August 04, 2005
(Sir Thomas) More on Financial Engineering
Posted by Victor Fleischer

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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