UW Business Law Ethical Perspectives on Enron Question

INTRODUCTION: Enron
Overview
Why are you required to take a class on business ethics? Enron! This week, we’re learning all
about the scandal that sparked interest in business ethics, and served as a catalyst for
introducing business ethics courses into MBA and undergraduate business curricula. All
necessary material for the week can be found in this Module. Note that there is no lecture video
for this week. Rather, you will be watching an amazing movie that covers the Enron scandal.
Links for this movie can be found in the Roadmap for the week, along with summaries of all
other required activities.
Week: 9
Topic: Enron
WATCH

The Smartest Guys in the Room
o Tubi (free with ads):
https://tubitv.com/movies/462800/enron_the_smartest_guys_in_the_room
?
o YouTube ($2.99 rental):

READ

Textbook, 4.20, 4.21
DISCUSS

No discussion this week.
ASSIGNMENTS

Reflection paper: Some believe that the misbehavior at Enron was attributable to
“bad apples”—people who would have acted unethically no matter where they
worked. Others believe that the misbehavior at Enron stemmed from contextual
factors (e.g., company culture, incentives, lax regulations, etc.) that would have
led many people to act unethically if they were in the same situation. Which
perspective(s) do you agree with? Provide evidence from the film or textbook
reading to support your position.
Submissions should be 1-2 pages long in 12-point font, Times New Roman, and
double-spaced. Due 11/30.
INTRODUCTION: Enron
Overview
Why are you required to take a class on business ethics? Enron! This week, we’re learning all
about the scandal that sparked interest in business ethics, and served as a catalyst for
introducing business ethics courses into MBA and undergraduate business curricula. All
necessary material for the week can be found in this Module. Note that there is no lecture video
for this week. Rather, you will be watching an amazing movie that covers the Enron scandal.
Links for this movie can be found in the Roadmap for the week, along with summaries of all
other required activities.
VIDEO: The Smartest Guys in the Room
The Smartest Guys in the Room
Tubi (free with ads): https://tubitv.com/movies/462800/enron_the_smartest_guys_in_the_room?
Required readings
Textbook, 4.20, 4.21
ASSIGNMENT: Reflection paper #4
Some believe that the misbehavior at Enron was attributable to “bad apples”—people who
would have acted unethically no matter where they worked. Others believe that the misbehavior
at Enron stemmed from contextual factors (e.g., company culture, incentives, lax regulations,
etc.) that would have led many people to act unethically if they were in the same situation.
Which perspective(s) do you agree with? Provide evidence from the film or textbook reading to
support your position.
The Industry Practices and Legal Factors
Section E
281
back in the Weill days and is necessary now as it moves forward and sheds the Weill and
Prince shadows and styles. Indeed, all the boards may want to revisit the notion of
expertise: Why did no one on the boards question the risk, the numbers, the operations,
or even, just three months prior to the announcements of the write-downs, whether the
subprime meltdown would affect their companies’ financials? An even more basic question is Why did the board members not take the time to understand the definitions and
risks of the instruments that were the cornerstone of the companies’ portfolios?
“The Sage Advice Lost in the Computer Models”
Even without the common traits analysis, we have some simpler principles that would
have helped the boards, the media, the analysts, and even the investors in these banks.
That old adage applies: “If it sounds too good to be true, it is too good to be true.” The
kinds of returns that the banks and their investors were enjoying on investments based
on subprime loans were too high to not have high risk associated with them. They simply had not been transparent about that risk.
There is another simple lesson, which is that there is no substitute for learning not
just what the numbers are, but how staff got to those numbers. In looking at the companies that have had the least impact we find that, as noted earlier, there was a culture of
“How exactly did you get these numbers?”—a natural and ongoing skepticism that signaled employees that the numbers had to be supportable, not just within range. The
value of dissent in companies had been vastly underestimated and underutilized.
One final lesson was noted in the introduction. A sustainable competitive business
model cannot be based on taking advantage of those with less information. A market
works, not because of asymmetrical information, but because of transparency. That
transparency was not there at the point of the subprime loan negotiations and the fog
carried through to the risk evaluation as well as the valuations of the collateralized mortgage bonds themselves. Throughout the chain, the terms, the value, and the risk were not
clear to the players. Such failure to disclose is neither the stuff of ethics nor of thriving
markets. The subprime mess, when all is said and done, comes down to the basic ethical
standard of forthrightness at all levels of companies and throughout the market.
Discussion Questions
1. What was not clear to investors in subprime
mortgages?
2. How could the adage “If it sounds too good to be
true …” influence the structure of an investment
portfolio?
3. What is the role of boards in curbing unethical
behavior at companies?
Case 4.20
Enron: The CFO, Conflicts, and Cooking
the Books with Natural Gas and Electricity349
Introduction
Enron Corp. was an energy company that was incorporated in Oregon in 1985, with its
principal executive offices located in Houston, Texas. By the end of 2001, Enron Corp.
349
Adapted from Marianne M. Jennings, “A Primer on ENRON: Lessons from a Perfect Storm of Financial Reporting,
Corporate Governance and Ethical Culture Failures,” 39 California Western Law Review 163 (2003).
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282
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was the world’s largest energy company, holding 25 percent of all of the world’s energy
trading contracts.350 Enron’s own public relations materials described it as “one of the
world’s leading electricity, natural gas, and communications companies” that “markets
electricity and natural gas, delivers physical commodities and financial and risk management services to companies around the world, and has developed an intelligent network
platform to facilitate online business.”351 Enron was also one of the world’s most
admired corporations, holding a consistent place in Fortune magazine’s 100 best companies to work for. The sign in the lobby of Enron’s headquarters read, “WORLD’S LEADING COMPANY.”352 Employees at Enron’s headquarters had access to an on-site health
club, subsidized Starbucks coffee, concierge service that included massages, and car
washes, all for free.353 Those employees with Enron Broadband received free Palm Pilots,
free cell phones, and free wireless laptops.354
In November 2001, a week following credit agencies’ downgrading of its debt to
“junk” grade, Enron filed for bankruptcy. At that time, it was the largest bankruptcy
($62 billion) in the history of the United States.355 Since then, it has dropped and is
now just one of the ten largest bankruptcies in the history of the United States.
Background on Enron
Enron began as the merger of two gas pipelines, Houston Natural Gas and Internorth,
orchestrated by Kenneth Lay, and emerged as an energy trading company. Poised to
ride the wave of deregulation of electricity, Enron would be a power supplier to utilities.
It would trade in energy and offer electricity for sale around the country by locking in
supply contracts at fixed prices and then hedging on those contracts in other markets.
There are few who dispute that its strategic plan at the beginning showed great foresight
and that its timing for market entry was impeccable. It was the first mover in this market
and enjoyed phenomenal growth. It became the largest energy trader in the world, with
$40 billion in revenue in 1998, $60 billion in 1999, and $101 billion in 2000. Its internal
strategy was to grow revenue by 15 percent per year.356
When Enron rolled out its online trading of energy as a commodity, it was as if there
had been a Wall Street created for energy contracts. Enron itself had 1,800 contracts in
that online market. It had really created a market for weather futures so that utilities
could be insulated by swings in the weather and the resulting impact on the prices of
power. It virtually controlled the energy market in the United States. By December
2000, Enron’s shares were selling for $85 each. Its employees had their 401(k)s heavily
invested in Enron stock, and the company had a matching program in which it contributed additional shares of stock to savings and retirement plans when employees chose to
fund them with Enron stock.
When competition began to heat up in energy trading, Enron began some diversification activities that proved to be disasters in terms of producing earnings. It acquired a
water business that collapsed nearly instantaneously. It also had some international
350
Noelle Knox, “Enron to Fire 4,000 from Headquarters,” USA Today, December 4, 2001, p. 1B.
351
From the class action complaint filed in the Southern District of Texas, Kaufman v. Enron, 761 F. Supp.2d 504 (S.D.
Tex. 2011).
352
Bethany McClean, “Why Enron Went Bust,” Fortune, December 24, 2001, pp. 59–72.
353
Alexei Barrionuevo, “Jobless in a Flash, Enron’s Ex-Employees Are Stunned, Bitter, Ashamed,” Wall Street Journal,
December 11, 2001, pp. B1, B12.
354
Id.
355
Richard A. Oppel Jr. and Riva D. Atlas, “Hobbled Enron Tries to Stay on Its Feet,” New York Times, December 4,
2001, pp. C1, C8.
356
“Why John Olson Wasn’t Bullish on Enron,” http://knowledge.Wharton.upenn.edu/013002_ss3. Accessed July 28,
2010.
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The Industry Practices and Legal Factors
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283
investments that had gone south, particularly power plants in Brazil and India. Its $1
billion investment in a 2,184-megawatt power plant in India was in ongoing disputes as
its political and regulatory relations in that country had deteriorated, and the state utility
stopped paying its bills for the power.357
In 1999, it announced its foray into fiber optics and the broadband market. Enron
over-anticipated the market in this area and experienced substantial losses related to
the expansion of its broadband market. Like Corning and other companies that overbuilt, Enron began bleeding quickly from losses related to this diversification.358
The Financial Reporting Issues
Mark-to-Market Accounting
Enron followed the FASB’s rules for energy traders, which permit such companies to
include in current earnings those profits they expect to earn on energy contracts and related
derivative estimates.359 The result is that many energy companies had been posting earnings, quite substantial, for noncash gains that they expect to realize some time in the future.
