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)

11. Posted by Jake on January 5, 2007 @ 17:56 | Permalink

Gosh, the notion that Enron involved nothing wrong is intriguing. I will soon establish a blog, to which persons who subscribe to this belief may buy shares in a big bridge that I own.

It's high time the Enron apologists got off their damn pity pot and make preparations for the next (and inevitable) lax cycle in public regulation of financial markets, at which time they can advise their clients accordingly in the spirit of unvarnished atavism.

12. Posted by Vic's dad on January 6, 2007 @ 13:01 | Permalink

There's an interesting column by Joe Nocera on the Gladwell piece on the front of today's NYT business page. He's grumpy on Gladwell, silent on my son, Victor's excellent tax analysis. But it's remarkable how the Gladwell piece has legs as they say in show-biz.

13. Posted by TF on January 18, 2007 @ 11:56 | Permalink


Nice work. Does that tax analysis work for all (or most) big US corporations? Are there studies out there on this? I seem to recall that lot of US corps have effective tax rates much lower (like below 30%) than the fed / state statutory rate(s). Also know, from my days at WR Grace, that lot of corps are in a loss position domestically but have high foreign tax bills and unutilized foreign tax credits. Anyway, not sure what Enron’s EFT was but, based on your paper, sounds like it would have been super low and thus, a good (and, it appears, overlooked) tool for determining cash-basis profitability, etc. Know that a lot of accountants (and analysts) are clueless when it comes to understanding deferred taxes.

In regard to the SPE’s, it would have helped if Enron had explicitly stated that many of the SPE’s were managed and controlled by Andy Fastow, Enron’s CFO. Because that is such a major omission, shouldn’t it be considered as more of a “puzzle” than a “mystery?”

In regard to Enron’s making money, seems to me that the reason they set up a lot of these SPEs was that they had dog investments that they didn’t want to report. They were incredibly smart at ducking and dodging the accounting rules and (based on the somewhat slanted “smartest guys in the room”) good at exploiting California’s energy crisis, but not so good at making money the old fashioned way.


14. Posted by Vic on January 18, 2007 @ 13:53 | Permalink

Good questions, TF: The most relevant empirical work on tax avoidance and firm value suggests that tax avoidance is a red flag when there are other indications that the firm has high agency costs. (Desai & Dharmapala). In other words, EFT by itself is a messy predictor of firm value, because there are both legitimate and illegitimate reasons for having a book-tax gap.

I agree, of course, that increased disclosure about the SPEs would have helped, so in that sense it was a puzzle. But it was also a mystery in the sense that analysts and investors failed to investigate much of the information that was available, instead treating Enron as a faith stock and giving it the benefit of the doubt at every turn.

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