Chapter 2 ACC 260
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Chapter 2 ACC 260

Course Number: ACC 260, Spring 2011

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Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron Purpose of the Chapter Enron and the subsequent Arthur Andersen and WorldCom fiascoes have triggered a sea change of new expectations for governance and the accounting profession in United States and Canada, and are in the process of informing expectations around the world. These fiascoes created such a serious crisis of credibility in the...

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Two Governance, Chapter Accounting, and Auditing Reform, Post-Enron Purpose of the Chapter Enron and the subsequent Arthur Andersen and WorldCom fiascoes have triggered a sea change of new expectations for governance and the accounting profession in United States and Canada, and are in the process of informing expectations around the world. These fiascoes created such a serious crisis of credibility in the corporate accounting, reporting, and governance processes that that U.S. politicians created new frameworks of accountability and governance within the Sarbanes-Oxley Act to restore sufficient confidence to allow capital markets to return to normal functioning. In essence, the fiascoes accelerated and then the Sarbanes-Oxley Act crystallized heightened expectations for ethical behavior by businesspeople and members of the accounting profession. Understanding the issues, principles, and practices involved in these new expectations is essential to the anticipation and consideration of what will be appropriate future governance and behavior for corporations and professional accountants. Faced with applying a stream of new guidelines and regulations, including many spawned by the Sarbanes-Oxley Act, businesspeople and professional accountants will find their task facilitated by understanding their essencethe ethical underpinningsof the new initiatives. Governance and Accountability Reform Overview and Timeline of Events and Developments Multiple huge shocks generated a crisis of investor confidence in corporate and professional ethics that underpin North American capital market values and the trust that allows modern commerce. President Bush and leaders around the world were calling for answers and solutions to ensure compliance with fair values that the public could support and the public interest demanded. Ultimately, corporate governance and the accounting profession were shown to need reform to restore the trust and credibility needed for financial markets to work effectively. In mid-October 2001, vaunted giant Enron restated manipulated earnings, and on December 2 filed for bankruptcy, destroying billions in value especially of retirement investmentin the process. Amid stories of huge sham and fraudulent off-statement transactions, it became clear that senior executives enriched themselves beyond belief while the board of directors and Arthur Andersen, the auditor, apparently were unaware or worse. Frequently, Enron executives claimed bad memories, ignorance, or the Fifth Amendment in front of 55 Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 56 Part One The Ethics Environment Senate and Congressional committees. Government and the SEC seemed at a loss to deal with the situation. Stories also began to surface about a blatant, self-interested, and apparently inyour-face shredding of Enron audit documents by Arthur Andersen that ultimately produced charges on March 7, 2002, and, after protracted jury deliberations, an obstruction of justice conviction on June 15, 2002. Throughout the period from October 2001 to June 2002, Arthur Andersens client base and practice disintegrated. A firm of 85,000 worldwide was essentially gone. In the United States, 24,000 employees lost their jobs because of the decisions of probably less than 100 colleagues. Finally, on June 25 when Senate and Congress hearings were well along and some governance changes were starting to be considered, came the incredible specter of giant WorldCom also applying for bankruptcy protection. When it became known that executives had again manipulated profits through accounting shenanigans and the CEO had essentially loaned himself over $400 million without the apparent oversight of the board, the Congress and Senate were galvanized by growing public outrage to produce the Sarbanes-Oxley Act (SOX) on July 30, 2002. SOX provides frameworks for reform of the corporate governance system based on integrity and accountability, and for the accounting profession based on independence and fiduciary duty to the public interest. The provisions of SOX will be observed by U.S. SEC registrants, and probably by the worlds largest corporations that want access to U.S. capital markets and their auditors. The worlds of corporate governance, governance of the accounting profession, and of business ethics have entered a time warp on fast-forward. Understanding what happened and why, and what the impact will be on corporations, the accounting profession, and upon business ethics will assist in interpreting and planning for