The Bottom Line

Enron and the Swindle Cycle

Like clockwork, rip-offs follow the booms.

Illustration by Robert Neubecker

Are we enduring an extraordinary epidemic of financial skulduggery? Doubts are being cast on the bookkeeping etiquette not just of Enron, but of Global Crossings, Computer Associates, Tyco, and a bunch of energy companies large and small. Early in February, officials at Allfirst Financial in Baltimore revealed that a currency trader, John Rusnak, had run up undetected losses of more than $690 million for the bank. A couple of weeks ago in South Carolina, two septuagenarians, Clif Goldstein, aka Dr. Noe, 71, and his brother Paul Noe, 74, were arrested on charges of swindling more than $1 million from investors looking for fast gains on “prime bank” notes. A week later, one Frank Gruttadauria, a former Lehman Brothers star broker, hit the financial fronts when he was picked up for having cheated clients out of some $40 million over the years. And then to top it all off came the revelation on the front page of the Wall Street Journal that an eBay merchant, specializing in the sale of “whimsical ceramic creatures,” had absconded with some quarter of a million bucks from would-be buyers of his “Wee Forest Folk.” It’s enough to shake your faith in the transparency of the world’s most admired financial system.

True, these scams—if such they are proved to be—are only the latest in a long, rich history of business fraud and chicanery, one likely extending back to some subcontractor who got a piece of the action on the pyramids. Still, while the recent cluster does seem unusually dense, the timing of these revelations is, in fact, characteristic of periods such as the present: the tail end of a boom.

You might have guessed that crime proliferates among the normally noncriminal classes when times are bad (or at least semi-bad) and breadwinners are pressed to meet their family’s needs. Not so, says Charles Kindleberger in his classic, Manias, Panics, and Crashes: A History of Financial Crises. Fraud is fed by plenty. “In a boom, fortunes are made, individuals wax greedy, and swindlers come forward to exploit that greed.” Moreover, with so much prosperity around them, the swindlers themselves tend to develop expensive tastes—a coach and 10, a mansion in Mayfair, or, more recently, a brace of condos in Aspen—which keeps them doubling their dubious bets. (“It is difficult to write on this subject without permitting the typewriter to drip with irony,” writes Kindleberger, adding, “An attempt will be made.”)

The Roaring ‘20s, for example, were rife with financial self-dealing and chicanery. Bad times, by contrast, do not so much engender peculation as reveal it. Credit becomes tighter, which is to say that suckers with spare change in their pockets become scarcer. This scarcity is especially hard on those engaged in variations of Mr. Ponzi’s eponymous scheme. In simplest terms, such machinations involve promising huge returns to an initial group of investors, and then making good on those promises by rounding up a still larger group of investors and using part of their subscriptions to pay returns to the earlier group. Still more investors are then enlisted, with the testimonials of the earlier group facilitating the recruitment process.

The pyramidal structure, of course, neither originated nor terminated with Mr. Ponzi. Consider, for example, the infamous South Sea Bubble of 1720. The insiders of the South Sea Co., having been granted a monopoly on trade in the South Atlantic, apparently soon lost interest in the dull mechanics of that pursuit. Instead they turned their attention to reaping capital gains on stock they had purchased from the company using loans secured by that same stock. Thus, writes Kindleberger, “In order to pay out profits, the South Sea Company needed both to raise more capital and to have the price of its stock moving continuously upward … both increases at an accelerating rate, as in a chain letter or Ponzi scheme.”

Say, doesn’t that sound awfully familiar? Does it remind you, perhaps, of Enron executives with their stock options and their trading of loans and stock guarantees with all those off-the-book subsidiaries with cutesy names? Also the strategy apparently pursued by Computer Associates. It used its high-flying stock to buy up smaller software firms. Then it booked the projected revenue from the contracts those firms had as if it had it already in hand, using the “mark to market” technique also employed by some of Enron’s offspring. Of course that meant the firm, having already counted the income, couldn’t recognize the income when it actually materialized (and it had to take account of any losses on the contracts when they occurred). This, in turn, kept Computer Associates busy searching for new acquisitions to plump up its claimed profits so as to keep its stock high so it could go on acquiring. … In other words, like the White Queen, it had to run hard just to stay in place. Actually, unlike the queen, it had to keep running faster and faster.

