“Relax,” said the client
“We are programmed to succeed
You can audit any time you like
But we will never bleed.”
-- from the "Hotel Kenneth Lay-a," by Arthur Andersen auditor James Hecker.
Thinking, said Gladwell circa 2005, is not very useful; far better to go on first impressions.
But now it turns out that first impressions were precisely what misled everyone who got bullshitted by one-time California energy giant Enron’s fast line of talk and Potemkin village accounts. They should have thought more, concludes Gladwell circa 2007.
Ooops. We wish he would take his own advice.
The occasion for Gladwell’s belated celebration of the life of the mind is the sentencing of Jeffrey Skilling, former CEO of Enron Corporation, on October 23, 2006 to 24 years and four months in jail on 19 felony counts. Gladwell’s defense of Skilling and Enron in the New Yorker in January 2007 relies on a somewhat woolly distinction he draws between “puzzles” -- which can only be solved by finding a missing piece of information. It, also, doesn’t require expertise so much as legwork (and informants) and “mysteries,” which require you to interpret evidence, all of which is readily at hand but indecipherable to anyone but brainy experts.
A transition from “deep throat” to deep thinking, if you will.
Of course, what constitutes a relevant fact, as well as how to recognize it’s missing, might also require some expertise and interpretation, but we will leave that for later. For now, let’s just accept Gladwell’s distinction.
Enron, he says, can’t be accused of hiding its accounting; the facts were all there in its books even if they were concealed in the footnotes. Too bad no one read them.
Ergo, Skilling and Enron weren’t at fault . . . the real culprits were the Wall Street analysts who gave a thumbs-up to the company. Wall Street analysts guilty of boosting unworthy stocks? Tsk, tsk. Who’d have thought?
1. Gladwell’s first mistake is a logical one. Because Skilling and Lay are not the only ones to blame, it does not follow that they are not primarily to blame.
There is plenty of blame to go around, yes: analysts, bankers, accountants . . .
But CEO’s -- who, especially in the US, feel justified in guzzling huge salaries as a reward for their talents -- cannot plausibly recast themselves as innocent bystanders when those companies violate the law. And they ought to be prepared to be first in the line of fire when things go wrong.
2. But, insinuates Gladwell, it wasn’t so much about illegality . . . but dumbness. Mistakes were made. Enron’s CFO, Andrew Fastow, himself did not understand the arcane and obscure accounting schemes the firm used. Poor, dear soul. It’s true that the general feeling at Enron was that Fastow was in over his head. A former boss even wondered if he could read a balance sheet right. But if Fastow was incompetent and promoted ahead of his skills on Skilling’s beat, whose fault was that? Surely Skilling’s.
But, as a matter of fact, former CEO Lay did sense that Fastow -- by then well-known to be especially greedy and unscrupulous even in what was by all accounts an exceptionally greedy and unscrupulous firm -- was under equipped for his job. That was why he made Rick Causey, the Chief Accounting Officer, Fastow’s equal (the CAO usually works under the CFO). Lay had Causey report on the day-to-day workings of the department directly to himself. 
And Causey was not incompetent. He had spent nine years at Arthur Anderson, the premier accounting firm in the country. And he had an army of CPAs -- more than 600 -- under him, many of whom had come out of the Financial Accounting Standards Board, which is the body which actually writes the rules of accounting.
Hard to plead dumb with those facts.
Former employees reveal that, actually, pretty much everyone knew that deception was the name of the game.
“Say you have a dog,” said one, “but you need to create a duck on the financial statements. Fortunately, there are specific accounting rules for what constitutes a duck: yellow feet, white covering, orange beak. So you take the dog and paint its feet yellow and its fur white and you paste an orange plastic beak on its nose, and then you say to your accountants, ‘This is a duck! Don’t you agree that it’s a duck?’ And the accountants say, ‘Yes, according to the rules, this is a duck.’ Everybody knows that it’s a dog, not a duck, but that doesn’t matter, because you’ve met the rules for calling its a duck.” 