Known as mark-to-market accounting, energy companies and other industries utilize a
financial reporting tool intended to provide insight into the true value of the company
through a matching of contracts to market price in commodities with price fluctuations.
However, those mark-to-market earnings are based on assumptions. An example helps to
illustrate the wild differences that might occur when values are placed on these energy contracts that are marked to the market price. Suppose that an energy company has a contract
to sell gas for $2.00 per gallon, with the contract to begin in 2004 and run through 2014. If
the price of gas in 2007 is $1.80 per gallon, then the value of that contract can be booked
accordingly and handsomely, with a showing of a 20 percent profit margin. However, suppose that the price of gasoline then climbs to $2.20 per gallon during 2008. What is the
manager’s resolution and reconciliation in the financial statement of this change in price?
The company has a ten-year commitment to sell gas at a price that will produce losses. Likewise, suppose that the price of gas declines further to $0.50 per gallon in 2008. How is this
change reflected in the financial statements, or does the company leave the value as it was
originally booked in 2007? And how much of the contract is booked into the present year?
And what is its value presently?
The difficulty with mark-to-market accounting is that the numbers that the energy
companies carry for earnings on these future contracts are subjective. The numbers
they carry depend upon assumptions about market factors. Those assumptions used in
computing future earnings booked in the present are not revealed in the financial
reports, and investors have no way of knowing the validity of those assumptions or
even whether they are conservative or aggressive assumptions about energy market
expectations. It becomes difficult for investors to cross-compare financial statements of
energy companies because they are unable to compare what are apples and oranges in
terms of earnings because of the futuristic nature of the income and the possibility that
those figures may never come to fruition.
For example, the unrealized gains portion of Enron’s pretax profit for 2000 was about
50 percent of the total $1.41 billion profit originally reported. That amount was onethird in 1999.
357
Saritha Rai, “New Doubts on Enron’s India Investment,” New York Times, November 21, 2001, p. W1.
358
Complaint, class action litigation, November 2001, In re Enron Corp. Securities, Derivatives, & ERISA Litigation, 761
F. Supp. 2d 504 (S.D. Tex. 2011).
359
Jonathan Weil, “After Enron, ‘Mark to Market’ Accounting Gets Scrutiny,” Wall Street Journal, December 4, 2001,
pp. C1, C2.
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This practice of mark-to-market accounting proved to be particularly hazardous for
Enron management because their bonuses and performance ratings were tied to meeting
earnings goals. The result was that their judgment on the fair value of these energy contracts, some as long as twenty years into the future, was greatly biased in favor of present
recognition of substantial value.360 The value of these contracts is dependent upon
assumptions and variables that are not discussed in the financial statements, are not
readily available to investors and shareholders, and include wild cards such as the
weather, the price of natural gas, and market conditions in general. One analyst has
noted, “Whenever there’s a considerable amount of discretion that companies have in
reporting their earnings, one gets concerned that some companies may overstate those
earnings in certain situations where they feel pressure to make earnings goals.”361 A
FASB study showed that when a hypothetical example on energy contracts was given at
a conference, the valuations by managers for the contracts ranged from $40 million to
$153 million.362
Some analysts were concerned about this method of accounting because these are
noncash earnings. Some noted that Enron’s noncash earnings were over 50 percent of
its revenues. Others discovered the same issues when they noted that Enron’s margins
and cash flow did not match up with its phenomenal earnings records.363 For example,
Jim Chanos, of Kynikos Associates, commented that no one was really sure how Enron
made money and that its operating margins were very low for the reported revenue.
Mr. Chanos concluded that Enron was a “giant hedge fund sitting on top of a
pipeline.”364 Mr. Chanos noted that Wall Street loved Enron because it consistently met
targets, but he was skeptical because of off-the-balance sheet transactions (see below for
more information).365 Mr. Chanos and others who brought questions to Enron were
readily dismissed. For example, Fortune reporter Bethany McClean experienced pressure
in 2000 when she began asking questions about the revenues and margins. ThenChairman, and now the late Ken Lay, called her editor to request that she be removed
from the story. The Enron CEO at the time, Jeffrey Skilling, refused to answer her questions and labeled her line of inquiry as “unethical.”366 During an analysts’ telephonic
conference with Mr. Skilling in which Mr. Chanos asked why Enron had not provided
a balance sheet, Mr. Skilling called Mr. Chanos an “a—h ______.”367 Mr. Chanos opted
for selling Enron shares short and declined to disclose the amount of money he made as
a result of his position.
John Olson, presently an analyst with a Houston company, reflected that most analysts were unwilling to ask questions. When Mr. Olson asked Mr. Skilling questions
about how Enron was making money, Mr. Skilling responded that Enron was part of
360
Susan Lee, “Enron’s Success Story,” Wall Street Journal, December 26, 2001, p. A11.
361
Id.
362
Weil, “After Enron, ‘Mark to Market’ Accounting Gets Scrutiny,” p. C2.
363
McClean, “Why Enron Went Bust,” pp. 62–63. Ms. McLean had written a story in the summer of 2001 entitled, “Is
Enron Overpriced?” for Fortune. The lead line to the story was “How exactly does Enron make its money?” The story
was buried. It enjoyed little coverage or attention until November 2001. Ms. McClean quickly became an analyst on
the Enron case for NBC and was featured on numerous news shows. Felicity Barringer, “10 Months Ago, Questions
on Enron Came and Went with Little Notice,” New York Times, January 28, 2002, p. A11. Ms. McClean wrote a book
with Peter Elkind, The Smartest Guys in the Room (2003), which was later made into a successful documentary film.
364
Id.
365
Cassell Bryan-Low and Suzanne McGee, “Enron Short Seller Detected Red Flags in Regulatory Filings,” Wall Street
Journal, November 5, 2001, pp. C1, C2.
366
McClean, “Why Enron Went Bust,” p. 60.
367
Bryan-Low and McGee, “Enron Short Seller Detected Red Flags in Regulatory Filings,” p. C2.
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The Industry Practices and Legal Factors
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285
the new economy and that Olson “didn’t get it.”368 Mr. Olson advised his company’s
clients not to invest in Enron because, as he explained to them, “Never invest in something you can’t understand.”369 Mr. Olson was fired by Merrill Lynch following the publication of his skeptical analysis about Enron. Merrill Lynch continues to deny that it
fired Mr. Olson for that reason. Enron was a critical client for Merrill Lynch. In fact,
Merrill would become known for its role in Andrew Fastow’s infamous “Wanna buy a
barge?” deal, in which Merrill purchased a barge temporarily from Enron. The purchase
permitted Enron to meet its numbers goals, and even the general counsel at Merrill had
expressed concern that Merrill might be participating in Enron’s earnings management.
Four former Merrill investment bankers were indicted and convicted for their roles in
the “Wanna buy a barge?” Enron transaction.370 All but one of the convictions were
reversed on appeal because the investment bankers could not have known the extent of
Fastow’s frauds or the full scope and meaning of the transaction. The court held that the
investment bankers were allowed to rely on the representations of a company’s officer
and could not be convicted of participating in fraud when an agent of the company
arranged the transaction.
When U.S. News & World Report published Mr. Olson’s analysis and advice, Kenneth
Lay sent Mr. Olson’s boss a handwritten note with the following:
John Olson has been wrong about Enron for over 10 years and is still wrong. But he is consistant [sic].
Upon reading the note sent to his boss, Mr. Olson responded, “You know that I’m old
and I’m worthless, but at least I can spell consistent.”371
Off-the-Books Entities
Not only did Enron’s books suffer from the problem of mark-to-market accounting, but
also the company made minimal disclosures about its off-the-balance-sheet liabilities that
it was carrying.372 These problems, coupled with the mark-to-market value of the energy
contracts, permitted Enron’s financial statements to paint a picture that did not adequately reflect the risk investors had.
Enron had created, by the time it collapsed, about 3,000 off-the-books entities, partnerships, limited partnerships, and limited liability companies (called special purposes
entities, or SPEs, in the accounting profession) that carried Enron debt and obligations
that had been spun off but did not have to be disclosed in Enron’s financial reports
because, under an accounting rule known as FASB 125, the debt and obligations in offthe-books entities did not have to be disclosed so long as Enron’s ownership interests in
the entities never exceeded 49 percent. Disclosure requirements under GAAP and FASB
kicked in at 50 percent ownership at that time. Under the old rules, when a company
owned 50 percent or more of a company, it had to disclose transactions with that company in the financials as related party transactions.
Enron created a complex network of these entities, and some of the officers of the
company even served as principals in these companies and began earning commissions
for the sale of Enron assets to them. Andrew Fastow, Enron’s CFO, was a principal in
368
“Why John Olson Wasn’t Bullish on Enron,” http://knowledge.Wharton.upenn.edu/013002_ss3. Accessed July 28,
2010.
369
Id.
370
Kurt Eichenwald, “Jury Convicts 5 Involved in Enron Deal with Merrill,” New York Times, November 4, 2004,
pp. C1, C4.
371
“Why John Olson Wasn’t Bullish on Enron.”
372
Richard A. Oppel Jr. and Andrew Ross Sorkin, “Enron Corp. Files Largest U.S. Claim for Bankruptcy,” New York
Times, December 3, 2001, pp. A1, A16.
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many of these off-the-book entities. His wife, Lea, also a senior officer at Enron, was also
involved in handling many of the SPEs. In some of the SPEs, the two discussed the possibility of having some of the payments come to their two small children.