future developments. See Figure 2.1. The Enron Debacle Background With hindsight, most observers agree that Enrons problems were caused by a failure of the board of directors to exercise adequate oversight. This allowed the misuse of special purpose entities (SPEs), a form of partnership, to manipulate FIGURE 2.1 Governance Reform Timeline Public outrage grows, governance credibility falls Enron Bankruptcy December 2, 2001 WorldCom Restatement June 25, 2002; Bankruptcy July 21, 2002 SEC Regulations Stock Exchange Guidance Arthur Andersen Court Case Winter/Spring 2002 Sarbanes-Oxley Act Signed July 30, 2002 Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 57 financial reports, mislead investors, and self-remunerate the perpetrators. Arthur Andersen, Enrons audit firm, has essentially disintegrated, and the accounting profession, as well as corporate governance, will be forever altered. All of this was not apparent until almost the end of the story. Throughout the late 1990s, Enrons stock rose slowly on the New York Stock Exchange, within a trading range from $20 to $40. Within a few months of the start of the new millennium as shown in Figure 2.2, Enrons stock price leapt to $70, based upon the overall buoyancy of the stock markets in general, the favorable assessment accorded the company by analysts, and Enrons own reports of earnings and prospects. During 2000, Enrons stock traded in a range of $60 to $90, peaked in August at $90.56, and closed the year close to $80. In 2001, however, the trend was precipitously downward until an Enron share was virtually worthless. Rumors of Enrons demise had been circulating for months when, on December 2, 2001, the company filed for protection from creditors under Chapter 11 of the U.S. Securities Act. On April 2, 2002, a share of Enron stock was worth only 24 cents on the over-the-counter market. How and why did this occur? Who was to blame? What were the repercussions to be? Investors were scandalized, pensioners lost their life savings, the public was outraged, and the credibility of the financial markets and of the corporate world was shaken. How could the alleged financial manipulations have occurred under the watchful eyes of Enrons auditor, Arthur Andersen, and a blue-ribbon board of directors? Amid allegations that Enron alumni had infiltrated the U.S. government and its agencies, the ability and resolve of the Securities and Exchange Commission (SEC) and of the U.S. Justice Department were questioned. Officials and politicians hurriedly looked for answers that would restore that credibility and the trust that had been lost. So great was the concern that FIGURE 2.2 Enron Stock Chart, Weekly Prices, 19972002 ENRNQ Weekly ENRNQ 80 60 US Dollars S 40 20 0 1997 1998 1999 2000 2001 2002 2003 0.09 Reprinted courtesy of NAQ, Inc. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 58 Part One The Ethics Environment President Bush himself pledged that the guilty would be punished aggressively by government agencies. Bush called for governance reforms and offered a 10point plan for legislative action.1 After considerable delay and outcry, Enrons audit firm, Arthur Andersen LLP (AA), the fifth largest audit firm in the United States and one of the largest in the world, was charged on March 7, 2002, with obstruction of justice for shredding documents allegedly important to the governments investigation. As a condition of the charge, the SEC placed restrictions on AA to serve its SEC-registered clients, thus jeopardizing the ability of AA to continue as a firm. Ultimately it disintegrated and was taken over piecemeal by competitors. A separate section is included later that contains a full discussion of the troubles of Arthur Andersen, and how probably less than 100 AA people were responsible for the disaster that ruined a once-revered firm that employed 85,000 worldwide. In addition, the self-regulatory framework that the profession had enjoyed in the United States was further eroded. Not surprisingly, the desire to know why the Enron disaster occurred spawned many investigations, including the following that are available for review and download from www.thomsonedu.com/accounting/brooks. The Powers Report by a specially formed subcommittee of Enrons BoardFebruary 1, 2002 (Powers) The Role of the Board of Directors in Enrons Collapse by the U.S. Senates Permanent Subcommittee on InvestigationsJuly 8, 2002 (Senate) The Accounting Treatment of Prepays by Robert Roach, Counsel and Chief Investigator, U.S. Senates Permanent Subcommittee on InvestigationsJuly 27, 2002 (Roach) In addition, new governance initiatives continued to be issued and become relevant throughout the Enron fiasco period, including: The Joint Toronto Stock Exchange/Canadian Institute of Chartered Accountants Report on Governance The New York Stock Exchange Blue Ribbon Task Force Report and Regulations NASDAQ Governance Regulations Toronto Stock Exchange Regulations U.S. Securities and Exchange Commission Guidance Ontario Securities Commission Guidance What Happened? Who Was to Blame? The Powers Report The Powers Report was prepared by a three-person subcommittee of the Enron board chaired by William Powers, Jr., who joined the board in September 2001 and resigned in February 2002. The Powers subcommittee was appointed on October 26, 2002, with the mandate to investigate related-party transactions that had surprised the board and resulted in several restatements of issued financial statements and reports. In the Powers Reports own words: 1 Speech of March 7, 2002. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 59 On October 16, 2001, Enron announced that it was taking a $544 million aftertax charge against earnings related to transactions with LJM2 Co-Investment, L.P. (LJM2), a partnership created and managed by Fastow. It also announced a reduction of shareholders equity of $1.2 billion related to transactions with that same entity. Less than one month later, Enron announced that it was restating its financial statements for the period from 1997 through 2001 because of accounting errors relating to transactions with a different Fastow partnership, LJM Cayman, L.P. (LJM1), and an additional related-party entity, Chewco Investments, L.P. (Chewco). Chewco was managed by an Enron Global Finance employee, Kopper, who reported to Fastow. The LJM1- and Chewco-related restatement, like the earlier charge against earnings and reduction of shareholders equity, was very large. It reduced Enrons reported net income by $28 million in 1997 (of $105 million total), by $133 million in 1998 (of $703 million total), by $248 million in 1999 (of $893 million total), and by $99 million in 2000 (of $979 million total). The restatement reduced reported shareholders equity by $258 million in 1997, by $391 million in 1998, by $710 million in 1999, and by $754 million in 2000. It increased reported debt by $711 million in 1997, by $561 million in 1998, by $685 million in 1999, and by $628 million in 2000. Enron also revealed, for the first time, that it had learned that Fastow received more than $30 million from LJM1 and LJM2. These announcements destroyed market confidence and investors trust in Enron. Less than one month later, Enron filed for bankruptcy.2 After investigation, the Powers Report presented the following in its Summary of Findings: Employees enriched themselves by millions without proper approvalsFastow by $30 million, Kopper by at least $10 million, two others by at least hundreds of thousands of dollars. PartnershipsChewco, LJM1, and LJM2-were established and used to enter into transactions that (1) could not be arranged with independent entities, (2) were designed to accomplish favorable financial statement results, not to achieve bona fide economic objectives or to transfer risk,3 and (3) did not conform to U.S. accounting rules that could have enabled the hiding of assets and liabilities (debt). Other transactions were improperly entered into hedge or offset almost $1 billion in losses on Enrons merchant investments and thus improperly keep reported profit approximately $1 billion higher between the third quarters of 2000 and 2001. Only Enron had assets at risk in these transactions.4 The original accounting treatments for the Chewco and LJM1 transactions were wrong, as were many others, in spite of extensive involvement and advice from Arthur Andersen. AA was paid $5.7 million above their audit fees for the Chewco and LJM1 advice. Much of the need for restatement arose because of the failure to satisfy two conditions required for special purpose entities (SPEs) to be independent from Enron. They are: 2 3 Powers Report, 2, 3. Ibid., 4. 4 Ibid., 4. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 60 Part One The Ethics Environment (1) an owner independent of the company must make a substantive equity investment of at least 3% of the SPEs assets, and that 3% must remain at risk throughout the transaction; and (2) the independent owner must exercise control of the SPE.5 If these conditions had been satisfied, according to US accounting rules, Enron could have recorded gains and losses on transactions with the SPE, and the assets and liabilities of the SPE would not have been included in Enrons balance sheet, even though Enron and the SPE were closely related. The Senate Subcommittee Report The Senate Permanent Subcommittee on Investigations released its Report on the Role of the Board of Directors in the Collapse of Enron, on July 8, 2002. Based upon the evidence before it, including over one million pages of subpoenaed documents, interviews of thirteen Enron Board members, and the Subcommittee hearing on May 7, 2002, the U.S. Senate Permanent Subcommittee on Investigations makes the following findings with respect to the role of the Enron Board of Directors in Enrons collapse and bankruptcy. 1. Fiduciary Failure. The Enron Board of Directors failed to safeguard Enron shareholders and contributed to the collapse of the seventh largest public company in the United States, by allowing Enron to engage in high risk accounting, inappropriate conflict of interest transactions, extensive undisclosed off-the-books activities, and excessive executive compensation. The Board witnessed numerous indications of questionable practices by Enron management over several years, but chose to ignore them to the detriment of Enron shareholders, employees and business associates. 