On one thing, Gladwell is perfectly right: Skilling wasn’t the only to one blame, nor was Kenneth Lay, who on May 25, 2006 was convicted on six counts of fraud and conspiracy and four counts of bank fraud, and then died of a heart attack before sentencing. A raft of colorful dealmakers at the company and gatekeepers on Wall Street contributed to the company’s demise. But what Gladwell seems to have missed (maybe while blinking) is the logical -- and obvious -- conclusion: prosecute them all, too.
Fourth problem: the New Yorker piece focuses only on two of Enron’s accounting strategies (Special Purpose Entities and mark-to-marketing), but even a page or two of company history reveals that unscrupulous dealing went a long way back in the firm, giving the lie to Gladwell’s defense. As one observer noted, all you have to do is to look at Ken Lay's involvement in the Valhalla energy trading scandal at Enron in 1987. 
Gas Bank Gas
Or take Rebecca Mark and the Dhabol deal: Mark, once the glamour girl head of Enron International and Skilling’s rival, made a fortune from the company but managed to wiggle out before the structure she played a huge role in erecting collapsed.
It was Mark who put together Enron’s biggest and most notorious project in Dhabol in the Indian state of Maharashtra. Dhabol, a hundred miles south of Bombay on a remote volcanic bluff over the Arabian Sea, was India’s largest ever foreign investment and so, critics said, “the biggest fraud in India’s history.”
The town was so remote that Enron was given the right to develop its own road, hospital, housing, and port without competing bids. The estimated cost of the monumental 2015 megawatt plant was $2.8 billion and the Maharashtra state board had to agree to buy 90% of the power produced for the length of the 20-year contract and pay it in dollars (transferring currency risk to the state), guaranteed by both the state and central governments.
It was a one-sided giveaway that quickly made Enron the most hated company in the country and raised a whirlwind of questions about the secrecy of the deal, the lack of competition, and what looked like a $20 million bribe to Maharashtra state. While human rights groups were counting up the abuses by Enron’s security squad against unhappy residents, Robert Rubin Clinton’s Treasury Secretary chipped in on the firm’s side.
Rubin was a former co-chairman of Goldman Sachs and during his tenure had worked with Enron. Now, he did his bit; the US Department of Energy came out with a statement threatening that foreign investment in India would suffer if Dhabol was canceled. The deal was redone to cut the price and let the state board get its own share of the loot, but even so, the contract gave Enron 30% returns -- considered astronomical in the business -- and required the Indians to purchase $30 billion in power, all told. 
Enron’s glamour girl (daughter of devout Baptists from a small town in the Midwest, she once roared into an Enron party on a Harley to the beat of “Eye of the Tiger”) came out with some honey of her own -- a lake house, a ten-acre retreat in Taos, an apartment in Manhattan’s Upper East side and a red Jaguar convertible. CEO Lay was living large too, in multimillion dollar homes in and around Houston. An Enron jet was once sent to Monaco to deliver a bed to his daughter and the company also ended up bailing out a son who had become mixed up with the embezzlement of another company. 
Dhabol was only one example of the grease of the political machine that was always part of the sizzle at Enron (its critics liked to call it end-run), once the 7th largest company in the world. Which makes Gladwell’s argument even less plausible.
Obviously, if a firm is in bed with the people who write the laws that are supposed to keep it in check, the laws are bound to end up filled with loopholes the firm can exploit, after which it can turn around and claim -- or let New Yorker journalists claim -- that the financial industry hasn’t kept up.
Created in 1985 through the merger of two Texan gas pipeline companies, Enron jumped quickly into the sack with the political establishment. First, Lay’s transformation of the firm into a big-time trader in the wild and woolly energy business couldn’t have happened without the privatization of public utilities and the deregulation of energy prices. And it couldn’t have happened without the abetting of a lot of big players who were in on the action, including banks like Goldman Sachs.
