Category Archives: Legal – Criminalizing Business

Enron, the documentary

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As noted several times on this blog, the most popular book on the Enron affair to date has been the one written by Fortune reporters Bethany McLean and Peter Elkind, Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (Portfolio 2003). If you want to read just one book on the Enron scandal, then Smartest Guys is the book for you.
Now, the Houston Chronicle reports that Smartest Guys is the basis of a documentary that will debut later this month at the Sundance Film Festival in Utah. Filmed by Alex Gibney, who is probably best known for producing the documentary — The Trials of Henry Kissinger (2002) — based on Christopher Hitchens’ searing book, The Trial of Henry Kissinger (Verso 2001), it does not appear from the following Sundance website description of the film that Mr. Gibney bothered to review any of Professor Ribstein’s writings on the portrayal of business in film in preparing the documentary:

Watching Enron: The Smartest Guys in the Room is a little like watching the outcome of a Super Bowl on ESPN Classic. Although you already know the final score, you’re still captivated by the drama of the game, entertained by the characters, and fascinated by the behind-the-scenes revelations. And Enron is indeed an engrossingly dramatic tale, especially as depicted in all of its exquisite detail by director/screenwriter Alex Gibney. The story of Enron is not simply a cautionary tale about greed and corruption. Nor is it a story that we are unlikely to witness again, for the rise and fall of Enron is as American as apple pie.
With this film, based on the book of the same title, Gibney has fashioned a history lesson that takes us “inside” the headquarters of the seventh-largest corporation in the United States and illustrates through a series of rapidly paced interviews, corporate footage, and news reports, the “new economy” of the 1990s: a climate where companies sold ideas rather than widgets, and a corporate culture where ethics became as old fashioned and out of date as value investing. Densely packed, with a world of information for the sophisticate and neophyte alike, Enron is riveting, muckraking filmmaking that should make any culture critic of the 1990s proud.

Hat tip to Charles Kuffner for the link to the Chronicle article.

Enron bankruptcy CEO takes over at Krispy Kreme

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Krispy Kreme Doughnuts Inc. took a big step closer to chapter 11 today as it announced that its chairman and chief executive, Scott A. Livengood, retired and that turnaround expert and current Enron CEO, Stephen F. Cooper, was named CEO and a director.
Steven G. Panagos — who works with Mr. Cooper at his consulting firm, Kroll Zolfo Cooper LLC — was also named president and chief operating officer of Krispy Kreme.
Somewhat surprisingly, the news sent Krispy Kreme’s shares soaring in mid-morning trading today. Expect that speculation to reverse itself as the reality of the situation becomes clearer over the next several days.
Krispy Kreme has been hammered over the past year by a gradual slowdown in sales and multiple investigations of its accounting practices and franchisee acquisitions. Here are the prior posts on the trendy doughnut maker’s demise.
Mr. Cooper and his firm are well-known in bankruptcy and corporate reorganization circles, as evidenced by the firm’s involvement in the high profile Enron chapter 11 case. Mr. Cooper and his firm will likely recover more than $100 million once their work is completed in the Enron reorganization.

Harvard Prof not impressed with Enron directors’ settlement

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Lucian Bebchuk is a professor at Harvard Law School and a co-author of Pay Without Performance: The Unfulfilled Promise of Executive Compensation. In this NY Times op-ed, Professor Bebchuk takes dead aim at the recent Enron directors’ settlement and he does not like what he sees:

With Enron, the failure of the board had disastrous consequences, leading to the second largest bankruptcy in American history and shaking investor confidence. It is difficult to envision a stronger case for imposing a meaningful financial penalty on directors. Yet the settlement fails to do so.
The settlement hardly heralds a new era in which directors who fail to act in shareholders’ interests pay the price. If even Enron’s board members are treated this gently, then other corporate directors can rest easy.

