Was Enron right?
The Supreme Court's decision on Jeffrey Skillings appeal discussed:
Enron conduct under Exxon pressure - a slight chance bad law-making due to parliamentary deficit becomes defined at last: (Oped xxell) ENRON & SARBOX OVERTURNED? EXXON CONTINUES!
High & Low Finance
By FLOYD NORRIS
Published: June 24, 2010
The timing is exquisite. First the Supreme Court of the United States provided a significant legal victory to the mastermind behind one of the greatest corporate frauds in American history. Next the court may throw out the law that Congress passed to reform corporate America — a law inspired by that very fraud.
Michael Stravato for The New York Times
Kamil Krzaczynski/European Pressphoto Agency
The end of a Supreme Court term is often the most interesting. The cases that produced the biggest arguments are delayed until the last minute — and that minute is upon us.
The term ends next week. It is expected that the final rulings will appear on Monday. It is then that the court will decide whether to throw out the Sarbanes-Oxley Act.
If it does, it will use the same basic argument it used Thursday. It will blame Congress for writing bad laws.
And that will clear the way for Congress, if it has the will, to swiftly rescue corporate reform and assure that future crooked corporate and government officials cannot take advantage of the rulings.
In one case decided Thursday, Jeffrey K. Skilling, the former chief executive of the Enron fraud, persuaded the Supreme Court that the concept of committing fraud through depriving an employer of “honest services” was not adequately defined in the law.
If the executive took a bribe or a kickback, then that is illegal under the law, the justices concluded. But if he did something else equally outrageous, the law is too vague and is therefore unconstitutional.
For Mr. Skilling, the victory is only partial and could prove fleeting. The justices refused to order a new trial for him. There were other legal theories advanced by the government in charging Mr. Skilling with conspiracy to commit fraud, and the lower courts will now hear arguments over whether the verdict was amply justified by evidence supporting the other theories.
The high court was equally kind to another disgraced corporate executive. Using the Skilling case as a precedent, it threw into doubt the conviction of Conrad M. Black, the newspaper baron who controlled The Daily and Sunday Telegraph of London and The Chicago Sun-Times. The lower courts will consider whether other prosecution arguments can still justify the verdict.
The decision expected next week is nominally about the Public Company Accounting Oversight Board and concerns an obscure constitutional clause regarding presidential powers. But it could lead to the entire Sarbanes-Oxley Act being thrown out.
The Sarbanes-Oxley Act was passed by Congress in 2002. The Enron scandal — in which it turned out that one of the largest companies in America had ridden roughshod over, under and through accounting rules to report billions in profits when it had no hope of paying its debts — got that effort started. The final push came when the WorldCom scandal broke.
Accounting firms had largely escaped any real regulation before, and the law created the board to inspect and regulate the firms. Board reports have forced major firms to change practices, and the board is generally viewed as having done a good job.
Under the law, the five members of the board are appointed by the Securities and Exchange Commission but are legally not government employees. The board is financed by fees paid by publicly listed companies, and its budget is subject to approval by the S.E.C.
The argument before the court is that under the Constitution, Congress should have allowed the president — or someone he directly appoints and can remove at will — to make the appointments. That argument could well appeal to some justices, particularly Samuel A. Alito Jr., who has supported stronger executive power.
By itself, that dispute over appointment powers might not be too important. But in passing the Sarbanes-Oxley Act, Congress did not put in a severability clause — a normal part of many laws saying that if part of the law is unconstitutional, the rest can stand on its own. So that has raised the prospect that the entire law would fall at the same time.
Out would go requirements for audits of corporate financial controls and for corporate executives to certify that their financial statements were accurate, among other things.
Just what Congress might do if that happened has become a subject of some speculation. Some corporate officials fear that in the current climate, Congress could enact new and tougher regulations. “It is conceivable that the re-proposed legislation would become a Christmas tree on which every ornament of corporate reform and governance will be hung,” said Susan Hackett, the general counsel of a trade group for corporate lawyers, the Association of Corporate Counsel.
But there are also signs that Congress is in no such mood. The financial reform bill that is expected to be passed seems likely to repeal the requirement for audited financial controls for most public companies, leaving it effective only for those with revenue above $75 million.
It also appears likely to grant corporate boards one of their greatest desires, by blocking planned S.E.C. rules aimed at permitting dissident shareholders from putting director candidates on the ballots sent to shareholders by the company. Instead, it would allow no such nominations unless the dissident owned at least 5 percent of the stock, a very high level.
In 2007, some of the same senators now supporting that provision, including Christopher J. Dodd, the Banking Committee chairman, argued that a 5 percent figure would gut any such rule.
