Question: Enron Corporation entered 2001 as the seventh

Enron Corporation entered 2001 as the seventh largest public company in the United States, only to later exit the year as the largest company to ever declare bankruptcy to that point in U.S. history. Investors who lost millions and lawmakers seeking to prevent similar reoccurrences were shocked by these unbelievable events. The following testimony of Rep. Richard H. Baker, chair of the House Capital Markets Subcommittee, exemplified these feelings:
We are here today to examine and begin the process of understanding the most stunning business reversal in recent history. One moment an international corporation with a diversified portfolio enjoying an incredible run-up of stock prices, the darling of financial press and analysts, which, by the way, contributed to the view that Enron had indeed become the new model for business of the future, indeed, a new paradigm. One edition of Fortune magazine called it the best place in America for an employee to work. Analysts gave increasingly creative praise, while stock prices soared…. Now in retrospect, it is clear, at least to me, that while Enron executives were having fun, it actually became a very large hedge fund, which just happened to own a power company. While that in itself does not warrant criticism, it was the extraordinary risk-taking by powerful executives which rarely added value but simply accelerated the cash burn-off rate. Executives having Enron fun are apparently very costly and, all the while, they were aggressive in the exercise of their own [Enron] stock options, flipping acquisitions for quick sale. One executive sold a total of $353 million in the 3-year period preceding the failure. What did he know? When did he know it? And why didn’t we?1
Although company executives were involved in questionable business practices and even fraud, Enron’s failure was ultimately due to a collapse of investor, customer, and trading partner confidence. In the boom years of the late 1990’s, Enron entered into a number of aggressive transactions involving “special purpose entities” (SPEs) for which the underlying accounting was questionable or fraudulent. Some of these transactions essentially involved Enron receiving borrowed funds without recording liabilities on the company’s balance sheet. Instead, the inflow of funds was made to look like it came from the sale of assets. The “loans” were guaranteed with Enron stock, trading at over $100 per share at the time. The company found itself in real trouble when, simultaneously, the business deals underlying these transactions went sour and Enron’s stock price plummeted. Debt holders began to call the loans due to Enron’s diminished stock price, and the company found its underlying financial positions increasingly difficult to maintain and its accounting increasingly untenable.
The August 2001 resignation of Enron’s chief executive officer (CEO), Jeffrey Skilling, only six months after beginning his “dream job” further fueled Wall Street skepticism and scrutiny over company operations. Shortly thereafter, The Wall Street Journal’s “Heard on the Street” column of August 28, 2001 drew further attention to the company, igniting a public fire storm of controversy that quickly undermined the company’s reputation. The subsequent loss of confidence by trading partners and customers quickly dried up Enron’s trading volume, and the company found itself facing a liquidity crisis by late 2001.
Skilling summed it up this way when he testified before the House Energy Commerce Committee on February 7, 2002:
It is my belief that Enron’s failure was due to a classic ‘run on the bank:’ a liquidity crisis spurred by a lack of confidence in the company. At the time of Enron’s collapse, the company was solvent and highly profitable - but, apparently, not liquid enough.That is my view of the principal cause of its failure.2
Public disclosure of diminishing liquidity and questionable management decisions and accounting practices destroyed the trust Enron had established within the business community. This caused hundreds of trading partners, clients, and suppliers to suspend doing business with the company—ultimately leading to its downfall.
Enron’s collapse, along with events related to the audits of Enron’s financial statements, caused a similar loss of reputation, trust, and confidence in Big-5 accounting firm, Andersen, LLP. Enron’s collapse and the associated revelations of alleged aggressive and inappropriate accounting practices caused major damage for this previously acclaimed firm. News about charges of inappropriate destruction of documents at the Andersen office in Houston, which housed the Enron audit, and the subsequent unprecedented federal indictment was the kiss of death. Andersen’s clients quickly lost confidence in the firm, and by June 2002, more than 400 of its largest clients had fired the firm as their auditor, leading to the sale or desertion of various pieces of Andersen’s
U.S. and international practices. On June 15th, a federal jury in Houston convicted Andersen on one felony count of obstructing the SEC’s investigation into Enron’s collapse. Soon after the June 15, 2002 verdict, Andersen announced it would cease auditing publicly owned clients by August 31. Although the U.S. Supreme Court later overturned the decision in May 2005, the reversal came nearly three years after Andersen was essentially dead. Thus, like Enron, in an astonishingly short period of time Andersen went from being one of the world’s largest and most respected business organizations into oblivion.
