THE REAL SCANDAL: Enron's 'crimes' were legal - legality of Enron's business practices is examined

There was plenty of illegality in the Enron debacle. Class-action lawyers are already ferreting out the company's affirmative misrepresentations and nondisclosures of material facts ("big lies" to nonlawyers). All of these will be found to have violated the federal securities laws. Corporate executives who profited from private deals with Enron-affiliated partnerships without disclosure to the shareholders probably will be found to have violated the company's own conflict-of-interest rules and breached their fiduciary obligations to shareholders. Arthur Andersen employees appear to have shredded documents related to the Enron audit, even though they knew the documents were relevant to pending or threatened civil and criminal investigations. It also appears that some executives engaged in classic insider trading by dumping their stock at a high price before the bad news about Enron's real financial condition became public.

The illegality is important because of the scale of the wrongdoing and its calamitous consequences for stockholders, employees, and the securities markets. But this illegality is not novel or particularly interesting. What is interesting is that legal and regulatory restraints did not work to prevent or limit the wrongdoing or to expose it to public scrutiny early enough to reduce the damage.

These restraints did not work because much of what Enron and the people around it did was either completely or arguably legal, and the watchdogs involved with Enron--its accountants, lawyers, and independent directors--allowed the company to push itself to the very limits of legality. Enron thus presents a crisis not of illegality, but of legality.

There was nothing illegal, for example, about the high concentration of Enron stock in its employees' 401(k) plans, which resulted in many lower-level employees' retirement savings going down the chute with the company's plummeting stock price. There was also nothing illegal about the company's restriction on the employees' ability to sell their Enron stock, even though senior managers were free to bail out. The use of off-balance sheet accounting to shift liabilities to affiliated "special-purpose entities," allowing the company to hide debt and inflate earnings to maintain the stock price, has become an accepted although controversial practice. The aggressive accounting techniques used by Andersen were permissible under generally accepted accounting principles (GAAP). Andersen not only fully exploited the GAAP rules to hide debt, it took advantage of the latitude given accountants to determine when financial information is not "material" and therefore not necessary to disclose, and to rely on the "reasonableness" of the dubious assumptions made by Enron managers in formulating financial data. Also permissible was Andersen's "mark-to-market" valuation technique, which allowed Enron to claim immediately projected earnings on energy transactions, even though any revenue from those highly speculative deals would be received only in the long term. Nor did the threat to an auditor's independence created by doing lucrative consulting business with the company it audits create a legal impediment to Andersen's dual auditing/consulting relationship with Enron.

The investment bankers to whom Enron confided information about their investment partnerships were not only permitted to withhold that information from their retail brokerage arms, and hence the investing public, but were required to do so because of the legally mandated "Chinese wall" between investment banking and brokerage functions in securities firms. Similarly, an argument can be made that Enron's practice of sharing substantial information about its off-the-books investments with potential investment partners (mostly large institutions), but not with its own shareholders, did not violate the securities laws. There is even an argument that many of the stock sales by Enron executives were part of preplanned program trading under their stock compensation agreements, and hence not actionable under the antifraud provisions of the federal securities laws.

Most telling, there was nothing illegal about Enron's uncanny ability to avoid regulatory scrutiny. Under both the Public Utilities Holding Company Act and the Investment Company Act, Enron managed to obtain, with public disclosure, exemptions from regulation by the Federal Energy Regulatory Commission, the Commodities Futures Trading Commission, and the Securities and Exchange Commission. The wisdom of those exemptive decisions is debatable, but they were lawful.

Significant revisions of the laws that have proven inadequate are likely. But the problem is greater than that of finding better laws. The real problem is the attitude toward legality that prevailed among Enron's independent directors, accountants, and lawyers. They may have asked themselves whether what they and Enron were doing was "legal." Very few, however, seem to have asked whether it was right. They were content to ask whether they could do it, not whether they should do it.

The response to this charge, particularly from the professionals, is predictable. They are likely to ask, "Who were we to judge? We are not moralists. We are simply providing a commodity: accounting and legal skills and knowledge. We were there to make judgments based solely on our professional expertise, not about right or wrong." And we, the independent directors would argue, were simply depending on what the accountants and lawyers told us.

All this is sophistry. The supposed conflict between a person's professional role and his or her responsibilities as a moral actor is an alibi, not a necessary reality. Accountants function as auditors on behalf of the public and must challenge the data and assumptions provided by management. This is particularly true when management's positions are novel or aggressive. The role of the auditor is to evaluate, not facilitate. That role should be quasi-adversarial, not quasi-conspiratorial. Auditors' professional obligations require a value judgment about the overall fairness of the picture presented by the financial statements they are charged with scrutinizing. By meeting this professional obligation, they would also have satisfied their moral obligation.

The lawyers' situation is similar. Most of Enron's in-house and outside counsel apparently signed off on numerous self-dealing transactions, staged perfunctory internal investigations, and facilitated a company policy of nondisclosure of highly significant information. Much of this arguably fell within the letter of legality, but apparently Enron's lawyers never realized that it is sometimes necessary to say "no" to a client. Saying no is partially a matter of fiduciary duty to the client. But a lawyer must also say no to arguably legal actions that seem to the lawyer, as an independent moral actor, to be wrong, even if that means losing the client. So far as we know, only one or two Enron lawyers seem to have had the courage to challenge the insiders' self-dealing. More courage by more lawyers could have made a difference.

The failure of Enron's independent directors to monitor the out-of-control behavior of its managers is not likely to produce any legal liability, but it leaves them with a heavy burden of moral responsibility. They will cite in their defense the reassurances provided by expert accountants and lawyers, but their passivity breached not only their fiduciary obligation to shareholders, but their own personal obligation to stand back, look at the totality of circumstances, and ask whether what was going on was good for anyone other than a handful of managers who profited directly from their own manipulations.

Will something like Enron happen again? Every culture gets the scandal it deserves. Our culture breeds the attitudes and values (or nonvalues) displayed in Enron, and our supposed watchdogs are as much infected as anyone else. As long as professionals and directors inhabit only a legal, and not a moral universe, it is sure to happen again.

Mark A. Sargent is dean of Villanova University's law school.

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