In 1999, Enron described one of these relationships in its 10K (an annual report companies must file with the SEC) as follows:
In June 1999, Enron entered into a series of transactions involving a third party and LJM Cayman, L.P.
(LJM). LJM is a private investment company, which engages in acquiring or investing in primarily energyrelated investments. A senior officer of Enron is the managing member of LJM’s general partner.373
The effect of all of these partnerships was to allow Enron to transfer an asset from its
books, along with the accompanying debt, to the partnership. An outside investor would
fund as little as 3 percent of the partnership, with Enron occasionally providing even the
front money for the investor. Enron would then guarantee the bank loan to the partnership for the purchase of the asset. Enron would pledge shares as collateral for these loans
it guaranteed in cases where the bank felt the asset transferred to the partnership was
insufficient collateral for the loan amount.374 By the time it collapsed, Enron had $38
billion in debt among all the various SPEs, but carried only $13 billion on its balance
sheet.375
To add to the complexity of these off-the-books loans and the transfer of Enron debt,
many of the entities formed to take the asset and debt were corporations in the Cayman
Islands. Enron had 881 such corporations, with 700 formed in the Cayman Islands, and,
in addition to transferring the debt off its balance sheet, it enjoyed a substantial number
of tax benefits because corporations operate tax-free there. The result is that Enron paid
little or no federal income taxes between 1997 and 2000.376 Comedian Robin Williams
referred to Enron executives as “the Investment Pirates of the Caribbean.”
Relatives and Doing Business with Enron
In addition to these limited liability company and limited partnership asset transfers,
there were apparently a series of transactions authorized by Mr. Lay in which Enron
did business with companies owned by Mr. Lay’s son, Mark, and his sister, Sharon Lay.
Jeffrey Skilling had hired Mark Lay in 1989 when Mark graduated with a degree in economics from UCLA. However, Mr. Lay left Enron feeling that he needed to “stand on his
own and work outside of Enron.”377 Enron eventually ended up acquiring Mr. Lay’s
son’s company and hired him as an Enron executive with a guaranteed pay package of
$1 million over three years as well as 20,000 stock options for Enron shares.378 There
was a criminal investigation into the activities of one of the companies founded by
Mark Lay, but he was not charged with wrongdoing. He did pay over $100,000 to settle
a civil complaint in the matter, but admitted no wrongdoing. Mark Lay entered a Baptist
seminary in Houston and plans to become a minister.379
Sharon Lay owned a Houston travel agency and received over $10 million in revenue
from Enron during the period from 1998 through 2001 years, one-half of her company’s
373
Enron Corp. 10K, Filed December 31, 1999, p. 16.
374
John R. Emshwiller and Rebecca Smith, “Murky Waters: A Primer on Enron Partnerships,” Wall Street Journal,
January 21, 2002, pp. C1, C14.
375
Bethany McLean and Peter Elkind, “Partners in Crime,” Fortune, October 27, 2003, p. 79.
376
David Gonzalez, “Enron Footprints Revive Old Image of Caymans,” New York Times, January 28, 2002, p. A10.
377
David Barboza and Kurt Eichenwald, “Son and Sister of Enron Chief Secured Deals,” New York Times, February 2,
2002, pp. A1, B5.
378
Id.
379
Id.
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The Industry Practices and Legal Factors
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287
revenue during that period.380 Both Ms. and the late Mr. Lay say that they made all the
necessary disclosures to the board and regulators about their business with Enron.
Enron’s Demise
Enron’s slow and steady decline began in the November–December 2000 time frame,
when its share price was at $85. By the time Jeffrey Skilling announced his departure as
CEO on August 14, 2001, with no explanation, the share price was at about $43.
Mr. Skilling says that he left the company simply to spend more time with his family,
but his departure raised questions among analysts even as Kenneth Lay returned as
CEO.381 The Wall Street Journal raised questions about Enron’s disclosures on August
28, 2001, as Enron was beginning an aggressive movement for selling off assets.382 By
October, Enron disclosed that it was reporting a third-quarter loss and it took a $1.2 billion reduction in shareholder equity. Within days of those announcements, CFO Andrew
Fastow was terminated, and in less than two weeks, Enron restated its earnings dating
back to 1997, a $586 million, or 20 percent, reduction.
Following these disclosures and the announcement of Enron’s liability on a previously
undisclosed $690 million loan, CEO Kenneth Lay left the company as CEO, but
remained as chairman of the board.383 Mr. Lay waived any rights to his parachute,
reportedly worth $60 million, and also agreed to repay a $2 million loan from the company.384 Mr. Lay’s wife, Linda, appeared on NBC with correspondent Lisa Meyer on January 28, 2002, and indicated that she and Mr. Lay were “fighting for liquidity.”385 She
indicated that all their property was for sale, but a follow-up check by Ms. Meyer
found only one of a dozen homes owned by the Lays was for sale. Mr. Lay consulted
privately with the Reverend Jesse Jackson for spiritual advice, according to Mrs. Lay.386
The Enron Culture
Enron was a company with a swagger. It had an aggressive culture in which a rating
system required that 20 percent of all employees be rated at below performance and
encouraged to leave the company. As a result of this policy, no employee wanted to be
the bearer of bad news.
Margaret Ceconi, an employee with Enron Energy Services, wrote a five-page memo
to Kenneth Lay on August 28, 2001, stating that losses from Enron Energy Services were
being moved to another sector in Enron in order to make the Energy Service arm look
profitable. One line from her memo read, “Some would say the house of cards are
falling.”387 Mr. Lay did not meet with Ms. Ceconi, but she was contacted by Enron
Human Resources and counseled on employee morale. When she raised the accounting
issues in her meeting with HR managers, she was told they would be investigated and
380
Id.
381
John E. Emshwiller and Rebecca Smith, “Behind Enron’s Fall, a Culture of Operating outside Public View,” Wall
Street Journal, December 5, 2001, pp. A1, A10.
382
John E. Emshwiller, Rebecca Smith, Robin Sidel, and Jonathan Weil, “Enron Cuts Profit Data of 4 Years by 20%,”
Wall Street Journal, November 9, 2001, p. A3.
383
Id.
384
Richard A. Oppel Jr. and Floyd Norris, “Enron Chief Will Give Up Severance,” New York Times, November 14,
2001, pp. C1, C10.
385
Alessandra Stanley and Jim Yardley, “Lay’s Family Is Financially Ruined, His Wife Says,” New York Times, January 29,
2002, pp. C1, C6.
386
Id.
387
Julie Mason, “Concerned Ex-worker Was Sent to Human Resources,” Houston Chronicle, January 30, 2002, www
.chron.com.
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taken very seriously, but she was never contacted by anyone about her memo. Her
memo remained dormant until January 2002, when she sent it to the U.S. House of
Representatives’ Committee on Energy and Commerce, the body conducting a series of
hearings on the Enron collapse.
Ms. Ceconi’s memo followed two weeks after Sherron Watkins, a former executive,
wrote of her concerns about “accounting scandals” at Enron. Ms. Watkins was a former
Andersen employee who had been hired into the executive ranks by Enron. Ms. Watkins
wrote a letter to Kenneth Lay on August 15, 2001, that included the following: “I am
incredibly nervous that we will implode in a wave of accounting scandals. I have heard
from one manager-level employee from the principal investments group say, ‘I know it
would be devastating to all of us, but I wish we would get caught. We’re such a crooked
company.’”388 She also warned that Mr. Skilling’s swift departure would raise questions
about accounting improprieties and stated, “It sure looks to the layman on the street that
we are hiding losses in a related company.”389 In her memo, she listed J. Clifford Baxter
as someone Mr. Lay could talk to in order to verify her facts and affirmed that her concerns about the company were legitimate. Ms. Watkins wrote the memo anonymously
on August 15, 2001, but by August 22, and after discussing the memo with former colleagues at Andersen, she told her bosses that she was the one who had written the
memo.
In the months prior to Enron’s collapse, employees became suspicious about what was
called “aggressive accounting” and voiced their concerns in online chat rooms.390 Clayton Verdon was fired in November 2001 for his comments about “overstating profits,”
made in an employee chat room. A second employee was fired when he revealed in the
chat room that the company had paid $55 million in bonuses to executives on the eve of
its bankruptcy.391 Enron indicated that the terminations were necessary because the
employees had breached company security.
In his testimony at the trial of his former bosses, Ken Lay and Jeffrey Skilling, former
CFO Andrew Fastow offered some insights into the culture at Enron and the tone he set
as a senior executive. Andrew Fastow, when confronted by Daniel Petrocelli, lawyer for
Jeffrey Skilling, about his clear wrongdoing, offered the following: “Within the culture of
corruption that Enron had, that valued financial reporting rather than economic value, I
believed I was being a hero.”392 He went on to add, “I thought I was being a hero for
Enron. At the time, I thought I was helping myself and helping Enron to make its
numbers.”393 He explained further, “At Enron, the culture was and the business practice
was to do transactions that maximized the financial reporting earnings as opposed to
maximizing the true economic value of the transactions.”394 However, Mr. Fastow said
he did see the writing on the wall near the end and encouraged others to reveal the
true financial picture at Enron: “We have to open up the kimono and show them the
skeletons in the closet, what our assets are really worth.”395
388
Michael Duffy, “What Did They Know and When Did They Know It?” Time, January 28, 2002, pp. 16–27.
389
Id.
390
Alex Berenson, “Enron Fired Workers for Complaining Online,” New York Times, January 21, 2002, pp. C1, C8.
391
Id.
