Former Enron CEO Jeff Skilling on his way to court, where jurors would convict him on charges that they didn't understand

Another asset bubble has burst, this one in American real estate and its financing. Precariously structured mortgage investments teeter and fall, bringing corporate titans down and crushing investor confidence. Financial firms, led by Citigroup and Merrill Lynch, have miscalculated and mismanaged key risks and seen more than $100 billion in shareholder assets vanish. Mortgage-related turmoil has roiled markets, with economists and ordinary Americans fearing that lending woes and a protracted home-price decline could trigger a recession.

It wasn’t supposed to be this way. After Enron imploded six years ago, Congress and President Bush enacted the Sarbanes-Oxley law, which aimed to reform corporate practices and prevent future market surprises. The law imposed new regulations on corporations and their executives, as well as new criminal sanctions for corporate wrongdoing under both the new law and existing ones. “How can you measure the value of knowing that company books are sounder than they were before?” asked sponsor Michael Oxley, defending the law. “Of no more overnight bankruptcies with the employees and retirees left holding the bag? No more disruption to entire sectors of the economy?”

But in the end, Sarbanes-Oxley has just made it easier for ambitious government attorneys to criminalize bad business judgment and complex accounting in hindsight. Further, in their focus on strengthening legal enforcement, the feds have passed up opportunities to create commonsense protections for investors. Worse still, the government has instilled investors with false confidence by implying that they can rely on prosecutors, not prudence, to protect their market holdings. Now the housing and mortgage meltdown—which could hurt the economy far more than Enron did—is reminding investors that no law or regulation can protect them from economic disruption.

Politicians and business pundits saw Enron’s collapse as an unprecedented market failure that cried out for a new remedy. Hadn’t the country’s best stock analysts believed the Enron “story”—permanently high growth through dazzling innovation? Hadn’t the nation’s bond-rating agencies awarded Enron a rating implying that prudent investors could lend to the doomed company? Hadn’t Enron’s “independent” auditors and outside counsel signed off on its crazy financial statements? And hadn’t Enron employees who had invested heavily in company stock seen their life savings evaporate?

Yet Enron was actually an example of how markets work—messily, sometimes tardily, but in the end with ruthless efficiency. Even as most Wall Street analysts bought Enron’s sales pitch and accepted its financial statements, investors slashed the value of the company’s shares in half—far surpassing declines in the broader market—during the year before the accounting scandal broke. Investors had begun to withhold money before the government launched investigations. When Enron declared bankruptcy in December 2001, the regulators were left only to certify the market’s verdict. Those investors and lenders who hadn’t scrutinized the company lost money, as they should have.

Though Enron didn’t signal a market failure, it was a business failure, of course. The company overvalued its assets while undervaluing its liabilities—the oldest trick in the fraud book but also sometimes an honest mistake. In the 1930s, Samuel Insull, a utility entrepreneur who created the modern power grid, did the same thing; so did savings and loan banks in the 1980s. Enron’s chief financial officer, Andy Fastow, did it by vastly overstating the company’s assets and hiding liabilities, such as off-the-books sums owed to outside “investment partnerships” (he stole cash on the side, too). It was easy for Enron to perform accounting hocus-pocus because many of its assets, such as a one-of-a-kind power plant in India and speculative broadband ventures, were difficult to value. Enron’s assets were worth what Enron said they were—until the market decided otherwise. By booking future profits right away, Enron worsened its predicament; a mistake or a lie compounded over 20 years is far greater than one that covers only one year. What’s more, the company didn’t disclose clearly enough, in hindsight, that it was funding those precarious investment partnerships with its own stock—which it might have to replace with cash if the stock price fell.

Less than a year after Enron’s collapse, President Bush signed Sarbanes-Oxley, which, among other things, gave white-collar prosecutors a powerful new weapon. But SarbOx was an unnecessary step at best, because America had been the world’s most robustly regulated securities market for decades. After the 1929 stock-market crash, voters demanded government protection, and FDR and Congress responded with the Securities Acts of 1933 and 1934. The first, a “truth in securities” law, mandated that companies with public investors register with the federal government, prohibited them from using “fraud or deceit” in selling securities, and required them to disclose financial and other significant information publicly. The second founded the Securities and Exchange Commission, with sweeping authority to regulate brokerage firms, investment banks, and securities exchanges, and specified that publicly traded companies release regular reports of their business and financial activities.