Because of the Congressional hearings and intense media coverage, along with the tremendous impact the company’s collapse had on the corporate community and on the accounting profession, the name “Enron” will reverberate for decades to come. Here is a brief analysis of the fall of these two giants.
ENRON IN THE BEGINNING
Enron Corporation, based in Houston, Texas, was formed as a result of the July 1985 merger of Houston Natural Gas and InterNorth of Omaha, Nebraska. In its early years, Enron was a natural gas pipeline company whose primary business strategy involved entering into contracts to deliver specified amounts of natural gas to businesses or utilities over a given period of time. In 1989, Enron began trading natural gas commodities. After the deregulation of the electrical power markets in the early 1990s—a change for which senior Enron officials lobbied heavily—Enron swiftly evolved from a conventional business that simply delivered energy, into a “new economy” business heavily involved in the brokerage of speculative energy futures. Enron acted as an intermediary by entering into contracts with buyers and sellers of energy, profiting by arbitraging price differences. Enron began marketing electricity in the U.S. in 1994, and entered the European energy market in 1995.
In 1999, at the height of the Internet boom, Enron furthered its transformation into a “new economy” company by launching Enron Online, aWeb-based commodity trading site. Enron also broadened its technological reach by entering the business of buying and selling access to high-speed Internet bandwidth. At its peak, Enron owned a stake in nearly 30,000 miles of gas pipelines, owned or had access to a 15,000-mile fiber optic network, and had a stake in several electricity-generating operations around the world. In 2000, the company reported gross revenues of $101 billion.
Enron continued to expand its business into extremely complex ventures by offering a wide variety of financial hedges and contracts to customers. These financial instruments were designed to protect customers against a variety of risks, including events such as changes in interest rates and variations in weather patterns. The volume of transactions involving these instruments grew rapidly and actually surpassed the volume of Enron’s traditional contracts involving delivery of physical commodities (such as natural gas) to customers. To ensure that Enron managed the risks related to these “new economy” instruments, the company hired a large number of experts in the fields of actuarial science, mathematics, physics, meteorology, and economics.3
Within a year of its launch, Enron Online was handling more than $1 billion in transactions daily. The website became a marketplace for buyers and sellers of various commodities to meet. The site’s success depended on cutting-edge technology and more importantly on the trust the company developed with its customers and partners who expected Enron to follow through on its price and delivery promises.
When the company’s accounting shenanigans were brought to light, customers, investors, and other partners ceased trading through the energy giant because they lost confidence in Enron’s ability to fulfill its obligations and act with integrity in the marketplace.
ENRON’S COLLAPSE
On August 14, 2001, Kenneth Lay was reinstated as Enron’s CEO after Jeffrey Skilling resigned for “purely personal” reasons after having served for only a six-month period as CEO. Skilling had joined Enron in 1990 after leading McKinsey & Company’s energy and chemical consulting practice and had become Enron’s president and chief operating officer in 1996. Skilling had been appointed CEO in early 2001 to replace Lay, who had served as chairman and CEO since 1986.4
Skilling’s resignation proved to mark the beginning of Enron’s collapse. The day after Skilling resigned, Enron's vice president of corporate development, SherronWatkins, sent an anonymous letter to newly reinstated CEO, Kenneth Lay (see Exhibit 1). In the letter, Ms. Watkins detailed her fears that Enron “might implode in a wave of accounting scandals.” When the letter later became public, Ms.Watkins was celebrated as an honest and loyal employee who tried to save the company through her whistle-blowing efforts.
EXHIBIT 1: SHERRON WATKINS LETTER TO ENRON CEO, KENNETH LAY
Dear Mr. Lay,
Has Enron become a risky place to work? For those of us who didn’t get rich over the last few years, can we afford to stay?
Skilling’s abrupt departure will raise suspicions of accounting improprieties and valuation issues. Enron has been very aggressive in its accounting - most notably the Raptor transactions and the Condor vehicle. We do have valuation issues with our international assets and possibly some of our EES MTM positions.
