April 25, 2006
The real presumption in the Lay-Skilling case
Although the key presumption in the criminal trial of former key Enron executives Ken Lay and Jeff Skilling is supposed to be that the men are innocent of the charges levied against them, a far different presumption is turning out to be the key one in the trial.
The Enron Task Force's case against Lay and Skilling heavily relies on an unstated presumption -- that Lay and Skilling are rich and Enron collapsed, so they must be guilty of something in connection with Enron's descent into bankruptcy. Although the presumption is superficially appealing because of the human instinct to find scapegoats for failure, it is insidious because it is not true.
Yesterday, during his initial direct examination, Lay challenged that presumption by testifying that Enron's meltdown was the result of an unfortunate series of events that coalesced in undermining the market's trust in the company. As regular readers of this blog know, I have studied the Enron case and come to much the same conclusion as Lay. Enron was a "trust-based" business -- that is, Enron's business model required that its customers rely on the company's financial integrity and not necessarily its net worth. Accordingly, when customer confidence in a company such as Enron is undermined, participants in that company's markets become less willing to engage in the purchase or sale of long-term contracts that might not be fulfilled. Consequently, as the "bid-ask" spreads on trading contracts in Enron's trading business diverged in late 2001, Enron's markets unraveled, Enron's formerly profitable trading business collapsed and the company melted down into bankruptcy.
A typical reaction of the media reporters covering the Lay-Skilling trial have labeled the "run on the bank" explanation of what happened to Enron as audacious, but it's really not. Although the bankruptcy of a company as large Enron is unusual, Enronesque experiences for even the largest trust-based companies are not. In fact, over the past couple of years, two of the largest companies in the U.S. -- American International Group and General Motors -- each have had their own Enronesque experience. AIG survived its Enronesque experience; it remains to be seen whether GM will. In understanding how companies deal with such a loss of trust in the marketplace, it is helpful to review a few previous posts about AIG and GM's experience:
AIG's Absolutely Enronesque experience, how AIG was reeling as its experience continued and continued until the company was able to wind it up by serving Hank Greenberg and a few other executives up to the Lord of Regulation.
Finally, although not related to either AIG or GM, this post discusses Allied Capital's strategy for avoiding an Enronesque experience.
Although AIG and GM are trust-based businesses, they are different companies than Enron was, and the market forces that AIG faced and that GM continues to face are different -- and in many ways, more favorable -- than the dicey market conditions that Enron confronted in 2001. However, the point remains that, if any trust-based company loses the trust of the market, then the same thing that happened to Enron could happen to any such company, and such a breach of trust is not necessarily the result of the criminal wrongdoing of its leaders. That's an important point to remember as the Enron Task Force continues to rely on its dubious presumption to prop up a fundamentally weak and flawed case in attempting to place Lay and Skilling in prison for most of the remainder of their lives.
Posted by Tom at April 25, 2006 5:31 AM |
Nobody trusts GM anymore, but the company keeps operating because it has hard assets anybody can see, and it makes and sells tangible products, namely cars. Creditors will still lend GM money because they know there is collateral to cover the loan. Somebody at Enron was cooking the books, and when it was revealed, there wasn't anything for the company to fall back on. The whole house of cards collapsed. You can argue whether or not Lay and Skilling knew about it or were responsible for it, but to suggest that Enron was a healthy company brought down by short sellers and a couple of WSJ reporters is absurd.
Posted by: Vergil at April 25, 2006 9:14 AM
Vergil, I disagree that GM has completely lost the trust of the marketplace. Its products are still purchased (albeit to a lesser degree) and its strong liquidity position provides security for its credit and equity markets. Nevertheless, the company is not out of the woods, yet.
And who has suggested that "Enron was a healthy company brought down by short sellers and a couple of WSJ reporters?" Certainly not me, and certainly not Lay and Skilling, unless you believe the slanted reporting of much of the media regarding the trial.
I read the transcript of the trial each day, and neither Skilling nor Lay have testified anything to that effect. Rather, both of them have stated that Enron's demise was caused by a breach of trust in the markets that resulted from a myriad of market conditions, including the disclosure of CFO Fastow effective embezzlement from Enron.
Although both have cited the effect of short sellers providing false or incomplete information to the WSJ and other publications as one of many factors in the markets turning against Enron, neither has testified that the company was brought down by short sellers and the WSJ reports.
Posted by: Tom K at April 25, 2006 9:58 AM
Arthur Andersen also comes to mind. Business based on trust. No hard assets to speak of. Government pulls the trigger too fast, and, it turns out, was shooting blanks. But the blank shots killed the business nonetheless.
Posted by: Jim Rhoads at April 25, 2006 10:13 AM
A better example is Refco. In that case, the CEO hid losses by creating a fictitious receivable with a hedge fund. One of the smartest investors in the world - Thomas Lee - invested hundreds of millions. Once the fraud was discovered the CEO repaid the receivable with his own money. Thus, the company's balance sheet was actually stronger than before. However, as a trading business, Refco had lost the confidence of its counter-parties and there was a run on the bank. Needless to say, Tom Lee lost everything. Thus, Tom Lee was duped by a dishonest CEO and saw a trading company collapse as a result of a run on the bank.
I am somewhat surprised that this analogue has not been mentioned at trial ......
Posted by: Cato at April 25, 2006 11:06 PM
Cato, I've previously blogged on Refco's Enronesque experience. However, I did not include it in the above post because the company was unlike Enron, AIG and GM in that it was a much smaller company that had not been an established public company at the time of the meltdown. You are correct that Refco was definitely a trust business, though.
Posted by: Tom K at April 25, 2006 11:27 PM
Reality check: ENRON was and is NOT a bank.