As the Great Depression was unfolding, distrust of finance was widespread. In 1932 and 1933, to take a famous example, a Senate committee’s chief counsel, Ferdinand Pecora, had riveted the press with his withering questioning of banking titans for their role in the stock-market crash. But the Securities Acts didn’t create an environment of close, constant government supervision of companies. While they gave the SEC sharp teeth to pursue civil enforcement and to recommend criminal prosecution to the Department of Justice in egregious cases, they mostly encouraged free disclosure. This philosophy helped propel American capital markets to dominance after World War II, formed the backbone of securities regulation for seven decades, and continues to work well. One reason Enron collapsed was that, under these very laws, it disclosed enough information for enterprising market participants to smell a rat eventually.

Wall Street prosecutions weren’t born with Sarbanes-Oxley. As prominent white-collar defense attorney Stan Arkin says, prestigious law firms regarded criminal-defense practices as unsavory 40 years ago, but the increased threat of white-collar prosecutions eventually led almost all of them to offer such services. Many in the financial world first understood the acute risks in the 1980s, when Rudy Giuliani—then the U.S. attorney for the Southern District of New York, which includes Wall Street—ordered three investment bankers arrested in their offices or homes, one of them in handcuffs, on suspicion of insider trading, though two of the three cases against them were later dropped.

Also during the 1980s, financial firms realized that if they didn’t cooperate quickly with government investigators, their investors and assets could disappear just as quickly, and even cooperation wasn’t a guarantee of survival. In what observers hailed as a far-reaching agreement, Drexel Burnham Lambert, junk-bond king Michael Milken’s investment company, cooperated with the feds, waiving some attorney-client privileges and agreeing to dismiss Milken in order to fend off securities-fraud charges. (Drexel, reeling from both the government investigation and the loss of Milken’s business, soon sold off its best assets anyway.) To get dirt on Milken, the feds also charged five principals at investment firm Princeton/Newport, a Milken trading partner, with racketeering, tax fraud, and other crimes. Even before the principals’ convictions—the most serious among them later overturned—the investigation and the threat to seize assets under antiracketeering law terrified investors and spelled the firm’s demise.

After the tech bubble burst in 2000, New York attorney general Eliot Spitzer pursued investment banks, mutual-fund companies, and insurance companies with headline-grabbing intensity—cratering their stock prices, exacting expensive settlements merely by threatening to prosecute, and reminding CEOs how much power an ambitious AG wields. For instance, in 2002, Spitzer went after Merrill Lynch for pushing its customers to buy wildly overvalued stock in companies that were paying Merrill hefty investment-banking fees at the same time. Hemorrhaging market value, Merrill cowered when Spitzer announced that its actions were “corrupt” and “maybe criminal.” The firm swiftly settled, agreeing to pay a $100 million fine—to the government, not to investors—and to change its business practices. Spitzer employed similar tactics and made even more egregious public statements in order to pressure other firms—notably AIG, forcing the insurance giant to fire longtime CEO and chairman Hank Greenberg, even though, as Spitzer biographer Brooke Masters writes, zero evidence had linked him to the company’s alleged accounting misdeeds.

Prosecutors have eagerly adopted all these techniques. Princeton/Newport, for example, was a direct precursor to Arthur Andersen, Enron’s auditor, which failed in 2002 because it couldn’t withstand an obstruction-of-justice indictment; the Supreme Court eventually overturned Andersen’s subsequent conviction, but the storied firm’s doors stay shuttered. Last fall, a health-care company, WellCare, watched three-quarters of its market value vaporize after government investigators invaded its offices without saying why. And today, firms routinely waive attorney-client privilege and turn over evidence against their workers in order to protect themselves from even the threat of indictment.

White-collar prosecutors have, moreover, long enjoyed two advantages over defense attorneys. The first is what lawyers call the “white-collar rationale,” under which courts are reluctant to impose limitations on prosecutors’ tactics, particularly before indictment, in everything from gathering physical evidence to interviewing witnesses. The white-collar rationale exists because courts see prosecuting white-collar crimes as unusually difficult. For other kinds of crime—homicide, for example—it’s obvious that something illegal has occurred, and the question is straightforward: Who did it? But for white-collar crime, while it’s often clear who acted—a CEO tells the public that his company’s prospects are good, but the company later fails; a debt underwriter tells a short-term investor that a piece of debt is worth $50 million, but later can’t find a price for more than $20 million; a trader chats with a company’s officer and then sells shares of the company’s stock just before the price plummets—it’s unclear whether the action is a crime or not.

