World Opinion Shifting On Skilling Guilt

Economist has a wonderful article about Jeff Skilling’s innocence. For the fifteen months he has been in prison (and actually far longer than that), most people have the distorted view that Skilling is the Guiltiest Man In America. Now this uninformed opinion may be  reconsidered with the March 14 revelation that the government witheld key exculpatory Brady evidence – that is, evidence that helps bolster the defense’s case. In this instance, it was the Fastow Notes, the raw notes taken by FBI agents during the interrogation of Andy Fastow.

Mr Fastow’s testimony was widely regarded, not least by the prosecution, as crucial to securing Mr Skilling’s conviction: it was the only direct evidence that Mr Skilling actually knew about the various frauds at Enron for which he was found guilty. Yet the new document reveals that, at least in his early interviews with the FBI, Mr Fastow did not appear to implicate Mr Skilling as unequivocally as he did when he testified in court. Indeed, on crucial points, his original answers appear to exonerate Mr Skilling.

Why is this inconsistency only now coming to light? Rather than handing over the original interview notes, the government instead produced a composite summary. This is standard practice, but the summary must accurately reflect what was said. Mr Skilling’s defence team, after eventually persuading the court to order the government to hand over its original notes, makes a strong case that the summary of Mr Fastow’s interview omits details in a way that consistently favours the government.

The Economist is being terribly British about the facts. They’re too polite to say outright that the government knowingly directed Fastow to lie about the “secret side deals” that were the cornerstone of every single count against Jeff Skilling.

Additionally, the “composite” summary given to the defense was not “standard practice.” Standard practice is that summaries for each meeting with such a witness are prepared, which are then (sometimes) turned over. That this very unusual composite was prepared appears to be what convinced the 5th Circuit to give Skilling’s team the notes in the first place. (For a more detailed treatment of this issue, see e.g. pp. 200-202 of the opening brief.)

Many of the allegations of fraud at Enron related to the accounting treatment of off-balance sheets and other transactions. Under accounting rules, Enron’s treatment of these transactions probably would have been acceptable if they involved a genuine transfer of risk to a third party (ie one independent of Enron).

The government argued, and Mr Fastow confirmed, that many of the transactions appeared to involve a risk transfer but in fact did not, as Enron had made secret promises to third parties guaranteeing they would lose no money. Therefore, the accounting was fraudulent.

Mr Skilling insisted there were no secret promises. Mr Fastow testified that there were, and that Mr Skilling was behind them. The composite summary appears to confirm that this was what Mr Fastow told the FBI from the start. Yet the original FBI notes appear to reveal that he initially told them a different story.

Oh really? The man who admits he stole from Enron actually lied about Enron and his boss at the company? How positively unique.

Take, for example, a couple of the alleged frauds that caught the attention of the public (in part because of Enron’s use of “Star Wars”-related names). Mr Fastow testified that he discussed with Mr Skilling a “Global Galactic” list that included details of the secret promises. The original FBI notes record that when first asked about it, Mr Fastow “doesn’t think [he] discussed list w/ JS.”

Likewise, Mr Fastow claimed that Mr Skilling knew of a “quid pro quo” between Enron and off-balance sheet vehicles known as “raptors”, yet the original FBI notes have him saying he was “not sure what Skilling knew”. And so on.

Of course, being interviewed by the FBI can be stressful, and memory can play tricks. Things once forgotten are remembered; further questioning clarifies stories. But Mr Fastow had a powerful incentive to come up with a story that helped the government convict Mr Skilling:by cooperating, and entering a plea bargain, Mr Fastow was sentenced to only six years in jail.

While it can never be said that I support Andy Fastow, for the sake of clarity and honesty, he pled to ten years. But for reasons that have to do with his willingness to be a good prosecution witness, and because he is taking advantage of the drug rehab program in prison (Fastow claims to be addicted to Xanax), and with a haircut for good behavior, Fastow will be out in three and a half years.

It was not known at not known at trial that Fastow would only get a six-year sentence. Indeed, he and the Task Force made a point of having Fastow repeatedly tell the jury he was locked into a 10-year sentence and thus had no incentive to lie. Then at Fastow’s sentencing hearing held well after Jeff’s trial, at which John Hueston of the Task Force praised Fastow’s cooperation, Fastow was given the six-year sentence. This is one of the issues the Skilling defense raised vigorously on appeal. (See, e.g., pp. 196-200 of opening brief.)