The spotlight will be on us, the market just can’t accept that Skilling is leaving his dream job. I think that the valuation issues can be fixed and reported with other goodwill write-downs to occur in 2002. How do we fix the Raptor and Condor deals? They unwind in 2002 and 2003, we will have to pony up Enron stock and that won’t go unnoticed.
To the layman on the street, it will look like we recognized funds flow of $800 mm from merchant asset sales in 1999 by selling to a vehicle (Condor) that we capitalized with a promise of Enron stock in later years. Is that really funds flow or is it cash from equity issuance?
We have recognized over $550 million of fair value gains on stocks via our swaps with Raptor, much of that stock has declined significantly - Avici by 98%, from $178 mm to $5 mm, The New Power Co by 70%, from $20/share to $6/share. The value in the swaps won’t be there for Raptor, so once again Enron will issue stock to offset these losses. Raptor is an LJM entity. It sure looks to the layman on the street that we are hiding losses in a related company and will compensate that company with Enron stock in the future.
I am incredibly nervous that we will implode in a wave of accounting scandals. My 8 years of Enron work history will be worth nothing on my resume, the business world will consider the past successes as nothing but an elaborate accounting hoax. Skilling is resigning now for ‘personal reasons’ but I think he wasn’t having fun, looked down the road and knew this stuff was unfixable and would rather abandon ship now than resign in shame in 2 years.
Is there a way our accounting gurus can unwind these deals now? I have thought and thought about how to do this, but I keep bumping into one big problem - we booked the Condor and Raptor deals in 1999 and 2000, we enjoyed a wonderfully high stock price, many executives sold stock, we then try and reverse or fix the deals in 2001 and it’s a bit like robbing the bank in one year and trying to pay it back 2 years later. Nice try, but investors were hurt, they bought at $70 and $80/share looking for $120/share and now they’re at $38 or worse. We are under too much scrutiny and there are probably one or two disgruntled ‘redeployed’ employees who know enough about the ‘funny’ accounting to get us in trouble.
What do we do? I know this question cannot be addressed in the all-employee meeting, but can you give some assurances that you and Causey will sit down and take a good hard objective look at what is going to happen to Condor and Raptor in 2002 and 2003?
Watkins, Sherron. Letter to Kenneth Lay, CEO. 15 Aug. 2001 (1st page only) http://www.justice.gov/archive/enron/exhibit/03-15/BBC-0001/Images/9811.001.PDF
Two months later, Enron reported a 2001 third quarter loss of $618 million and a reduction of $1.2 billion in shareholder equity related to partnerships run by chief financial officer (CFO), Andrew Fastow. Fastow had created and managed numerous off-balance-sheet partnerships for Enron, which also benefited him personally. In fact, during his tenure at Enron, Fastow collected approximately $30 million in management fees from various partnerships related to Enron.
News of the company’s third quarter losses resulted in a sharp decline in Enron’s stock value. Lay even called U.S. Treasury Secretary, Paul O’Neill, on October 28 to inform him of the company’s financial difficulties. Those events were then followed by a November 8th company announcement of even worse news—Enron had overstated earnings over the previous four years by $586 million and owed up to $3 billion for previously unreported obligations to various partnerships.This news sent the stock price further on its downward slide.
Despite these developments, Lay continued to tell employees that Enron’s stock was undervalued. Ironically, he was also allegedly selling portions of his own stake in the company for millions of dollars. Lay was one of the few Enron employees who managed to sell a significant portion of his stock before the stock price collapsed completely. In August 2001, for example, he sold 93,000 shares for a personal gain of over $2 million.
Sadly, most Enron employees did not have the same chance to liquidate their Enron investments. Most of the company employees’ personal 401(k) accounts included large amounts of Enron stock. When Enron changed 401(k) administrators at the end of October 2001, employee retirement plans were temporarily frozen. Unfortunately, the November 8th announcement of prior period financial statement misstatements occurred during the freeze, paralyzing company employee 401(k) plans. When employees were finally allowed access to their plans, the stock had fallen below $10 per share from earlier highs exceeding $100 per share.