2. High Risk Accounting. The Enron Board of Directors knowingly allowed Enron to engage in high risk accounting practices. 3. Inappropriate Conflicts of Interest. Despite clear conflicts of interest, the Enron Board of Directors approved an unprecedented arrangement allowing Enrons Chief Financial Officer to establish and operate the LJM private equity funds which transacted business with Enron and profited at Enrons expense. The Board exercised inadequate oversight of LJM transaction and compensation controls and failed to protect Enron shareholders from unfair dealing. 4. Extensive Undisclosed Off-the-Books Activity. The Enron Board of Directors knowingly allowed Enron to conduct billions of dollars in off-the-books activity to make its financial condition appear better than it was and failed to ensure adequate public disclosure of material off-the-books liabilities that contributed to Enrons collapse. 5. Excessive Compensation. The Enron Board of Directors approved excessive compensation for company executives, failed to monitor the cumulative cash drain caused by Enrons 2000 annual bonus and performance unit plans, and failed to monitor or halt abuse by Board Chairman and Chief Executive Officer Kenneth Lay of a company-financed, multi-million dollar, personal credit line. 5 Ibid., 5. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 61 6. Lack of Independence. The independence of the Enron Board of Directors was compromised by financial ties between the company and certain Board members. The Board also failed to ensure the independence of the companys auditor, allowing Andersen to provide internal audit and consulting services while serving as Enrons outside auditor.6 These findings lead the Senate Subcommittee to make recommendations for (1) strengthening the oversight of directors, and (2) strengthening the independence of directors, the audit committee, and auditors of publicly traded companies.7 Failure of the Directors to Oversee or Govern Enron Adequately What Are Directors Expected to Do? According to the Senate Subcommittee, the governance model should function as follows: Fiduciary Obligations of Boards of Directors. In the United States, the Board of Directors sits at the apex of a companys governing structure. A typical Boards duties include reviewing the companys overall business strategy; selecting and compensating the companys senior executives; evaluating the companys outside auditor; overseeing the companys financial statements; and monitoring overall company performance. According to the Business Roundtable, the Boards paramount duty is to safeguard the interests of the companys shareholders.8 Directors operate under state laws that impose fiduciary duties on them to act in good faith, with reasonable care, and in the best interest of the corporation and its shareholders. Courts generally discuss three types of fiduciary obligations. As one court put it: Three broad duties stem from the fiduciary status of corporate directors: namely, the duties of obedience, loyalty, and due care. The duty of obedience requires a director to avoid committing . . . acts beyond the scope of the powers of a corporation as defined by its charter or the laws of the state of incorporation. . . . The duty of loyalty dictates that a director must act in good faith and must not allow his personal interest to prevail over the interests of the corporation. . . . [T]he duty of care requires a director to be diligent and prudent in managing the corporations affairs.9 In most states, directors also operate under a legal doctrine called the business judgment rule, which generally provides directors with broad discretion, absent evidence of fraud, gross negligence or other misconduct, to make good 6 7 Senate Subcommittee Report, 3. Ibid., 4. 8 Statement of Corporate Governance, The Business Roundtable, (September 1997), at 3. 9 Gearheart Industries v. Smith International, 741 F.2d 707, 719 (5th Cir.1984). Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 62 Part One The Ethics Environment faith business decisions. Most states permit corporations to indemnify their directors from liabilities associated with civil, criminal or administrative proceedings against the company. In addition, most U.S. publicly traded corporations, including Enron, purchase directors liability insurance that pays for a directors legal expenses and other costs in the event of such proceedings. Among the most important of Board duties is the responsibility the Board shares with the companys management and auditors to ensure that the financial statements provided by the company to its shareholders and the investing public fairly present the financial condition of the company. This responsibility requires more than ensuring the companys technical compliance with generally accepted accounting principles. According to the Second Circuit Court of Appeals, this technical compliance may be evidence that a company is acting in good faith, but it is not necessarily conclusive. The critical test, the Court said, is whether the financial statements as a whole fairly