It is interesting to consider why the court thinks it is Congress’s fault that it must rule as it did. The legal concepts at stake were largely based on judicial opinions beginning in the 1940s. The court blocked those opinions in 1987, saying that the law did not justify the “honest services” doctrine and inviting Congress to fix that.
Congress did just that in 1988. But now the justices say Congress did not define the doctrine very well. So it looked at the pre-1987 rulings and decided that they amply established that bribery and kickbacks were covered. But there was not enough consensus on other ways of violating that doctrine, like simple thievery. So Mr. Black and Mr. Skilling may walk. If Congress is unhappy, it can pass a better law.
If ever there was a corporate executive who viewed shareholders as inconvenient pests, it was Mr. Black. Eventually, after those shareholders complained over and over, a board committee advised by Richard C. Breeden, a former S.E.C. chairman, concluded that Mr. Black and his colleagues had been running a “corporate kleptocracy.” Facts the committee set out led to the Mr. Black’s conviction.
Mr. Black explained his concept of corporate governance in a 2002 e-mail message when he was under criticism from shareholders for excessive personal spending of corporate money:
“I’m not prepared to re-enact the French Revolutionary renunciation of the rights of nobility. We have to find a balance between an unfair taxation on the company and a reasonable treatment of the founder-builders-managers. We are proprietors, after all, beleaguered though we may be.”
Thanks to the Supreme Court, he may soon feel less beleaguered. Next week, all of corporate America may feel the same way.
THE BEAR'S LAIR Was Enron right? By Martin Hutchinson The huge profits reported by Goldman Sachs and the investment banking end of JP Morgan Chase last week surprised markets and demonstrated once again the power of trading operations to earn spectacular returns for their protagonists and even occasionally for investors. It was of course the theory of Jeff Skilling and the late lamented Enron, of which he was president and chief executive, that in the new wired world, business would increasingly be done from trading platforms to the great benefit of all. So was Enron not, in fact, an obviously malevolent scam that deserved to get its top official a 25-year jail term, but a noble misunderstood pioneer of 21st-century business? The Enron thesis was an attractive one at first blush. Commodity and energy distribution is an expensive business, but the advent of Internet technology and efficient communications enabled costs to be taken out of it by making each stage of the distribution process tradable, with price discovery through open bidding rather than by wholesalers negotiating individually with utilities. Similarly, financial services could be made more efficient by taking loans off balance sheets through securitization, enabling home mortgages to be traded in bulk across New York trading desks and packaged to investors in Dusseldorf. Removing all those middlemen and shining the light of the market into obscure local operations should both normalize prices and reduce costs. It all sounded very plausible when I heard Skilling expound it at a conference in April 2001, even as Enron's stock prices had gone into unexpected freefall. Whatever the man's failings, he gave a hell of a presentation. We now know the fate of Enron and the home mortgage securitization market, which suggests there had to have been a flaw in Skilling's glossy presentation, whether applied to energy or financial markets. Nevertheless, the most recent earnings of Goldman, JP Morgan and indeed Bank of America (the last of which rested largely on good results at Merrill Lynch) suggest that 25-year jail sentences are not the inevitable outcome of practicing this theory; great wealth may also eventuate, at least for traders. Trading is among the most intellectually opaque of all ways of making money. Modest analysis can uncover the secrets of profitability at almost all businesses, at least post facto, but not those of trading. Traders seem no cleverer than the rest of us, and rather less endowed with charm, although they clearly have excellent nerves. They are also unable to explain how they make money, or at least extremely unwilling to do so. Even books such as the excellent if annoyingly arrogant best-sellers of successful ex-traders such as Nassim Nicholas Taleb (The Black Swan) offer little further enlightenment beyond massive helpings of rather dubious philosophy. One can understand "buy low and sell high". But if it were as easy as that, why couldn't everybody do it? Furthermore, why are the most successful traders almost all concentrated in the same houses? There appears to the naked eye very little difference between a trader at Goldman Sachs and a trader at a second-tier European bank, yet only the Goldman guy is likely to become seriously rich. There are two major secrets to success as a trader. One is to figure out a methodology that works in the short term, even if it is likely to cause a gigantic disaster later on. Most of the money made in trading mortgage bonds resulted from this approach. The existence of fashionable, fallacious risk-management models such as "Value at Risk", for example, enabled traders to pile on debt and thereby achieve attractive returns through huge leveraging of modest differentials between interest rates. This strategy becomes particularly attractive if the US Federal Reserve is forcing short-term interest rates down to levels far below long-term rates, as it has since 1995. Indeed, since long-term interest rates declined steadily from 1981 to December 2008, many traders in the debt area were able to spend their entire careers in an arena in which a modest level of profit, year after year, was built into the structure of their operations. Yes, there was the occasional year in which short-term and long-term interest rates backed up, but the last such year in which debt trading was economically unattractive was as long ago as 1994. That works for debt products, but not so well for stocks, which are less attractive vehicles for leverage games because their prices bounce around too much, so that even the doziest risk managers won't let you borrow too much against them. However, during the glory years of 2003-07, trading desks found an attractive alternative means of generating steady leveraged gains, through their investments in privately held hedge