Perverse incentives strike again.

Cross-posted at my main blog here.

Two reasons to watch the Dewey & LeBoeuf indictments.

Here's one.  The other one is the use of RICO to include lawyers in conspiracies (here).  It will be interesting to see if the two intersect.

Skilling's sentence is reduced.

See here.  Is fourteen years enough for the havoc caused by those who led Enron (after Rich Kinder left)?  It's hard to say.  I've never been in a federal prison, even as a visitor.  I can't imagine what life "inside" is like.  I know it's not easy, even in a minimum security prison.  But I also know that there are many, many people who can't retire until they die, thanks to those who manipulated financial information at Enron, WorldCom, and the like.  The people whose pension funds were wiped out have life sentences, so to speak.

Is stealing worse than lying?

The NYT's Dealb%k* feature is one of my favorite parts of the newspaper, and this morning's column (here) was no exception.  In today's column, the very smart Steven Davidoff makes an interesting argument that Jeff Skilling may have been less culpable than Bernie Madoff and should therefore have his sentence reduced.  His argument is a perfect demonstration of the principle that reasonable people can disagree.  I disagree with his rank-ordering of stealing and lying.

Here's a key paragraph from today's column:

But if Mr. Skilling did lie, as the jury found, that does not make his sentence right. It all boils down to whether there is a difference between lying — that is, telling an untruth — and stealing, or taking something that does not belong to you. Some may argue that they are equally bad, but the difference comes out in comparing Mr. Skilling with other recent financial criminals.

Professor Davidoff and I part ways when it comes to this comparison.  Had Jeff Skilling merely been negligent in his management, his negligence would have been awful, but it wouldn't have been intentional, the way that outright lying is intentional.  Even if Enron did disclose what it was doing (albeit in vague footnotes in its SEC filings), and even if all of the warning signs about Enron were out there (which they were), there's still a problem with Enron's intentional misrepresentations about the financial health of the company.  Those half-truths and sneaky partial disclosures may not have fooled sophisticated financial folks, but they fooled most normal people.  Fooling folks meant that the market had nowhere near the "perfect information"** that Enron investors wanted, and that led in part to the losses that Enron investors incurred.

Lying prevents the non-specialist from being able to make intelligent decisions.  Let's say that my car has some sort of a hiccup going on, and I take it to my mechanic.  The mechanic will see all sorts of things going on with my car that are obvious to him but not at all obvious to me.  He can make a better decision about what to do than I can, even though we have equal access to the information.  Let's say that he lies to me about the severity of a particular problem, saying that the cost to fix the problem is several times higher than it should be.***  I'm likely to follow his recommendation about what to do, even though it'll be more expensive than it should be. 

Lying makes the already opaque market worse, which in turn causes people to make worse investment decisions.  That's why lying and stealing are equally bad, in my view.

Sorry, Professor Davidoff.  But I still love your work.





*  The column's name is Deal%k, with the "%" sign in the name.  I could've written "Dealb[oo]k," but "Dealb%k" is just a much better name.

**  I've yet to see a market that has perfect information, but it'd be nice to see one with truthful information all the way down the line.

*** Note to my mechanic:  I'm talking about a hypothetical mechanic, not you.  You wouldn't lie to me.

What do you get when conflicts are ubiquitous?

You get people who wake, as if from a dream, to realize that what they've been doing has (a la Arthur Andersen) come 180 degrees away from the firm's original culture (see Greg Smith's NYT op-ed, here) and what they've been facilitating hasn't been nearly as clean as it should have been (see Andrew Ross Sorkin's NYT Dealbook columns here and here).

Greg Smith's "Why I Leaving Goldman Sachs" includes this paragraph:

It might sound surprising to a skeptical public, but culture was always a vital part of Goldman Sachs’s success. It revolved around teamwork, integrity, a spirit of humility, and always doing right by our clients. The culture was the secret sauce that made this place great and allowed us to earn our clients’ trust for 143 years. It wasn’t just about making money; this alone will not sustain a firm for so long. It had something to do with pride and belief in the organization. I am sad to say that I look around today and see virtually no trace of the culture that made me love working for this firm for many years. I no longer have the pride, or the belief.

Mr. Smith is right about the importance of leadership in a firm's culture.  It matters that a company's officers and directors reward the right behavior and punish the wrong behavior.  But what I liked most about Mr. Smith's op-ed is that it recognizes that culture isn't up to the C-level suite and the board alone.  Senior people have to reinforce the culture all the way down the line.  They have to watch what their people do and say (and reinforce the right behavior).

As I've said before, the problem isn't that all people are evil.  It's that all people are human, and humans have an unlimited capacity to fool themselves into thinking that what they're doing is the right thing to do, even when it isn't.  When senior people rationalize their behavior, a company's decline isn't far behind.

As for the board, it can start thinking about how to turn around this very important company, or it can continue down the same path.  I'll be interested in watching what happens.

Not just one but two great op-eds.

The first, from Nassim Taleb, in today's New York Times, points out that bonuses are not the best idea when it comes to bankers taking on too much risk (here); the second, from Joe Nocera, showed up in today's Las Vegas Sun but isn't on the Sun's web page.  It is on the New York Times's webpage (here).

Both op-eds remind us that it's important to pay attention to the facts:  study the behavior of people whose compensation isn't linked to the prudence of their decisions (Enron, anyone?) to see if bonuses make sense; pay attention to the the factors pushing people toward strategic defaults on their mortgages and try to think of sensible solutions (reductions of principal) as a way out of the mess.

What doesn't work?  Ignoring the facts.  For example, check out Andrew Ross Sorkin's column today on the continuing saga that is the H-P board (here).

Boards that don't pay attention to actual performance before awarding incentives?  Check.  Bonuses not linked to actual performance?  Check.  Reasons why underperforming boards need to consider different ways of finding good new board members?  Oh, about a few trillion.

Good teachers inspire good students.

Click here for a post on the Enron rap that one of Daniel Sokol's students wrote.