The oil company-turned-gas bank was a bank with a difference, and Gladwell might do well to pay attention to that difference rather than ascribe Enron’s woes to some kind of New Economy paradigm hitherto unknown to mankind:
Enron was not subject to the same monitoring as traditional banks.
Why? Because energy trading was exempted from government oversight by a law pushed through in 2000 by Senators Gramm and DeLay, whose campaigns had been funded heavily by Enron, and by Wendy Gramm, who joined the Enron board only five weeks after leaving her government job regulating futures trading.
At one time the firm supported 71 out of 100 senators, and 188 out of 435 members of the House of Representatives, and seemed to have funded everyone from the Army secretary to the Vice President and President.
Enron made its way in the new economy with the help of a good deal of old corruption. 
With government involved, could that most political of investment banks, Goldman Sachs, be far behind?
It wasn’t. In 1993 the bank invented a special accounting stratagem to prettify Enron’s books: "Monthly income preferred shares" (or MIPS), it was called, proving again that chicanery at the firm did not start and end with Andrew Fastow and the SPE’s, as Gladwell seems to imply.
MIPS let Enron sell fifty-year securities through companies that Goldman created specifically for the purpose in the Caribbean. To the IRS, Enron described the preferred stock as "debt" and claimed tax deductions on the interest payments. To shareholders, Enron called the same stock "equity" and counted it in the company's capital value. And Goldman pocketed huge underwriting fees from the scheme.
Within a year, Goldman had helped 17 companies besides Enron sell 2.7 billion MIPS, with $4 billion to come, making an offering each week that progressively skirted IRS rules more and more finely. Average commission and interest rates on MIPS were well above that on normal debt, running between 1 and 1.2%. Goldman made tens of millions from the new securities, usually from cash-hungry, debt-riddled firms, the only ones likely to pay the premium given the uncertainty of tax laws.
Soon, the IRS, Treasury and the SEC were desperate to plug a loophole that was costing them hundreds of millions of dollars a year. Afraid they might lose a major source of revenue, Goldman and Merrill Lynch, along with the Bond Market Association, an industry trade group, began lobbying government strenuously. Goldman CEO Jon Corzine -- later to become a US senator and NY Jersey governor -- was especially active working the bank’s government contacts. It paid off. The legislation was abandoned and the Enron gambit became wildly popular as a way to raise cheap capital offshore while reducing US taxes.
Comes 1994 and Robert Rubin (Corzine’s predecessor as Goldman chief), with his Enron connection, was now Treasury Secretary. He immediately wrote to his former client that he "looked forward to continuing to work with you in my new capacity." 
It was Rubin’s clout which turned Enron’s gas global.
The energy business was the gold rush of the '90s. And there was no bigger rush than in the emerging markets in Latin America and Asia, where plant requirements were figured by the company to grow by 560,000 megawatts by the end of the century. The developing world needed energy, loads of it. And cheap. Soon, Enron had laid pipe down in countries from Argentina to the Philippines, employing as consultants the likes of Henry Kissinger and James Baker. Enron made out big time.
But, Lay claimed, hadn’t he saved consumers 30 billion in lower natural gas prices over a decade? Wasn’t that what the free market was all about?
Perhaps. Except that that the free market had had nothing to do with any of it; Enron was completely dependent on agencies like the Export Import bank and the World Bank to guarantee its loans and finance it to the tune of $7.2 billion between 1989 and 2001. 
The first Bush even offered Lay the position of commerce secretary, which he declined. He was holding out for a bigger plum: Treasury Secretary.
How could Lay say he believed in the free market and then lobby to continue funding for the Export Import Bank and the Overseas Private Investment Corporation? The guru of gas saw no contradiction: “Public finance agencies are the only reliable sources of the financing that is essential for private infrastructure projects in developing countries,” he said. 
Why you would call that a private project, he didn’t explain. At Enron, the self-deception -- like the chicanery -- ran deep.
The Hotel Kenneth Lay-a
MIPS were not Enron’s only creative twist to financing. The firm generated huge revenue numbers by buying and selling the same goods and counting each sale at full value as revenue. Enron’s financial wizards had “black belts in structured finance,” and they exploited the system of accounting, which was mark-to-market, as Gladwell notes.
