Enron's wealth transfer

Kenneth Lay and Jeffrey Skilling were found guilty. They’ll go to jail for a long time, maybe the rest of their lives, just as they should. But all the media reports say they destroyed billions of dollars of shareholder wealth with their fraud.

Something’s missing. Their fraud created those billions of dollars in shareholder wealth, so that wealth never should have existed in the first place. But people sold stock on the way up, and again as it started to come down, and they made a lot of money. The government taxed all of that money. But then we find out about the fraud, all the shareholders at the time the fraud is discovered get hammered, and we say that lots of wealth was destroyed – there’s no mention of all the wealth that was fraudulently created.

The real measure of the wealth that was destroyed should be the difference between the value of the company when the fraud started and what they sold their assets for in bankruptcy. That’s still a big number, but it’s much smaller than the number bandied about. Maybe the exact amount of wealth destroyed isn’t important since we punish the perpetrators either way.

It seems like most of the wealth “destroyed” was actually “transferred.” If I sold you a share of Enron stock at $75 but the non-fraud price should have been $20 and you rode the stock to zero, there’s $20 of real wealth destroyed and $55 of your wealth transferred to me. (Maybe less than $55 if I bought in after the fraud, since I transferred some wealth to someone else in the chain.) Sure, you don’t feel any better about the loss of your $75 if we call most of it a transfer instead of a loss, but the vocabulary difference might implicate some legal remedies.

Quick thoughts:

The IRS correctly lets you write off the full $75, since they taxed the gain on sales all the way up. There’s some mismatch, but unless they make me refile my tax returns, there’s really no way to stop that.

If I knew of the fraud and sold you the stock, I’m probably guilty of insider trading (or fraud) and on trial with Lay and Skilling. The civil fines I’d pay would probably eliminate my gain. You should be able to recover the amount you transferred to me, and you probably can try in a civil suit. If I’m guilty of insider trading, though, I might have spent the money or moved it to a place where you can’t get it. No good, but hard for you to prevent.

Technically, it seems like the “right” thing to do is to let you get back the amount you transferred to me even if I knew nothing about the fraud. That makes me feel like the victim, but I never should have had that wealth anyway since it was based on fraud. Maybe we don’t rescind the sale, and we make the person holding the bag at the end suffer the actual wealth destruction – but we could at least undo the transfer. This is impractical to implement, though.

A really hard special case is the situation where Enron took in the money (as in a secondary sale of stock) at a fraudulently-inflated valuation and then paid that money to its employees. Now the improper transfer goes from the people buying stock in the secondary to the employees (and there’s another whole layer of taxation issues). Technically, those employee payments were based on fraud and the “right” thing to do would be to claw them back. Of course, that’s even less practical and makes those people feel even more victimized.

Except that I hate writing papers, sometimes I think it might be fun to be an academic.

Related Tags: enron, kenneth lay, jeffrey skilling