Reexamining Enron’s Regulatory Consequences

STEVEN L. SCHWARCZ[1] WITH THE ASSISTANCE OF ALEX BARTLOW[2]

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ABSTRACT

The downfall of Enron Corporation often epitomizes corporate fraud. One of the world’s fastest growing and most inventive companies, Enron had engaged in a range of complex structured hedging transactions designed to achieve accounting rather than operating results. Its principal motivation, though, was to avoid the risk of incurring financial-statement losses that could impair its credit rating and thereby destroy its primary business of derivatives-based energy trading.

Enron’s management has been criticized for engaging in these structured hedging transactions, and some of its managers were sent to jail. This symposium article concerning “Business and Financial Crimes” attempts to set forth the facts objectively. It observes, among other things, that in engaging in the structured hedging transactions, Enron’s managers complied with reasonable corporate processes, had the help of outside counsel, obtained independent fairness opinions, and received at least cautious approval from the big-five accounting firm that acted as external auditor. The article ultimately asks, “If you were advising Enron, what would you have recommended the managers should do?”

The article suggests that Enron’s collapse and the resulting congressional response illustrate how society can overreact to dramatic business failures and how regulatory responses can sometimes miss the mark. It contends that corporate managers often must—as Enron’s managers did—take risks that, ex ante, are viewed as reasonable to enable their firms to remain competitive in a global economy. That makes it inevitable that some firms will fail. Failure, therefore, should not automatically be judged as managerial misfeasance.

I. Enron’s Accounting-Motivated Hedging Transactions

The downfall of Enron Corporation (Enron) was, and still is, considered the “posterchild of corporate fraud.”[3] One of the world’s fastest growing and most inventive companies, Enron had engaged in a range of complex structured transactions designed to achieve accounting rather than operating results. Its principal motivation was to minimize volatility and avoid the risk of incurring financial-statement losses[4] which could impair its credit rating and thereby destroy its primary business of derivatives-based energy trading.[5] A common factor in many of these transactions[6] was the use of non-consolidated (that is, off-balance-sheet) special purpose entities, or SPEs, to hedge the value of certain Enron “merchant asset” investments.[7] Under generally accepted accounting principles (GAAP), these assets[8] must be fair valued periodically.[9] Enron thus must account for any change in the fair value of the assets as a gain or loss, as the case may be, to its reported income.[10] If the merchant assets’ fair value drops significantly, the resulting accounting-driven paper “loss” would likely cause the credit-rating agencies, including Standard & Poor’s and Moody’s, to downgrade Enron’s credit rating.[11]

Because its credit rating was then barely investment grade,[12] a downgrade could cause Enron to lose its investment-grade rating. That, in turn, would destroy Enron’s derivatives business.[13] Hedging the value of those assets would protect that business by allowing Enron to avoid having to account for a drop in their fair value as a loss.[14]

In a typical hedge, Enron would transfer its own stock to one of the non-consolidated SPEs in exchange for a note or cash,[15] and also directly or indirectly guarantee the SPE’s value.[16] The SPE, in turn, would hedge the value of Enron’s merchant assets, using the transferred Enron stock as the principal source of payment.[17]

II. The Failure of the Hedging

Because of its historically rising stock price, Enron judged the risk that it would have to pay on its guarantees as remote.[18] But the value of Enron’s merchant assets and Enron’s stock price both simultaneously fell, causing the SPEs’ value to fall and triggering the Enron guarantees.[19] Notwithstanding those guarantees, the SPEs lacked sufficient assets to validly hedge the value of the merchant assets.[20] The failure of the hedges required Enron to account for the fall in value of its merchant assets as a loss to reported income, causing the rating agencies to downgrade Enron’s credit rating and ending Enron’s derivatives business—thereby forcing Enron into bankruptcy.[21]

III. How Would You Have Advised Enron?

Enron’s management has been criticized for engaging in these SPE hedging transactions,[22] and some of the managers were sent to jail.[23] But if you were advising Enron, what would you have recommended the managers should do?

