy MBA in a Box.

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Box Tops 4 Education

When corporate law types talk about corporate social responsibility, most activities fall into two categories. First, corporations can publicize steps they take to minimize the negative impact of its operations or its industry, such as energy companies researching alternative fuels or investing in nonrenewable resources strategies. Second, corporations can make direct investments in community projects as part of its budget, such as a restaurant chain donating a percentage of its proceeds on a certain day to a specific cause. The General Mills Box Tops 4 Education campaign falls into the latter category. This campaign, which gives schools 10 cents for every box top submitted, is only one of many community, outreach, and environmental programs listed in General Mills' Corporate Social Responsibility 2004 Report. The report also quotes a Harvard Business School case study of a different General Mills program, Hawthorne Huddle, as being a "model of corporate citizenship and direct social investment in engaging and building local communities."

I have become obsessed with the box tops program.

Last year, my daughter and I probably submitted 20 box tops a month at a minimum. (FYI -- the "box top" is now just a symbol that appears on the label of a variety of General Mills brands, whether the product is in a can, tube, or box.) I was very adept at knowing what products had box tops and whether the additional cost of the Old El Paso chiles was worth the box top. This year, I am not the only mom to have noticed that the box tops are almost microscopically small. Small and in hard to find places. Also, the list of box top products has changed, although I cannot tell if it is a smaller list. I do know that we eat the same foods we did last year, but our box top accrual is way, way down.

If General Mills decides that the eight-year box tops program is too costly, can they change the program without a backlash? The box tops that I've been clipping state that they are good until 2006, but that doesn't guarantee that new products rolling off the assembly line will continue to have box tops on them. Is shrinking and hiding the box top a way to scale down the program under the radar?

I can't help but think that a community program like this is like a stated dividend policy. You get a lot of good press when you announce the policy, but you have to be committed to maintaining the dividend.

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Donald Rumsfeld: "I take full responsibility." (story)

What exactly does it mean to take responsibility? This is scene replayed over and over again in the United States. Someone in a position of power is attempting to address public outrage by apologizing and "taking responsibility." And more often than not, it seems, the person equates the two things. In my view, however, saying "I'm sorry" is not the same as "taking responsibility." Rumsfeld should resign. This is an easy call.

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Like many commuters, I listen to books on tape while driving to and from work. The main selection criterion is that the book be available at the Middleton Public Library. After that, I usually look for books that I would not otherwise read ... and that includes almost all novels. Jeffrey Archer and I are not likely to have a long-term relationship, but I am currently listening to The Fourth Estate, Archer's semi-fictional account of the rise of Rupert Murdoch and Robert Maxwell.

This book is too easy. Both protagonists are greedy, conniving businessmen, devoid of morals and undeserving of respect or sympathy. They are completely predictable in their hatred of each other. Moreover, since the book is based on real people, I already know how the story ends. (At least with Maxwell. Murdoch, of course, is still going.) After writing all of this, I am not sure why I keep listening, except that the reader has a great voice. Oh, and the fact that the Middleton library doesn't have much of a selection of recorded books.

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