Let me hasten to say that, at least with the right outside auditors, accountants, and lawyers, such accounting gigs may not necessarily be adjudged illegal. Having a flossy board of directors sign off on them also helps—and here again there is ample historical precedent. Nobles and grandees decorated the boards of railroads, banks, and other enterprises for which, one 19th-century critic wrote, “they have no capacity.” And if called to account, an executive might well get away with the already immortal “I am not an accountant” disclaimer, even if like Enron’s Jeffrey Skilling, he or she has an MBA from Harvard. After all, so does George W. Bush.

Plus ça change. … Is there nothing new in the current batch of scams and debacles? One thing that pops out from both the Enron case and the Long-Term Capital Management debacle of a few years ago is the fairly novel presumption that it is possible both to hedge against risk and make big profits at the same time. Would that it were so. Hedging one’s entrepreneurial bets is, of course, a time-honored and perfectly legitimate pursuit. If you’re a farmer wanting to be sure you won’t come a cropper when your soybean harvest comes in, you’re willing to sign a contract obliging you to sell at a fixed price some months hence. This at the risk of forgoing a possibly larger profit should soybean prices spike when the time for delivery comes due. Ditto if you’re a buyer, wanting to lock in a sure price even though a soybean glut may send prices tumbling in the interim. Hence the venerable Chicago Board of Trade, the New York Mercantile Exchange, and other on- and off-exchange markets for futures in everything from pork bellies and currencies (LTCM’s specialty) to energy (Enron’s signature, though far from sole, commodity). But the market makers who deal in futures have traditionally contented themselves with relatively small margins, sweeping up the “golden crumbs”—as Tom Wolfe described the bond dealers in The Bonfire of the Vanities—from which, over time, an ample feast can be made. Such gradual accumulation did not, however, suffice to slake the appetites (or meet the promises) of the LTCM theoreticians or of the Enron hotshots. And so they dabbled in the accumulation of real assets or made bets that were not, in fact, well-hedged. So perhaps there is a new lesson here, that, in the free market that all capitalists claim to worship, big profits and low risk do not meld.

Otherwise, it’s pretty much business as usual. One semi-distinctive feature of the Wee Forest Folk scam is that its perpetrator, a Michigan entrepreneur named Stewart Richardson, seems to have gotten out while the going was still good. As of this writing, the FBI, called onto the case by the local police, has not determined Mr. Richardson’s whereabouts. By contrast, most con artists tend to let their greed run them into ground. Even the infamous Ponzi ignored the advice of associates to go on the lam and ended up instead going to jail, albeit while sneering at the sucker public he had so fruitfully preyed upon. But that is not to say most swindlers get their just desserts. In rare instances those touched by scandal chose self-inflicted death over dishonor—South Sea Bubble insider Charles Blunt slit his own throat; most recently, former Enron executive J. Clifford Baxter seems to have opted out of exposure to further infamy.

But sophisticated inveiglers generally manage to continue their gilded lives, if only after a short interruption for jail service. Junk bond king Michael Milken now runs his own big think tank and foundation while associating with worthy causes and high-profile celebs. Marc Rich, of Clinton pardon fame, lives on in monarchial splendor in Zug, Switzerland, with his blond second wife by his side. S & L kingpin Charles Keating, having done nearly five years’ time on counts of fraud and racketeering, now suns himself in Phoenix while consulting for an investment operation in the tax haven of Belize. Even young Nicholas Leeson, who cost Britain’s venerable Barings Bank $400 million in losses, having survived a four-year prison stay, a divorce, and a bout with colon cancer, now commands as much as $100,000 on the speech circuit while doing TV gigs. (He specializes in warnings about the need for corporate controls and tighter regulation.) And while the British House of Commons ruled that the South Sea Co.’s directors should pay back losing investors from their own pockets, Robert Knight, the man who finagled the firm’s books, escaped from an Antwerp jail, and went on to make another fortune in Paris. Take heart, Jeffrey Skilling and Kenneth Lay: The annals of defalcation offer few lessons in divine retribution.