Wayne State law professor Peter Henning writes in the University of Pittsburgh Law Review that “the acceptance of the white-collar rationale . . . to permit the government to seek incriminating statements from participants, and to limit the privilege against self-incrimination, means that the cases will continue to be decided generally in favor of the government.” Baker Botts defense lawyer J. Bradley Bennett says that “while the most obvious result of federal law enforcement’s aggressive pursuit of white-collar prosecutions has been the criminalization of conduct” formerly treated as civil violations, a subtler shift is that “the government has dramatically changed the way in which it investigates and prosecutes business crime”—using search warrants that effectively shut down small securities firms, for example, before those firms can hire criminal lawyers.

Another reason for the white-collar rationale is that judges often consider wealthy defendants fully able to take care of themselves. This points to prosecutors’ second advantage: predisposition against executives during the trial itself. “For many judges and jurors, what goes on in an executive suite may just as well be happening on Mars,” says University of Illinois law professor Larry Ribstein. “Newspapers, films, and other media sources . . . portray corporate executives as selfish, greedy, and irresponsible.” So if a trial reveals, say, that a firm’s chief accountant questioned a particular valuation method and that the CEO then directed other employees to challenge the accountant, a jury may see the CEO’s defiance as criminal conspiracy, not normal corporate give-and-take.

The Enron trials are object lessons in how prosecutors can use their advantages to devastating effect. Business leaders may think that what happened to the Enron defendants will never happen to them, since they don’t do what Enron did. But there’s no guarantee that they won’t someday confront the same strategies and tactics that the government used during the Enron cases.

Contrary to popular perception and despite millions of documents, the feds had no smoking-gun evidence against Enron chiefs Jeff Skilling and Ken Lay. The two men, each of whom served as CEO at times during the company’s final two years, faced charges that included conspiring to conceal Enron’s true financial state before it collapsed and, in Skilling’s case, selling company shares using information about that conspiracy. Fastow, the CFO, had already pled guilty to misrepresenting Enron’s precarious condition to investors, among other things. Even so, the prosecutors’ problem was twofold. First, no proof existed that Skilling or Lay had directed Fastow’s actions. Second, even if jurors, who heard the Skilling and Lay cases together, decided that the two men knew about Fastow’s deals, that just meant that the execs had participated in “a complex issue requiring application of contract, accounting, and SEC disclosure rules,” as Skilling’s attorney, Daniel Petrocelli, writes in his client’s now-pending appeal. It didn’t mean that they had approved Fastow’s strategy, or that they knew that it was criminal, or that they had conspired with others to commit the offense.

But in court, any complex accounting is suspect. “They were accountants,” said juror Freddy Delgado of some witnesses. “They mumbled, and I didn’t know anything about what they talked about.” Further, prosecutors pressed companies and people to cooperate who might otherwise have cleared up what Skilling and Lay knew about that accounting. Banks like CIBC and Merrill Lynch, which participated in Enron’s financing, reached deals with the government that kept employees from testifying for the defense. Of course, free-speech protections theoretically meant that the employees were free to talk, but they knew that if they did, reprisals from their bosses or prosecutors were likely. Such conditions proved devastating to Skilling’s and Lay’s defense. Before his firm agreed to cooperate, one CIBC worker “emphatically denied the allegation that Fastow had ever made a guarantee” of profit on certain side deals, according to Skilling’s appeal. After CIBC secured its deal, the worker refused to testify.

From an honest businessman’s perspective, the most worrisome thing about the Enron case was the jurors’ unconcealed prejudice and the court’s lack of concern about it. One juror wrote on a pretrial questionnaire: “I think [Skilling and Lay] probably knew they were breaking the law.” Another wrote that the “collapse was due to greed and mismanagement.” A third said that “pure greed” motivated all CEOs and that “some get caught and some don’t,” adding: “Anyone that takes home the salaries and bonuses and the stuff they have, they got to be greedy.” These prejudices somehow didn’t bother the court, which had already refused the defense’s request to move the trial from Houston, where Enron-related emotions ran high.

After the trial, it became clear that some jurors didn’t even understand what they had convicted the two defendants of doing. Describing how he had reached the guilty verdict, Delgado said: “To say you didn’t know what was going on in your own company was not the right thing.” Another juror, Dana Fernandez, said that if Lay and Skilling “didn’t know, they should have found out somehow what was going on.” But the burden of the government’s case was to prove beyond reasonable doubt that Lay and Skilling had engineered a conspiratorial fraud. If they didn’t know about the conspiracy—regardless of whether they should have known about it—the jury should have found them not guilty. (To be fair, the judge may have improperly instructed the jury on this point.)

