Chronicle business columnist Loren Steffy responds to this weekend post on the high price of asserting innocence and hindsight bias in prosecutions of corporate agency costs by urging us to remember the supposed lies that Ken Lay and Jeff Skilling told in regard to Enron.
Steffy is a talented writer and has consistently pulled no punches in expressing his belief that Lay and Skilling are guilty, although his guilty verdict at this point in the trial is a bit difficult to square with this prior column. In fact, Steffy’s blog post reminded me of this funny story about one of my experiences on jury duty. Still, I admire Steffy’s honest stance more than the disingenuous positions taken by some in the media, who cloak an anti-Lay-Skilling bias with a transparent jacket of objectivity.
In the Lay-Skilling trial, the prosecution is only through about a third to 40% of its case in chief. Four out of the five substantive prosecution witnesses to date have testified under agreements with the prosecution in which they hedged the risk of a long prison sentence and loss of virtually all of their net worth in return for their testimony against Lay and Skilling. Moreover, the prosecution’s case to date bears little resemblance to the highly-publicized indictment and related charge pleadings against Lay and Skilling, and the prosecution has gone to great lengths to chill witnesses from testifying who have potentially exculpatory testimony for Lay and Skilling. Meanwhile, Lay and Skilling patiently wait for the opportunity to tell their side of the story.
Against that backdrop, Steffy has already decided that Lay and Skilling are guilty. That’s his perogative, but I prefer to view Lay and Skilling as innocent until the entire story is told and the prosecution has proven — beyond a reasonable doubt — that these men are guilty of a crime.

Alexei Barrionuevo, who has been doing a fine job covering the day-to-day developments in the Lay-Skilling trial for the New York Times, and his Times colleague Kurt Eichenwald — who has written the best overall book on the Enron scandal, Conspiracy of Fools (Broadway 2005) — collaborated on this article in today’s Sunday Times that addresses one of the more troubling aspects of the government policy of criminalizing corporate agency costs — the exorbitant cost of a defense to charges in such a case.

The article lucidly points out that Ken Lay — who at one time was worth about half-a-billion dollars and now is almost broke — has paid or dedicated about $10 million to his defense team, which is on top of another $20 million that his lawyers were paid from Enron’s D&O insurance policies before the proceeds of those policies were locked up in connection with the Enron independent directors’ settlement in the Enron class action securities litigation last year.

Inasmuch as Lay’s co-defendant, Jeff Skilling, has reportedly paid over twice as much out of his pocket than Lay to his defense team and presumably received about as much of the insurance proceeds as Lay, an estimate of $70 million in defense costs for the case is certainly well within the ballpark of accuracy.

And as enormous as the defense expenditures have been, you can bet that the cost of the prosecution is much higher.

So, what are we to make of this extraordinary expenditure of resources?

My sense is that it is a stark reflection of the folly of engaging in the the type of criminalization of corporate agency costs — which is legalese for the prosecution of merely questionable business decisions — that has been a large part of the Enron Task Force’s largely ineffective trials to date in the Enron-related cases.

While the Task Force has properly obtained plea bargains from former Enron CFO Andrew Fastow and the relative few of his cohorts who effectively embezzled money from Enron, the Task Force prosecutors have not limited themselves to such clear cases of theft and fraud.

Rather, the Task Force has spent an enormous amount of time and resources criminalizing business decisions that simply do not involve the black-and-white circumstances of theft.

Indeed, these types of business decisions involve judgments over various possible alternatives, a number of which — given the nature of business risk — will turn out badly and result in a loss for the company.

As Stephen Bainbridge points out in this insightful TCS Daily column, hindsight bias of juries with regard to such bad outcomes results in penalizing beneficial risk-taking rather than punishing true criminal conduct.

Many judges and most lay juries usually have only a minimal understanding of the nature of business risk-taking and, therefore, improperly conclude that a bad result from a business decision had a high probability of occurring (and, thus, should have been prevented by the decision-maker) simply because the bad result occurred.

Consequently, juries are generally biased in favor of finding criminal liability against a business executive under such circumstances even if, at the time the business judgment was made, the probability of the bad result was reasonably low and hedging the risk of the bad result was too expensive. Professor Bainbridge explains the counterproductive effects of this syndrome:

[T]here is a substantial risk that juries will be unable to distinguish between competent and negligent management because bad outcomes often will be regarded, [viewed with 20-20 hindsight], as having been foreseeable and, therefore, preventable. . . . If liability results from bad outcomes, without regard to the [looking forward] quality of the decision and/or the decisionmaking 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.

