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August 6, 2008

Cutting the Pai

Former Enron Bldg Former Enron executive Lou Pai's recent settlement with the Securities and Exchange Commission confirmed that the Greed Narrative is still embraced by much of mainstream American society. Take, for example, Charles Kuffner's reaction:

Reading this story reminds me why I was bothered less than folks like Tom were about the criminal cases that were brought against the likes of Ken Lay, Jeff Skilling, and so on. Pai was (eventually) punished through the civil process, but the punishment he received doesn't come close to balancing the scales, in my view. He's still a millionaire many times over - assuming he hasn't blown it all, of course - while so many other people, employees and shareholders, got wiped out. I think the only way the civil justice system could really make these guys pay for their wrongdoings is if it left them in the same shape as the people who were affected by their actions - namely, in a situation where they'd have to work for the rest of their lives because they no longer had any accumulated wealth. Here's a bit I wrote from my review of "The Smartest Guys In The Room":

There's a really poignant scene in which Portland General Electric lineman Al Kaseweter matter-of-factly states that he sold his entire retirement portfolio, which was worth $348,000 at its peak, for $1200.

PGE had been bought by Enron before the crash; like most Enron employees were encouraged to do, Kaseweter put the bulk of his retirement funds into Enron stock. Put Lou Pai in Al Kaseweter's shoes, and I'd agree that justice had been served. Same with Skilling and the rest of that crowd. But that's not how it works, so despite the problems associated with the Enron prosecutions, I think they were necessary.

Stated simply, Charles' view is that "Pai got rich at Enron and a bunch of people lost money when Enron went down in flames, so he must have done something criminal and must be punished." Chron business reporter Loren Steffy, who really ought to know better, spews a similar view.

Frankly, given the societal bias against nearly everything related to Enron, such reactions are not particularly surprising. But it remains disappointing -- and, frankly, a reflection of our human instinct to demonize those in regard to whom we feel morally superior -- that reasonably intelligent people dismiss as a virtual white-collar criminal a man of considerable talent without even passing mention of what he supposedly did wrong.

In reality, Pai was a former SEC economist who became one of the commodities traders who helped Jeff Skilling transform Enron into a multi-billion dollar corporation with earnings that rose from a couple of hundred million dollars in 1990 to $1.6 billion in 1998, over half of which was generated by Enron's trading division. By 2000, Enron's revenue had risen to $100 billion and, on in late August of that year, Enron’s stock price peaked at $90 per share.

As virtually every mainstream media article about Pai's settlement reported, Pai had a legendary fondness for strippers and was a frequent patron of Houston's famous topless club near the Galleria, Rick's Cabaret. Pai met a woman at Rick's with whom he had a long affair, leading Pai and his wife to divorce in 2000 (Pai eventually married his mistress). Pai sold a large amount of his Enron stock in 2000 to fund the divorce settlement, so although he was a wealthy man before selling the stock, Pai was a wealthy and liquid man after doing so.

But the SEC charges against Pai did not involve any of that. Rather, the SEC alleged that between May 18, 2001 and June 7, 2001, Pai sold 338,897 shares of Enron stock and exercised stock options that resulted in the sale of 572,818 shares. According to the SEC, before making those sales, Pai -- who previously headed an Enron division called Enron Energy Services ("EES") -- learned from the successor EES management team that it had identified substantial contract-related losses in the division. The SEC theorized that, had Enron reported EES's contract-related losses in its retail energy services segment, that segment would have shown a quarterly loss of at least $60 million rather than the profit of $40 million that Enron reported in its Form 10-Q for the first quarter of 2001. By selling in May and June, the SEC alleged that Pai avoided the substantial losses that he would have suffered had he still been holding the stock when Enron's stock price collapsed in late 2001.

However, the SEC's allegations against Pai were anything but a slam dunk. Mirroring the SEC's theory of the case against Pai, the Enron Task Force attempted in the Lay-Skilling trial to prove that Enron and Skilling had lied about EES’s growth while simultaneously hiding mounting EES losses. Relying on the testimony of plea-bargainers David Delainey and Timothy Belden, the Task Force asserted that EES first moved an allegedly non-collectible account receivable to Enron's profitable Wholesale division in the fourth quarter of 2000 and then transferred the entire EES risk management book to Wholesale in the first quarter of 2001 ("the resegmentation"). According to the Task Force's theory against Skilling and the SEC's theory against Pai, these events occurred solely to make EES look more profitable than it really was.

