Having tended to my day job at the end of last week, I wanted to pass along some further thoughts on the lively discussion that erupted between Vic Fleischer, Larry Ribstein, other commentators, and me last week in regard to my post on the four former Merrill Lynch executives who are appealing their convictions in the Enron-related Nigerian Barge case to the Fifth Circuit Court of Appeals.

Given the importance of the issues addressed in this blog thread to businesspeople, the American economy and the rule of law, I appreciate everyone’s interest in the thread and their contributions.

For those who want to read the prior posts in order:

Here is my original post on the former Merrill Lynch executives’ appeal;

Here is Larry’s first post noting my post;

Here is Vic’s first post responding to both Larry and my post;

Here is Larry’s response to Vic’s first post;

Here is my response to Vic’s first post;

Here is Larry’s post regarding my response to Vic’s first post; and

Here is Vic’s second post that replies to my response to his first post.

This post replies to Vic’s latest post and attempts to circle the thread toward a coherent close.

In his post regarding my response to Vic’s first post, Larry really asks the right questions and identifies the importance of the issues:

The question raised . . . is whether the criminal prosecution of this transaction, particularly in the way it has been done by the government, . . . was appropriate?

If the existence of a promise is essential to criminal liability, does the evidence . . . look even close to enough to hang a substantial prison sentence on?

[W]e academics . . . have an obligation to get this right. This is about how the power of government is and should be used against business, and so is immensely important to this country’s economic well-being. The newspapers and movies have slanted this issue, and the partisans either side will be discounted. We in the academy therefore have special influence.

So, really what we have is a narrower issue regarding whether Enron accounted properly for the Nigerian Barge transaction with Merrill Lynch — an issue that Vic focuses on more than Larry and me — and the broader issue of whether the government should be criminalizing such a transaction, which Larry and I tend to focus on more than Vic.

On the narrower issue, Vic is skeptical that the Nigerian Barge transaction constituted a true sale upon which Enron could book immediate earnings. He is suspicious of the deal’s structure, but more substantively, believes that Fastow probably made an oral promise (albeit unenforceable) that Enron would backstop Merrill’s investment either through an Enron repurchase of Merrill’s interest or by brokering a sale of that interest to a third party.

Vic reasons that the existence of this oral promise — although neither Fastow nor anyone who heard the alleged promise testified during the trial — means that no or inadequate risk was shifted from Enron to Merrill for the transaction to constitute a true sale.

On the larger issue, Vic concludes that Enron probably booked improper earnings intentionally. Apparently because each of the Merrill defendants was involved in the transaction in at least some small way, Vic reasons that the prosecution of the Merrill defendants was not particularly unreasonable, even though he concedes that it’s probably not a particularly strong criminal case.

On the other hand, my position on the narrower issue is that transaction was a true sale. The structure may have been for expediency, to facilitate a future transaction, or simply because Enron liked doing structured finance transactions, as noted in this earlier post.

Moreover, there was nothing inherently wrong with the structure of the deal. Moreover, Merrill undertook plenty enough risk for the transaction to constitute a true sale, probably best reflected by the fact that Fastow’s crime partner Kopper would not agree to have LJM2 buy the interest from Merrill until the risk of non-payment from the source of Merrill’s dividend stream was hedged through the pledge of security from a third party.

Consequently, my sense is that whatever unenforceable assurance that Fastow may have provided to Merrill — and the evidence is reasonably clear that Fastow never promised that Enron itself would buy back the interest — had a negligible effect on Merrill’s considerable risk in the deal.

However, putting aside for a moment the competing arguments on the narrower “true sale” issue that could make for lively debate in a corporate accounting class or civil lawsuit, the more important issue is the one that Larry raises:

Is there evidence of criminality here in regard to the four former Merrill Lynch executives that even comes close to fulfilling the government’s burden of establishing proof beyond a reasonable doubt?