Once a stodgy natural gas pipeline company, Enron had transformed itself into a high-tech enterprise engaged in extensive trading in energy derivatives, and it had been named by Fortune magazine as “the most innovative company in corporate America” for six consecutive years.[24] To successfully engage in derivatives trading, Enron needed to maintain an “investment grade” credit rating.[25] If Enron’s credit rating fell below investment grade, many of its derivatives agreements required it to post cash collateral, which would be impractically expensive.[26] Some of those agreements even treated the rating downgrade as a default.[27]

Ordinarily, Enron would simply sell the merchant assets, which given fair value at the time would avoid any loss. Unfortunately, Enron was prohibited from selling the assets for a period of time pursuant to a lock-up agreement.[28] Another option would be for Enron to commercially hedge the value of the merchant assets. This option, however, was not practicable due to the illiquidity of the merchant assets and the size of the positions to be hedged.[29] Lacking other options, Enron found a creative alternative to hedge the value of the merchant assets: to create SPEs to perform that hedge by engaging in the structured transactions previously described.[30] The key to these transactions is that Enron’s publicly-traded stock had real value in the hands of a third party. As such, the non-consolidated SPEs providing the hedging[31] were structured for accounting purposes as third parties.[32]

In creating these transactions, Enron’s managers complied with reasonable corporate processes. They engaged in these transactions with the help of Enron’s outside counsel, they obtained independent fairness opinions,[33] and they received at least cautious approval[34] of the accounting treatment from the company’s external auditor—the big-five accounting firm Arthur Andersen.[35] They also judged the chance of a simultaneous drop in both Enron’s stock price (which had been steadily rising for a decade) and the value of the merchant assets to be extremely unlikely.

IV. How Should the Actions of Enron’s Managers be Judged?

In retrospect, Enron’s collapse represents a failure to fully appreciate the risk that a significant fall in the value of its merchant assets might be correlated with a significant fall in the price of its stock.[36] “Viewed with the benefit of hindsight,” Enron’s SPE hedging transactions might also “appear foolish, reckless, or fraudulent.”[37]

In perspective, though, Enron’s managers were making exquisitely fine judgment calls—shades of grey that, for accounting, must be rendered as black or white.[38] The culpability of those actions should be assessed ex ante, not ex post. Ex ante, the SPE hedging transactions not only could have been considered ingenious but were seemingly the company’s only plausible hope at maintaining its investment-grade credit rating and, consequently, its business.

This disconnect in judging Enron’s managers’ actions is due to several cognitive biases. As Professor Bratton observes,[39] the most obvious is hindsight bias: “the tendency, after an event has occurred, to overestimate the extent to which the outcome could have been foreseen.”[40] With the benefit of hindsight, we know how the story ends. “Consider the prosecution of the defendants in the aftermath of Enron’s collapse. Is it not reasonable to believe that some of the jurors reasoned backwards from the effects of the collapse on stockholders and employees to the conclusion that the cause of the collapse must have been . . . fraudulent conduct” of Enron’s managers?[41] Hindsight bias “shows that people blame others for failing to have predicted adverse outcomes that could not have been predicted.”[42]

Another relevant cognitive bias is ultimate attribution error: the human tendency to “determine that any bad acts by members of [a group] . . . are caused by internal attributes or traits rather than by outside circumstances or situations.”[43] In other words, for every wrong, there must be a blameworthy wrongdoer. Shortly after Enron’s collapse, the media demonized Enron’s managers.[44] Ultimate attribution error could be at least partly responsible for that demonization.

Furthermore, Enron’s managers themselves would have been subject to cognitive biases, such as optimism bias.[45] This is a tendency “to be unrealistically optimistic when thinking about negative events with which one has no recent experience, and devaluing the likelihood and potential consequences of those events.”[46] The logic of those managers operating under optimism bias is reinforced by the reality that, absent engaging in the structured transactions, Enron’s business would have collapsed if and when the value of the merchant assets fell.[47] The structured transactions were, in fact, the only way to try to avoid that collapse.