Meanwhile, the flipside of the high-cost of asserting innocence is the financial pressure to plead guilty, which is underscored by the motion that former Lay-Skilling co-defendant Richard Causey filed late last week.

As a result of his plea deal, Causey in his motion requests (with the Enron Task Force’s approval) that U.S. District Judge Sim Lake release several million dollars of property to Causey that the government had previously frozen and not allowed Causey to use (except to pay some living expenses) while he was defending himself from the government’s charges.

Thus, the first three substantive prosecution witnesses in the Lay-Skilling trial were each able to preserve a significant net worth by copping a plea deal with the Task Force.

While some speculate that Causey’s decision to plead guilty was the result of a personal revelation of wrongdoing, Causey’s motion and other circumstantial evidence reflects that the true reasons for that decision are far more nuanced and troubling.

Peter Lattman — whose WSJ Law Blog has quickly become essential daily reading on business law matters — points us to this Corporate Crime Reporter article on former Enron Task Force director Andrew Weissmann, who is leaving the Justice Department for a position in the white collar criminal defense section of Jenner & Block.

As this Mary Morrison article explains in detail, Weissmann’s dubious decision to prosecute American accounting icon Arthur Andersen out of business over the firm’s work for Enron was an egregious breach of prosecutorial discretion. In the Corporate Crime Reporter article, Weissman is asked about his decision to prosecute Andersen:

Weissmann defends the prosecution of Andersen against a growing consensus in the defense bar that the firm should not have been prosecuted.

“The company through its choices had given the Department of Justice an ‘all or nothing’ ultimatum,” Weissmann said. “People need to remember that Andersen had been offered a deferred prosecution agreement and rejected it.”

He believes that as a result of the Andersen prosecution, more and more corporations are jumping at deferred and non-prosecution agreements when offered.

“One of the fallouts from Andersen is that corporations are much more willing to say yes to deferred prosecution agreements, because they can see what happened to Andersen,” Weissmann said. “What major corporation is now going to gamble that the Justice Department is going to go away and issue a declination? That’s one of the reasons you are seeing a dramatic rise in deferred prosecution agreements and non-prosecution agreements.”

H’mm, let’s break this reasoning down.

An improper prosecution that cost people and communities in the U.S. over 30,000 jobs was really Andersen’s fault because the firm didn’t agree to a deferred prosecution agreement in regard to crimes that the firm did not commit.

Besides, despite the cost of thousands of jobs and millions of dollars in retirement benefits, the improper prosecution was still justified because it achieved the better good of scaring other companies into selling out their employees and copping deferred prosecution agreements.

That such appalling reasoning goes unchallenged in the article is a daunting sign of our times.

Prosecution of business crimes has become a game of roulette for prosecutors such as Weissmann, who play on an ugly cauldron of public cynicism, resentment, and tolerance for abusive use of governmental power to prosecute the unpopular business executive of the moment.

When the frightening loss of thousands of jobs and the destruction of careers and families is glibly rationalized by a former high governmental official as merely a tolerable cost of the use of the state’s awesome prosecutorial power for the better good of society, we are well on our way to a time when, as Sir Thomas warns us, we will not be able to “stand upright in the winds” of abusive state power that will blow then.

And what about the criminalization of business mindset that Weissmann reflects?

Ayn Rand summed it up well with regard to her observation about socialism (courtesy of Bryan Caplan):

[T]he truth about their souls is worse than the obscene excuse you have allowed them, the excuse that the end justifies the means and that the horrors they practice are means to nobler ends. The truth is that those horrors are their ends.

Long trials tend to settle into a rhythm, and the criminal trial against former key Enron executives Ken Lay and Jeff Skilling is no exception.

After four weeks of trial, the prosecution has put on three substantive witnesses. Each one has gone through a heavily-scripted direct examination in which they confidently accuse Lay and Skilling of making various misleading statements to the investing public and employees.

Then, defense attorneys on cross-examination chip away at the prosecution witnesses’ testimony on direct, and the witnesses gradually become far less decisive in their accusations than they were during their testimony on direct examination. Much of the testimony is quite boring, but — as with a baseball game — short bursts of really interesting activity breaks up the tedium. And U.S. District Judge Sim Lake provides a steady hand and a dry wit to the proceedings.

The testimony this week of former Enron investor relations executive Paula Rieker was a case in point.