Enron’s precedent is scary enough for today’s executives, but Sarbanes-Oxley makes things scarier still. When Congress passed SarbOx in 2002, it intended the new law to keep future defendants from arguing, as Lay and Skilling had, that they didn’t understand their own companies’ accounting and financing methods. Sarbanes-Oxley requires that top executives of publicly traded companies and their outside auditors carefully analyze and report on their “internal controls”—their formal checks and balances—to ensure that a new Enron doesn’t happen on their watch. Another requirement calls on CEOs and CFOs to attest to their financial disclosures’ veracity.

While most critics focus on the new regulatory burden that the act imposes—requiring executives to approve thousands of pages of “internal control” documents prepared by thousands of employees—the more frightening aspect is its criminal sanctions. The potential criminal penalty for “willfully” signing off on statements that are less than “fairly representative,” notes UCLA law professor Stephen Bainbridge, is a 20-year prison sentence. Since devising and supervising internal controls and preparing accurate financial statements are tasks that top execs must delegate to others—otherwise, a CEO could spend all year on them—SarbOx could criminalize what Arkin calls a lack of “ability to read minds.” Given such penalties, and the attitudes of jurors, small wonder the government rarely has to prosecute to force companies to adhere to new business practices and management changes. It only has to threaten.

Criminalizing bad internal controls ignores another big problem. As the Wall Street Journal’s George Anders wrote recently of the mortgage blowup, paraphrasing John Reed, Citicorp’s CEO for much of the 1980s and ’90s, “Everyone in banking points to risk management as a top priority . . . but that is often just lip service. Risk analysis can easily become a series of routine chores that offer little protection from the unexpected.” Sarbanes-Oxley, a burdensome risk-management tool, isn’t free of this weakness.

The most recent round of spectacular business misjudgments raises the question of what happens, in this new era, when a CEO misses a warning sign in his company that later becomes painfully obvious. In the mortgage debacle, the world’s most sophisticated financiers, as well as ratings agents who signaled that it was prudent to invest in ever-riskier mortgage-backed securities, seemed to believe that housing prices would keep going up, in large part thanks to cheap and easy credit. Bankers and executives also thought that careful engineering—and, yes, complex accounting and financing—would insulate these securities from precipitous losses even if the housing market did tank eventually. Were their huge and unexpected losses the results of poor internal controls? After all, didn’t CEOs, who signed off on such controls, know that their employees, pursuing big bonuses, had an incentive to take bigger risks than shareholders might have recognized? And didn’t the CEOs realize that their opaque models for structuring and valuing these securities were disastrously vulnerable to error? Or did the losses simply result from spectacular misjudgments—unavoidable from time to time in a free-market economy?

With foreclosures piling up because borrowers and lenders both made overoptimistic assumptions about the housing market, the government is already using its implicit prosecutorial power to bully banks with a role in the crisis. When treasury secretary Henry Paulson, with President Bush’s backing, “encourages” mortgage lenders to freeze interest rates on subprime mortgages so that some borrowers won’t face foreclosure, those banks understand that they’d better take his words to heart: the next government caller may not be so encouraging.

It would be no surprise if an ambitious state attorney general or U.S. attorney seized on citizen and media anger and hauled some executives into the courtroom, not only over internal controls but over possible conflicts of interest. In fact, New York AG Andrew Cuomo, Spitzer’s successor, has already subpoenaed Wall Street banks, including Merrill Lynch and Bear Stearns, to find out what was going on when they structured and sold mortgage-backed securities; his counterparts in other states aren’t far behind. For example, did bankers ever discuss the risks of such securities among themselves but neglect to mention those risks to potential investors? The FBI has also launched a criminal investigation of 14 banks, looking into possible insider trading, accounting fraud, and disclosure omissions surrounding the mortgage crisis.

There’s also the issue of public statements and omissions. Countrywide Financial CEO Angelo Mozilo last year told investors that he expected his firm to turn a profit last quarter despite the mortgage meltdown—the worst crisis that his company, until recently the nation’s largest mortgage lender, had ever faced. Instead, the bank reported another hefty loss. Was Mozilo's comment just optimism, however irrational in hindsight? Or was it a fraudulent lie, meriting prison? Similarly, many observers say that banks should have disclosed clearly to shareholders that they might have multibillion-dollar obligations, in certain market conditions, to outside investment partnerships holding subprime securities. But no company can clearly disclose every potential obligation in every conceivable market condition; the resulting paperwork would be too voluminous for any investor to digest. Showing how easy it is to paint gray areas of disclosure black, however, New York Times business columnist Floyd Norris recently mentioned “signs that banks were either lying about their results or were taking large risks that were not fully disclosed.” The CEOs were lying . . . or they were lying. Not a tough choice for a jury.