But, mark-to market (which adjusts the values on the balance sheet to conform to changes in the market as they happen) is not per se to blame, as Gladwell implies. In fact, it’s quite appropriate for assets traded publicly on the stock exchange, say experts. The problem was that Enron used mark-to-market for non-exchange traded, private, illiquid assets -- a different deal altogether, especially since the estimates of values were not generated by the market but conveniently provided by . . . guess who? . . . Enron itself.
How much arcane expertise and genius-level IQ is needed to figure out that estimates of future value generated thus are bound to be abused? 
Nor should it have taken a ‘quant’ with a PhD to figure out that Enron’s Byzantine SPEs were not kosher. SPE’s or Special Purpose Entities, are independent outfits that a company can set up to buy its securitized assets.
How do you securitize an asset? You simply figure out how much cash something will generate in the future and then sell it at a discount on the market, letting the buyer take on the risk.
But SPEs, which are supposed to isolate an asset’s risk from the rest of the company, again, aren’t the problem per se, as Gladwell implies. They are quite common and can be useful instruments. Most credit card and mortgage payments flow through special purpose entities.
The real problem was Enron’s brand of SPEs, which weren’t really independent at all. In fact, some of the SPEs were actually managed by Fastow, who invested family money in them. And though they denied it, the lenders -- some of Wall Street’s biggest banks -- knew what was going on.
“E gets money that gives them c flow but does not show up on the books as big D Debt,” wrote a Citigroup banker in 2000. 
Enron used SPEs and derivatives three ways. First, it hid its huge losses in them. Second, it covered up the loans it took. Third, it used the wildly inflated sale figures (basically, sales made to itself) to boost the value of the assets on its books. Because it inserted one miniscule footnote that told the real story, Enron was not at fault, says Gladwell. It followed the rules of accounting, didn’t it?
Maybe technically, although even that is not clear. But there can’t be serious doubt that Enron’s intent was to deceive rather than inform investors. Simply put, Enron’s SPEs took the company’s indebtedness off balance sheet. They hid it. You’d think it wouldn’t need too much deep thinking to suss that out; a gut-level “blink” ought to have been enough to sense something was wrong. Apparently not.
The problem is not, as Gladwell argues disingenuously, the complexity of financial disclosure today. The problem is not that the “disclosure paradigm” has been made outdated by the sophistication of financial instruments (in support of which fluff analysis, Gladwell claims that Enron’s summaries of its SPEs would run to over 120 thousand pages; its original filings, to three million pages).
The choice between short and inadequate company statements and voluminous unreadable ones is simply a false alternative. The flood of paper released by Enron was not really entailed by the nature of SPEs -- but by the firm’ intent to cover up what it was doing. Hiding a damaging fact in a footnote in a tidal wave of dusty facts is not a New Economy development. It’s a very, very old ploy in any game of deceit. 
And here the question of blame comes up. For, even a footnote should have been enough -- as it was for some savvy traders, who promptly began shorting the stock (selling it). But it wasn’t. Why not?
And, here, if Gladwell had only named some names -- instead of talking generically about Wall Street not keeping up -- he would have been onto something.
He might have mentioned that in 1999, when Hank Paulson (now Treasury Secretary) was at the helm, Goldman Sachs had actually joined in a scheme initiated by Enron’s "smart guys" to conduct massive energy futures trading. And Goldman’s leverage, like Enron’s, had ballooned.
He could have added that after Enron collapsed in 2001, former Treasury Secretary Rubin, who had by then joined Citigroup as chairman, called up a senior Treasury Department official, Peter Fisher, to consider advising the bond-rating agencies against immediately downgrading Enron’s debt. Citigroup which was a big creditor of Enron would thus have profited hugely. So would Goldman. The request was outrageously unethical and would actually have been illegal were it not that a longstanding executive order preventing senior officials from lobbying their former department for five years after their departure had been cancelled by President Clinton in his last days as President. 