V. Reexamining the Regulatory Consequences

In response to the collapse, Congress passed the Sarbanes-Oxley Act of 2002 (SOX),[48] which then-President Bush called one of “the most far-reaching reforms of American business practices since the time of Franklin Delano Roosevelt.”[49] These and other reforms included “increased penalties for fraud; new requirements for independent corporate directors, audit committees and accountants; and new disclosure requirements.”[50] Nonetheless, at least some observers conclude that “the regulatory response to Enron was in large part misguided . . . .”[51] Many provisions of SOX, for example, were said to be

easy fixes that look good in thirty-second television commercials [and] simply follow[] headlines from Enron and other corporate scandals, with little appreciation for whether those headlines highlight systemic problems that need legislative attention. Many other provisions, particularly the vaunted criminal provisions, represent little more than political grandstanding and are unlikely to have any real deterrent effect. . . . [T]here was little appreciation that markets still work and can right themselves.[52]

This Article does not purport to comprehensively rethink SOX and its consequences. Rather, it reexamines what that Act failed to regulate or, at least, to regulate adequately. It also considers whether—and if so, how—new regulation could remedy that failure.

For example, SOX imposed new disclosure requirements,[53] which directed the SEC to adopt regulations regarding the disclosure of off-balance-sheet transactions.[54] There is no doubt, however, that the existence of the SPE hedging transactions had been disclosed to Enron investors.[55] The real problem was that those “transactions were so complex that disclosure [was] necessarily imperfect – either oversimplifying the transactions, or providing detail and sophistication beyond the level of an ordinary investor in Enron’s securities.”[56] Unfortunately, neither SOX’s disclosure requirements nor the SEC’s regulations adopted pursuant thereto address the problem of complexity.[57]

Regulators need to study how to address that problem. One approach, for instance,[58] might be to minimize complexity by incentivizing the standardization of off-balance-sheet transactions. To that end, European Union regulation has been favoring simple, transparent, and standardized (STS) securitization transactions.[59] This approach requires careful balancing, however, because excessive standardization can stifle business innovation.[60]

SOX also failed, at least directly, to regulate cognitive biases. Recall that Enron’s managers were subject to optimism bias, causing them to be unrealistically optimistic about the SPE hedging transactions.[61] Although human nature cannot be easily changed, some now believe that “[w]e have the means to overcome some of our [human] limitations, through education, through institutions, through enlightenment.”[62] Analyzing how that could be done is beyond the scope of this Article.[63]

One could argue that SOX might have helped, at least indirectly, to reduce optimism bias by increasing penalties for fraud.[64] This is because loss aversion, the “tendency to go to disproportionately great lengths to avoid perceived losses”[65]—such as those increased penalties—“curtails the inclination to act on” optimistic beliefs.[66] It is unclear, though, whether SOX’s increased penalties for fraud would have reduced the optimism bias of Enron’s managers.[67] Because Enron’s SPE hedging transactions had been approved in compliance with reasonable corporate processes,[68] those managers would not have expected to become liable for fraud—and thus would unlikely have experienced loss aversion.

Happily, Enron’s collapse did not represent a systemic failure, triggering a wider collapse of the real economy. That limited impact should not be surprising. If Enron existed today, it would almost certainly not be regulated as a systemically important financial institution (SIFI).[69]

VI. Conclusion

Enron’s collapse and the resulting legislation illustrate how society can overreact to dramatic business failures and how regulatory responses can sometimes miss the mark. Corporate managers often must—as Enron’s managers did—take risks that, ex ante, are viewed as reasonable to enable their firms to remain competitive in a global economy. That makes it inevitable that some firms will fail. Failure, therefore, should not automatically be judged as managerial misfeasance.[70] Furthermore, the occurrence of non-systemically-important failures, such as the failure of Enron,[71] “should not, in and of itself, be a basis to change the legal, financial, and accounting infrastructure of business that has . . . served us so well.”[72]

  1. Stanley A. Star Distinguished Professor of Law & Business, Duke University School of Law; Senior Fellow, the Centre for International Governance Innovation (CIGI); Founding Director, Duke Global Financial Markets Center. Although the author was an expert witness for Enron’s outside law firm in the Enron-related litigation, the views expressed herein are entirely his own and intended to be impartial. ↩︎

  2. J.D. candidate, Duke Law School Class of 2024. ↩︎

  3. Mark Chediak et al., Enron’s Cast of Characters: Where They Are 20 Years After the Fall, BLOOMBERG (Dec. 2, 2021), https://www.bloomberg.com/news/articles/2021-12-02/enronscandal-executives-20-years-later-where-are-they-now [https://perma.cc/FBF3-ZQEL]. ↩︎

  4. Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp. [William C. Powers, Jr., Chair] 4, 68, 78, 97 (Feb. 1, 2002) [hereinafter Powers Report]. Enron may have been additionally motivated to accelerate profits. Id. at 56. ↩︎