funds and private equity funds, and complex untraded securitization structures. These investments were justified as asset diversification, though in reality most were not "alternative" at all but heavily correlated to the stock or real estate markets. Their true attraction was that their value could be assessed only through the mathematical models of the trading desks themselves. Through the fashionable "mark to market accounting", their book value could then be marked up by a moderate amount each year, and profits taken into earnings on which bonuses were based. Leveraged with debt at low interest rates, those moderate returns were sufficient to provide juicy bonuses to participants. Since many of these investments eventually produced losses in 2008 (and many others will eventually do so), the traders were essentially playing the same game as the Ponzi schemer Bernard Madoff - the difference being that at least some of them may have been unaware of the fundamental swindle of outside shareholders that was taking place. While the intrinsic profitability of leveraged long bond positions in a secular 27-year bond bull market explains the sleek appearance of even regional bank debt traders in the last couple of decades, it does not explain the profitability of Goldman Sachs and JP Morgan today, as interest rates have been rising in 2009. Private equity and hedge funds have had quite good years so far, but that could not have been relied upon in advance. However, for the largest participants in each market, there is another source of trading products - the ability of dealers to profit from insider information. Trading on insider information about the operations of client companies was a major source of Pierpont Morgan's original fortune, and of those of many London merchant bankers, but has been illegal since the 1930s and prosecuted with gradually increasing ferocity by the Securities and Exchange Commission. Presumably, investment banks today profit from this kind of information only occasionally, although there will certainly be some leakage between the client side of the largest banks and their trading arms (and most of them also have research operations, whose information falls into a gray area). However, there are many forms of inside information, in the sense of information that the general universe of investors does not have. Probably the most important, even more important than company operating information, is information about large investors' moves into particular securities or markets. Armed with this knowledge, a trader can manipulate the market so that his positions always swim with the market current, never against it. In the less transparent markets, such as those for options, credit default swaps and many other derivatives, traders who are aware of a substantial portion of the money flows can manipulate prices, let alone the parameters such as volatility that serve as inputs to the ubiquitous mathematical valuation models. This explains the recent sudden increase in the profitability of the largest trading desks. Bear Stearns and Lehman Brothers have exited the market, and the number of large non-US participants dabbling in US markets is way down from two years ago. Hence the profitability of trading in general for the remaining houses has jumped because their level of information on market activity has jumped. I would expect that to have been particularly the case in markets such as options and credit default swaps, in which prices are opaque and manipulation relatively straightforward (apart from the possibility in CDS markets of playing profitable games with actual defaults, the number of which has risen in the recession far above the long-term average). That's why Goldman and JP Morgan were particularly keen to get away from Trouble Asset Relief Program funding, and reestablish their independence from government interference. The existence of hobbled competitors, such as Citigroup and Bank of America, who have not managed to escape from the government and whose management is in turmoil, doubtless gives Goldman and JP Morgan an additional advantage. A lengthy recession, with international banks licking their wounds from losses in the US market, would be their ideal; in such an environment their trading market shares will remain dominant. Skilling of course understood the advantages of superior knowledge of market flows; that's why he leveraged Enron to the hilt to gain market share (the leverage eventually proved fatal - it proved to be impossible to run a huge derivatives operation with a BBB credit rating). The supposed benefits to society of distribution migrating to trading desks were mostly flim-flam. The additional profits gained by such migration go almost entirely to the traders, not to society as a whole. Likewise in the home mortgage market, the migration from Jimmy Stewart making home mortgages directly to Wall Street securitizing them added about 20 basis points (0.20%) to the cost of a home mortgage, expressed as a margin over Treasury bond yields. Both Enron's and Wall Street's trading operations were primarily rent-seeking exercises, and extremely successful ones. The selective bailout of Wall Street, by increasing market concentration, has increased the profitability of the Goldmans and JP Morgans, as well as made it even more difficult for small and even medium-sized finance providers to compete - I think it almost certain that the juicy second quarters at Goldman and JP Morgan will prove NOT to have been shared by the regional banks. (CIT's bankruptcy or near-bankruptcy is another data item proving the same point; if credit provision itself had been profitable in 2009, CIT would now be laughing). For the rest of us, there are clear antitrust implications. "Too big to fail", if it includes a trading operation, needs to be broken up to prevent the rent-seeking of market dominance (which comes at the expense of the rest of us). If President Barack Obama and Treasury Secretary Tim Geithner were not getting their advice from Wall Street, they would already be preparing legislation to achieve this. As it is, such legislation will have to come from such anti-establishment figures as Rep Ron Paul (R-Texas), sponsor of a bill to audit the Fed, and Rep Maxine Waters (D-Calif), sponsor of a bill to ban credit default swaps. Meanwhile, justice demands that they free poor Jeff Skilling, who was only a far-sighted pioneer of the new Wall Street. Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found at www.greatconservatives.com.