It’s important to note that in the mortgage debacle, just as in previous meltdowns, the market noticed problems before the government did. Four years ago, Wall Street Journal columnist Herb Greenberg points out, PMI, a company that insures mortgages for lenders, began hiking its prices and pulling back from the subprime market, likely considering it too risky. By last summer, short-term lenders balked at providing new debt to investment partnerships whose assets were in subprime mortgages and similar securities. That action sent a message to the government, to ratings agencies, and to executives that something was wrong.

The worst thing about criminalizing what should often be civil regulatory matters is that it creates a false sense of security for investors, who may think that aggressive prosecutions protect them from losses. Disclosure—even if it’s slow and imperfect—is still their best protection. “We find little evidence that public enforcement benefits stock markets, but strong evidence that laws mandating disclosure and facilitating private enforcement through liability rules benefit stock markets,” observed Dartmouth business professor Rafael La Porta, University of Amsterdam professor Florencio Lopez-de-Silanes, and Harvard professor Andrei Shleifer in a recent Journal of Finance study.

Adequate disclosure is no easy feat, however, in a world where even the Federal Reserve chairman says of banks’ outside investment partnerships that he wishes he “knew what the damn things are worth.” Part of the government’s job is to see that the public understands the limitations of disclosure. “There’s no such thing as accounting transparency,” says the American Enterprise Institute’s Alex Pollock, former president and CEO of Chicago’s Federal Home Loan Bank. Accounting, he says, is the result of hundreds of decisions, guesses, and estimates. History shows, too, that disclosure works slowly and imperfectly. Investors often ignore a disclosed and obvious risk for years, until, for reasons best known to themselves, they decide not to ignore it any longer.

Accounting’s immutable imperfections are apparent in today’s mortgage mess. After Enron, the feds set up a new quasi-governmental agency, the Public Company Accounting Oversight Board, to compel firms to make more pertinent and timely disclosures to investors. But the agency didn’t force perfect disclosure of banks’ subprime-related obligations. Nor could it force a perfect market reaction to the disclosures that were available. Investors lost money again. So did homeowners, of course, who—seduced by a rising market—would probably have undertaken their dubious mortgages even if the risks had been clearly disclosed.

Because perfect knowledge and disclosure of risk, and perfectly rational responses to available disclosure, aren’t attainable, what might be done to mitigate personal losses in future crises? One partial solution is for the government to put checks on a normally beneficial force: natural optimism. For retirement savings, the feds should use the tax code to discourage investors from putting all their eggs into one basket. Though investors should be free to speculate on the next big thing, they shouldn’t be free to do so in retirement accounts like 401(k)s and IRAs, accorded favorable tax treatment by the government. Perhaps Enron’s worst sin was what a human-resources director said at a 1999 company assembly, when an employee asked, “Should we invest all of our 401(k) in Enron stock?” “Absolutely!” the director responded. “Don’t you guys agree?” she added to the enthusiastic Lay and Skilling, who stood nearby. The result: many workers lost not only their jobs but much of their retirement savings.

The feds should thus revive a failed Enron-era proposal banning companies from allowing employees to invest more than 10 percent of in-house retirement savings in their companies’ stock. Congress should also prohibit the owner of any independent 401(k) or IRA from investing more than 15 percent of retirement assets in one company or 20 percent in one industry. (Investors could still do so elsewhere, of course.) And Congress should continue to prevent people from using their 401(k) accounts to invest in their homes, despite suggestions that lifting the ban would prop up the housing market. Housing assets, just as vulnerable to market bubbles as stocks are, already make up too large a percentage of Americans’ savings.

As the economy heads into a possible downturn, calls will grow for someone to pay for the pain of another burst bubble—and for yet more onerous rules, regulations, and prosecutions of businesses to prevent future crises. But no government mandate or punishment, however harsh, will stop companies and markets from being imperfect collections of fallible human beings. At the end of a decade of financial surprises, that may be the most enduring lesson of all.

Research for this article was supported by the Brunie Fund for New York Journalism.

Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst.