Enron Squared

Mother of all Bailouts Likely to Spawn
Mother of all Litigation

It turns out that Enron was just a harbinger.

For those who don't remember, Enron was a cutting-edge energy company that spectacularly collapsed in 2002. At the heart of the melt-down were complex securities that few people outside the company even knew existed, let alone understood (it turns out that people inside Enron didn't exactly understand them either -- or at least that's what they claimed at trial).

Thanks to the accounting rules at the time -- which the industry helped write -- Enron officials argued that they didn't have to disclose billions in off-balance sheet obligations that would ultimately sink the company.

Sound familiar?

As one commentator put it, "Enron is long gone, but this episode . . . [was] as much a warning for our financial security as the 1993 World Trade Center bombing was to the threat of wider terrorism." ("The Crisis Last Time"; The New York Times, 9/24/08).

Superficial Reform

Congress' response to Enron was something called Sarbanes-Oxley, essentially a piece of legislation mandating better accounting controls, as well as fuller disclosure. Post-Enron, senior management also had to personally vouch for ("certify") the accuracy of the financial statements that they were signing.

Big business has screamed ever since that Sar-Box, as it's known, imposed wasteful costs and hindered American competitiveness.

Well, so does a $700 billion Wall Street bail-out, not to mention all the other economic fall-out associated with the ongoing financial crisis.

Mother of all Litigation

At this point in the mess, about the only thing that can be predicted with confidence is that the mother of all financial crises will eventually give rise to the mother of all litigation.

At least on this score, the Enron legacy (and legal precedent) is encouraging.

At trial, Enron Chairman and CEO Ken Lay famously argued that he was out of the loop at his own company, and didn't understand its house-of-cards financial structure. Unfortunately, the evidence showed that Lay in fact did know what was going on, and he was subsequently convicted.

Even if the jury believed Lay, it still could have convicted him on the alternative grounds that he should have known. After all, when you're paid hundreds of millions, that would seem to be part of your job description.

"Knew -- or Should Have"

It is precisely this Hobson's choice that's likely to confront senior Wall Street executives when it's their turn as defendants.

If they knew the risks they exposed their shareholders to -- not to mention the broader economy -- but didn't adequately disclose them, they're guilty of fraudulent misrepresentation. On the other hand, if they didn't know, but should have, they're guilty of gross negligence.

Of course, theoretically, you can be both incompetent and dishonest . . .

P.S.: Ultimately, the narrow legal ground Enron officials were convicted on involved "cooking the books" as the company's financial situation deteriorated near the end. It would be a big surprise if executives at many Wall Street companies didn't do the same (See, "FBI Looks into 4 Firms at the Center of the Economic Turmoil"; The New York Times, 9/24/08)