Professor Bebchuk has a point, but it’s a bit simplistic. The main mitigating factor in the Enron directors’ settlement is Enron’s liberal D&O insurance policy, which is the primary source of funding for the settlement. In the absence of such a liberal policy, plaintiffs’ lawyers would hold out for larger contributions of personal assets from individual directors, such as occurred in the directors’ settlement in the Worldcom case, where the directors’ contributed 20% of their non-exempt net worth.
After Enron, Worldcom and other corporate scandals, liberal D&O policies are rare and more costly. Without that hedge to the risk of director liability, the risk to outside directors has racheted up considerably, as this recent WSJ ($) article reflects. So, it would appear that the market indications are quite contrary to Professor Bebchuk’s conclusion that outside directors can “rest easy” with regard to their risk of director liability.

Looking upstream and downstream in prosecuting accounting fraud

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This this NY Times article reported last week that nine executives from a several food supply companies have been charged with crimes for their part in a revenue pumping scheme at U.S. Foodservice, a subsidiary of the Dutch company Royal Ahold N.V.. All the executives are accused of participating in a scheme to inflate U.S. Foodservice’s profits by confirming to the company’s auditors that the company was owed millions of dollars more in rebates than was actually the case. According to the article, most of the executives are expected to plead guilty.
The U.S. Foodservice case reflects a growing trend in white collar criminal prosecutions — i.e., employees of a company doing business with a target company being accused of participating with the target company’s employees in an accounting scheme to inflate the target company’s profits. The same approach was taken in the recent Enron-related Nigerian Barge case, in which four Merrill Lynch executives were convicted of participating in an accounting fraud with various Enron sharpies.
On the surface, the cases appear to be similar. The U.S. Foodservice prosecution appears to involve blatantly fraudulent conduct in which vendor representatives falsified documents so that U.S. Foodservice auditors would be misled regarding the true amount of the company’s revenues. The documents were clearly false because the vendors had no legal obligation to provide the rebates set forth in the documents. Based on the false documents, the U.S. Foodservice’s auditors booked illusory revenue that inflated profits.
Similarly, the Nigerian Barge case also involved an oral side deal that was not disclosed to Enron’s auditors. As a result, the government successfully contended at trial that Enron was able to take advantage of the accounting benefit of selling the three Nigerian energy production barges to Merrill Lynch even though it secretly remained obligated to repurchase the barges. But for non-disclosure of the oral side deal, Enron would have had to book lower than expected earnings, which would have resulted in lower stock price, lower compensation to the executives involved, etc.
Thus, the two cases appear to have much in common — false documents, undisclosed side deals, and false disclosures to auditors. But the nuances reflect significant differences between the cases, and those differences point to the dangers of criminalizing common business transactions, particularly in the anti-business environment fueled by anti-Enron animus.
Unlike the apparent false documents in the U.S. Foodservice case, there was a real question during the Nigerian Barge trial whether the contract under which Enron sold the barges to Merrill Lynch was true or false. This is particularly important because the written contract included a standard provision that specifically provided that any prior oral agreements between the parties — which would include the oral side deal in which Enron agreed to repurchase the barges — were superceded by the written contract that included no such obligation. Thus, if the written contract was enforceable, then Merrill Lynch could not have required Enron to repurchase the barges. If Merrill could not have enforced the oral side deal, Merrill was truly at risk with regard to the transaction, and Enron’s accounting for the transaction was at least arguably correct. If that’s the case, then what’s the crime?
Undaunted, the Nigerian Barge prosecution trotted a few former Enron executives who had previously copped pleas to the witness stand to testify regarding the existence of the oral side deal and to opine that Merrill was not truly at risk with regard to its acquisition of the barges. The prosecution put on no evidence that the written contract was unenforceable. Rather, the prosecution focused the jury on the horrors of Enron and the bad judgment that a couple of the Merrill Lynch defendants had used in investing personally with former Enron CFO Andrew Fastow in a special purpose entity that ultimately ended up with the barges. Finally, the prosecution case was buttressed by U.S. District Judge Ewing Werlein‘s questionable decision to exclude a key defense expert, who would have opined that Merrill Lynch was truly at risk in regard to the barge transaction because the written contact rendered unenforceable the oral side deal for Enron to repurchase the barges.
In the end, the jury in the Nigerian Barge trial convicted five of six of the defendants, including all four of the former Merrill Lynch executives. Interestingly, the Enron in-house accountant — who was the only defendant in the case who ratified the supposedly faulty accounting of the underlying transaction to Enron’s auditors — was acquitted. The trial court’s ruling that excluded the defense expert testimony regarding Merrill’s risk in the underlying transaction will be one of the central issues on the appeal of the convictions.
Thus, few would quibble with the proposition that clear fraudulent conduct should be vigorously prosecuted. But such clear cases of criminal fraud should not be confused with ones that are based more on playing to the jury’s anti-business bias than proving the fraudulent nature of the underlying transaction. The difference is that the type of conduct that apparently occurred in regard to U.S. Foodservice would surely be prosecuted regardless of what companies were involved. However, it is highly unlikely that the defendants involved in the Nigerian Barge case would have ever been prosecuted had any company other than Enron been involved in the underlying transaction.