  5. Id. at 36. ↩︎

  6. Although Enron also has been criticized for aggressive mark-to-market accounting, this Article focuses on its use and potential abuse of special purpose entities. See infra notes 15–17 and accompanying text. ↩︎

  7. Powers Report, supra note 4, at 77. ↩︎

  8. These assets included, for example, Enron’s investment in Rhythms NetConnections, an internet service provider. Id. at 13. Under GAAP, these were intercorporate investments that Enron presumably held for trading. George J. Benston, Fair-Value Accounting: A Cautionary Tale from Enron, 25 J. ACCT. & PUB. POL’Y 465, 470 (2006). ↩︎

  9. E-mail from Jennifer Francis, Assoc. Professor of Acct., The Fuqua Sch. of Bus. to author (Apr. 8, 2002). ↩︎

  10. Cf. id. (“The fair valuing process causes the value of the merchant investment (an asset on Enron’s books) to go up when the value of the equity in the [investment] goes up, and to go down when the value of the equity in the [investment] goes down. The key is that the change in the fair value of the merchant investment is an unrealized gain/loss that goes to income in the period. Hence, if fair values of these merchant investments swing about, so will Enron’s income.”). ↩︎

  11. Moody’s, for example, had placed “the debt obligations of Enron on review for downgrade following the announcement by Enron of significant write-downs and charges, reflecting substantially reduced valuations in several of its businesses,” including “its merchant portfolio.” Moody’s Places All Long Term Debt Obligations of Enron Corp on Review for Downgrade; Senior Unsecured at Baa1, MOODY’S INVS. SERV. (Oct. 16, 2001), https://www.moodys.com/research/ MOODYS-PLACES-ALL-LONG-TERM-Rating-Action–PR_49754?cy=cze&lang=cs [https://perma.cc/7GHH-XU6L]. ↩︎

  12. See Moody’s Downgrades Enron Corp Long Term Debt Ratings and Keeps Them Under Review for Downgrade; Senior Unsecured to Baa3. Lowers Rating for Commercial Paper to Not Prime, MOODY’S INVS. SERV. (Nov. 9, 2001), https://www.moodys.com/research/MOODYS-DOWNGRADES-ENRON-CORP-LONG-TERM-DEBT-RATINGS-AND-KEEPS–PR_50422 [https://perma.cc/FHJ9-WLUA]. ↩︎

  13. See infra notes 25–27 and accompanying text (explaining why losing its investment-grade rating would destroy Enron’s derivatives business). ↩︎

  14. See Powers Report, supra note 4, at 13. ↩︎

  15. See, e.g., id. ↩︎

  16. Id. at 36–37. ↩︎

  17. See, e.g., id. at 13. Andrew Fastow, Enron’s chief financial officer, served as general partner of many of the SPEs. ↩︎

  18. Steven L. Schwarcz, Enron and the Use and Abuse of Special Purpose Entities in Corporate Structures, 70 U. CIN. L. REV. 1309, 1310, 1315 (2002) [hereinafter Enron and the Use and Abuse of Special Purpose Entities in Corporate Structures]. ↩︎

  19. These guarantee payments in turn apparently further reduced Enron stock value, triggering additional guarantees. Cf. Powers Report, supra note 4, at 125 (noting that Enron unwound the Raptor transactions because, under its guaranties, it would have to “deliver so many shares of its stock to the Raptors that its reported earnings per share would be diluted significantly”). ↩︎

  20. Moreover, these drops in the SPE’s value caused the SPEs to breach the 3% independent equity requirement for non-consolidation, thereby bringing the SPEs’s debt onto Enron’s balance sheet. E-mail from Jennifer Francis to author, supra note 9 (observing that “[t]he insufficient assets to meet the hedge was also biting into the SPE’s equity, causing the SPE to fall below the 3% requirement”). In at least one case, the ab initio lack of sufficient SPE third-party equity caused the SPEs to breach the 3% independent equity requirement for non-consolidation. See Powers Report, supra note 4, at 41–42, 49–50, 52 (observing that the financing structure Enron created for the Chewco SPE was at least 50% short of the required third-party equity need for non-consolidation because certain employees of Enron improperly, if not fraudulently—and apparently without senior management’s knowledge—arranged reserve accounts funded by Enron to protect a portion of that equity). ↩︎