392
March 8, 2006, trial testimony of Andrew Fastow, in Greg Farrell, “Fastow ‘Juiced’ Books,” USA Today, March 8,
2006, p. 1A.
393
Id.
394
Farrell, “Fastow ‘Juiced’ Books,” p. 1A.
395
Alexei Barrionuevo, “Ex-Enron Official Insists Chief Knew He Was Lying,” New York Times, March 2, 2006, p. C3.
(Mixed metaphors aside.)
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The Industry Practices and Legal Factors
Section E
289
The Enron Board
Some institutional investors have raised questions about conflicts and the lack of independence in Enron’s board.396 Members of Enron’s board were well compensated with
a total of $380,619 paid to each director in cash and stock for 2001. One member of
the board was Dr. Wendy L. Gramm, the former chairwoman of the Commodity Futures
Trading Commission and wife of Senator Phil Gramm, the senior U.S. senator from
Texas, who has received campaign donations from Enron employees and its PAC.
Dr. Gramm opted to own no Enron stock and accepted payment for her board service
only in a deferred compensation account.
Dr. John Mendelsohn, the president of the University of Texas M.D. Anderson Cancer Center in Houston, also served on the Enron board, including its audit committee.
Dr. Mendelsohn’s center received $92,508 from Enron and $240,250 from Linda and
Ken Lay after Dr. Mendelsohn joined the Enron board in 1999.397
After the Fall
Enron fired 5,100 of its 7,500 employees by December 3, 2001. Although Enron continues to operate as a company today, only 1,900 employees retained their jobs. Each
employee received a $4,500 severance package. However, many of the employees were
looking forward to a comfortable retirement, basing that assumption on the value of
their Enron stock. Many held Enron stock and were compensated with Enron stock
options. The stock was trading at $0.40 per share on December 3, 2001, following a
high of $90 at its peak. Employee pension funds lost $2 billion. Enron employees’ 401(k)
plans, funded with Enron stock, lost $1.2 billion in 2001. “Almost everyone is gone.
Upper management is not talking. No managing directors are around, and police are on
every floor. It’s so unreal,” said one departing employee.398 One employee, George Kemper,
a maintenance foreman, who is part of a suit filed against Enron related to the employees’
401(k) plans, whose plan was once worth $225,000 and is now worth less than $10,000,
said, “How am I going to retire now? Everything I worked for the past 25 years has been
wiped out.”399 The auditors have admitted that they simply cannot make sense of the company’s books for 2001, but have concluded that the cash flow of $3 billion claimed for 2000
was actually a negative $153 million and that the profits of $1 billion reported in 2000 did
not exist.400
Just prior to declaring bankruptcy, Enron paid $55 million in bonuses to executives
described as “retention executives,” or those the company needs to stay on board in
order to continue operations.401
Tragically, J. Clifford Baxter, a former Enron vice chairman, and the one officer Ms.
Watkins suggested Mr. Lay talk with, took his own life in his 2002 Mercedes Benz about
a mile from his $700,000 home in Sugar Land, Texas, a suburb twenty-five miles from
Houston. Mr. Baxter, who earned his MBA at Columbia, had left Enron in May 2001,
following what some employees say was his voicing of concerns over the accounting
396
Reed Abelson, “Enron Board Comes under a Storm of Criticism,” New York Times, December 16, 2001, p. BU4.
397
Jo Thomas and Reed Abelson, “How a Top Medical Researcher Became Entangled with Enron,” New York Times,
January 28, 2002, pp. C1, C2.
398
Richard A. Oppel Jr. and Riva D. Atlas, “Hobbled Enron Tries to Stay on Its Feet,” New York Times, December 4,
2001, pp. C1, C8.
399
Christine Dugas, “Enron Workers Sue over Retirement Plan,” USA Today, November 27, 2001, p. 5B.
400
Cathy Booth Thomas, “The Enron Effect,” Time, June 5, 2006, pp. 34–36.
401
Richard A. Oppel Jr. and Kurt Eichenwald, “Enron Paid $55 Million for Bonuses,” New York Times, December 4,
2001, pp. C1, C4.
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290
Unit Four
Ethics and Company Culture
practices of Enron and its disclosures.402 SEC records disclose that Mr. Baxter sold
577,000 shares of Enron stock for $35.2 million between October 1998 and early
2001.403 He had been asked to appear before Congress to testify, was a defendant in all
the pending litigation, and was last seen in public at his yacht club, where he took his
yacht out for a sail. Those who saw him indicated that his hair had become substantially
grayer since October, when the public disclosures about Enron’s condition began.
Mr. Baxter was depicted as a philanthropist in the Houston area, having raised money
for charities such as Junior Achievement and other organizations to benefit children.
He had created the Baxter Foundation with $200,000 from Enron and $20,000 of his
own money to assist charities such as Junior Achievement, the American Cancer Society,
and the American Diabetes Association.404
As noted, Enron had a matching plan for its employees on the 401(k). However, 60 percent of their plan was invested in Enron stock. Between October 17 and November 19,
2001, when the issues surrounding Enron’s accounting practices and related transactions
began to surface, the company put a lockdown on the plan so that employees could not
sell their shares.405 Prior to the lockdown, most of the executives had sold off large blocks
of Enron stock. For example, Jeffrey Skilling, who left the company in August 2001, sold off
500,000 shares on September 17, 2001.406 He had sold 240,000 shares in early 2001 and at
the time of Enron’s bankruptcy owned 600,000 shares and an undisclosed number of
options.407 Mr. Lay also sold a substantial amount of stock in August 2001, but his lawyer
had indicated the sale of the stock was necessary in order to repay loans.408
Person
Title
Charges
Disposition
Ken Lay
Chairman,
CEO
Securities
fraud
Jeffrey
Skilling
CEO
Wire fraud
Securities
fraud
Convicted; conviction reversed following Mr. Lay’s untimely death on
July 5, 2006, one month after his
conviction.
Same as above.
Convicted on all but two counts; serving a sentence of 24.4 years, but a
2010 U.S. Supreme Court decision on
honest services fraud remanded the
case after reversing his conviction for
honest services fraud because he had
not engaged in bribery (required for
proof of honest services fraud). With
that conviction out of the mix,
Mr. Skilling must be resentenced to a
lesser period of time.
402
Elissa Gootman, “Hometown Remembers Man Who Wore Success Quietly,” New York Times, January 30, 2002,
p. C7.
403
Mark Babineck, “Deceased Enron Executive Earned Respect in the Ranks,” Houston Chronicle, January 26, 2002,
http://www.chron.com.
404
Id.
405
Id.
406
Richard A. Oppel Jr., “Former Head of Enron Denies Wrongdoing,” New York Times, December 22, 2001, pp. C1,
C2.
407
Id.
408
Richard A. Oppel Jr., “Enron Chief Says His Sale of Stock Was to Pay Loans,” New York Times, January 21, 2002,
pp. A1, A13.
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The Industry Practices and Legal Factors
Person
Andrew
Fastow
Title
CFO
Section E
291
Charges
Disposition
Wire fraud
Same as above.
Securities
fraud
Guilty plea; six years (will probably
be released in four because of his
extensive cooperation in the criminal
trials of Skilling and Lay as well as the
civil suits)
Guilty plea.
Guilty plea.
Guilty plea; one year; served
(ended with last month in halfway
house in July 2005) her term first
so that Andrew Fastow could be
at home with their two young
children before he began his term
in 2006.
Guilty plea; served slightly over one
year.
Guilty plea; five years.
Guilty plea to one count of securities
fraud in exchange for seven-year
sentence recommendation and
cooperation with federal prosecutors
on Skilling and Lay case.409 He was
sentenced to 5.5 years.
Guilty plea to money laundering and
conspiracy to commit wire fraud;
sentenced to three years and one
month.
Guilty plea to one count.
Wire fraud
Tax evasion
Tax evasion
Lea Fastow
Senior Officer
David
Delainey
Ben Glisan
Richard
Causey
CEO Enron
North America
Treasurer
Chief
Accounting
Officer
Insider trading
Michael J.
Kopper
Officer who
worked directly
with Fastow
Fraud
Kenneth D.
Rice
Mark
Koenig
CEO, Enron
Broadband
Vice president
of investor
relations
Conspiracy
Insider trading
Guilty plea to one count of aiding
and abetting securities fraud; eighteen months.
Note: Thirty-two Enron executives were indicted in total, with guilty pleas or convictions for all. Mr. Lay was the
last Enron official indicted, in July 2004.
In addition to the impact on Enron, its employees, and Houston, there was a worldwide ripple effect. Enron had large stakes in natural gas pipelines in the United States
and around the world as well as interests in power plants everywhere from Latin
America to Venezuela. It is also a partial owner of utilities, including telecommunications networks. Congressional hearings were held as the House Energy and Commerce
Committee investigated the company’s collapse. Representative Billy Tauzin of Louisiana
scheduled the investigations and noted, “How a company can sink so far, so fast, is very
troubling. We need to find out if the company’s accounting practices masked severe
409
John Emshwiller, “Enron Prosecutors, after Plea Bargain, Can Reduce Technical Jargon at Trial,” Wall Street
Journal, January 4, 2006, pp. C1, C5.