The premise that ENRON failed because there was a "run on the bank" is misinformation at best and/or ignorance at its worse.
If ENRON's business model was correct and workable ENRON would have survived a call on its shares. It did not.
Houston's own investor Mr. Serafim didn't invest a penny on ENRON. Why you may ask? "Because I don't know how they make their money".
Skilling's business plan was flawed and he doesn't have the intestinal fortitude to admit it and Ken Lay was busy crying all the way to the bank to do anything.
Posted by: Alfonso at April 26, 2006 9:51 AM
If a confluence of bad news descending upon a trust-based business is an "Enronesque experience," then are such "experiences" not relatively commonplace--writ large and small hundreds or even thousands of times day in markets around the world?
Experienced investors know that markets are moved by emotion, BS, the herd (and thug) mentality, coincidence, and misinformation, perhaps even more than they are by the free flow of factual information. Sometimes these forces combine to beat a company up; at other times they lift it up. Certainly Enron benefited from the "reverse Enronesque experience," during its brief golden era, when most of these forces seemed to work in its favor.
Bad news, even if it is false, is a nasty fact of life for publicly-held companies, and they should be built and managed to weather it. Mr. Kirkendall's examples--AIG and GM--suggest a telling analogy. If a building burns, but ultimately survives, or collapses slowly enough that no lives are lost, it might be considered an accident. If a building burns in a giant incendiary flash, giving no one an opportunity to escape, this would almost certainly be considered negligence, and society would--quite understandably--demand accountability from its architects and managers.
Posted by: BC at April 26, 2006 9:52 AM
BC, an interesting but flawed analogy. Our criminal laws do not -- nor should -- penalize negligent citizens of serious crimes that require intent and criminal acts.
Lay and Skilling are both subject to voluminous civil litigation in which their responsibility -- including any negligence -- in regard to Enron's demise will be sorted out along with that of all other actors. But criminalizing that responsibility -- particularly in the absence of a clear crime, such as embezzlement or theft -- is a dubious and dangerous extension of our criminal laws. See the Arthur Andersen decision.
Alfonso, no one ever suggested that Enron was a bank, although its market maker status in regard to its online trading business certainly gave Enron a powerful financial presence. The point is that Enron's business -- like that of a bank or an insurance company -- depended on the trust of the marketplace for its viability. Accordingly, once that trust was lost, the "run on the bank" analogy is quite appropriate.
By the way, even if Lay and Skilling presided over a flawed business model, that does not mean that they were involved in any crime.
Posted by: Tom K at April 26, 2006 10:28 AM
Enron had long before it's collapse in 2001, got out of the business of actually making money. To pay it's bills and to fund it's business operations, Enron had to borrow heavily and, of course, with act of borrowing come the interest payments and the debt repayments themselves. So even if Enron had not, as a result of "an unfortunate series of events that coalesced in undermining the market's trust in the company", in 2001 collapsed and had continued to trade, it would have continued to borrow and borrow to finance it's operations and would have eventually run itself into the ground.
Enron may have been a 'trust-based' business, but at the end of the day, if you're not making money (Enron was, by 2001, chucking money out of the door) and you're borrowing heavily to finance your operations, and aren't in a position to make the interest payments (let alone pay back the debts in full) then you're a ticking time bomb, just waiting to go off.
The reason Lay has stuck to this belief that, to borrow a phrase from Tom K, "the company was brought down by short sellers and the WSJ reports" has more to do, I think, with his attempting to salvage his own reputation, rather than that of the company's.
On a seperate note, I have just come away from reading 'Conspiracy of Fools' by Kurt Eichenwald, and I couldn't help get the feeling that in being party to the signing off on Fastow's off-balance sheet special purpose entitites, which on the face of it look like they were primarily intended to conceal Enron losses, Lay and Skilling are guilty of criminal negligence. Here they were, involved in setting up the CFO of Enron as head of partnerships which existed solely to do business with Enron. Both Lay and Skilling have claimed that they were aware of no illegal activity occurring at Enron, but isn't that beside the point?
Fastow was being charged with taking into consideration the best inerests of Enron (which assets to shift to the partnerships he ran), his own wallet (as co-head of the special purpose entities, of which LJM was just one) and the wallets of the partnership investors. Obviously there were significant conflicts of interest at play, yet Lay and Skilling signed off on the partnerships.
Posted by: Frank B at April 26, 2006 10:35 AM
Tom, stick to the law because you obviously don't understand business concepts, or integrity.
Lay and Skilling are still putting their "spin" on their testimony, never really answering the questions put to them. EES was not a poor business model, it was a Las Vegas crap shoot that went bust. They bet the whole house on fooling the market and they got caught. EES never made a penny, only made fake profits. The company didn't fail for poor business decisions, but because they couldn't keep the scam going long enough to bail themselves out.
These men were paid millions of dollars to run a legitimate business, and they couldn't, so they cheated, and got caught. Now they don't want to pay the price that all of their employees paid. For Lay and Skilling to say they thought the company was in good shape is insulting to every CEO and Executive in every public company in the US. Skilling was the mastermind, and keep in mind, Lay is a PHd in Economics. Fastow did what he was told to do....CHEAT, LIE and Steal to make all the executives rich....at the expense of everyone.....These people had not integrity..
Posted by: Margaret Ceconi at April 27, 2006 9:32 AM
Margaret, thank you for your comment.
I have one question for you. I presume that you believe that David Delainey's testimony was true during the Lay-Skilling trial regarding wrongdoing at Enron.
My question: Was Delainey's testimony about you during the trial true?
Posted by: Tom K at April 27, 2006 3:55 PM
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