  21. See Rating Action: Moody’s Downgrades Enron Corp’s Long-Term Debt Ratings (Senior Unsecured to B2); Commercial Paper Confirmed at Not-Prime; Ratings Remain Under Review for Downgrade, MOODY’S INVS. SERV. (Nov. 28, 2001), https://www.moodys.com/research/MOODYS-DOWNGRADES-ENRON-CORPS-LONG-TERM-DEBT-RATINGS-SENIOR-UNSECURED–PR_50940?cy=kor&lang=ko [https://perma.cc/3NZT-K4CN] (noting that “disclosures in [Enron’s] recent 10-Q and required restatement of prior period earnings are of concern”). ↩︎

  22. See infra note 44 and accompanying text. ↩︎

  23. See, e.g., See What Happened to Key Players in Enron Scandal, HOUS. CHRON. (Aug. 31, 2018), https://www.chron.com/business/article/Jeffrey-Skillings-release-to-halfway-house-13196786.php. ↩︎

  24. Bethany McLean & Peter Elkind, The Guiltiest Guys in the Room, CNN MONEY (July 5, 2006), https://money.cnn.com/2006/05/29/news/enron_guiltyest/ [https://perma.cc/9HGC-BS7D]. ↩︎

  25. Enron’s former President, Greg Whalley, indicated in an interview with Senate Committee staff that Enron’s “business model [did not] exist below investment grade.” Staff of S. Comm. on Governmental Affairs, 107th Cong., Enron’s Credit Rating: Enron’s Bankers’ Contacts with Moody’s and Government Officials 2 (Comm. Print 2003). ↩︎

  26. Id. Because a derivatives contract creates credit risk, an investment-grade derivatives counterparty can be viewed as sufficiently creditworthy. But a derivatives counterparty lacking such a rating may be required to collateralize or otherwise secure its potential payment obligation, which can be very costly. See, e.g., Over-the-counter Derivatives, Hearing Before the Subcomm. on Sec., Ins., and Inv. of the S. Comm. on Banking, Hous., and Urban Affairs, 110th Cong. 34–46 (2008) (statement of Patrick M. Parkinson, Deputy Dir., Fed. Reserve Div. of Rsch. and Statistics). ↩︎

  27. Staff of S. Comm. on Governmental Affairs, supra note 25, at 2. ↩︎

  28. Powers Report, supra note 4, at 77. ↩︎

  29. Id. at 78. ↩︎

  30. See supra notes 4–17 and accompanying text. ↩︎

  31. See supra notes 4–5 and accompanying text ↩︎

  32. See, e.g., Powers Report, supra note 4, at 79; see also Enron and the Use and Abuse of Special Purpose Entities in Corporate Structures, supra note 18, at 1312–13. ↩︎

  33. See, e.g., Powers Report, supra note 4, at 79, 81 (referring to PriceWaterhouseCoopers fairness opinion (regarding exchange of the Enron shares for the SPE-put and note) on the Rhythms transaction). ↩︎

  34. The external auditor cautioned that the proposed accounting treatment “presented a high degree of risk of non-compliance with [GAAP].” See S. Permanent Subcomm. on Investigations of the Comm. on Governmental Affairs, 107th Cong., The Role of the Board of Directors in Enron’s Collapse 15 (Comm. Print 2002). ↩︎

  35. Powers Report, supra note 4, at 83. Management was not perfect, however, not always obtaining approval of potential conflicts in compliance with Enron’s Code of Conduct. Id. at 41. ↩︎

  36. Iman Anabtawi & Steven L. Schwarcz, Regulating Systemic Risk: Towards an Analytical Framework, 86 NOTRE DAME L. REV. 1349, 1359 (2011). ↩︎

  37. William W. Bratton, Enron and the Dark Side of Shareholder Value, 76 TUL. L. REV. 1275, 1326 (2002). ↩︎

  38. For example, a central question was whether Fastow’s position as general partner of the SPEs constituted, for accounting purposes, sufficient “control” by Enron to require the SPEs to be consolidated with Enron, even though the SPE partnership agreements permitted the limited partners to remove Fastow as general partner. The Powers Report admits, in these circumstances, that “the criteria for determining control with respect to general partners are subjective [and that there are] substantial questions whether Fastow was in effective control.” Powers Report, supra note 4, at 75–76. ↩︎