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292
Unit Four
Ethics and Company Culture
underlying financial problems.”410 Senator Jeff Bingham, then-chairman of the Senate
Energy Committee, said, “I believe that our committee is keenly aware of the need for
enhanced oversight and market monitoring.”411
Enron’s bankruptcy filing included a list of creditors fifty-four pages long. Although
the bankruptcy filing showed $24.76 billion in assets and $13.15 billion in debt, these
figures did not include those off-the-balance sheet obligations, estimated to be about
$27 billion.412
Enron energy customers, which include Pepsico, the California state university system, JCPenney, Owens-Illinois, and Starwood Hotels & Resorts, also felt the effects of
the company’s collapse. Enron had contracts with 28,500 customers. These customers
had to revise their contracts and scramble to place energy contingency plans in place.
California’s state universities were in negotiations for renewal of their 1998 contract
with Enron, but those talks went into a stalemate, and the university system found
another provider.413
Trammell Crow halted the groundbreaking ceremony for its planned construction of
new Enron headquarters, a building that would have been fifty stories high and included
offices, apartments, and stores.414
The ripple effect stretched into unrelated investments. Five major Japanese money
market funds with heavy Enron investments fell below their face value by December 3,
2001.415 These losses had additional consumer-level effects because these funds were held
by retirees because they were seen as “safe haven” funds for investors.
The Enron board hired Stephen F. Cooper as CEO to replace Mr. Lay. Mr. Cooper is
a specialist in leading companies through bankruptcy, including TWA and Federated
Department Stores.416
Enron’s collapse ended the movement toward the deregulation of electricity. Following Enron’s collapse, federal and state regulators saw the impact on consumers of allowing energy companies to operate in a regulatory no-man’s land, and the state moved
back to the model of price regulation of the sale of energy to consumers.417
The SEC, a national team of lawyers, and the Justice Department began a six-year
investigation of the company, its conduct, and it officers.418 The civil suits press on,
with Andrew Fastow providing the plaintiffs in the cases, many of them former employees, information and details that are aiding them in recovering funds from banks, auditors, and insurers. In the bankruptcy, Enron’s creditors received 18.3 cents on the dollar,
an amount far below the normal payout in a bankruptcy.419
410
Richard A. Oppel Jr. and Andrew Ross Sorkin, “Ripples Spreading from Enron’s Expected Bankruptcy,” New York
Times, November 30, 2001, pp. C1, C6, C7.
411
“Financial Threat from Enron Failure Continues to Widen,” Financial Times, December 1, 2001, p. 1.
412
Rebecca Smith and Mitchell Pacelle, “Enron Files for Chapter 11 Bankruptcy, Sues Dynegy,” Wall Street Journal,
December 3, 2001, p. A2.
413
Rhonda L. Rundle, “Enron Customers Seek Backup Suppliers,” Wall Street Journal, December 3, 2001, p. A10.
414
Allen R. Myerson, “With Enron’s Fall, Many Dominoes Tremble,” New York Times, December 2, 2001, pp. 3–1,
MB1.
415
Ken Belson, “Enron Causes 5 Major Japanese Money Market Funds to Plunge,” New York Times, December 4,
2001, p. C9.
416
Shaila K. Dewan and Jennifer Lee, “Enron Names an Interim Chief to Oversee Its Bankruptcy,” New York Times,
January 30, 2002, p. C7.
417
Rebecca Smith, “Enron Continues to Haunt the Energy Industry,” Wall Street Journal, March 16, 2006, p. C1; and
Joseph Kahn and Jeff Gerth, “Collapse May Reshape the Battlefield of Deregulation,” New York Times, December 4,
2001, pp. C1, C8.
418
Jo Thomas, “A Specialist in Tough Cases Steps into the Legal Tangle,” New York Times, January 21, 2002, p. C8.
419
Mitchell Pacelle, “Enron’s Creditors to Get Peanuts,” Wall Street Journal, July 11, 2003, pp. C1, C7.
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The Industry Practices and Legal Factors
Section E
293
Many noted at the time of Enron’s collapse that “evidence of fraud may well be elusive” as the SEC and prosecutors investigate.420 Professor Douglas Carmichael, a professor of accounting at Baruch College, is one who agrees: “It’s conceivable that they
complied with the rules. Absent a smoking-gun e-mail or something similar, it is an
issue of trying to attack the reasonableness of their assumptions.”421 One auditor said
that it never occurred to him that anyone would “use models to try and forecast energy
prices for 10 years, and then use those models to report profits, but that the rule had not
placed a limit on such trades.”422 When asked about the accounting practices of Enron,
Mr. Skilling said, “We are doing God’s work. We are on the side of angels.”423
Mr. Skilling and Mr. Lay were tried in a case that ran from February to June 2006.
They were both convicted following six days of deliberations by the jurors. Mr. Fastow
was the government’s key witness against the two men. Both men took the stand as part
of their defense, and both men got angry on the stand when faced with crossexamination. Mr. Lay was convicted on all counts. Mr. Skilling was convicted on eighteen of twenty-seven counts, Mr. Lay died of a massive heart attack on July 5, 2006,
while at his Colorado vacation home.424 His conviction was set aside because he had
not had the opportunity to appeal the verdict. One comment on his passing was “His
death was a cop-out.”425 A former Enron employee told the Houston Chronicle, “Glad
he’s dead. May he burn in hell. I’ll dance on his grave.”426
Mr. Skilling awaits his resentencing following a U.S. Supreme Court reversal of his
“honest services” fraud conviction. Mr. Petrocelli was paid $23 million from a trust
fund Mr. Skilling had set aside for his defense, and Enron’s insurer paid $17 million to
Mr. Petrocelli’s firm of O’Melveny and Myers, for a total of $40 million. However, the
firm and Mr. Petrocelli are still owed $30 million for their defense work, an amount
Mr. Skilling is unable to pay.427
Discussion Questions
1. Can you see that Enron broke any laws? Andrew
Fastow testified at the Lay and Skilling trial as
follows: “A significant number of senior management participated in this activity to misrepresent
our company. And we all benefited financially
from this at the expense of others. And I have
come to grips with this. That, in my mind, was
stealing.”428 Is Mr. Fastow correct? Was it stealing? How should Fastow’s’ relationships with
Enron’s partially owned subsidiaries have been
handled in terms of disclosure.
2. Do you think that Enron’s financial reports gave a
false impression? Does it matter that most investors in Enron were relatively sophisticated financial institutions? What about the employees’
ownership of stock and their 401(k) plans?
3. What questions could the officers of Enron have
used to evaluate the wisdom and ethics of their
decisions on the off-the-book entities and
mark-to-market accounting? Be sure to apply the
various models you have learned.
4. Did Mr. Fastow have a conflict of interest?
420
Floyd Norris and Kurt Eichenwald, “Fuzzy Rules of Accounting and Enron,” New York Times, January 30, 2002,
pp. C1, C6.
421
Id.
422
Id.
423
Neil Weinberg and Daniel Fisher, “Power Player,” Forbes, December 24, 2001, pp. 53–58.
424
Bethany McClean and Peter Elkind, “Death of a Disgraced Energy Salesman,” Fortune, July 30, 2006, pp. 3–32.
425
Id.
426
Id.
427
Carrie Johnson, “After Enron Trial, Defense Firm Is Stuck with the Tab,” Washington Post, June 16, 2006, pp. D1,
D3.
428
Alexei Barrionuevo, “Fastow Testifies Lay Knew of Enron’s Problems,” New York Times, March 9, 2006, pp. C1,
C4.
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294
Unit Four
Ethics and Company Culture
5. What elements for your personal credo can you
take away from the following testimony from
David Delainey and Andrew Fastow? As you
think about this question, consider the following
from their testimony at the Skilling and Lay trial.
When asked why he did not raise the issue or
simply walk away, Mr. Delainey responded, “I
wish on my kids’ lives I would have stepped up
and walked away from the table that day.”429 Mr.
Fastow had the following exchange with Daniel
Petrocelli, Mr. Skilling’s lawyer (Mr. Petrocelli
represented the Brown and Goldman families in
their civil suit against O. J. Simpson):
Petrocelli:
Fastow:
To do those things, you
must be consumed with
insatiable greed. Is that fair
to say?
I believe I was very greedy
and that I lost my moral
compass.430
Fastow also testified as follows: “My actions
caused my wife to go to prison.”431 Defense attorneys, being the capable souls that they are,
extracted even more: “I feel like I’ve taken a lot
of blame for Enron these past few days. It’s not
relevant to me whether Mr. Skilling’s or Mr. Lay’s
names are on that page . … I’m ashamed of the
past. What they write about the past I can’t affect.
I want to focus on the future. Even after being
caught, it took me awhile to come to grips with
what I’d done.… I’ve destroyed my life. All I can
do is ask for forgiveness and be the best person I
can be.”432 Mr. Fastow also said, “I have asked my
family, my friends, and my community for forgiveness. I’ve agreed to pay a terrible penalty for it. It’s
an awful thing that I did, and it’s shameful. But I
wasn’t thinking that at the time.”433
Mr. Fastown has quoted Herman Melville’s
Moby Dick as to why Ishmael let himself be
dragged into the doomed ship by Captain Ahab
as a way of explaining what he did and for so
long. “Ishmael said, ‘But when a man suspects
any wrong, it sometimes happens that if he be
already involved in the matter, he insensibly
strives to cover up his suspicions even from himself. And much this way it was with me. I said
nothing, and tried to think nothing.’” What does he
mean by this quote? Apply one of the categories of
ethical personalities to his behavior? Amoral
technician?
6. Was Ms. Watkins a whistleblower? Discuss the
timing of her disclosures. Compare and contrast
her behavior with Paula Reiker’s. Paula H. Reiker,
the former manager of investor relations for Enron,
was paid $5 million between 2000 and 2001. She
testified that she was aware during teleconferences
that the numbers being reported were inaccurate.