Warren Buffett, meet Eliot Spitzer

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General Re Corp., the wholly-owned insurance subsidiary of Warren Buffett‘s Berkshire Hathaway Inc., has been receiving some interesting mail lately.
Berkshire issued a press release on last week (see Form 8-K announcement here) disclosing that the insurer had received subpoenas from the SEC, New York AG (“Aspiring Governor”) Eliot Spitzer, and a grand jury in the Eastern District of Virginia.
Expect Mr. Buffett to push for a global settlement quickly. Descriptions of broad and uncontrollable criminal investigations are a bit difficult for Mr. Buffett to explain in his his annual letter to Berkshire shareholders.
Besides, Mr. Spitzer could use Mr. Buffett’s political support in his upcoming political campaigns. ;^)

Enron outside directors settlement

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On the heels of this post earlier this week about the impending outside directors’ settlement in the WorldCom case, this NY Times article reports on the impending $168 million settlement involving the class action securities fraud and related claims against eighteen former directors on Enron Corp.’s Board of Directors. Most of the settling directors were outside directors of Enron.
This settlement has actually been in the works for several months as the class action plaintiffs’ lawyers became concerned that the extraordinary defense costs of Enron’s former officers and directors would soon exhaust the insurance proceeds available to fund a settlement under Enron’s officers & directors’ liability insurance policies.
Consequently, in October, the plaintiffs reached a tentative settlement with the Enron board members that provided for payment of the remaining insurance proceeds ($200 million) under the O&D policies despite the fact that such a result would leave dozens of former Enron officers and directors not included in the settlement without insurance coverage for their defense costs. In addition, certain settling directors agreed to pay an additional total of $13 million out of their own pockets, which was essentially 10% of each such director’s net gain from their Enron stock sales during the class period. The D&O liability insurers agreed to contribute $155 million toward the settlement, which exhausted the insurance coverage for the non-settling directors and officers.
With that agreement in principle in hand, Enron’s outside directors in late October obtained an injunction against Enron’s O&D liability insurers from the U.S. District Court in Houston that enjoined the insurers from using any further policy proceeds to pay defense costs of former Enron officers and directors pending the District Court’s consideration of the proposed settlement. Since that time, the plaintiffs, the outside directors, and non-settling former Enron officers and directors such as Kenneth Lay and Jeffrey Skilling have cut a deal in which $13 million of the insurance proceeds will be set aside for their future defense costs in return for the non-settling officers and directors’ consent to the outside directors’ settlement. The class action plaintiffs will get $155 million of the remaining insurance proceeds under the settlement and $32 million of the proceeds has been earmarked in the settlement for the Enron bankruptcy estate. The settlement does not include many former Enron officers, including all former Enron officers who have either pleaded guilty to criminal charges or who are currently facing criminal charges.
The outside directors settlement is the fourth major settlement in the class action lawsuit that was commenced against Enron’s former officers, directors, and financial institutions nearly three years ago on the heels of Enron’s hyper-publicized accounting scandal. Including the latest settlement, the class action has generated just under $500 million, which is really rather paltry compared to the over $30 billion in damages that the plaintiffs have alleged in the class action.