He might have noted that the separation between commercial and investment banking and insurance instituted by the Glass-Steagall Act had been systematically eroded and then finally repealed by the Gramm-Leach-Bliley Act in 1999, which enabled the consolidation of the banking and finance industry. GLBA was enacted while Rubin was Treasury Secretary and was sponsored by Senator Phil Gramm (as chair of the Senate Banking Committee). Gramm later joined UBS Warburg, at the time the investment banking arm of the largest Swiss bank.
He could have pointed out that, among other changes, GLBA made the Fed the financial system's primary regulator. But, the Fed's beat isn't stopping financial fraud; it’s keeping the US banking system on even keel -- a.k.a. covering for the big banks. And what were the big boys up to? Why couldn’t they “keep up” with the quantum leap in financial paradigms?
Because it appears they were too busy making out from it:
* Enron paid $52 million (in 2000) to its audit firm, Arthur Andersen, most of which was for non-audit consulting work, yet Andersen still failed to spot the problem. At least one of the other “Big 5” accounting firms was itself in on one of Enron’s SPEs.
* Enron paid several hundred million dollars in fees to the big banks, and yet none pointed out the problems at Enron. As late as October 2001, almost sixteen out of seventeen securities analysts covering Enron rated it a “strong buy” or “buy.”
* The big three credit-rating agencies, Moody’s, Standard & Poor’s, and Fitch/IBCA, took home huge fees from Enron, yet while the stock was trading at just $3 per share, all three gave its debt investment grade ratings.
The conclusion one draws from this is not that Skilling and Lay should have got off. But that a whole bunch of enablers and opportunists on the Street should have joined them on the dock. If nothing else, as a warning to the industry.
For, Enron is not past history only but a harbinger of the future. Unknown to most of the public, it was ultimately not an energy firm so much as a trading firm, one trading in the riskiest and most volatile of all financial instruments -- derivatives (contracts based on [derived from] the value of an underlying asset -- contracts like futures, options and swaps).
How big a trader? Compare Enron to Long-Term Capital Management, whose blow up in the late '90s sent shock waves through the financial industry. LTCM generated losses of only a few billion dollars; meanwhile, Enron wiped out $70 billion of shareholder value and defaulted on tens of billions of dollars of debts. LTCM employed only 200 people; Enron employed 20,000.
Turnover in derivatives, which hardly existed a few decades ago, is now reckoned in the hundreds of trillions of dollars (several times world output), and the biggest part of it takes place outside the exchanges -- as Enron’s was -- in over-the-counter (OTC) markets that are completely unregulated.
Indeed, in December 2000, after proposals for regulating the derivatives market were rejected, Congress passed the Commodity Futures Modernization Act -- establishing firmly that derivatives markets were to continue to remain unregulated.
Meanwhile, Gladwell say we need more “experts” to figure out what’s up in the “mystery” of modern finance. But the record shows that the experts have the mystery figured out already -- and are cashing in on that knowledge. At a time when international agencies have warned that the OTC derivatives markets are a ticking time bomb that could set off a collapse in the global economy, the real need is for more disclosure not less.
And the real question is: with this post-mortem defense of Enron, what is Malcolm Gladwell preparing us for?
And where’s deep throat when you need her?
Lila Rajiva is a freelance journalist and the author of The Language of Empire: Abu Ghraib and the US Media (Monthly Review Press, 2005) and the forthcoming, Mobs, Messiahs and Markets (with Bill Bonner-Wiley, September, 2007). She has also contributed chapters to One of the Guys (Ed., Tara McKelvey and Barbara Ehrenreich, Seal Press, 2007), an anthology of writing on women as torturers, and to The Third World -- Opposing Viewpoints (Ed., David Haugen, Greenhaven, 2006). She is currently working on creating her own website and finishing a new book on mass thinking.
1) “The Smartest Guys in the Room,”
Bethany McLean and Peter Elkind, Penguin 2003, p. 141.
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