Upon cross-examination she was asked why she
didn’t speak up, as Mr. Petrocelli queried, “Why
didn’t you just quit?” Her response: “I considered
it on a number of occasions. I was very well compensated. I didn’t have the nerve to quit.”434 Did she
make the right decision?
Compare & Contrast
1. Evaluate Enron’s culture. Be sure to compare and contrast with that of Fannie Mae, Bausch & Lomb,
Goldman, and Krispy Kreme. As you evaluate, consider the revelations from the testimony of David W. Delainey
at the Skilling and Lay criminal trial. Mr. Delainey, the former head of Enron Energy Services. Energy Services
retail unit, testified that he saw the legal and ethical issues unfold ing as he worked for Enron. When he was
asked to transfer $200 million in losses from his unit to another division in order to then show a profit, he
429
Id.
430
John Emshwiller and Gary McWilliams, “Fastow Is Grilled at Enron Trial,” Wall Street Journal, March 9, 2006,
pp. C1, C4.
431
Emshwiller and McWilliams, “Fastow Is Grilled at Enron Trial,” pp. C1, C4.
432
Greg Farrell, “Defense Goes after Fastow’s ‘Greed’ with a Vengeance,” USA Today, March 9, 2006, p. 1; and
Alexei Barrionuevo, “Fastow Testifies Lay Knew of Enron’s Problems,” New York Times, March 9, 2006, pp. C1, C4.
433
Alexei Barrionuevo, “The Courtroom Showdown, Played as Greek Tragedy,” New York Times, March 12, 2006,
pp. 1, 3.
434
Alexei Barrionuevo, “Enron Defense Chips Away at Witness’s Motives,” New York Times, February 24, 2006,
p. C3.
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The Industry Practices and Legal Factors
Section E
295
testified, “That was the worst conduct I had ever been a part of and everybody knew exactly what was going on
at that meeting.”435
Now compare and contrast the decisions and actions of Mr. Olson and Merrill Lynch.
2. Experts have commented that one of the reasons for the success of the Enron task force is that it
worked its way up through employees in the company. That is, it got plea agreements and information
from lower-level employees and then used the information to go after higher-ranking officers in the company. For example, Mr. Fastow was facing over 180 years in prison if convicted of all of the charges in
his indictment. He agreed to turn state’s evidence in exchange for a recommendation of a prison sentence of eleven years. He did such a good job in testifying against Mr. Skilling and Mr. Lay that the
judge sentenced him to only six years. He was released from prison in 2011 and is on supervised probation until December 2013. Mr. Skilling, on the other hand, was sentenced to 24.4 years. What is the
moral of this story? What can we learn about our role as employees? As officers? When asked to comment about the reduction in Mr. Skilling’s sentence, Mr. Fastow noted that fourteen years is still a very
long time.
At a speech to the Association of Certified Fraud Examiners in June 2013, Mr. Fastow said, “I’m here
because I’m guilty, and this is a much different place than I thought I would be when I was named CFO of
the year in 2000.”436 He then added, “I did not embezzle, avoid taxes or do any sort of insider trading. What
I am guilty of is creating financial structures that made Enron look better to the public than it actually was.
Accounting rules can be vague and we at Enron viewed that vagueness as an opportunity.”437 Are there any
inconsistencies in the two statements?
Case 4.21
Arthur Andersen: A Fallen Giant438
Arthur Andersen, once known as the “gold standard of auditing,” was founded in
Chicago in 1913 on a legend of integrity as Andersen, Delaney & Co. In those early
years, when the business was struggling, Arthur Andersen was approached by a wellknown railway company about audit work. When the audit was complete, the company
CEO was outraged over the results and asked Andersen to change the numbers or lose
his only major client. A twenty-eight-year-old Andersen responded, “There’s not enough
money in the city of Chicago to induce me to change that report!” Months later, the railway filed for bankruptcy.439
Over the years Andersen evolved into a multiservice company of management consultants, audit services, information systems, and virtually all aspects of operations and
financial reporting. Ultimately, Andersen would serve as auditor for Enron, WorldCom,
Waste Management, Sunbeam, and the Baptist Foundation, several of the largest bankruptcies of the century as well as poster companies for the corporate governance and
audit reforms of the Sarbanes-Oxley Act, federal legislation enacted in the wake of the
Enron and WorldCom collapses. However, it would be Andersen’s relationship with
Enron that would be its downfall.
435
Alexei Barrionuevo, “Ex-Enron Official Insists Chief Knew He Was Lying,” New York Times, March 2, 2006, p. C3.
436
Walter Pavlo, “Former Enron CFO Andrew Fastow Speaks At ACFE Annual Conference,” Forbes, June 26, 2013,
http://www.forbes.com/sites/walterpavlo/2013/06/26/fmr-enron-cfo-andrew-fastow-speaks-at-acfe-annual-conference/.
Accessed August 31, 2013.
437
Id.
438
Adapted with permission from Marianne M. Jennings, “A Primer on Enron: Lessons from A Perfect Storm of Financial Reporting, Corporate Governance, and Ethical Culture Failures,” 39 California Western Law Review 161 (2003).
439
Barbara Ley Toffler, Final Accounting: Ambition, Greed, and the Fall of Arthur Andersen (2003), p. 12.
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Andersen served as Enron’s outside auditor, and the following information regarding
various conflicts of interest became public both through journalistic investigations and
via the Senate hearings held upon Enron’s declaration of bankruptcy:440
• Andersen earned over one-half ($27 million) of its $52 million in annual fees from consulting services furnished to Enron.441
• There was a fluid atmosphere of transfers back and forth between those working for Andersen doing Enron
consulting or audit work and those working for Enron who went with Andersen.442
David Duncan, the audit partner in the Houston offices of Andersen who was in
charge of the Enron account, was a close personal friend of Richard Causey, Enron’s
chief accounting officer, who had the ultimate responsibility for signing off on all of
CFO Andrew Fastow’s off-the-books entities.443 The two men traveled, golfed, and fished
together.444 Employees of both Andersen and Enron have indicated since the time of
their companies’ collapses that the two firms were so closely connected that they were
often not sure who worked for which firm. Many Andersen employees had permanent
offices at Enron, including Mr. Duncan. Office decorum thus found Enron employees
arranging in-office birthday celebrations for Andersen auditors so as to be certain not
to offend anyone. In addition, there was a fluid line between Andersen employment
and Enron employment, with auditors joining Enron on a regular basis. For example,
in 2000, seven Andersen auditors joined Enron.445
Andersen’s Imprimatur for Enron Accounting
Enron’s executives and internal accountants and the Andersen auditors resorted to two
discretionary accounting areas, special purposes entities (SPEs), and mark-to-market
accounting, for booking the revenues from its substantial energy contracts, approximately 25 percent of all the existing energy contracts in the United States by 2001.446
Their use of these discretionary areas allowed them to maintain the appearance of sustained financial performance through 2001. One observer who watched the rise and fall
of Enron noted, in reference to Enron but clearly applicable to all of the companies
examined here, “If they had been going [at] a slower speed, their results would not
have been disastrous. It’s a lot harder to keep it on the track at 200 miles per hour.
You hit a bump and you’re off the track.”447 The earnings from 1997 to 2001 were ultimately restated, with a resulting reduction of $568 million, or 20 percent of Enron’s
earnings for those four years.448
440
“The Role of the Board of Directors in Enron’s Collapse,” report of the Permanent Subcommittee on Investigations
of the Senate Government Affairs Committee, 107th Congress, Report 107-70, July 8, 2002, 39–41 (hereinafter, “PSI
Report”).
441
Deborah Solomon, “After Enron, a Push to Limit Accountants to … Accounting,” Wall Street Journal, January 25,
2002, p. C1.
442
Seven Andersen audit employees became Enron employees in the year 2000 alone. John Schwartz and Reed
Abelson, “Auditor Struck Many as Smart and Upright,” New York Times, January 17, 2002, p. C11.
443
Anita Raghavan, “How a Bright Star at Andersen Fell along with Enron,” Wall Street Journal, May 15, 2002, pp. A1,
A8. See also Cathy Booth Thomas and Deborah Fowler, “Will Enron’s Auditor Sing?” Time, February 11, 2002, p. 44.
444
Id.
445
John Schwartz and Reed Abelson, “Auditor Struck Many as Smart and Upright,” New York Times, January 17,
2002, p. C11.
446
Noelle Knox, “Enron to Fire 4,000 from Headquarters,” USA Today, December 4, 2001, p. 1B.
447
Bob McNair, a Houston entrepreneur who sold his company to Enron in 1998, quoted in John Schwartz and Richard
A. Oppel Jr., “Risk Maker Awaits Fall of Company Built on Risk,” New York Times, November 29, 2001, p. C1.
448
John R. Emshwiller, Rebecca Smith, Robin Sidel, and Jonathan Weil, “Enron Cuts Profit Data of 4 Years by 20 percent,” Wall Street Journal, November 9, 2001, p. A3.