Indeed, contrary to the generally laudatory press accounts relating to this and other settlements in cases such as Enron and WorldCom, the handling of the Enron class action by the plaintiffs’ lead lawyers — Lerach Coughlin Stoia Geller Rudman & Robbins LLP — has been subject to sharp criticism among professionals close to the case. The genesis of that criticism was the plaintiffs’ lawyers alleged involvement in allowing a proposed $750 million settlement with Arthur Andersen slip away in early 2002 during the early stages while Anderson was still a going concern operation. In addition to the substantial settlement payment, that proposed settlement would have involved a resolution of the criminal charges against Andersen in a manner that would have allowed Andersen to continue in business as a major accounting firm, saving thousands of jobs in the process. When the proposed deal allegedly blew up in a dispute between the plaintiffs’ lawyers and the financial institution defendants, Andersen’s criminal trial went forward, resulting in the felony conviction of Andersen that prompted Andersen’s demise as an accounting firm. Andersen remains a defendant in the Enron class action, but it is a virtual shell that no longer has the resources necessary to pay $750 million in either damages or a settlement in the Enron class action. Consequently, the plaintiff’s lawyers appear to have left a considerable amount on the table, and have not made up for it yet.
Nevertheless, the plaintiffs in the class action are still seeking billions in damages from a large group of financial institutions for allegedly assisting Enron in defrauding shareholders and creditors. The financial institutions include J.P. Morgan Chase & Co., Citigroup Inc., Merrill Lynch & Co., and Credit Suisse First Boston, to name just a few.
The Enron directors paying the total of $13 million out of their pockets are Robert Belfer, Norman Blake, Ronnie Chan, John Duncan, Joe Foy, Wendy Gramm, Robert Jaedicke, Charles LeMaistre, Rebecca Mark-Jubasche and Ken Harrison. The other directors covered by the settlement who are not required to pony up any money out their own pockets are Paulo Ferraz-Pererira, John Mendelsohn, Jerome Meyer, Frank Savage, John Urquhart, John Wakeham, Charles Walker and Herbert Winokur. As is typical in such deals, none of the directors are admitting any wrongdoing as part of the settlement, which still requires final court approval.

SCOTUS grants cert in Arthur Andersen appeal

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The U.S. Supreme Court granted certiorari on Friday on Arthur Andersen’s appeal of its conviction of felony criminal charges in connection with allegedly destroying and altering Enron Corp.-related documents.
The Supreme Court will review this Fifth Circuit Court of Appeals ruling that upheld the former Big Five accounting firm’s June 2002 conviction by a jury in a Houston federal court. The key issue in the case will be whether the jury instructions that U.S. District Judge Melinda Harmon approved during the trial were too vague and broad for jurors to determine whether Andersen’s actions constituted obstruction of justice. The specific issue to be addressed is this: “Must Arthur Andersen’s conviction for witness tampering under 18 U.S.C. 1512(b) be reversed because the jury instructions misinterpreted the ‘corrupt persuasion’ and ‘official proceeding’ elements of the offense?”
The Justice Departent charged Andersen with obstruction of justice for its mass destruction of Enron-related documents in late 2001 as the Securities and Exchange Commission and Congressional Committees began investigating Enron’s complicated financial structure. As we all know, Enron catapulted into bankruptcy in early December 2001 amid revelations of accounting schemes to mask debt and inflate profits.
As Enron’s auditor, Andersen contended that it was only implementing its document-retention policy that called for destroying unneeded documentation to streamline files. Andersen argued during trial that employees who shredded thousands of documents simply followed the policy and had no intent to undermine any investigation of Enron.
Although an Andersen victory at the Supreme Court would be a Pyrrhic victory for the now defunct firm, this is a positive development for the Enron case in general. The Justice Department’s heavy-handed prosecution of Andersen reflected an egregious lack of prosecutorial discretion — the prosecution of Andersen ultimately caused the loss of thousands of jobs, most of which never had anything to do with Enron. Moreover, as noted here awhile back, the accounting industry has still not recovered from the Andersen fallout, and big business is finding it difficult to find enough auditors to fulfill the new Enron-era regulatory obligations.
Thus, a Supreme Court reversal will not help Andersen much, but it just might send the right message to a Justice Department that increasingly appears oblivious to the negative economic impact that results from criminalizing merely questionable business practices.

