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January 10, 2007

Reacting to Gladwell's Enron article

enron%20sinking%20logo36a.gifIt's been a week now since Malcolm Gladwell's New Yorker article on the injustice of the case against Jeff Skilling. One of the more revealing reactions to the article resulted from a question that Gladwell posed in this blog post relating to his article:

Can anyone explain—in plain language—what it is Jeff Skilling and Co. did wrong? . . . The question is strictly a legal one: according to the way the accounting rules were written at the time, what specific transgressions were Skilling guilty of that merited twenty-four years in prison?

Peter Lattman forwarded Gladwell's question to former Enron Task Force prosecutor John Hueston, who is now in private practice. You may recall Hueston from the Lay-Skilling trial -- he was the prosecutor who conducted a largely disingenuous cross-examination of the late Ken Lay (see also here) and then bragged after the trial to the New York Times that he and the other Task Force prosecutors had brilliantly convicted Lay even though the case against him was weak (he is proud of that "accomplishment"?).

At any rate, Hueston's response to Lattman's request largely avoids addressing Gladwell's straightforward question, preferring instead to speak in the platitudes that have become all too familiar to anyone who attempts to have an objective discussion of anything having to do with Enron. However, toward the end of his email to Lattman, Hueston makes three conclusory statements that are at least somewhat responsive to Gladwell's question:

Skilling was found guilty because he was caught flat-footed in lies about the performance of highly-touted business units such as Enron Broadband Services, telling employees the sour truth about the dismal state of the EBS business and then reversing course in a public call with analysts just eight days later.
Skilling didn’t suspect earnings manipulation, he condoned and promoted it with CFO Fastow and CAO Causey, who kept a tally sheet that included accounting side deals that unequivocally violated accounting rules.
Likewise, Ken Lay repeatedly and falsely misrepresented the performance of Enron’s business units, told employees and others to ignore the Wall Street Journal exposes and reports from short sellers, and lulled them with reports of his purchases of Enron stock as he quietly dumped $70 million of his Enron holdings.

Taking Hueston's point about EBS first, and as noted in this earlier comprehensive post on the Enron Task Force's case against Skilling, the Task Force attempted to prove that Enron lied about the health of EBS exclusively through the testimony of four cooperating witnesses who had copped pleas with the Task Force to hedge the risk of long prison sentences -- former Broadband executives Ken Rice and Kevin Hannon, and former Enron investor relations executives Mark Koenig and Paula Rieker. Of course, Hueston doesn't mention that fact, nor the fact that the Task Force effectively prevented (see also here) witnesses with exculpatory testimony for Skilling from testifying during the trial and disputing the cooperating witnesses' allegations.

Moreover, the documentary evidence regarding EBS introduced during the trial actually supported Skilling's defense. Documents showed that EBS experienced substantial growth during 2000 in volumes traded and number of counterparties, and that Enron repeatedly had disclosed sales of fiber through monetizations as part of EBS’s business. Even more importantly, far from being the vehicle for fraud that Hueston suggests, Enron's broadband unit was attempting to develop and deliver the video-on-demand service that is now a popular and profitable product of cable television and Apple's iPod. These systems are a creative accomodation to copyrighted music and video programming under which enormous wealth is generated for artists and shareholders. As Skilling passionately testified during his trial:

And one last thing -- I'll make the last one argument for Broadband because people criticize me about Broadband, and I will take the criticism. We -- certainly, we made a mistake. But it wasn't big. I mean, it was a billion dollars. We invested a billion dollars in the Broadband business. If it had worked, it could have been worth $30 billion. It didn't work. We lost a billion dollars, but if you can make those kinds of bets, that's the kind of the risk you [should be taking] as a corporation. And if you do a lot of [deals with a] downside of a billion and upside of 30 [billion], you're doing a good job for your shareholders in the long run, in my opinion. This one didn't work.

Frankly, given the current value of video-on-demand technology, Skilling's valuation of Enron's Broadband business -- had the company been able to capitalize on its investment -- was probably low. Yes, Enron ended up being ahead of the market in regard to this investment. But what public policy does it serve to have the likes of Hueston use government power to prosecute businesspeople who take the risks necessary to facilitate the development of this type of valuable asset?

Moving on to Hueston's other allegation against Skilling, the evidence that Skilling engaged in earnings manipulation is so sketchy (see more extensive discussion in the earlier comprehensive post) that Hueston resorts to attempting to tie Skilling to the alleged Global Galactic agreement between Fastow and Causey. Revealingly, only the non-believable Fastow testified during the trial that Skilling knew about Global Galactic. Moreover, even after Causey copped a courthouse steps plea deal to hedge the risk of the effective life sentence that Skilling received, the Task Force chose not to call Causey as a witness. More than likely, the reason that the Task Force did not call Causey is that Causey wouldn't have corroborated Fastow at all, which raises a quite reasonable question -- why did the Task Force prosecutors use Fastow's testimony to convict Skilling when they knew that there was reasonable doubt about Fastow's veracity? Indeed, what does Hueston have to say about the Task Force's duplicity with regard to Fastow's testimony during the Lay-Skilling trial? And again, what does Hueston have to say about the numerous witnesses who the Task Force effectively prevented from testifying who would have provided exculpatory testimony for Skilling and refuted Fastow's testimony?

