Friday, May 26, 2006

The Verdict in the Enron Case: Some Unintended Consequences?

I watched on Thursday as government lawyers, news commentators, and former Enron employees celebrated the guilty verdict against Lay and Skilling. Judging by the general celebratory atmosphere that attended the jury’s announcement, it appears that virtually the entire American public believes that the two corporate executives had it coming. Many are proclaiming that beyond justice, the verdict was just what the markets need. It sends a clear message to corporate America that no one and no company is so powerful that it need not play by the rules, rules that are intended to protect investors and employees from unscrupulous CEO’s and executives. The result will be increased investor confidence in markets and increased confidence on the part of American citizens in big business and Wall Street. All of this is good for business, economic growth, and jobs.

Leaving aside the issue of whether the jurors in fact constituted Mr. Lay’s and Mr. Skilling’s peers (and were therefore qualified to pronounce a judgment based on an accurate understanding of the responsibilities, span of control, and limitations that come with being a corporate executive), I am nonetheless not so sanguine about the effect of the verdict. I admit that very little information is yet available, but early indications are that the jury did not find Lay and Skilling guilty based on the evidence that they knew about Enron’s true financial situation, rather they were convicted on the notion that they _should_ have known. If that is the case, then just what might an ambitious and aspiring corporate executive conclude?

Here is what I would conclude. First, the risks involved in being a corporate executive have just been made a lot higher. Maybe it’s not worth it, unless the salary on offer is higher. So much for helping to lower executive compensation. Second, if one accepts the risk (and the higher salary), one still needs to protect oneself. Since the standard is no longer what one does (or did) know but what one should know, me thinks that many new executives are likely to opt for a more hands-on management style (read micro-management). The last I checked that is a recipe for corporate stagnation, and that is not good for business, growth, jobs, or investor confidence. Third, many will calculate that no salary is high enough to compensate for the increased risk involved in corporate management. Consequently, the best and brightest will increasingly opt for other than careers in business.

Just some thoughts from a skeptic.


Ed Morse said...

I have not yet studied the result in this case or the particular findings. However, let me offer one comment on the distinction between known and should have known. Focusing on "should have known" looks at objective reality. Actual knowledge can be difficult to prove, as the defendant is the one with real basis for proof (and we don't expect him/her to tell the truth on such matters). Proving what a reasonable person in that position should know in light of all the facts may be the only alternative that makes sense.

Terry Clark said...

Thanks for the question, Ed. I am not sure how "should have known" constitutes an objective reality. But let us suppose that I accept that, then how does a jury composed primarily of those with no experience with management at this level judge what Lay, or Skilling, "should have known?" I rather doubt that most people have any idea of the necessity of delegation, dealing as they do with details at their levels. Hence, my comment that the verdict will incentivize micro-management, which never works at the level that Lay and Skilling were working at.
The problem as I see it is that "should have known" is open to subjective judgement in a way that "did know" is not. Admittedly the standard is high, but should it not be in a system that assumes innocence and not guilt?

Raneta Mack said...

The "should have known" standard for corporate liability or individual liability in the corporate context is not new. The standard has been used in myriad contexts since the government began aggressively prosecuting corporations and corporate executives after the junk bond scandals of the late '80s/early '90s. Sarbanes/Oxley is rife with this standard for criminal liability.

This standard says to executives that they have specialized knowledge, unique access to information, and a corresponding fiduciary duty to look out for the best interests of employees and shareholders. If we were to stick with the standard of actual knowledge, that might encourage an "ostrich syndrome," i.e., executives shielding themselves from obvious wrongdoing.

As far as I know, the term "jury of one's peers" is leftover from the English common law when there were well-defined and legally recognized class structures, e.g., noblemen, commoners, etc. There is certainly no legal recognition of class difference in the U.S., and I am not aware of any jury statutes that require peer equivalence as a basis for jury service. Instead, once a group of 12 (or 6 in some cases) citizens has expressed an ability to be impartial about a case, it's the job of the prosecutor and defense attorneys to make their cases understandable. Obviously this is one of the reasons the Enron prosecutors chose to forego explaining the complicated "debt vehicles" Enron created. They focused instead on misleading statements made by the defendants.