The criminalization of investment banking

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NY Times business columnist Floyd Norris hits the nail on the head in his column today in which he observes that the rebound in the investment banking industry this year must be tempered with the plight of Daniel Bayly, the former head of global investment banking at Merrill Lynch. Mr. Bayly was one of five defendants convicted in the Justice Department’s questionable Enron-related prosecution known as the Nigerian Barge case. As Mr. Norris notes:

[T]he real man of the year on Wall Street – or at least the man whose plight is emblematic of the new Wall Street reality – will not be sharing in those bonuses. Instead, Daniel Bayly is awaiting sentencing in federal court in Houston, where he is likely to be ordered to spend a few years in prison for doing something that few on Wall Street would have seen as a crime.
Mr. Bayly, the former head of global investment banking at Merrill Lynch, was caught up in the Enron scandal. He signed off on a deal that Merrill did with Enron, in which Merrill “bought” the now-infamous Nigerian barges from Enron at the end of 1999, thereby allowing Enron to report phony profits. The government viewed the transaction as a disguised loan.
Mr. Bayly’s role in all this was not a large one. His approval was needed for Merrill to go ahead, and he seems to have been principally concerned that there were safeguards to ensure Merrill would get its money back.
The amount of money involved inflated Enron’s profits by only $12 million, just over 1 percent of the $893 million in profits Enron reported for the year. But it allowed the company to meet investor expectations.
The government persuaded the jury that Merrill officials understood the purpose of the transaction was to inflate Enron’s profits and that the accounting was phony. Mr. Bayly’s lawyers said he believed it was proper.

The result, notes Mr. Norris, is that prosecutors are now treating investment bankers as if they were bartenders:

To many on Wall Street, however, whether or not the client’s accounting was proper was a question of little importance, just as a Porsche dealer has no reason to worry that he will get in trouble if a customer chooses to drive faster than the speed limit.
The risk that bankers now confront is that they will be treated the same way bartenders are in some states, where the man who sold the drunk driver his final drink can be held liable for the damages that result.
It used to be that when a company went bankrupt as a result of fraud, the only deep pocket available belonged to the auditor. The collapse of Arthur Andersen after the Enron fraud served as a warning that that pocket might not be so deep, a fact that has been reinforced by the limited insurance now available to auditors.
The current reality is that investment and commercial bankers are the new deep pockets. They used to get high fees for devising transactions whose primary purpose was to mislead investors. Now they will be sued by the Securities and Exchange Commission and by private lawyers if there is any evidence the bankers knew the company’s accounting was suspicious. The Justice Department may even deem such an act to be a felony, and there is no assurance that it will not bring criminal charges against an investment bank as well as against its officials.

How does this new risk reality affect the market? Mr. Norris has a suggestion:

As the profits pour in from the rebound in investment banking fees, investors might hesitate in bidding up the industry’s shares. As Mr. Bayly’s conviction demonstrates, the risks of the investment banking business are much greater than they used to be.

Read the entire piece. And as you ponder the policy implications of the Justice Department’s prosecution of businessmen such as Mr. Bayly over merely questionable business transactions, take note of the fact that Mr. Bayly is currently facing a prison sentence that could be longer than that of true business criminal Martin Frankel.