The prosecution rolled through direct examination of the business-like Ms. Rieker in a little less than a day, and the prosecution appeared to score some jury points when she testified on Tuesday afternoon that an Enron director characterized (how was this not excluded as inadmissible hearsay?) Lay’s use of the line of credit component of his compensation package “as an ATM machine.”

Then, Bruce Collins, the member of the Lay defense team who handled cross-examination of Ms. Rieker, opened his cross-examination on a questionable note, suggesting in a question to Rieker that Lay’s draw of about a million dollars on his company line of credit days before the company filed its chapter 11 case was just “a drop in the bucket” given the magnitude of the company’s other matured liabilities at the time.

Inasmuch as Rieker’s “no, sir” response to that question was probably the same as every juror would have answered if asked the same question, Tuesday concluded as a good day for the prosecution, particularly in its case against Lay, who had barely been mentioned by the first two witnesses, Mark Koenig and Ken Rice.

Collins steadied himself over the next day and a half of cross-examination and methodically took Rieker through each one of her accusations against Lay, and she conceded that Lay had never asked her to make any misleading statements or to do anything wrong, for that matter.

However, Rieker was composed responding to questions from Collins and she often extrapolated on her answers despite Collins’ attempts to cut off her off. Thus, a day and a half of initial cross-examination was rather dull in comparison to the relative excitement of Rieker’s Tuesday afternoon testimony.

But that all changed quickly when Skilling lawyer Daniel Petrocelli began his cross-examination late yesterday morning.

In as effective cross-examination of a difficult prosecution witness that I have seen in awhile, Petrocelli immediately disassembled Rieker, catching her right off the bat in a lie about her duties at Enron (“I overstretched,” conceded Rieker).

He then took her through the extraordinary compensation that she had earned ($5 million combined in 2000 and 2001 alone) and the confidential $300,000 bonus that she had accepted from the company just three days before Enron declared bankruptcy (how on earth did the prosecution not attempt to diffuse that fact by bringing it out on direct?).

You were being paid all this money and you never told Skilling or Lay that they were making misleading statements?, Petrocelli effectively asked Rieker repeatedly.

Almost instantaneously, the previously poised Rieker became tense and agitated, and her answers to Petrocelli’s questions increasingly were evasive and often simply non-responsive.

The prosecution’s frequent objections (most of which were overruled) to Petrocelli’s questioning only underscored how effective Petrocelli’s cross-examination was in bringing the best prosecution witness in the trial to date back down to earth.

By the time Petrocelli had Rieker admitting that neither Skilling nor Lay had ever asked her to do anything wrong and that she had not been involved in any criminal activity in her position at Enron other than the insider trade on which her plea deal is based, the Enron Task Force lawyers had to be asking themselves “what happened to that advantage we had after Tuesday?”

Consequently, despite the enormous public relations advantage that the Enron Task Force enjoys in this case, my sense is that the Task Force continues to have big problems in making its case in court.

Almost a month into the trial, each of the Task Force’s substantive witnesses have initially lied to investigators for years until copping a plea in which they bargained for a reduced prison term and a substantial net worth in return for testifying against Lay and Skilling.

Virtually none of the testimony has supported a key element of the prosecution’s case — the alleged huge conspiracy within Enron to cover up the wrongdoing at the company — and Rieker admitted under questioning from Petrocelli that she had engaged in nothing of the sort while at Enron.

Despite alleging now that Lay and Skilling were involved in lying about Enron to the investment community years ago, none of the witnesses have produced any corroborating documentary evidence that they had any reservations at the time about the statements that Lay and Skilling were making. Similarly, none of the witnesses have testified that Lay or Skilling at the time ever admitted that they thought they were making misleading statements.

Doesn’t sound like much of a conspiracy, does it?

Meanwhile, a couple of behind-the-scenes developments also reflect disarray in the Task Force camp. Mirroring Rice’s infamous false testimony in the Enron Broadband Trial and the Task Force’s abysmal handling of that false testimony, it now appears that the prosecution had Rice testify, during the late stages of his testimony last week, regarding a dubious presentation document that the prosecution had failed to produce to the defense.

That prosecution oversight prompted the Lay-Skilling defense to consider bringing Rice back to testify regarding that suspicious document during the defense’s case-in-chief.

It’s usually not a good sign for the prosecution when a key prosecution witness performs so badly that the defense wants to use the witness in the defense’s case-in-chief.

But even more telling of the problems in the prosecution’s case is how little it has to do with the indictment against Lay and Skilling.

The prosecution does not want the jury to see the indictment and does not even want the Lay-Skilling defense team to be able to question witnesses about it.