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The Industry Practices and Legal Factors
Section E
297
Sherron Watkins, who became one of Time’s persons of the year for her role in bringing the financial situation of Enron to public light, was the vice president for corporate
development at Enron when she first expressed concerns about the company’s financial
health in August 2001. A former Andersen employee, she was fairly savvy about
accounting rules, and with access to the financial records for purposes of her new job,
she quickly realized that the large off-the-books structure that had absorbed the company’s debt load was problematic.449 Labeling the SPEs “fuzzy” accounting, she began
looking for another job as she prepared her memo detailing the accounting issues,
because she understood that raising those issues meant that she would lose her Enron
job.450 Ms. Watkins did write her memo, anonymously, to Kenneth Lay, then-chair of
Enron’s board and former CEO, but she never discussed her concerns or discussed writing the memo with Jeffrey Skilling, then Enron’s CEO, or Andrew Fastow, its CFO,
because “it would have been a job-terminating move.”451 She did eventually confess to
writing the memo when word of its existence permeated the executive suite. Mr. Fastow
reacted by noting that Ms. Watkins wrote the memo because she was seeking his job.452
Andersen recognized the focus on numbers in an internal memo as it evaluated its
exposure in continuing to have Enron as a client. What follows is an excerpt from a
2000 memo that David Duncan and four other Andersen partners prepared as they evaluated what they called the “risk drivers” at Enron. Following a discussion of “Management Pressures” and “Accounting and Financial Management Reporting Risks,” the
following drivers were listed:
• Enron has aggressive earnings targets and enters into numerous complex transactions to achieve those
targets.
• The company’s personnel are very sophisticated and enter into numerous complex transactions and are
often aggressive in restructuring transactions to achieve derived financial reporting objectives.
• Form-over-substance transactions.453
Mr. Duncan presented the board with a one-page summary of Enron’s accounting
practices.454 The summary, called “Selected Observations 1998 Financial Reporting,”
highlighted Mr. Duncan’s areas of concern, and it was presented to the board in 1999,
a full two years before Enron’s collapse. Called “key accounting issues” by Mr. Duncan,
the areas of concern included “Highly Structured Transactions,” “Commodity and Equity
Portfolio,” “Purchase Accounting,” and “Balance Sheet Issues.” Mr. Duncan had assigned
three categories of risk for these accounting areas, which included “Accounting Judgments,” “Disclosure Judgements [sic],” and “Rule Changes,” and he then assigned letters
to each of these three categories: H for high risk, M for medium risk, and L for low
risk.455 Each accounting issue had at least two H grades in the three risk categories.
Andersen’s Concerns about Conflicts
Enron’s Code of Ethics had both a general and a specific policy on conflicts of interest,
both of which had to be waived in order to allow its officers to function as officers of the
449
Jodie Morse and Amanda Bower, “The Party Crasher,” Time, January 6, 2003, pp. 53–55.
450
Id.
451
Rebecca Smith, “Fastow Memo Defends Enron Partnerships and Sees Criticism as Ploy to Get His Job,” Wall
Street Journal, February 20, 2002, p. A3.
452
Id.
453
“PSI Report,” Hearing Exhibit 2b, Audit Committee Minutes of 2/7/99, p. 18.
454
Id., p. 16.
455
Id.
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Unit Four
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many off-the-books entities that it was creating. The general ethical principle on conflicts
is as follows:
Employees of Enron Corp., its subsidiaries, and its affiliated companies (collectively the “Company”) are
charged with conducting their business affairs in accordance with the highest ethical standards. An
employee shall not conduct himself or herself in a manner which directly or indirectly would be detrimental
to the best interests of the Company or in a manner which would bring to the employee financial gain
separately derived as a direct consequence of his or her employment with the company.456
Enron’s code also had a specific provision on conflicts related to ownership of businesses that do business with Enron, which provides,
The employer is entitled to expect of such person complete loyalty to the best interests of the Company . …
Therefore, it follows that no full-time officer or employee should: … (c) Own an interest in or participate,
directly or indirectly, in the profits of another entity which does business with or is a competitor of the Company, unless such ownership or participation has been previously disclosed in writing to the Chairman of the
Board and Chief Executive Officer of Enron Corp., and such officer has determined that such interest or participation does not adversely affect the best interests of the Company.457
The board’s minutes show that it waived this policy for Andrew Fastow on at least
three different occasions.458 In post-collapse interviews, members of the board have
insisted that they were not waiving Enron’s code of ethics for Mr. Fastow. In its defense
in shareholder lawsuits, the board members and company have argued that in granting a
waiver they were simply following the code’s policies and procedures.459 Granting the
waiver was a red flag. Even the conflicted Enron board saw the issue and engaged, at
least once, in what was called in the minutes “vigorous discussion.”460
David Duncan was concerned about this conflict of interest, and when Mr. Fastow
first proposed his role in the first off-the-books entity, Mr. Duncan, on May 28, 1999,
e-mailed a message of inquiry about the Fastow proposal to Benjamin Neuhausen, a
member of Andersen’s Professional Standards Group in Chicago. Mr. Neuhausen
responded, with some of the response in uppercase letters for emphasis: “Setting aside
the accounting, idea of a venture entity managed by CFO is terrible from a business
point of view. Conflicts galore. Why would any director in his or her right mind ever
approve such a scheme?” Mr. Duncan wrote back to Mr. Neuhausen on June 1, 1999,
“[O]n your point 1 (i.e., the whole thing is a bad idea), I really couldn’t agree more.
Rest assured that I have already communicated and it has been agreed to by Andy that
CEO, General [Counsel], and Board discussion and approval will be a requirement, on
our part, for acceptance of a venture similar to what we have been discussing.”461
Mr. Duncan, the Andersen audit partner responsible for the Enron account, had
expressed concern about the aggressive accounting practices Enron sought to use. Attorney Rusty Hardin, who served as Andersen’s lead defense lawyer in the obstruction of
justice case against the company for document shredding, noted that “no question
David Duncan was a client pleaser.”462 Mr. Duncan also experienced pressure from his
client and even consulted his pastor about how to resolve the dilemmas he faced in
terms of approval of the financial statements: “He basically said it was unrelenting. It
456
Enron Corporation, “Code of Ethics, Executive and Management,” (July 2000), p. 12.
457
Id., p. 57.
458
“PSI Report,” p. 26.
459
Id., p. 25.
460
Id., p. 28, citing the Hearing Record, p. 157.
461
Id., p. 26.
462
Raghavan, “How a Bright Star at Andersen Fell Along with Enron,” pp. A1, A8.
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The Industry Practices and Legal Factors
Section E
299
was a constant fight. Wherever he drew that line, Enron pushed that line—he was under
constant pressure from year to year to push that line.”463
Enron and Andersen Fall
The special report commissioned by the Enron board following its collapse described
Enron’s culture as “a flawed idea, self-enrichment by employees, inadequately designed
controls, poor implementation, inattentive oversight, simple (and not so simple)
accounting mistakes, and overreaching in a culture that appears to have encouraged
pushing the limits.”464 In an interview with CFO Magazine in 1999, when he was
named CFO of the year, Mr. Fastow explained that he was able to keep Enron’s share
price high because he spun debt off its books into SPEs.465
As the problems at Enron began to go from percolating to parboil, there was a cloud
of nervousness that hung over Andersen. Based on an increasing number of questions
that were coming into the Chicago office as Enron stories continued to appear in the
news, Andersen’s in-house counsel, Nancy Temple, sent around a memo that included
the following advice on the firm’s document destruction policy: “It will be helpful to
make sure that we have complied with the policy.”466 Andersen’s policy allowed for
destruction of records when those records “are no longer useful for an audit.467 There
ensued a bit of a fine-line scramble on the Enron papers and documents that Andersen
held.
When Enron announced, on October 16, 2001, its third quarter results, the $1.01 billion charge to earnings was not an easy thing for the market to absorb. The release characterized the charge to earnings as “non-recurring.” Andersen officials had spoken with
Enron executives to express their doubts about this characterization of the charge, but
Enron refused to alter the release. Ms. Temple wrote an e-mail to Duncan that “suggested deleting some language that might suggest we have concluded the release is
misleading.”468 The following day, the SEC notified Enron by letter that it had opened
an investigation in August and requested certain information and documents. On October 19, 2001, Enron forwarded a copy of that letter to Andersen.
Also on October 19, 2001, Ms. Temple sent an internal team of accounting experts
a memo on document destruction and attached a copy of the document policy. On
October 20, 2001, the Enron crisis-response team held a conference call, during
which Temple instructed everyone to “[m]ake sure to follow the [document] policy.”
On October 23, 2001, then–Enron CEO Lay declined to answer questions during a call
with analysts because of “potential lawsuits, as well as the SEC inquiry.” After the call,
Duncan met with other Andersen partners on the Enron engagement team and told
them that they should ensure team members were complying with the document policy.
Another meeting for all team members followed, during which Duncan distributed the
policy and told everyone to comply. These and other smaller meetings were followed by
substantial destruction of paper and electronic documents.
On October 26, 2001, one of Andersen’s senior partners circulated a New York Times
article discussing the SEC’s response to Enron. His e-mail commented that “the problems are just beginning and we will be in the cross hairs. The marketplace is going to
463
Id., p. A8.
464
Kurt Eichenwald, “Enron Panel Finds Inflated Profits and Few Controls,” New York Times, February 3, 2002, p. A1.
465
David Barboza and John Schwartz, “The Finance Wizard behind Enron’s Deals,” New York Times, February 6,
2002, pp. A1, C9.
466
Tony Mauro, “One Little E-Mail, One Big Legal Issue,” National Law Journal, April 25, 2005, p. 7.
467
Id.