The correct answer is a resounding “no,” and my big difference with Vic is that I do not believe that this is even a close call. The question of whether Enron booked its earnings relating to the Nigerian Barge transaction correctly, improperly, or fraudulently is different from the issue of whether the Merrill defendants engaged in criminal conduct by carrying out their duties in connection with the transaction.

Inasmuch as Enron and Merrill always viewed Merrill as a “bridge” owner of the interest, there was nothing wrong — much less criminal — with Merrill obtaining assurances from Fastow that Enron would assist in finding a buyer who would take Merrill out of the investment after a short hold.

This is not much different than a banker seeking a business owner’s personal assurance that a non-recourse loan to the owner’s business will be repaid even if the company defaults and its security for the loan turns out to be inadequate. That’s just part of the process in which businesspeople gain trust in taking on risks.

Indeed, if Fastow’s assurance to Merrill in the Nigerian Barge transaction was — as Vic suggests — the basis of a crime, then dozens of Merrill executives, lawyers, and accountants who reviewed and approved the transaction were also involved in that criminality. They all knew and agreed that having Dan Bayly obtain Fastow’s assurance that Merrill would be taken out was a good idea.

Why have they not been prosecuted? Why are the four former Merrill executives being singled out? Why on earth is William Fuhs — who had nothing to do with structuring or approving the transaction, and handled only a few ministerial tasks in regard to the deal — going to jail for over three years away from his wife and two young children when the other Merrill executives, lawyers, and accountants who structured and approved the deal get off scott free?

Don’t get me wrong. I don’t believe that either Merrill or its four former executives came even close to crossing the line of criminality in regard to this transaction. But if you accept Vic’s analysis that they did, then you cannot logically stop with the four sacrificial lambs named Bayly, Furst, Brown and Fuhs. You must prosecute the company and everyone involved in the transaction, and then prepare to take shelter from the economic storms that would follow as implementation of such a dubious criminalization policy would inevitably lead to a raft of Arthur Andersen-type meltdowns. That is why corporate and individual responsibility in such matters — as Larry has repeatedly pointed out on his blog — is best sorted out in civil lawsuits.

Finally, Vic does not add much to the discussion by observing that the prosecution of the Merrill defendants has been fair because they have been afforded procedural due process. Although rather sad and humorous at the same time, it’s a reflection of the post-Enron era of anti-business sentiment that “fairness” in regard to Enron-related criminal proceedings is being measured by the fact that at least procedural due process has not yet been suspended in regard to those proceedings.

But even where procedural due process is provided, justice and the rule of law are undermined when the government uses its daunting power to criminalize individual behavior that, as Chief Justice Rehnquist put it in Anderson, “is by itself innocuous.” As the Chief Justice goes on to explain:

“We have traditionally exercised restraint in assessing the reach of a federal criminal statute, both out of deference to the prerogatives of Congress, Dowling v. United States, 473 U. S. 207 (1985) and out of concern that ‘a fair warning should be given to the world in language that the common world will understand, of what the law intends to do if a certain line is passed.’ McBoyle v. United States, 283 U. S. 25, 27 (1931).”

Thus, as with its Andersen prosecution, the Enron Task Force had to overreach badly — distorted application of criminal statutes, suppression of evidence, intimidation of key witnesses, primary reliance on the “shoddy merchandise” of hearsay testimony, etc. — to make a case against the Merrill defendants in the Nigerian Barge case.

Similarly, the list of Enron Task Force abuses in other Enron-related criminal cases is also getting quite lengthy. So, regardless of whether the prosecution of the Merrill defendants was a “witch hunt,” it’s clear that the government is exercising its formidable prosecutorial powers in the Enron-related cases in a highly troubling manner.