Corporate “white knights” appeared shortly thereafter, spurring hopes of a rescue. Dynegy Inc. and ChevronTexaco Corp. (a major Dynegy shareholder) almost spared Enron from bankruptcy when they announced a tentative agreement to buy the company for $8 billion in cash and stock. Unfortunately, Dynegy and ChevronTexaco later withdrew their offer after Enron’s credit rating was downgraded to “junk” status in late November. Enron tried unsuccessfully to prevent the downgrade, and allegedly asked the Bush administration for help in the process.
After Dynegy formally rescinded its purchase offer, Enron filed for Chapter 11 bankruptcy on December 2, 2001. This announcement pushed the company’s stock price down to $0.40 per share. On January 15, 2002, the NewYork Stock Exchange suspended trading in Enron’s stock and began the process to formally de-list it.
It is important to understand that a large portion of the earnings restatements may not technically have been attributable to improper accounting treatment. So, what made these enormous restatements necessary? In the end, the decline in Enron’s stock price triggered contractual obligations that were never reported on the balance sheet, in some cases due to “loopholes” in accounting standards, which Enron exploited. An analysis of the nuances of Enron’s partnership accounting provides some insight into the unraveling of this corporate giant.
Unraveling the “Special Purpose Entity” Web
The term “special purpose entity” (SPE) has become synonymous with the Enron collapse because these entities were at the center of Enron’s aggressive business and accounting practices. SPEs are separate legal entities set up to accomplish specific company objectives. For example, SPEs are sometimes created to help a company sell off assets. After identifying which assets to sell to the SPE, under the rules existing in 2001, the selling company would secure an outside investment of at least three percent of the value of the assets to be sold to the SPE.5 The company would then transfer the identified assets to the SPE. The SPE would pay for the contributed assets through a new debt or equity issuance.The selling company could then recognize the sale of the assets to the SPE and thereby remove the assets and any related debts from its balance sheet.The validity of such an arrangement is, of course, contingent on the outside investors bearing the risk of their investment. In other words, the investors are not permitted to finance their interest through a note payable or other type of guarantee that might absolve them from accepting responsibility or shift responsibility back to the seller if the SPE suffers losses or fails.6
While SPEs are fairly common in corporate America, they have been controversial. Some argued at the time that SPEs represented a major loophole in accounting standards. Accounting rules now dictate that once a company owns 50% or more of another, the company must consolidate, thus including the related entity in its own financial statements. However, such was not the case with SPEs in 2001.
While SPEs can serve legitimate business purposes, it is now apparent that Enron used an intricate network of SPEs, along with complicated speculations and hedges—all couched in dense legal language—to keep an enormous amount of debt off the company’s balance sheet. Enron had literally hundreds of SPEs. Through careful structuring of these SPEs that took into account the complex accounting rules governing their required financial statement treatment, Enron was able to avoid consolidating the SPEs on its balance sheet.Three of the Enron SPEs have been made prominent throughout the congressional hearings and litigation proceedings. These SPEs were widely known as “Chewco,” “LJM2,” and “Whitewing.”
Chewco was established in 1997 by Enron executives in connection with a complex investment in another Enron partnership with interests in natural gas pipelines. Enron’s CFO, Andrew Fastow, was charged with managing the partnership. However, to prevent required disclosure of a potential conflict of interest between Fastow’s roles at Enron and Chewco, Fastow employed Michael Kopper, managing director of Enron Global Finance, to “officially” manage Chewco. In connection with the Chewco partnership, Fastow and Kopper appointed Fastow relatives to the board of directors of the partnership. Then, in a set of complicated transactions, another layer of partnerships was established to disguise Kopper’s invested interest in Chewco. Kopper originally invested $125,000 in Chewco and was later paid $10.5 million when Enron bought Chewco in March 2001.7 Surprisingly, Kopper remained relatively unknown throughout the subsequent investigations. In fact, Ken Lay told investigators that he did not know Kopper. Kopper was able to continue in his management roles through January 2002.8
The LJM2 partnership was formed in October 1999 with the goal of acquiring assets chiefly owned by Enron. Like Chewco, LJM2 was managed by Fastow and Kopper. To assist with the legal and accounting technicalities of this partnership, LJM2 engaged PricewaterhouseCoopers, LLP and the Chicago-based law firm, Kirkland & Ellis. Enron used the LJM2 partnership to take its less-productive assets and associated debts off its balance sheet.These actions initially generated a 30 percent average annual return for the LJM2 limited-partner investors.