468
544 U.S. at 700.
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Unit Four
Ethics and Company Culture
keep the pressure on this and is going to force the SEC to be tough.”469 On October 30,
the SEC opened a formal investigation and sent Enron a letter that requested accounting
documents. Throughout this time period, the document destruction continued, despite
reservations by some of Andersen’s managers. On November 8, 2001, Enron announced
that it would issue a comprehensive restatement of its earnings and assets. Also on
November 8, the SEC served Enron and petitioner with subpoenas for records. On
November 9, Duncan’s secretary sent an e-mail that stated, “Per Dave—No more
shredding.… We have been officially served for our documents.”470
Andersen maintained that the shredding was routine, but the federal government
indicted the company and Mr. Duncan. Mr. Duncan entered a guilty plea to obstruction
of justice and ultimately testified against Andersen in court. Andersen was convicted of
obstruction of justice. Its felony conviction meant that it could no longer conduct audits,
and those clients that remained were now required to hire other auditors. Within a period of two years, Andersen went from an international firm of 36,000 employees to
nonexistence.
However, Andersen did take the case to the U.S. Supreme Court, which ruled in its
favor the conviction for obstruction of justice.471 The court found that although there
may have been intent on the part of the individuals involved in the shredding, the jury
was not properly instructed on the proof and intent required to convict the accounting
firm itself. Following the Supreme Court’s reversal of the decision, Mr. Duncan withdrew
his guilty plea. The government has the option of prosecuting Mr. Duncan but has, so
far, declined to do so.
Discussion Questions
1. With regard to the destruction of the documents,
was there a difference between what was legally
obstruction of justice and what was ethical in
terms of understanding what was happening at
Enron? When the U.S. Supreme Court reversed
the Andersen decision, the Wall Street Journal
noted that the Andersen case was a bad legal
case and a poor prosecutorial decision on the
part of the Bush administration.472 Why do you
think the prosecutors took the case forward?
What changes under SOX would make the case
easier to pursue today?
2. David Duncan was active in his church, a father of
three young daughters, and a respected alumnus
of Texas A&M. Mr. Duncan’s pastor talked with
the New York Times following Enron’s collapse
and Duncan’s indictment, and discussed with the
reporter what a truly decent human being Duncan
was.473 What can we learn about the nature of
those who commit these missteps? What can you
add to your credo as a result of Duncan’s experience? Was the multimillion-dollar compensation
he received a factor in his decision-making processes? Can you develop a decision tree on Duncan’s thought processes from the time of the first
SPE until the shredding? Using the models you
learned in Units 1 and 2, what can you see that
he missed in his analysis?
3. In 2000, a full two years before WorldCom’s collapse, Steven Brabbs, WorldCom’s director of
international finance and control, who was based
in London, raised objections when he discovered
after he had completed his division’s books for the
year that $33.6 million in line costs had been
dropped from his books through a journal
entry.474 He was told that the changes were
made pursuant to orders from CFO Scott Sullivan.
He next suggested that the treatment be cleared
469
544 U.S. at 701.
470
544 U.S. at 702.
471
Arthur Andersen LLP v. U.S., 544 U.S. 696 (2005).
472
The editorial is “Arthur Andersen’s ‘Victory,’” Wall Street Journal, June 1, 2005, p. A20. The court decision is
Arthur Andersen LLP v. U.S., 544 U.S. 696 (2005).
473
Raghavan, “How a Bright Star at Andersen Fell Along with Enron,” pp. A1, A8.
474
Kurt Eichenwald, “Auditing Woes at WorldCom Were Noted Two Years Ago,” New York Times, July 15, 2002,
pp. C1, C9.
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The Industry Practices and Legal Factors
with Arthur Andersen.475 When there was no
response to his suggestion that the external auditor be consulted, Mr. Brabbs again raised his
objections in a meeting with internal financial
executives a few months later. Following the
meeting, Mr. Brabbs was chastised by WorldCom’s controller for raising the issue again.476
The following quarter, Mr. Brabbs received orders
from WorldCom headquarters to make another
similar change, but to do so at his level rather
than having it done from corporate headquarters
via journal entry. Unwilling to have the entries
generate from his division, he created another
entity and transferred the costs to it.477 He voiced
his concerns again and was told that there was no
choice because the accounting was a “Scott Sullivan directive.”478 Mr. Brabbs also had a meeting
with Arthur Andersen auditors to discuss his concerns. Following the meeting he received an
e-mail from WorldCom’s controller, David Myers,
which directed that Mr. Brabbs was “not [to] have
any more meetings with AA for any reason.”479
When WorldCom’s internal audit staff began to
raise questions about the reserves and the capitalization of ordinary expenses, they were prohibited
from doing further work and, for the most part,
worked nights and weekends to untangle the
accounting nightmare they had first discovered
with a simple question about receipts for some
Section E
301
capitalized expenses. CFO Scott Sullivan asked
the audit staff to wait at least another quarter
before continuing with their investigation. Andersen auditors reported any internal audit inquiries
to Sullivan and did not follow through on questions and concerns raised.480 What controls were
missing? Why the reporting lines to Sullivan?
4. One of the tragic ironies to emerge from the collapse of Arthur Andersen, following its audit work
for Sunbeam, WorldCom, and Enron, was that it
had survived the 1980s savings-and-loan scandals
unscathed. In Final Accounting: Ambition, Greed
and the Fall of Arthur Andersen, the following
poignant description appears: “The savingsand-loan crisis, when it came, ensnared almost
every one of the Big 8. But Arthur Andersen skated
away virtually clean, because it had made the
decision, years earlier[,] to resign all of its clients
in the industry. S&Ls for years had taken advantage of a loophole that allowed them to boost
earnings by recording the value of deferred
taxes. Arthur Andersen accountants thought the
rule was misleading and tried to convince their
clients to change their accounting. When they
refused, Andersen did what it felt it had to: It
resigned all of its accounts rather than stand
behind accounting that it felt to be wrong.”481
What takes a company from the gold standard to
indictment and conviction?
Compare & Contrast
Following its declaration of bankruptcy, Lehman Brothers’ trustee released a report that
indicated it was able to spin off its risky debt instruments to SPEs under what was
known as Repo 105. Lehman controlled 25 percent of the boards of these SPEs, although
its relationship with the SPEs was depicted as arms-length.482 As a result of these layers
of transfer, Lehman was able to look financially sound right up until the collapse of the
market in 2008 when the CDO market collapsed.
The bankruptcy trustee gave this summary of the Lehman practices:
Lehman employed off-balance sheet devices, known within Lehman as “Repo 105” and “Repo 108” transactions, to temporarily remove securities inventory from its balance sheet, usually for a period of seven to
ten days, and to create a materially misleading picture of the firm’s financial condition in late 2007 and
475
Id., p. C9. The information was taken from Mr. Brabbs’s statement to the government during its initial investigation
of WorldCom.
476
Id.
477
Id.
478
Id.
479
Jessica Sommar, “E-Mail Blackmail: WorldCom Memo Threatened Conscience-Stricken Exec,” New York Post,
August 27, 2002, p. 27.
480
Pulliam and Solomon, “How Three Unlikely Sleuths Discovered Fraud at WorldCom,” pp. A1, A6.
481
Toffler, Final Accounting, 19.
482
Louise Story and Eric Dash, “Lehman Channeled Risks Through Alter Ego’ Firm,” New York Times, April 13, 2010,
p. A1.
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Unit Four
Ethics and Company Culture
2008. Repo 105 transactions were nearly identical to standard repurchase and resale (“repo”) transactions
that Lehman (and other investment banks) used to secure short-term financing, with a critical difference:
Lehman accounted for Repo 105 transactions as “sales” as opposed to financing transactions based upon
the overcollateralization or higher than normal haircut in a Repo 105 transaction. By recharacterizing the
Repo 105 transaction as a “sale,” Lehman removed the inventory from its balance sheet.
The bankruptcy trustee does not address whether the transactions complied with
accounting rules because he concludes that the failure to disclose their escalating debt
and increasingly worthless securities was material. What does the bankruptcy trustee
mean that compliance with the accounting rules is not the issue? Analyze why the lessons of other collapsed companies are not internalized by businesses that use the same
strategies.
Case 4.22
The Ethics of Walking Away
Facing foreclosure, mortgagors who have loans that exceed their property value often
have a sense of hopelessness and “nothing to lose.” These mortgagors simply leave the
property, something that is likely in an underwater mortgage because they have so little
to lose. Their credit rating is affected, but they no longer have the payments or the worries of maintenance. In some cities, mortgagors who have abandoned their homes have
stripped the property of everything from the stove to the copper plumbing. The federal
government has set up special task forces to try to stop the stripping of properties by
mortgagors.
Most mortgage agreements require the mortgagor to maintain the property in livable
condition, but again, desperate times bring desperate actions. Also, taking items from the
mortgaged property is not theft unless and until title has been taken back through the
foreclosure process. Stripped and abandoned properties bring down the value of neighborhoods and result in increased crime levels. Areas with high levels of abandoned properties now unoccupied and held by lenders that are unable to sell them have been labeled
“foreclosure ghettos.” In cities with high foreclosure rates, “walk-aways” and stripping
have resulted in urban blight in certain areas. Cities are passing ordinances that require
lenders to maintain the abandoned properties, or are actually taking back the properties
through eminent domain so that the abandoned homes do not become drug houses or
residences for the homeless.
Discussion Questions
1. Does the fact that many are walking away or selling their properties through “short sales” (a sale of
the property below the mortgage amount that is
approved by the original lender) make it ethical for
all owners to do the same?
2. List who is affected by a decision to walk away.
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