Based on the prosecution’s presentation of its case to date, it’s easy to see why — a substantial amount of the testimony that the prosecution has elicited from its witnesses is simply not in either the indictment or the statements in compliance against Lay and Skilling.

While reading the transcripts from the trial, I keep a copy of the indictment and the statements in compliance handy so that I can refer to them when I read about something in the transcripts that I had not previously read about in those documents.

I have counted at least three substantive areas that the prosecution has raised extensively during direct examination of its witnesses that are not in either the indictment or the statements in compliance — disclosure issues relating to sales of the “Peaker plants” in 2001, the alleged “newfound” penny of earnings in the fourth quarter of 1999, and issues relating to warrants and monetizations on something called ResCo.

Apart from the Constitutional issue that defendants must be given fair notice of what the government intends to prove at trial — particularly in regard to an indictment that paints as broad a brush as this one does — the raising of new issues during trial is yet another indication that the Task Force is not confident in its case and is willing to take substantial trial risks in an attempt to make a case against Lay and Skilling.

Such tactics are at least consistent with the Task Force’s fingering of dozens of unindicted co-conspirators under its increasingly hollow conspiracy theory, which is a transparent tactic to induce former Enron executives who have exculpatory testimony for Lay and Skilling to assert their Fifth Amendment privilege and not testify out of fear of being indicted themselves.

After the typical three day weekend break, the trial cranks back up Monday as the prosecution calls former Enron trading unit accountant Wes Colwell, who cut a deal with SEC and who apparently has been cooperating with the Task Force under some sort of non-prosecution agreement. After Colwell, the order of witnesses is currently expected to be accountant Wanda Curry, former trader Timothy Belden and former trading executive David Delainey.

U.S. District Judge Sim Lake is widely-considered to be one of the best jurists in Houston, and his no-nonsense handling so far of the criminal trial of former Enron executives Ken Lay and Jeff Skilling reflects why he is so well-thought of in local bar circles.
Time limitations have prevented me from sitting in on the Lay-Skilling trial as much as I would have liked to date, but I have access to the transcripts from the trial, so I’m able to keep up with what goes on in court each day. From reading the transcripts, I have found that Judge Lake’s most interesting and witty observations often occur before and after the jury is in the courtroom, such as the following exchange that occurred yesterday afternoon after testimony had concluded for the day and the jurors had been excused:

COURT: Be seated, please. (To Bruce Collins, one of Lay’s attorneys) How much more do you have left in your cross-examination?
MR. COLLINS: It’s hard to estimate. I think I’ll be done by lunch tomorrow.
THE COURT (to Skilling lawyer, Daniel Petrocelli): How much do you have, Mr. Petrocelli?
MR. PETROCELLI: I have less than a day.
THE COURT: So it’s doubtful that we will finish (on Thursday)?
MR. PETROCELLI: I don’t think so.
THE COURT: Okay. Is there anything else we need to go into this afternoon?
MR. (Prosecutor John) HUESTON: Your Honor, I’d like to suggest something, and just maybe hear that. I worked hard to keep my direct to less than a day. And I’d like to introduce the thought of some rule of reasonableness when we work to get directs confined and moving quickly, and cross just goes on for days. I think two times the amount, over two times the amount of the direct time for cross, should have been more than sufficient, and I was hoping we would be done with all of this by tomorrow.
THE COURT: Well, probably you’re not the only one who hoped that, but the government covered a lot of discrete information in a very general way that opens the — creates the need by defendants to explore in greater detail. And if you think cross-examination is beyond the scope or it’s not relevant, you can make an objection and I’ll sustain it. But it’s not appropriate, I don’t believe, to impose a timing order in a criminal case where there are liberty issues at stake and there’s a Sixth Amendment right. I will say, in response to a lot of your objections today that I overruled, that cross-examination entitles the questioner to some leeway and to ask leading questions. So fewer objections by you might move things along a little bit.
MR. HUESTON: Yes, sir.
THE COURT: Do you need to respond?
MR. PETROCELLI and MR. COLLINS: No, sir.
THE COURT: Anything else we need to take up?
MR. PETROCELLI: No, Your Honor.
THE COURT (to Mr. Hueston): And I’m perfectly willing to cut off unreasonable and irrelevant questioning, but there hasn’t been much today.
MR. PETROCELLI: Thank you, Judge.
THE COURT (to Mr. Petrocelli, I’m sure with a wry grin): But don’t take that as an encouragement. We’ll see you-all tomorrow morning.