The Whitewing partnership, another significant SPE established by Enron, purchased an assortment of power plants, pipelines, and water projects originally purchased by Enron in the mid-1990s that were located in India, Turkey, Spain, and Latin America. The Whitewing partnership was crucial to Enron’s move from being an energy provider to becoming a trader of energy contracts.Whitewing was the vehicle through which Enron "sold" many of its physical energy production assets.
In creating this partnership, Enron quietly guaranteed investors in Whitewing that if Whitewing’s assets (transferred from Enron) were sold at a loss, Enron would compensate the investors with shares of Enron common stock. This obligation—unknown to Enron’s shareholders—totaled $2 billion as of November 2001. Part of the secret guarantee to Whitewing investors surfaced in October 2001, when Enron’s credit rating was downgraded by credit agencies. The credit downgrade triggered a requirement that Enron immediately pay
$690 million to Whitewing investors. It was when this obligation surfaced that Enron’s talks with Dynegy failed. Enron was unable to delay the payment and was forced to disclose the problem, stunning investors and fueling the fire that led to the company’s bankruptcy filing only two months later.
In addition to these partnerships, Enron created financial instruments called “Raptors,” which were backed by Enron stock and were designed to reduce the risks associated with Enron’s own investment portfolio. In essence, the Raptors covered potential losses on Enron investments as long as Enron’s stock price continued to hold up. Enron also masked debt using complex financial derivative transactions.Taking advantage of accounting rules to account for large loans from Wall Street firms as financial hedges, Enron hid $3.9 billion in debt from 1992 through 2001. At least $2.5 billion of those transactions arose in the three years prior to the Chapter 11 bankruptcy filing. These loans were in addition to the $8 to $10 billion in long and short-term debt that Enron disclosed in its financial reports in the three years leading up to its bankruptcy. Because the loans were accounted for as a hedging activity, Enron was able to explain away what looked like an increase in borrowings, (which would raise red flags for creditors), as hedges for commodity trades, rather than as new debt financing.9
The Complicity of Accounting Standards.
Limitations in generally accepted accounting principles (GAAP) are at least partly to blame for Enron executives’ ability to hide debt, keeping it off the company’s financial statements. These technical accounting standards lay out specific “bright-line” rules that read much like the tax or criminal law codes. Some observers of the profession argue that by attempting to outline every accounting situation in detail, standard-setters were trying to create a specific decision model for every imaginable situation. However, very specific rules create an opportunity for clever lawyers, investment bankers, and accountants to create entities and transactions that circumvent the intent of the rules while still conforming to the “letter of the law.”
In his congressional testimony, Robert K. Herdman, SEC Chief Accountant at the time, discussed the difference between rule- and principle-based accounting standards:
Rule-based accounting standards provide extremely detailed rules that attempt to contemplate virtually every application of the standard. This encourages a check-the-box mentality to financial reporting that eliminates judgments from the application of the reporting. Examples of rule-based accounting guidance include the accounting for derivatives, employee stock options, and leasing. And, of course, questions keep coming. Rule-based standards make it more difficult for preparers and auditors to step back and evaluate whether the overall impact is consistent with the objectives of the standard.10
In some cases it is clear that Enron neither abode by the spirit nor the letter of these accounting rules (for example, by securing outside SPE investors against possible losses). It also appears that the company’s lack of disclosure regarding Fastow’s involvement in the SPEs fell short of accounting rule compliance.
These “loopholes” allowed Enron executives to keep many of the company’s liabilities off the financial statements being audited by Andersen, LLP. Given the alleged abuse of the accounting rules, many asked, “Where was Andersen, the accounting firm that was to serve as Enron’s public ‘watchdog,’ while Enron allegedly betrayed and misled its shareholders?”
THE ROLE OF ANDERSEN
It is clear that investors and the public believed that Enron executives were not the only parties responsible for the company’s collapse. Many fingers also pointed to Enron’s auditor, Andersen, LLP, which issued “clean” audit opinions on Enron’s financial statements from 1997 to 2000 but later agreed that a massive earnings restatement was warranted. Andersen’s involvement with Enron ultimately destroyed the accounting firm— something the global business community would have thought next to impossible prior to 2001. Ironically, Andersen ceased to exist for the same essential reasons Enron failed–the company lost the trust of its clients and other business partners.
Andersen in the Beginning
Andersen was originally founded as Andersen, Delaney & Co. in 1913 by Arthur Andersen, an accounting professor at Northwestern University in Chicago. By taking tough stands against clients' aggressive accounting treatments, Andersen quickly gained a national reputation as a reliable keeper of the public’s trust:
In 1915,Andersen took the position that the balance sheet of a steamship-company client had to reflect the costs associated with the sinking of a freighter, even though the sinking occurred after the company’s fiscal year had ended but before Andersen had signed off on its financial statements. This marked the first time an auditor had demanded such a degree of disclosure to ensure accurate reporting.11
Although Andersen’s storied reputation began with its founder, the accounting firm continued the tradition for years. An oft-repeated mantra at Andersen was, “there’s the Andersen way and there's the wrong way.” Another was “do the right thing.” Andersen was the only one of the major accounting firms to back reforms in the accounting for pensions in the 1980s, a move opposed by many corporations, including some of its own clients.12 Ironically, prior to the Enron debacle, Andersen had also previously taken an unpopular public stand to toughen the very accounting standards that Enron exploited in using SPEs to keep debt off its balance sheets.
Andersen’s Loss of Reputation
While Andersen previously had been considered the cream of the crop of accounting firms, just prior to the Enron disaster Andersen’s reputation suffered from a number of high profile SEC investigations launched against the firm. The firm was investigated for its role in the financial statement audits of Waste Management, Global Crossing, Sunbeam, Qwest Communications, Baptist Foundation of Arizona, and WorldCom. In May 2001, Andersen paid $110 million to settle securities fraud charges stemming from its work at Sunbeam. In June 2001, Andersen entered a no-fault, no-admission-of-guilt plea bargain with the SEC to settle charges of Andersen’s audit work on Waste Management, Inc. for $7 million. Andersen later settled with investors of the Baptist Foundation of Arizona for $217 million without admitting fault or guilt (the firm subsequently reneged on the agreement because the firm was in liquidation). Due to this string of negative events and associated publicity, Andersen found its once-applauded reputation for impeccable integrity questioned by the market for assurance services, where integrity, independence, and reputation are the primary attributes affecting demand for a firm’s services.
Andersen at Enron
By 2001, Enron had become one of Andersen’s largest clients. Despite the firm’s recognition that Enron was a high-risk client, Andersen apparently had difficulty sticking to its guns at Enron. The accounting firm had identified $51 million of misstatements in Enron's financial statements but decided not to require corrections when Enron balked at making the adjustments Andersen proposed. Those adjustments would have decreased Enron's income by about half, from $105 million to $54 million--clearly a material amount--but Andersen gave Enron's financial statements a clean opinion nonetheless.13
Andersen's chief executive, Joseph F. Berardino, testified before the U.S. Congress that, after proposing the $51 million of adjustments to Enron’s 1997 results, the accounting firm decided that those adjustments were not material.14 Congressional hearings and the business press alleged that Andersen was unable to stand up to Enron because of the conflicts of interest that existed due to large fees and the mix of services Andersen provided to Enron.
In 2000, Enron reported that it paid Andersen $52 million—$25 million for the financial statement audit work and $27 million for consulting services.Andersen not only performed the external financial statement audit, but also carried out Enron’s internal audit function, a relatively common practice in the accounting profession before the Sarbanes-Oxley Act of 2002. Ironically, Enron’s 2000 annual report disclosed that one of the major projects Andersen performed in 2000 was to examine and report on management’s assertion about the effectiveness of Enron’s system of internal controls, a service not required in the days prior to the Sarbanes- Oxley Act of 2002.
Comments by investment billionaire, Warren E. Buffett, summarize the perceived conflict that often arises when auditors receive significant fees from clients: “Though auditors should regard the investing public as their client, they tend to kowtow instead to the managers who choose them and dole out their pay.” Buffett continued by quoting an old saying: “Whose bread I eat, his song I sing.” 15
It also appears that Andersen knew about Enron’s problems nearly a year before the downfall. According to a February 6, 2001 internal firm e-mail, Andersen considered dropping Enron as a client due to the risky nature of its business practices and its "aggressive" structuring of transactions and related entities. The e-mail, which was written by an Andersen partner to David Duncan, partner in charge of the Enron audit, detailed the discussion at an Andersen meeting about the future of the Enron engagement.