Enron pipeline sales close

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Enron Corp.‘s liquidating chapter 11 plan accelerated on Wednesday when the company closed the $2 billion sale of its prized remaining assets — its interest in three natural gas pipelines.
Enron’s Bankruptcy Court approved the sale in September of Enron’s interest in the three natural gas pipelines to CCE Holdings LLC, a joint venture of Southern Union Co. and a unit of GE Commercial Finance. CCE Holdings will assume $430 million in debt as a part of the deal.
A $1.25 billion sale of Portland General Electric, which is Enron’s Pacific Northwest utility, is still up in the air pending regulatory approval. If approved, a Texas Pacific Group-backed holding company will acquire the utility and assume $1.1 billion in debt.
Once the Portland General deal closes, the scraps of Enron will become Prisma Energy International Inc., which will own Enron’s remaining pipeline and power assets. When that happens and sufficient claims objections have been resolved (probably sometime in mid to late 2005), Enron will begin distributing dividends to its unsecured creditors. The total amount to be distributed is expected to be approximately $12 billion comprised of 92% in cash and 8% in Prisma stock. That computes to about a 20% dividend on unsecured claims against Enron.
Meanwhile, the Enron name will live on primarily for the benefit of lawyers, who will continue to pursue litigation claims on behalf of the Enron estate for years to come.

Enron’s legal tab

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This Atlanta Constitution-Journal (free registration required) article takes the first stab at an issue that deserves more scrutiny — the nearly $1 billion legal fee tab that the attorneys involved in the Enron chapter 11 case are charging the estate in that case:

The lead law firm, Weil, Gotshal & Manges of New York, is seeking $158 million in fees and expenses. Some New York lawyers are charging $15 a minute ? $900 an hour ? for their work. And other law firms have billed hundreds of dollars an hour for time their lawyers spent reading newspapers to keep up with the case.

One of [Atlanta’s] most venerable law firms, Alston & Bird, has billed Enron nearly $90 million for its 18-month examination of the company’s bankruptcy.
If that number seems staggering, consider this: Just preparing its bills in the case took Alston & Bird employees nearly 1,700 hours, for which the firm billed $496,000, according to documents filed with the bankruptcy court.

All told, more than 200 Alston & Bird lawyers, many billing at least $500 an hour, worked on the Enron examination, according to documents the law firm filed with the court. Nineteen of the firm’s attorneys submitted bills for more than $1 million apiece in legal fees.
Eighty-nine of the firm’s paralegals, librarians, analysts and clerks worked on the Enron case. The firm’s lawyers and support staff calculated they spent 264,332 hours on the examination, . . .

The professionals interviewed in the story fall over themselves defending the amount of fees incurred in the Enron case, and the reporter does not try to challenge their assertions much. Certainly the Enron case justified some premium over the normal legal cost of a typical large chapter 11 case because of the size and emergency nature of the case. Moreover, the fact that the Enron Bankruptcy Judge in New York declined early in the case to transfer venue of the case to Houston also contributed to the high cost attributable to attorneys’ fees. Those $900 per hour fees that were routinely approved in New York likely would not have passed muster in Houston.
Nevertheless, the $1 billion legal tab to date is scandalous, and is particularly galling because that tab does not include the additional legal cost that lawyers will incur in the future pursuing claims on behalf of the Enron estate. Moreover, apart from the attorneys’ fees charged to the Enron estate, there are hundreds of millions of additional charges attributable to other professionals (such as accountants and management and investment banking experts) that are being charged to the Enron estate. It would not surprise me to see the ultimate legal tab attributable to lawyers feeding from the Enron trough to climb another 25% before the case is closed.
Here’s hoping that an enterprising investigative reporter or law professor takes on this subject. My sense is that an objective cost-benefit analysis would reflect that the value of benefits truly derived for the Enron estate from the high legal cost incurred is far less than the attorneys involved in the case would lead us to believe.