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David A. Skeel, Jr.

The Lessons of Enron

Enron claimed to be a business unlike any the nation had ever seen

Enron claimed to be a business unlike any the nation had ever seen—the ultimate exemplar of a world where (in then-chairman Kenneth Lay's words) "the rules have changed" and "what you own is not as important as what you know." Almost every analyst on Wall Street seemed to agree.

In the wake of Enron's spectacular fall and the scandal that followed, we know that Enron wasn't as different from other American businesses as we'd been led to believe. Indeed, Enron's trajectory fits a very old pattern. All too often, the success of America's most brilliant entrepreneurs has been followed by an equally dramatic collapse. Why is this so? To answer this question, and to see what we can learn from the Enron mess, consider a few of these predecessors.

One of the most remarkable was Jay Cooke. Although largely forgotten now, Cooke achieved great fame in the nineteenth century as a financial innovator who, like the architects of Enron, was the first to recognize the potential of a new market. Cooke began his career selling U.S. war bonds to ordinary citizens during the Civil War. After the war, he realized he could use the same door-to-door strategy to raise money for railroads and other private companies. Whereas businesses had always raised money solely from banks and rich investors, Cooke showed that corporate bonds, like other products, could be sold to large numbers of ordinary Americans.

Cooke's ingenuity opened up a new source of financing for American business, and he quickly became fabulously wealthy. But he overexpanded, and within a few years numerous competitors were vying for the same markets. The end came in 1873, when the American markets were stunned by the news that the famous entrepreneur and his business had been thrown into bankruptcy by one of his creditors. Cooke's demise helped to usher in the Panic of 1873, one of the worst depressions the nation has ever seen.

The infamous robber barons emerged during the same era, and many met a similar fate. Realizing that the railroads held the key to the nation's economic future, men like Jay Gould bought up large swatches of track and built new ones. As often as not, they too overexpanded and their empires came crashing down, with claims of improper political influence or outright fraud swirling around them.

The twentieth century brought new examples of brilliant innovation that ended in shocking failure. Most eerily similar to Enron was the collapse of Samuel Insull's vast energy company, Middle West Utilities, during the Great Depression. As with Enron, Middle West's expansion had been fueled by a transformative insight. Insull realized that he could minimize the costs of generating electricity by building enormous, centralized power plants and keeping them running 24 hours a day. Insull then built up his customer base by selling the energy at astonishingly low prices. Through this process, which he referred to as "massing production" long before historians gave Henry Ford credit for the term, Insull easily outcompeted traditional suppliers, whose costs were much higher because their equipment lay idle much of the day.1

Unfortunately, Insull expanded much too far and too fast—sound familiar?—gobbling up numerous small energy companies and branching from utilities into manufacturing, construction, and other businesses. In the early 1930s, his empire collapsed amid allegations of fraud and misleading accounting. During the hearings that led to wide-ranging securities and utility reforms, Congress accused Insull of duping vulnerable investors by withholding information about the true liabilities of Middle West Utilities.

Much closer to the present was the spectacular collapse of Michael Milken and his investment banking firm Drexel Burnham. Milken pioneered the use of junk bonds—bonds that have a high risk of default and do not qualify as "investment grade," usually because the company that issues them has a great deal of debt. Although investors traditionally had steered clear of junk bonds, Milken realized that their high yield, together with investors' ability to reduce much of the risk through diversification, made junk bonds a promising new source of financing. Milken's discovery quickly transformed the world of investment banking, and junk bonds were used to finance nearly all of the high-profile takeovers of the 1980s. Drexel threw an annual party, the "Predator's Ball," at which the leaders of Wall Street hobnobbed with Washington politicians. Yet, in less than a decade, Milken found himself in jail, and Drexel Burnham filed for bankruptcy shortly thereafter.

