Double Standard

Jeff Skilling of Enron essentially sits in jail for being too publicly optimistic about his company's prospects in the face of a liquidity crisis  (despite popular perceptions, he was not convicted for accounting issues associated with off balance sheet entities).

I didn't follow the trial that closely, but my sense is that Skilling denied this charge.  But even if he had admitted it, it strikes me that he would have had an interesting case in his favor.  US securities law takes as an absolute core principle that relevant information must always be disclosed quickly and completely to both shareholders and potential shareholders alike.  It presumes that total openness is the best way to serve shareholders.

But in a short-term liquidity crisis, openness is the kiss of death.  As we have seen over the last 6 months, the merest hint that a liquidity crisis may exist at a company creates a real crisis, even if one did not exist before.  Liquidity crises are crises of confidence among short-term lenders, and the only way to fight such a crisis is to build confidence.  So what happens if the best way to serve shareholders is to keep silent about problems?  What if the best way to fulfill one's fiduciary responsibility to maintaining shareholder value is to be overly rosy in one's pronouncements during difficult times?

Fast forward to the Bear Stearn failure last year, from the Economist:

As recently as March 12th, Alan Schwartz, the chief executive of Bear Stearns, issued a statement responding to rumours that it was in trouble, saying that "we don't see any pressure on our liquidity, let alone a liquidity crisis." Two days later, only an emergency credit line arranged by the Federal Reserve was keeping the investment bank alive. (Meanwhile, as its share price tumbled on rumours of trouble on March 17th, Lehman Brothers issued a statement confirming that its "liquidity is very strong.")

And now, we hear that the Federal Government urged Bank of America's Kenneth Lewis to do exactly what Lay and Skilling were convicted of.

Federal Reserve Chairman Ben Bernanke and then-Treasury Department chief Henry Paulson pressured Bank of America Corp. to not discuss its increasingly troubled plan to buy Merrill Lynch & Co. -- a deal that later triggered a government bailout of BofA -- according to testimony by Kenneth Lewis, the bank's chief executive.

Mr. Lewis, testifying under oath before New York's attorney general in February, told prosecutors that he believed Messrs. Paulson and Bernanke were instructing him to keep silent about deepening financial difficulties at Merrill, the struggling brokerage giant. As part of his testimony, a transcript of which was reviewed by The Wall Street Journal, Mr. Lewis said the government wanted him to keep quiet while the two sides negotiated government funding to help BofA absorb Merrill and its huge losses.

Federal Reserve Chairman Ben Bernanke and then-Treasury Department chief Henry Paulson pressured Bank of America Corp. to not discuss its increasingly troubled plan to buy Merrill Lynch & Co. -- a deal that later triggered a government bailout of BofA -- according to testimony by Kenneth Lewis, the bank's chief executive.

Mr. Lewis, testifying under oath before New York's attorney general in February, told prosecutors that he believed Messrs. Paulson and Bernanke were instructing him to keep silent about deepening financial difficulties at Merrill, the struggling brokerage giant. As part of his testimony, a transcript of which was reviewed by The Wall Street Journal, Mr. Lewis said the government wanted him to keep quiet while the two sides negotiated government funding to help BofA absorb Merrill and its huge losses.

Many observers found it odd when Skilling was convicted of giving false information to shareholders but not for insider trading.  The implication, then, was that Skilling was guilty of lying to shareholders but not for personal gain.  Why then, people asked, did he do it?  It is becoming increasingly clear that putting on a happy face during an impending liquidity crisis is the only responsible approach for a leader to take.  Whether he goes to jail for it or gets rewarded by the Feds for it comes down to, what?  PR?

Update: In fact, one can argue that the Enron situation is more honorable than the BofA situation.  Enron management was trying to protect the value of Enron shareholders.  In the case of BofA, the feds demanded that BofA management hide information in order to complete a transaction that BofA shareholders might rightly oppose.

  • http://firstconservative.com/blog MAS1916

    You bring up a good point.

    So.. Obama tells the public that GM is a fine company and will thrive under his leadership. People actually invest in and buy product from this company and then GM fails. GM stock then takes a dive. Do we get to sue Obama for mismanagement and presenting false information, too?

  • morganovich

    this is a very timely topic given the impending results of the "stress test".

    how are they to be released? to announce you failed and then go looking for private money seems an unattractive option as the announcement will slash your stock price and make capital more expensive.

    so what do you do? banks will get their results before they are made public and apparently are being urged to go raise private $ if needed before the public announcement.

    how are they to do this? surely they must disclose the results to someone they are asking for funding. even if they don't, anyone asked will be able to infer that they failed the test pretty easily just from the request.

    so now what? this is exactly the sort of informational asymmetry that they are legally bound to avoid. it's a damned if you do damned if you don't. if you don't tell the new investors about the stress test, you are defrauding them. if you do, you are giving them privileged information and harming your existing holders. further, such information will obviously leak, spreading the asymmetry and encouraging rumors.

    there's almost no way for a CEO not to break the law under this system.

  • Dr. T

    "In the case of BofA, the feds demanded that BofA management hide information in order to complete a transaction that BofA shareholders might rightly oppose."

    Of note is the fact that Mr. Lewis was forced to step down as CEO due to his mishandling of the Merrill-Lynch buyout and his excessive kowtowing to Paulson. At present, Banc of America Investment Services is in turmoil due to the buyout. A number of key persons quit because they were being ordered to Merrill-Lynch branches in other cities. Merrill-Lynch was deeper in debt than anyone knew, and what looked like a bargain buyout may become a non-profitable headache.

  • Pieter

    "Many observers found it odd when Skilling was convicted of giving false information to shareholders but not for insider trading."

    Huh? That's not what wikipedia says. Here's a link to the original NYTimes article. Paragraph two, second sentence:

    "Mr. Skilling was convicted of 18 counts of fraud and conspiracy and one count of insider trading."

    http://www.nytimes.com/2006/05/25/business/25cnd-enron.html?_r=2&oref=slogin

    This was upheld after appeal:

    http://www.businessweek.com/bwdaily/dnflash/content/jan2009/db2009016_313568.htm?chan=top+news_top+news+index+-+temp_companies

  • Peter

    MAS1916 Obama may actually be guilty of a very elaborate ponzi scheme. By buying GM shares with taxpayer dollars he boots the stock value while telling people to buy in themselves. Since the company is an actual failure the only way for people to get a positive return is to support the company with more tax dollars. Sooner or later people buying the stock will realize that the only return they are getting is their own money and the last ones out (the taxpayer of course) will have nothing. Its almost like watching a schizophrenic day trader running up his own stock price by working with two different brokerage firms. When he finally decides to sell he will realize no one is buying.