I imagine a person of average intelligence can understand that when a person makes a public statement about the tremendous health of the company while simultaneously selling off millions of dollars of his own holdings in the company...well, that might be a bit misleading.

Raneta Mack said...

I forgot to comment on the potential for the verdict to incentivize micromanagement at the corporate executive level. Remember, Enron filed bankruptcy 5 years ago. In the interim, Congress enacted Sabanes/Oxley, which essentially puts numerous accounting and financial reporting checks and balances in place. So executives don't have to micromanage. The government via SOX has already done so indirectly. Whether this is good law/policy is debatable, but I doubt that the Enron verdict will provide incentives for corporations to do more than SOX already requires.

In other words, we've already seen the consequences of the Enron fallout. The convictions yesterday were just a period at the end of a sentence (no pun intended).

Terry Clark said...

Thanks for the response, Raneta! It is quite stimulating to discover that a blog posting has generated some response! Permit me a rejoinder to your carefully considered comments.

You note that "the 'should have known' standard for corporate liability or individual liability in the corporate context is not new." It has in fact been around since the late 1980s. In the scheme of things that seems new to me. It takes some time before the effects of "new law" become clear. Might I suggest that the Enron case may well be a good time to reflect on just how well this standard has served us?

I confess that you may be right that a return to the standard of actual knowledge (which to my mind is a standard far less subjective and far more objective than "should know") "might encourage executives to shield [my edit] themselves from obvious wrongdoing." But I am asking if that might not be a lower price to pay than the continued application of a standard that may disincentivize our best and brightest from seeking to be corporate executives? I am quite frankly more willing to accept that a few corporate executives may well "hide their heads in the sand" than to run the risk of paying a higher price involved in the proposed "fix" in this instance.

As for the Enron case coming at the tail end of the corporate world's reaction to the whole affair, again I am not so sure that you are not being a little too sanguine about this. The corporate world was not in a position to fully assess (and therefore react to) the entire affair until the verdict was rendered. In fact, numerous business analysts believed that Lay and Skilling would not be convicted. It is only now that the uncertainty has been resolved that we are likely to begin to see the fall out from all of this -- of the kind that concerns me.

Sarbanes/Oxley may only compound the problem. As you note, the reporting requirements are themselves micromanagement. Worse, they introduce the government into the picture as a potential micromanager. Having been involved in upper-level management at one point in my life, I know what that means -- I will be sure to go over the reports that the government will be seeing in excrutiating detail (with as much lead time as possible). Is that not micro-management? Is that how you wish for executives to spend their time? Might it not be better spent in reflecting on strategies to move the corporation forward instead of tactical concerns with protecting themselves from law suits brought by those who thought that they "should have known?"

The concern laying behind my blog posting is that a continued push to routinization and proceduralization that to my mind is reflected in the Enron affair (and others like it) will surely make for a lot of jobs for lawyers and accountants, but it will come at an economic price to the rest of us. I fear that the further codification of economic life in America only serves to severely disincentivize risk-taking and the entrepreneurial spirit. Instead of leaders, we will be "growing" bureaucratic managers, well-schooled in the art of following procedures and routines.

It may well be that Lay and Skilling were (are) guilty and had it coming, but the "fix" here seems to be worse than the disease. That is all the more the case given the relatively small number of corporations in the business community infected by the disease. (I am of course assuming that you agree with me that the vast majority of companies and corporations are led by executives who are at least as concerned with the welfare of their employees and stockholders as they are their own?) If your position is that the response is justified if even one person is harmed by business, then that will inevitably lead us to more government, which in my view has perfected the art of causing harm to huge masses of citizens. (As Ronald Reagan is purported to have said, "The most terrifying words in the English language are: I'm from the government and I'm here to help.")

Finally, you are right that a "jury of peers" is not the norm in this country. But you make my point for me that the consequences in this case were that the prosecutor could not address major issues related to the Enron scam. By the same logic (as I argue), the jury had no way of judging just what might constitute "should have known" on the part of a corporate executive. I am not sure I need cite the literature that critiques the current jury system for these and other reasons. I will leave it at that.

Having said all of that, it remains that the majority, at least at present, clearly sides with you. I can only hope that my lone and pitiful(?) dissent might cause the majority to pause for a moment and reflect a little more carefully on just where all of this might be taking us.