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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Comments (14)

1. Posted by Adam White on January 2, 2007 @ 11:51 | Permalink

I think it's a safe bet that enterprising hedge funds *did* spot the problems with Enron. If I recall correctly, Bethany McLean has said that hedge funds were the first to tip her off on the Enron story.

See, e.g., http://www.cjr.org/archives.asp?url=/02/2/sherman.asp

Cf. http://www.ephblog.com/archives/000645.html


2. Posted by 2L on January 2, 2007 @ 15:35 | Permalink

Jim Chanos, Kynikos Associates


3. Posted by Kate Litvak on January 2, 2007 @ 21:48 | Permalink

I don’t even remember the last time when the New Yorker cited a law professor who didn't talk about Bush or terrorism or social security. Way cool. (Ok, green with envy on the floor. What’s next, the spread in GQ? Very well done).


4. Posted by Jeff Lipshaw on January 3, 2007 @ 5:38 | Permalink

Congratulations, Vic. If you had quoted the French existentialist Gabriel Marcel, who ruminated on the differences between puzzles and mysteries, you might be writing for the New Yorker!


5. Posted by Nicholas on January 3, 2007 @ 10:06 | Permalink

Mr. Fleischer, were you suggesting in your 2002 article and are you still suggesting that Enron's net marked-to-market income from its trading contract portfolio wouldn't have been taxable absent deductions and other offsets? As point of reference, that income was a significant part of Enron Wholesale Energy Operations and Services' $2.3 billion IBIT in year 2000.


6. Posted by Vic on January 3, 2007 @ 11:47 | Permalink

Nicholas,

Good question.

No, my focus was on the SPEs, where the realization rule applied.

As for forward contracts and other derivatives, I would assume that with respect to contracts in which Enron is a trader, it would have elected mark to market tax accounting under section 475. To the extent it was sheltering tax income from trading operations, it was doing that through illegitimate tax shelters. (See my more recent paper on Options Backdating, Tax Shelters and Corporate Culture for a discussion of Enron's use of tax shelters.) In either case, the book-tax gap raises concerns. See the recent empirical work of Desai & Dharmpala for further discussion of the relationship between tax avoidance and firm value.


7. Posted by Nicholas on January 4, 2007 @ 3:29 | Permalink

I am not a tax lawyer, so forgive me for having to rely on the special training of others. But I take it that section 475 rendered Enron’s sizable MTM income from its trading portfolio, whether “largely illusory” or not, taxable. I’m curious about the “concerns” you mention using that section might raise, and with respect to Enron whether you have any evidence that those concerns are justified?


In any event, Gladwell references your February 2002 article for pointing out that “one of the critical clues about Enron’s condition lay in the fact that it paid no income tax in four of its last five years.” He focuses on the SPE example you included, and your conclusion that any cash Enron would have received from the SPE would have been a “non-event” for tax purposes. Gladwell then concludes his paragraph on this subject by echoing the hypothesis you set forth in that earlier article – i.e. “Enron’s dirty secret is that it didn’t have any income, not that it had income but didn’t pay taxes” – by saying “Enron wasn’t paying any taxes because, in the eyes of the I.R.S., Enron wasn’t making any money.”


Perhaps Gladwell’s important insights into the fact that Skilling, and others for that matter, have been sent to jail based upon a mistaken prosecution theory of non-disclosure should be supplemented further. That is, shouldn’t they also include that the hypothesis that Enron didn’t have any income, which he apparently got from you, has similarly proven mistaken?


8. Posted by Vic on January 4, 2007 @ 22:21 | Permalink

Nicholas, it sounds like you have an agenda here. There's lots of evidence out there if you are actually interested in finding things out. Broadly speaking, Enron made money from trading operations, lost money on a lot of other things, and its low tax liability reflects those two facts put together. One significant source of the book-tax gap was Enron's ability to recognize book income from transactions with SPEs while not recognizing income for tax purposes. Another source of the gap was its use of tax shelters, which is details in the report of the Joint Committee on Taxation.


9. Posted by Nicholas on January 5, 2007 @ 4:21 | Permalink

Victor, you wrote a completely speculative article about Enron only weeks after its collapse, using among others the words “dirty little secret,” “illusory,” “grubby fingers” and “abuse” while describing Enron. Your mistaken speculation, that Enron didn’t have significant income, has been picked up and repeated as fact in articles written years later, e.g. by Macey in 2003 and now Gladwell in 2007. This cycle of speculation becoming fact has been repeated countless times with regard to Enron, and has among other things resulted in tragic consequences for many innocents caught up in the Enron witch-hunt. I’m very interested – no, appalled – by that. If this means I have an agenda, then I suppose its true.


10. Posted by Vic on January 5, 2007 @ 12:59 | Permalink

Nicholas -- We can debate the source of the gap between Enron's financial income and its taxable income, but your position that Enron was, in fact, profitable seems hard to defend. The company obviously was not profitable (netting trading operations against other operations), and it certainly didn't collapse because of some academic conspiracy.

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