The Andersen Indictment
Although the massive restatements of Enron’s financial statements cast serious doubt on Andersen’s professional conduct and audit opinions, ultimately it was the destruction of Enron-related documents in October and November 2001 and the resulting March 2002 federal indictment of Andersen that led to the firm’s rapid downward spiral. The criminal charge against Andersen was for obstruction of justice for destroying documents after the federal investigation had begun into the Enron collapse. According to the indictment, Andersen allegedly eliminated potentially incriminating evidence by shredding massive amounts of Enron-related audit workpapers and documents. The government alleged that Andersen partners in Houston were directed by the firm’s national office legal counsel in Chicago to shred the documents. The U.S. Justice Department contended that Andersen illegally continued to shred Enron documents after it knew of the SEC investigation, but before a formal subpoena was received by Andersen. The shredding stopped on November 8th when Andersen received the SEC’s subpoena for all Enron-related documents.
Andersen denied that its corporate counsel recommended such a course of action and assigned the blame for the document destruction to a group of rogue employees in its Houston office seeking to save their own reputations. The evidence is unclear as to exactly who ordered the shredding of the Enron documents or even what documents were shredded.
However, central to the Justice Department’s indictment was an email forwarded from Nancy Temple, Andersen’s corporate counsel in Chicago, to David Duncan, the Houston-based Enron engagement partner. The body of the email states, “It might be useful to consider reminding the engagement team of our documentation and retention policy. It will be helpful to make sure that we have complied with the policy. Let me know if you have any questions.”16
The Justice Department argued that Andersen’s general counsel’s email was a thinly veiled directive from Andersen headquarters to ensure that all Enron-related documents that should have previously been destroyed according to the firm’s policy were destroyed. Andersen contended that the infamous Nancy Temple memo simply encouraged adherence to normal engagement documentation policy, including the explicit need to retain documents in certain situations and was never intended to obstruct the government’s investigation. However, it is important to understand that once an individual or a firm has reason to believe that a federal investigation is forthcoming, it is considered obstruction of justice to destroy documents that might serve as evidence, even before an official subpoena is filed.
In January 2002,Andersen fired Enron engagement partner David Duncan, for his role in the document shredding activities. Duncan later testified that he did not initially think that what he did was wrong and initially maintained his innocence in interviews with government prosecutors. He even signed a joint defense agreement with Andersen on March 20, 2002. Shortly thereafter, Duncan decided to plead guilty to obstruction of justice charges after “a lot of soul searching about my intent and what was in my head at the time.” 17
In the obstruction of justice trial against Andersen, Duncan testified for the Federal prosecution team, admitting that he ordered the destruction of documents because of the email he received from Andersen’s counsel reminding him of the company’s document retention policy. He also testified that he wanted to get rid of documents that could be used by prosecuting attorneys and SEC investigators.18
Although convicted of obstruction of justice, Andersen continued to pursue legal recourse by appealing the verdict to the Fifth U.S. Circuit Court of Appeals in New Orleans. The Fifth Court refused to overturn the verdict, so Andersen appealed to the U.S. Supreme Court.The firm claimed that the trial judge “gave jurors poor guidelines for determining the company’s wrongdoing in shredding documents related to Enron Corp.”19 The Supreme Court agreed with Andersen and on May 31, 2005, the Court overturned the lower court’s decision.
Sadly, the Supreme Court’s decision had little effect on the future of Arthur Andersen. By 2005, Andersen employed only 200 people, most of whom were involved in fighting the remaining lawsuits against the firm and managing its few remaining assets. However, the ruling may have helped individual Arthur Andersen partners in civil suits named against them personally. The ruling also may have made it more difficult for the government to pursue future cases alleging obstruction of justice against individuals and companies.
The End of Andersen
In the early months of 2002, Andersen pursued the possibility of being acquired by one of the other four Big-5 accounting firms: PricewaterhouseCoopers, Ernst & Young, KPMG, or Deloitte & Touche. The most seriously considered possibility was an acquisition of the entire collection of Andersen partnerships by Deloitte &Touche, but the talks fell through only hours before an official announcement of the acquisition was scheduled to take place. The biggest barrier to an acquisition of Andersen apparently centered around fears that an acquirer would assume Andersen’s liabilities and responsibility for settling future Enron-related lawsuits.