Why is it that, throughout American history, today's brilliant innovator so often becomes tomorrow's disgraced failure? One explanation is simple hubris. "Pride goes before a fall," we are reminded in Proverbs. Very frequently, the same qualities that make entrepreneurs special—brilliance, self-confidence, visionary insight—also bring them crashing down. Brilliant innovators often underestimate their own limitations, and think that everything they do is destined to succeed. Enron's "Darth Vader," former chief executive Jeffrey Skilling, is a vivid example of the type. Shortly before Enron's bubble burst, Skilling sneered at any analyst who dared to question Enron's business plan.

The second crucial ingredient is competition. Although entrepreneurs make enormous profits when they create or discover a new market, their success is sure to attract competitors—and the more spectacular the success, the fiercer the efforts to get a piece of the pie. As competitors enter their market, innovators often see their lavish profits begin to slip away. Spurred by a dangerous combination of pride and desperation, they may take misguided and even illegal risks as they attempt to replicate their early success.

If anything, the remarkable market innovations of the past two decades have magnified the risk of future Enrons, both by enabling competitors to respond ever more quickly to new advances and by creating new financial devices that desperate innovators can use to place enormous bets on the future direction of the markets. Drexel Burnham's collapse was precipitated, in part, by competition from lenders who could provide quicker and more complete financing for takeovers. Only a few years later, Long Term Capital, a hedge fund masterminded by several Nobel laureates, created a worldwide liquidity crisis when its massive bets on esoteric securities turned sour.

Enron has all of the attributes of these previous scandals and more. Enron's energy trading business was a brilliant innovation, but its managers took more and more gambles as competitors emerged. They then tried to obscure Enron's true condition through their now infamous off-balance-sheet partnerships.

What should Christians make of the Enron mess? The most important point is to recognize the limitations of legal solutions to the problems that made Enron possible. There is a tendency, among Christians and non-Christians alike, to assume that we can use legislation to force people to act morally. This impulse has inspired many of the reforms that have been proposed in the wake of the Enron debacle. The problem, as legal scholar William Stuntz has pointed out, is that these kinds of reforms often have effects precisely the opposite of what they intend. Prohibition is the most obvious example, and there are many others.

The risk that regulatory solutions will prove counterproductive (that law causes sin to increase, to borrow a concept from Paul) does not mean that we should simply move full steam ahead with deregulation. While advocates of deregulation recognize the dangers of governmental intervention, they often underestimate the misbehavior of individuals and businesses in the marketplace. Clearly it was a mistake to leave the derivatives contracts that were traded in Enron's energy business almost entirely unregulated.

What this suggests is that lawmakers should fill in the regulatory gaps, but that we must avoid the temptation to try to prevent future Enrons by enacting a tangled web of precise new regulatory rules. Indeed, it was regulation—not the absence of regulation—that made Enron's off-the-balance-sheet partnerships (many of which seemed to comply with the existing accounting rules) possible.

There is another, related lesson as well. One of the most stunning revelations about Enron concerned its flagship energy trading business. When Wall Street analysts came to Houston, Enron's employees pretended to be engaged in vibrant energy trading operations. They made fake telephone calls and negotiated imaginary trades. This incident shows just how deeply sin can work its way into an institution. Rather than involving only a few executives at the top, Enron's misbehavior extended all the way down through the organization.

Some of the excesses of Enron can be addressed by regulation. But the rest comes down to business ethics and individual morality—the commitment of ordinary men and women to resist the often subtle temptations to sin. Although few of us work for brilliant innovators like Michael Milken, Kenneth Lay, and Jeffrey Skilling, many of us work in organizations that have a similar structure. This means that the lessons of Enron are lessons for every one of us.

1. See Rebecca Smith, "Enron's Rise and Fall Gives Some Scholars A Sense of DÉjÀ vu." Wall Street Journal, February 4, 2002. Insull's techniques are described in more detail in Forrest McDonald, Insull (Univ. of Chicago Press, 1962), pp. 97-99, 104.

David A. Skeel, Jr., is professor of law at the University of Pennsylvania Law School and the author of Debt's Dominion: A History of Bankruptcy Law in America (Princeton Univ. Press, 2001).

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