Tuesday, July 3, 2012

Rules based or principles based

Lessons from Enron based on Peter Elkind and Bethany McLean’s The Smartest Guys in the Room and Kurt Eichenwald’s Conspiracy of Fools. One of the reasons I read these books was to understand what exactly it was that Enron did - i.e the structure of the SIVs etc. Neither book helped. Both tried to explain it but it made no sense to me.

And perhaps it is because that they made no sense at all. The accountants (Fastow and Causey among others at Enron and Duncan at Arthur Andersen) really seemed to do what they could to inflate profits using whatever machinations they could under the existing rules at the time. It was all about following the rules and stretching their definitions as far as possible. It really seemed as the Elkind and McLean book pointed out that in order to produce a duck and if they did not have a duck they would get a pig, stick a yellow beak on it, paint its feet yellow and paste feathers on it and call it a duck just because the rules defined a duck as an animal with yellow feet and beak and white feathers.

Two factors seemed play a large role - rules based accounting and the ability to mark to market. The latter allowed the accountants to manipulate cash flow and to use definitions and rules to exclude themselves from being classified as a trading firm. Market failure played a role in this and in this sense I mean failure of free markets. All the information on what Enron was doing was available but analysts (e.g. John Olson) who pointed out Enron’s weaknesses were fired by the investment banks who wanted Enron’s business.

Corporate shenanigans will always occur especially during boom and the answer may be that it will have to be a little bit of both - rules and principles although it’s hard to see how it can possibly work. Both books were a bit of a letdown. I thought that I was reading about two different companies. Eichenwald’s book gives less emphasis on the role of Lou Pai and focuses more on Fastow and Kopper.  This was the book that I thought would provide most insight but it reads more like a diary of their activities. Elkind and McLean’s book provided a broader sweep and the narrative is a little better but I wouldn’t recommend either book. I’m a little ambivalent about the role of Lay and Skilling. Neither book convinced me that they knew what was going on but it is hard to believe that they did not know that nothing was going on in order for Enron to meet analyst expectations quarter after quarter. One thing clear was that greed conquers all. Nothing could get in the way of their greed.

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