The Right Coast

Editor: Thomas A. Smith
University of San Diego
School of Law

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Sunday, May 28, 2006

Enron and all that
Tom Smith

Lay and Skilling get convicted, and I don't understand.  I await the publication of some journalistic accounts.  I hope that will catch me up on what exactly the frauds consisted of.  I understand generally the idea of hiding losses through complex derivative transactions and insider trading after 9/11, oh, oops, I meant to say 9/6.  But given that I teach corporate law, I suppose I have some obligation to know the story in some detail, even though I find it all rather depressing, rather than an exhilirating confirmation of the essential rot at the heart of blah blah blah.  What I don't understand is what makes Lay and Skilling tick.  First, if you are already really rich, why take foolish chances to get somewhat more risk?  And second, if are going to engage in fraud, why not put ten or twenty million in a few offshore accounts, as well as a spare passport or two under a flagstone in the garden?  These two guys are going to spend the rest of their lives in a federal penn.  That has got to come in second to fishing for carpies or whatever they have in the upper Orinoco.  I asked my lovely wife Jeanne about this, and she suggested that it was just part of the arrogance of such people that they can't believe they will be caught and convicted.  Perhaps that's it, and why I can't understand what Lay and Skilling were thinking.  While they perhaps thought it would be impossible to be caught, my tendency is to think it would be impossible to get away with such things.

I also don't understand what the defense lawyers thought they were doing.  Is it not possible to convince your client not to seem arrogant, to at least fake humility and sorrow?  It must be harder to control clients than I realize, or do the defense lawyers just not care that much as long as they get paid?  In retrospect, it also seems that Lay would have been better off pleading to something, if that was a possibility, though maybe it wasn't.  If they really are guilty, and I tend not to trust juries too much on this score, I don't feel sorry for them.  They inflicted a lot of harm on a lot of people.

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Tom Smith


I'll bet they sincerely believe they are innocent. That explains their behavior precisely.

Corkie the Dog

Posted by: Corkie the Dog | May 28, 2006 12:12:45 PM

I've wondered why the common law of fraud isn't used to catch such people. Probably the jury used it in this case, even if the prosecutor's pleadings weren't quite right.

Posted by: Eric Rasmusen | May 29, 2006 11:06:04 AM

Corkie is probably right. They built their business by pushing the boundaries and didn't realize that they had gone over the line. A few points:

1. Remember how prevalent "earnings management" was in the 1990s - that intrinsically involves varying accounting standards from quarter to quarter to smooth out fluctuations. So this sort of deceit was a "normal" practice, and winked at by the regulators. One difficulty is it's hard to distinguish random fluctations from a shift in the trend. When results start to go south, "earnings management" requires overstating them. So they were following "normal" practices.

2. So much of a corporation's success is reputational; and in the service of the shareholders, senior management is expected to promote the company and project an image that's better than reality, so that potential partners, customers, investors, etc. will be more inclined to attach themselves to the company. When does normal "selling" go over the line to deceit? When does refusing to sell shade over to incompetence? In general, it's not good sales practice to expose all the faults of what you're selling. Caveat emptor. So if senior management is supposed to "sell" the company, and at the same time accurately disclose to public shareholders, then they necessarily have to push the ethical boundaries.

Since senior management has to operate right on the ethical line between selling and open disclosure if they are to be competitive, and there is sure to be some variance in where companies see the line falling, there are bound to be outliers who go overboard on the selling and fail at the disclosure. Enron was such an outlier.

Then they were in a highly leveraged, highly reputational business where relatively slight perturbations in reputation could send the business value to zero. This interacts with pont #2 -- management at failing companies has to hide the risk of failure, or the chance to rescue the company goes to zero. I've been at failing companies who still had a chance to succeed, and optimism, even reckless optimism, and enthusiastic selling was essential to success. People need hope.

It was only a matter of time before the randomness of life posed a fateful challenge to either Enron, or a similar company, and exposed some managers who pushed the ethical boundaries the farthest.

What made the Enron managers worth punishing, though, is that they were extremely self-serving at the same time. They couldn't stop giving themselves company money. In the end, it's less a matter of law and more a matter of character that did them in.

Posted by: pj | May 29, 2006 11:39:59 AM