  39. See supra note 37 and accompanying text. ↩︎

  40. See, e.g., APA Dictionary of Psychology: Hindsight Bias, AM. PSYCH. ASSOC., https://dictionary.apa.org/hindsight-bias [https://perma.cc/J3LH-YCAE] (last updated Apr. 19, 2018). ↩︎

  41. Jon May, Countering Hindsight Bias in White Collar Prosecutions, CRIM. JUST. 34, 36 (2006). ↩︎

  42. Jeffrey J. Rachlinski, A Positive Psychological Theory of Judging in Hindsight, 65 U. CHI. L. REV. 571, 588 (1998). ↩︎

  43. See, e.g., APA Dictionary of Psychology: Ultimate Attribution Error, AM. PSYCH. ASSOC., https://dictionary.apa.org/ultimate-attribution-error [perma.cc/6AK3-6A3K] (last updated Apr. 19, 2018). ↩︎

  44. See, e.g., Gretchen Morgenson, A Bubble No One Wanted to Pop, N.Y. TIMES (Jan. 14, 2002), https://www.nytimes.com/2002/01/14/business/enron-s-collapse-news-analysis-a-bubble-no-one-wanted-to-pop.html (admonishing Enron’s managers for “ma[king] sure that [Enron] was one hell of a stock” although it was “not much of a company”). ↩︎

  45. Bratton, supra note 37, at 1321–32. ↩︎

  46. Steven L. Schwarcz, Regulating Complacency: Human Limitations and Legal Efficacy, 93 NOTRE DAME L. REV. 1073, 1080 (2018). ↩︎

  47. See supra notes 25–27 and accompanying text. ↩︎

  48. Pub. L. No. 107-204, 116 Stat. 745 (2002). ↩︎

  49. Elisabeth Bumiller, Bush Signs Bill Aimed at Fraud in Corporations, N.Y. TIMES, July 31, 2002, at Al. ↩︎

  50. Frank Partnoy, A Revisionist View of Enron and the Sudden Death of “May”, 48 VILL. L. REV. 1245, 1246 (2003). ↩︎

  51. Id. at 1246. ↩︎

  52. Michael A. Perino, Enron’s Legislative Aftermath: Some Reflections on the Deterrence Aspects of the Sarbanes-Oxley Act of 2002, 76 ST. JOHN’S L. REV. 671, 671 (2002). ↩︎

  53. See supra note 50 and accompanying text. ↩︎

  54. SOX § 401(a). ↩︎

  55. Powers Report, supra note 4, at 200–01. ↩︎

  56. Enron and the Use and Abuse of Special Purpose Entities in Corporate Structures, supra note 18, at 1316–17. ↩︎

  57. Cf. Partnoy, supra note 50, at 1278 (discussing why the regulation adopted by the SEC in response to SOX “would not likely have prevented the problems associated at Enron”). ↩︎

  58. Another possible approach would be less direct: to require corporate managers to be free of any material conflicts of interest in “disclosure-impaired transactions,” thereby increasing the chance that such managers act in the firm’s best interests. Steven L. Schwarcz, Rethinking the Disclosure Paradigm in a World of Complexity, 2004 U. ILL. L. REV. 1, 35. Cf. Enron and the Use and Abuse of Special Purpose Entities in Corporate Structures, supra note 18, at 1317 (explaining how that approach could have helped Enron). ↩︎

  59. See European Commission, Capital Markets Union: First Status Report, at 2–3, 21, SWD (2016) 147 final (Apr. 25, 2016), https://ec.europa.eu/info/system/files/cmu-first-statusreport_en.pdf [[https://perma.cc/MY8F-J84Z]] (expressing the goal of increasing investor confidence). The STS framework includes requiring a true sale or similar transfer of the underlying financial assets, that those financial assets must themselves meet simplicity requirements, including being homogenous, creditworthy (e.g., not in default, not from obligors that are insolvent or have adverse credit history or low credit scores), and not constituting already securitized financial assets; that interest-rate risk and exchange-rate risk must be hedged; other than to effect such hedging, the financial assets cannot be supported by derivatives, as would occur in a “synthetic” securitization; the transaction documents must clearly specify the obligations, duties, and responsibilities of the servicer and back-up servicer to ensure efficient and continuing servicing of the financial assets and must also include clear provisions facilitating the timely resolution of conflicts among different classes of investors; investors must receive a cash-flow model of anticipated collections on the financial assets, supported by information on historical default, delinquency, and loss performance for substantially similar financial assets to those being securitized. Also, a sample of the financial assets may be subject to external verification by an independent party. See Steven L. Schwarcz, A Global Perspective on Securitised Debt, in CAPITAL MARKETS UNION IN EUROPE 484 (Guido Ferrarini et al. eds.) (2018). ↩︎