To a large degree, the overreaching nature of these prosecutions is a by-product of the vagaries of pursuing a policy of criminalizing corporate agency costs in the first place. In this excellent TCS Central op-ed, Stephen Bainbridge — who, along with Professor Ribstein — is one of most cogent scholars on corporate law issues (and one of Vic’s colleagues at U.C.L.A.) — criticizes the type of prosecution of corporate agency costs that Vic views as reasonable in the prosecution of the Merrill defendants:

Few serious persons would deny that fraud and theft are appropriate subjects of the criminal law. When corporate executives loot the corporation, . . . they should go to jail. Unfortunately, however, ambitious prosecutors have not limited themselves to cases of fraud or theft. . .

Business decisions rarely involve black-and-white issues; instead, they typically involve prudential judgments among a number of plausible alternatives. Given the vagaries of business, moreover, even carefully made choices among such alternatives may turn out badly.

At this point, the well-known hindsight bias comes into play. Decision makers tend to assign an erroneously high probability of occurrence to a probabilistic event simply because it ended up occurring. If a jury knows that the plaintiff was injured, the jury will be biased in favor of imposing negligence liability even if, viewed ex ante, there was a very low probability that such an injury would occur and that taking precautions against such an injury was not cost effective.

Hence, there is a substantial risk that juries will be unable to distinguish between competent and negligent management because bad outcomes often will be regarded, ex post, as having been foreseeable and, therefore, preventable ex ante. If liability results from bad outcomes, without regard to the ex ante quality of the decision and/or the decision making process, however, managers will be discouraged from taking risks. If it is true that lack of gumption is the single largest source of agency costs, as somebody once said, rational shareholders will disfavor liability rules discouraging risk-taking, as Judge Ralph Winter opined in Joy v. North:

[B]ecause potential profit often corresponds to the potential risk, it is very much in the interest of shareholders that the law not create incentives for overly cautious corporate decisions. . . . Shareholders can reduce the volatility of risk by diversifying their holdings. In the case of the diversified shareholder, the seemingly more risky alternatives may well be the best choice since great losses in some stocks will over time be offset by even greater gains in others. . . . A rule which penalizes the choice of seemingly riskier alternatives thus may not be in the interest of shareholders generally.

Hence, when juries review the merits of even bad corporate governance, they run the risk of effectively penalizing “the choice of seemingly riskier alternatives.”

In sum, shareholders deserve protection from theft, but not from risk taking, . . . Unfortunately, it’s not clear that prosecutors know the difference — or even care.

Yes, Vic, we can agree that this is not as bad as the Inquisition or the Holocaust. But it is still a gravely important issue when the state misuses its overwhelming power to prosecute and convict unpopular people for doing their job, which — in Mr. Bayly’s case — he had been doing in an exemplary manner for the past 30 years.

Even an appellate decision overturning the convictions of Mr. Bayly and the three other Merrill defendants cannot undo the emotional carnage that those men and their families have endured, just as the Supreme Court’s decision in Andersen could not breath life back into the 30,000 jobs that were lost as a result of the government’s overreach in that case.

However, as great as my compassion is for the Merrill defendants and their families, and as concerned as I am with the economic damage that is resulting from the government’s dubious criminalization policy, my greater concern remains for the principles of justice and respect for the rule of law upon which the success of American society is largely based. It is simply impossible to reconcile the convictions of the Merrill defendants with the results in such cases as the Enron Broadband trial, the Richard Scrushy case, the Arthur Andersen case, the William Sihpol case, the Martha Stewart case, the sad case of Jamie Olis, the DOJ’s handling of the Global Crossing case, the Frank Quattrone case, and many others.

Accordingly, the roulette wheel-nature of the results in these cases is precisely what casts the public’s respect for the rule of law into an ugly cauldron of cynicism, resentment, and tolerance for the abuse of the government’s daunting power to prosecute the unpopular people of the moment.

That’s why when a bright law professor rationalizes a travesty such as the conviction of the Merrill defendants as merely an unfortunate result of an otherwise legitimate use of the state’s prosecutorial power, I am concerned that we are well on our way to a time when, as Sir Thomas More warns us, we will not be able to “stand upright in the winds” of abusive state power that will blow then.