That was already known at the trial. What was not known was that Mr Fastow’s recollections over time became more hostile to Mr Skilling and more helpful to the government. The defence surely would have grilled Mr Fastow about his fickle memory.

Mr Skilling’s defence team allege serious prosecutorial misconduct of the sort that ought to result in Mr Skilling’s conviction being overturned, with no possibility of a retrial. Brady v Maryland held that the government had to provide the defence all favourable evidence. That is because the government has “substantial resources and considerable other advantages” over defendants and the “system reposes great trust in the prosecutor to place the ends of justice above the goal of merely securing a conviction.”

The government is expected to argue that the inconsistencies between the FBI notes and the composite are trivial and did not affect the verdicts.

For what it is worth, prosecutors have had a tougher time in the appeals court with Enron-related cases than in the initial jury trials. Convictions have been overturned in a case relating to Nigerian barges that Enron sold to Merrill Lynch. The conviction of the chief financial officer of Enron Broadband has also been vacated, after two trials. So, too, was the decision to convict Enron’s auditor, Arthur Andersen (albeit too late to save the venerable firm from liquidation).

For many people, the mere fact of Enron’s collapse is evidence that Mr Skilling and his old mentor and boss, Ken Lay, who died between his conviction and sentencing, presided over a fraudulent house of cards. Yet Mr Skilling has always argued that Enron’s collapse largely resulted from a loss of trust in the firm by its financial-market counterparties, who engaged in the equivalent of a bank run. Certainly, the amounts of money involved in the specific frauds identified at Enron were small compared to the amount of shareholder value that was ultimately destroyed when it plunged into bankruptcy.

Yet recent events in the financial markets add some weight to Mr Skilling’s story—though nobody is (yet) alleging the sort of fraudulent behaviour on Wall Street that apparently took place at Enron. The hastily arranged purchase of Bear Stearns by JP Morgan Chase is the result of exactly such a bank run on the bank, as Bear’s counterparties lost faith in it. This has seen the destruction of most of its roughly $20-billion market capitalisation since January 2007. By comparison, $65 billion was wiped out at Enron, and $190 billion at Citigroup since May 2007, as the credit crunch turned into a crisis in capitalism.

Mr Skilling’s defence team unearthed another apparent inconsistency in Mr Fastow’s testimony that resonates with today’s events. As Enron entered its death spiral, Mr Lay held a meeting to reassure employees that the firm was still in good shape, and that its “liquidity was strong”. The composite suggested that Mr Fastow “felt [Mr Lay’s comment] was an overstatement” stemming from Mr Lay’s need to “increase public confidence” in the firm.

The original FBI notes say that Mr Fastow thought the comment “fair”. The jury found Mr Lay guilty of fraud at least partly because it believed the government’s allegations that Mr Lay knew such bullish statements were false when he made them.

As recently as March 12th, Alan Schwartz, the chief executive of Bear Stearns, issued a statement responding to rumours that it was in trouble, saying that “we don’t see any pressure on our liquidity, let alone a liquidity crisis.” Two days later, only an emergency credit line arranged by the Federal Reserve was keeping the investment bank alive. (Meanwhile, as its share price tumbled on rumours of trouble on March 17th, Lehman Brothers issued a statement confirming that its “liquidity is very strong.”)

Although it can do nothing for Mr Lay, the fate of Bear Stearns illustrates how fast quickly a firm’s prospects can go from promising to non-existent when counterparties lose confidence in it. The rapid loss of market value so soon after a bullish comment from a chief executive may, judging by one reading of Enron’s experience, get prosecutorial juices going, should the financial crisis get so bad that the public demands locking up some prominent Wall Streeters.

Thank you, Economist, for giving this story the attention it richly deserves. Thank you for a generally unbiased report. I do hope that others will begin to take note and understand this isn’t a ‘rich guy is asking for special treatment’ case, which seems to be the misunderstanding of many. It’s a ‘this guy was framed by the government’ case.

Skilling must be exonerated.

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