Finally, as to Hueston's allegations regarding the late Mr. Lay, one can only ponder what he is remembering? Lay was charged with wrongdoing for only about a two-month period following his return to Enron's CEO position after Skilling resigned unexpectedly in mid-August, 2001. Had Lay not made that ill-fated return at the behest of the Enron board, he presumably would not have been charged at all. Moreover, as noted here and here, Hueston spent most of his time cross-examining Lay during the trial about his lavish lifestyle and his line of credit arrangement with Enron, neither of which represented the core basis of any of the criminal charges against Lay.

In fact, the entire line of credit issue reflects how the Task Force elevated form over substance in the Lay-Skilling prosecution. Lay traditionally took a substantial part of his compensation from Enron in stock, which was a good thing for both the company and him. As an accommodation to Lay, Enron’s board approved a line of credit -- eventually reaching $7.5 million -- that allowed Lay to monetize the stock efficiently by borrowing on the line and then repaying it with his Enron stock. Each year, Lay and Enron complied with the requirement under SEC rules to disclose Lay’s use of stock to pay the credit line.

That arrangement probably wouldn’t have made any difference except that Lay made what turned out to be a bad decision in regard to his personal financial affairs well before the time that the Task Force contended he was involved in wrongdoing at Enron. Because his at-one-time $300 million-plus net worth was almost entirely invested in Enron stock, Lay and his financial advisers decided that he should diversify his portfolio. However, Lay continued to believe that Enron stock was the best value in his portfolio. So, rather than selling the stock and using the proceeds to buy other securities, Lay borrowed $100 million from third party financial institutions, pledged his Enron stock as collateral and began buying other assets with the loan proceeds. Accordingly, Lay was actually exhibiting an optimism and confidence in the underlying value of Enron, a fact that the Hueston blithely ignores in alleging that Lay knew that Enron was a sinking ship.

The steady decline in Enron stock price during 2001 undermined the value of the Enron stock collateral for the $100 million in personal loans that he had used to diversify his portfolio. Thus, as the collateral value fell and margin calls resulted, Lay used the most efficient facility at his disposal to repay about $70 million of debt in 2001 — i.e., the proceeds from draws on his company line of credit, which he repaid with his Enron stock.

During his cross-examination of Lay, Hueston hammered Lay relentlessly over the fact that Lay did not disclose to Enron employees in late October, 2001 that he was using Enron stock to repay the line of credit, on one hand, while advising the employees at the same time that he was purchasing Enron stock and that the stock remained a good value, on the other. However, Hueston is simply wrong in his contention that Lay was dumping Enron stock at a time when he was advising employees and the market that it was a good value. In September 2001, Lay accepted $10 million in cash and another $10 million in Enron stock in return for agreeing to step back into the CEO role after Skilling resigned, and Lay used the $10 million in cash to repay a portion of his margin loans. In so doing, Lay effectively bought $10 million in Enron stock, meaning that Lay acquired over $20 million in Enron stock roughly a month before he made the statements to Enron employees of which Hueston complains. Consequently, even though Lay was also paying his line of credit with Enron stock at the same time, his acquisition of another $20 million in Enron stock is consistent with the optimistic view about Enron that Lay was communicating to employees and the public. In his quest to demonize Lay, Hueston simply ignores that fact.

So at the end of the day, Hueston falls squarely into what Gladwell calls the Higgs Boson syndrome with regard to answering Gladwell's question. Hueston is gung ho for nailing Skilling and Lay, but he just can't plainly explain their guilt without leaving out important parts of the story. Of course, it is far easier to conclude that someone is guilty of a crime if you start from the presumption that they are guilty of the crime.

In reality, Hueston's view simply plays to the real presumption in the case against Skilling and Lay -- that Skilling and Lay were rich, Enron went bust, and investors had big losses, so Skilling and Lay must be guilty of something. Although they made some bad business judgments (as well as some very good ones, too), Skilling and Lay are not the villians that Hueston and many in the mainstream media portray them to be. Skilling and Lay may not have been saints, but it should give us all pause that the government's overwhelming prosecutorial power has been manipulated to hand them effective life sentences for, at worst, denying that their business dream had ended.

Posted by Tom at January 10, 2007 8:32 PM |

Comments

One of the real tragedies is that the great information you provide regarding the terribly unfair conviction of Jeff Skilling and Ken Lay doesn't make it to the general public. Thank you for caring enough to continue to discuss this important issue.

Posted by: Ann Author Profile Page at January 10, 2007 9:12 AM

I think you're wrong that Lay wouldn't have been charged had he not returned to Enron. Wouldn't the prosecutors have gone after Lay for something else, because, as you put it nicely, their view was "Skilling and Lay must be guilty of something".

Posted by: steve sturm Author Profile Page at January 10, 2007 5:54 PM

Steve, maybe so, but I doubt it. The Task Force was not relunctant about throwing as much mud against the wall as they thought had a chance of sticking. My guess is that they looked at the pre-Skilling resignation facts and concluded that they didn't have anything on which to prosecute Lay. It's not as if they had much to prosecute him on even post-Skilling resignation.

Posted by: Tom K. Author Profile Page at January 10, 2007 6:06 PM

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