Longtime Houston attorney Tom Kirkendall's observations on developments in law, business, medicine, culture, sports, and other matters of general interest to the Houston business, professional, and academic communities.
April 1, 2008
The Wall Street Journal's Enron embarrassment
In anticipation of the oral argument on Wednesday in New Orleans on former Enron CEO Jeff Skilling's appeal of his criminal conviction, don't miss this Larry Ribstein post on Wall Street Journal Enron reporter John Emshwiller's tardy realization that Skilling may just have legitimate grounds for reversal of his conviction and that the Enron Task Force's record is not what its sycophants crack it up to be. This comes from Emshwiller after his newspaper last year characterized the Enron Task Force as having "a good record overall."
I can't improve upon Professor Ribstein's post regarding the irony of the nation's leading business newspaper just now realizing that the corporate criminal case of the decade was badly mishandled. However, even before the Lay-Skilling trial, it was clear that the WSJ's coverage of Enron was open to serious questions (see also here). That the newspaper continues to soft pedal coverage of wide-ranging evidence of serious prosecutorial misconduct in the Enron-related criminal cases reflects a troubling blind spot. Even in the current article, Emshwiller is less than forthright in assessing what is truly going on in the Skilling appeal regarding the Fastow interview notes:
Emshwiller fails to explain that the Fifth Circuit granted the Skilling team's motion to obtain the raw notes because the Enron Task Force took the highly unusual step of providing the Lay-Skilling defense team a "composite summary" of the Form 302 ("302s") interview reports that federal agents prepared in connection with their interviews of former Enron CFO and chief Skilling accuser, Andrew Fastow. Those composites claimed that the Fastow interviews provided no exculpatory information for the Lay-Skilling defense, even though Fastow's later testimony at trial indicated all sorts of inconsistencies.
In point of fact, the process of taking all the Fastow interview notes or draft 302s and creating a composite is offensive in that it allowed the prosecution to mask inconsistencies and changing stories that Fastow told investigators as he negotiated a better plea deal from the prosecutors over time. Likewise, the Task Force's apparent destruction of all drafts of the individual 302s of the Fastow interviews in connection with preparing the final composite is equally troubling. Traditionally, federal agents maintain their rough notes and destroy draft 302s. However, in regard to the Fastow interviews, what turned out to be the draft 302s were probably not "drafts" in the traditional sense. They were probably finished 302s that were deemed “drafts” when the Task Force prosecutors decided to prepare their highly unusual composite summary of the 302s.
Meanwhile, while manipulating Fastow's story, Task Force prosecutors were also preventing other exculpatory evidence from being introduced at trial on behalf of Skilling and Lay by taking the unprecedented step of fingering over 100 unindicted co-conspirators in the Lay-Skilling case (see also here) and implicitly threatening those co-conspirators with indictment if they testified on behalf of Skilling and Lay at trial.
None of the foregoing is explained in Emshwiller's article. Regardless of what happens in the Skilling appeal, the WSJ has some deep soul-searching to do regarding its coverage of the aftermath of Enron's demise. Engaging in media myths and morality plays regarding business interests is bad enough. Ignoring the abuse of the government's overwhelming prosecutorial power to levy a life sentence on an executive who created enormous wealth elevates poor judgment in business reporting to a much more troubling level.
Update: Larry Ribstein comments further here, while Ellen Podgor has a pre-appellete argument post for the Skilling appeal here. The Chronicle's Kristen Hays, who has done the best job in the mainstream media of covering the latest developments in the Skilling appeal, previews the oral argument here.
Posted by Tom at April 1, 2008 12:01 AM
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