In the aftermath of Enron’s collapse, Andersen began to unravel quickly, losing over 400 publicly traded clients by June 2002—including many high-profile clients with which Andersen had enjoyed long relationships.20 The list of former clients includes Delta Air Lines, FedEx, Merck, SunTrust Banks, Abbott Laboratories, Freddie Mac, and Valero Energy Corp. In addition to losing clients, Andersen lost many of its global practice units to rival accounting and consulting firms, and agreed to sell a major portion of its consulting business to KPMG consulting for $284 million as well as most of its tax advisory practice to Deloitte & Touche.
On March 26, 2002, Joseph Berardino, CEO of AndersenWorldwide, resigned as CEO, but remained with the firm. In an attempt to salvage the firm, Andersen hired former Federal Reserve chairman, Paul Volcker, to head an oversight board to make recommendations to rebuild Andersen. Mr. Volcker and the board recommended that Andersen split its consulting and auditing businesses and that Volcker and the seven-member board take over Andersen in order to realign firm management and to implement reforms. The success of the oversight board depended on Andersen’s ability to stave off criminal charges and settle lawsuits related to its work on Enron. Because Andersen failed to persuade the justice department to withdraw its charges, Mr. Volcker suspended the board’s efforts to rebuild the firm in April 2002.
Andersen faced an uphill battle in its fight against the federal prosecutors’ charges of a felony count for obstruction of justice, regardless of the trial’s outcome. Never in the 215-year history of the U.S. financial system had a major financial-services firm survived a criminal indictment, and Andersen would not likely have been the first, even had the firm not actually been convicted of a single count of obstruction of justice on June 15, 2002. Andersen, along with many others, accused the justice department of a gross abuse of governmental power, and announced that it would appeal the conviction. However, the firm ceased to audit publicly held clients by August 31, 2002.
On May 31, 2005, the U.S. Supreme Court unanimously reversed Andersen's convictions. The main reason given for the reversal was that the instructions given to the jury "failed to convey properly the elements of 'corrupt persuasion'."21
REQUIRED
[1] In your own words, summarize how Enron used SPEs to hide large amounts of company debt.
[2] What were the business risks Enron faced, and how did those risks increase the likelihood of material misstatements in Enron’s financial statements?
[3] (a) What are the responsibilities of a company’s board of directors?
(b) Do you think the board of directors at Enron—especially the audit committee—could have prevented the fall of Enron?
(c) Should they have known about the risks and apparent lack of independence with Enron’s SPEs? What do you think they should have done about it?
[4] Explain how “rules-based” accounting standards differ from “principles-based” standards. How might fundamentally changing accounting standards from “bright-line” rules to principles-based standards help prevent another Enron-like fiasco in the future? Some argue that the trend toward convergence with or even adoption of international accounting standards represents a move toward more “principles-based” standards. Are there dangers in removing “bright-line” rules? What difficulties might be associated with such a change?
[5] What are the current auditor independence issues surrounding the provision of external auditing services, internal auditing services, and management consulting services for the same client? Develop arguments for why auditors should be allowed to perform these services for the same client. Develop separate arguments for why auditors should not be allowed to perform non-audit services for their audit clients. What is your view of the arguments on both sides, which side do you take, and why?
[6] A perceived lack of integrity caused irreparable damage to both Andersen and Enron. How can you apply the principles learned in this case personally? As part of your answer, generate an example of how involvement in unethical or illegal activities, or even the appearance of such involvement, might affect your career. What are the possible consequences when others question your integrity? What can you do to preserve your reputation throughout your career?
[7] Enron and Andersen suffered severe consequences because of their perceived lack of integrity and damaged reputations. In fact, some people believe the fall of Enron occurred because of a form of “run on the bank.” Some argue that Andersen experienced a similar “run on the bank” as many top clients quickly dropped the firm in the wake of Enron’s collapse. Is the “run on the bank” analogy valid for both firms? Why or why not?
[8] Why do audit partners struggle with making tough accounting decisions that may be contrary to their client’s position on an issue? What changes do you think the profession could make to eliminate or minimize these obstacles?