  60. Severe standardization would reduce complexity at the cost of depriving firms of the benefits of off-balance-sheet transactions, which include “increasing financial flexibility, decreasing the cost of borrowing, reducing taxes, increasing profitability, and improving financial statement ratios.” Uday Chandra et al., Enron-Era Disclosure of Off-Balance Sheet Entities, 20 ACCT. HORIZONS 231, 232 (issue no. 3, 2006). ↩︎

  61. See supra notes 45–46 and accompanying text. ↩︎

  62. Robert A. Burton, ‘Black Box Thinking’ and ‘Failure: Why Science Is So Successful’, N.Y. TIMES (Dec. 29, 2015), http://www.nytimes.com/2016/01/03/books/review/black-box-thinkingand-failure-why-science-is-so-successful.html [https://perma.cc/M5YP-9SVJ] (book review) (quoting Harvard psychologist Steven Pinker). But cf. id. (contrasting Daniel Kahneman’s view, consistent with the tragedy of the human condition, that human nature has inherent flaws). ↩︎

  63. For a comprehensive analysis of how regulation could attempt to reduce cognitive biases, see Schwarcz, Regulating Complacency, supra note 46. ↩︎

  64. But cf. Partnoy, supra note 50, at 1246 (criticizing those increased penalties). ↩︎

  65. APA Dictionary of Psychology: Behavioral Economics, AM. PSYCH. ASSOC., https://dictionary.apa.org/behavioral-economics [https://perma.cc/NWR8-QB59] (last updated Apr. 19, 2018). ↩︎

  66. Chris Dawson & David De Meza, “Wishful Thinking, Prudent Behavior: The Evolutionary Origin of Optimism, Loss Aversion and Disappointment Aversion” (Jan. 31, 2018 working paper), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3108432. ↩︎

  67. SOX could have attempted, but also failed, to reduce optimism bias by requiring independent perspectives to be integrated into financial decision-making. Cf. HUM. DIMENSION CAPABILITIES DEV. TASK FORCE, COGNITIVE BIASES AND DECISION MAKING: A LITERATURE REVIEW AND DISCUSSION OF IMPLICATIONS FOR THE US ARMY 21 (2015) (arguing for an outsider’s perspective to reduce overconfidence and facilitate more analytical thinking). ↩︎

  68. See supra notes 33–35 and accompanying text. ↩︎

  69. Cf. Nonbank Financial Company Designations, U.S. DEPT. OF THE TREASURY, https://home.treasury.gov/policy-issues/financial-markets-financial-institutions-and-fiscalservice/fsoc/designations [https://perma.cc/H9VL-8PQT] (only four nonbank institutions have been classified as SIFIs since the passage of the Dodd-Frank Act). The Financial Stability Oversight Council rescinded three of those nonbank SIFI classifications, and the remaining SIFI-classified nonbank institution, MetLife, shed its SIFI classification through litigation. Metlife, Inc. v. Fin. Stability Oversight Council, 177 F. Supp. 3d 219, 242 (D.D.C. 2016). ↩︎

  70. Cf. Steven L. Schwarcz, Corporate Governance and Risk-taking: A Statistical Perspective, 3.1 U CHI. BUS. L. REV.(forthcoming 2023), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4542464 (further developing that analysis). ↩︎

  71. See supra note 69 and accompanying text. ↩︎

  72. Enron and the Use and Abuse of Special Purpose Entities in Corporate Structures, supra note 18, at 1318. Cf. id. (observing that in order to “remain competitive in a global economy, we must favor flexibility over rigidity, innovation over consistency – even at the risk of another Enron”). ↩︎