Unfortunately for the Task Force and the SEC, that's not what the testimony reflected during the Lay-Skilling trial. The various witnesses expressed differing opinions as to the purpose for the moves with regard to EES, but not one of them stated that anyone had told them that the reason for the moves was to bolster EES’ profitability. Likewise, not one of the witnesses attributed knowledge of that alleged motive to Pai (or Skilling, for that matter). With respect to the transfer of the fourth-quarter 2000 receivable, Enron auditor Arthur Andersen had analyzed the transfer and approved the accounting treatment. Indeed, Skilling defense witness Diann Huddleson testified that Enron management believed it could collect on the questionable receivable and ultimately did collect most of it.

As for the resegmentation, Skilling testified that moving the EES risk book to Wholesale made sense from a business standpoint, and former Wholesale division executive Rogers Herndon confirmed Skilling's version by testifying that the Wholesale unit improved the efficiency and value of that risk book. Even Delainey, the Task Force's main witness on this issue, conceded that he ultimately recommended to Skilling that the risk book be moved. Indeed, the only independent accounting expert who testified during the Lay-Skilling trial -- Walter Rush -- testified that the transfer of the risk book complied with applicable accounting rules.

Thus, the SEC's civil case against Pai was similar to what we've seen in most of the criminal cases against former Enron executives -- long on bombast, short on substance.

But the promoters of the Greed Narrative protest, what about the innocent victims who lost their nest eggs as a result of Enron's collapse?

Well, one of the main reasons that those victims' nest eggs ever had value in the first place was because Pai helped Skilling transform Enron into the world's leading energy risk management company through the creative use of futures and options contracts to hedge price risk for natural gas producers and industrial consumers. Although there is nothing wrong with feeling compassion for folks who lose money on an investment, rarely is it mentioned in the Greed Narrative with regard to Enron that many of those "victims" who lost their nest eggs were imprudent in their investment strategy. They should have diversified their Enron holdings or bought a put on their Enron shares that would have allowed them to enjoy the rise in Enron's stock price while being protected by a floor in that share price if it fell below a certain value. Such is the risk of investing in the trust-based business model

Thus, while virtually all of those Enron "victims" hedged the risk of their investment in their homes by purchasing homeowner's insurance, few of them hedged the risk of their investment in Enron stock. More than likely, most of them simply did not understand how Enron's risk management services created their nest egg in the first place. Thus, when those nest eggs evaporated during the bank run on Enron, they didn't even try to understand what had occurred. They simply embraced the easy-to-understand Greed Narrative.

Sadly, apart from the its egregious human toll and the serious abuse of state power that its promoters ignore, the Greed Narrative's devastating impact is that it obscures the true nature of investment risk and fuels the myth that investment loss results primarily from someone else's misconduct. As Larry Ribstein has been asking for years, do we really want to be sending a message to investors that risk is bad when it often leads to valuable innovation and wealth creation? For example, self-settled derivative prepay transactions are not particularly intuitive (no product actually changes hands) and are not well-understood outside the trading business. Nevertheless, such transactions provide the valuable benefit of hedging risk for companies, who pass along that benefit to consumers in the form of lower prices for their products and services.

Do we really want to allow prosecutors and regulators to paint such beneficial transactions as frauds and then manipulate the public's ignorance to demonize innovative risk-takers who were attempting to create wealth? How does throwing creative and productive business executives such as Michael Milken and Jeff Skilling in prison do anything to educate investors about the true nature of risk and the importance of diversification and hedging?

A truly civil society would find a better way.

Posted by Tom at August 6, 2008 12:01 AM |


One question that might be asked was why was EES segmented seperately to begin with. The answer I believe is that EES's original business model (under Andy Fastow) was to sell power to residential customers in California. That didn't work, a testament to Andrew's lack of business acumen. EES then evolved to an energy service model focused on commerical and industrial customers. Power sales were much more incidental to this effort and were much closer to the wholesale company framework, hence the resegmentation made sense.

I believe it is the case that Enron made available to all employees some independent financial planning services as a perk. Of course it comported with financial planning advice 101 which was diversify.

Posted by: Brucest Author Profile Page at August 6, 2008 1:19 PM

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