present the financial position of the company.10 Within this governance framework, Enrons directors were responsible for oversight of Enrons lines of business and strategies for financing them. One of the lines of businessthe online energy trading businessrequired access to large lines of credit to ensure settlement of trading positions at the end of each day. At the same time, the nature of this business caused large earnings fluctuations from quarter to quarter, which made it a challenge to maintain a low credit rating, and therefore access to low-cost financing. Other lines of business, such as optical fiber networks (that were mostly not in use), represented cash drains as well. Therefore, according to the Senate Subcommittee: In order to ensure an investment-grade credit rating, Enron began to emphasize increasing its cash flow, lowering its debt, and smoothing its earnings on its financial statements to meet the criteria set by credit rating agencies like Moodys and Standard & Poors. Enron developed a number of new strategies to accomplish its financial statement objectives. They included developing energy contracts Enron called prepays in which Enron was paid a large sum in advance to deliver natural gas or other energy products over a period of years; designing hedges to reduce the risk of long-term energy delivery contracts; and pooling energy contracts and securitizing them through bonds or other financial instruments sold to investors. Another high profile strategy, referred to as making the company asset light, was aimed at shedding, or increasing immediate returns on, the companys capital-intensive energy projects like power plants that had traditionally been associated with low returns and persistent debt on the companys books. The goal was either to sell these assets outright or to sell interests in them to investors, and record the income as earnings which top Enron officials called monetizing or syndicating the assets. A presentation made to the Finance Committee in October 2000 summarized this strategy as follows.11 It stated that Enrons [e]nergy and communications investments typically do not generate significant cashflow and earnings 10 U.S. v. Simon, 425 F.2d 796, 805-6 (2nd Cir. 1969), quoting, in part, the trial judge. See also 15 USC 77s and 78m (Every user . . . shall . . . keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and disposition of the assets of the issuer.) 11 Hearing Exhibit 39, Private Equity Strategy, Finance Committee presentation, October 2000. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 63 for 1-3 years. It stated that Enron had [l]imited cash flow to service additional debt and [l]imited earnings to cover dilution of additional equity. It concluded that Enron must syndicate or share its investment costs in order to grow. One of the problems with Enrons new strategies, however, was finding counterparties willing to invest in Enron assets or share the significant risks associated with long-term energy production facilities and delivery contracts.12 The October 2000 presentation to the Finance Committee showed that one solution Enron had devised was to sell or syndicate its assets, not to independent third parties, but to unconsolidated affiliatesbusinesses like Whitewing, LJM, JEDI, the Hawaii1250 Trust and others that were not included in Enrons financial statements but were so closely associated with the company that Enron considered their assets to be part of Enrons own holdings. The October 2000 presentation, for example, informed the Finance Committee that Enron had a total of $60 billion in assets, of which about $27 billion, or nearly 50 percent, were lodged with Enrons unconsolidated affiliates. All of the Board members interviewed by the Subcommittee were well aware of and supported Enrons intense focus on its credit rating, cash flow, and debt burden. All were familiar with the companys asset light strategy and actions taken by Enron to move billions of dollars in assets off its balance sheet to separate but affiliated companies. All knew that, to accomplish its objectives, Enron had been relying increasingly on complicated transactions with convoluted financing and accounting structures, including transactions with multiple special purpose entities, hedges, derivatives, swaps, forward contracts, prepaid contracts, and other forms of structured finance. While there is no empirical data on the extent to which U.S. public companies use these devices, it appears that few companies outside of investment banks use them as extensively as Enron. At Enron, they became dominant; at its peak, the company apparently had between $15 and $20 billion involved in hundreds of structured finance transactions.13 How Was Enrons Board Organized, and How Did It Function? In 2001, Enrons board of directors had 15 members, several of whom had 20 years or more experience on the board of Enron or its predecessor companies. Many of Enrons directors served on the boards of other companies as well. At the hearing, John Duncan, former chairman of the Executive Committee, described his fellow board members as well educated, experienced, successful businessmen and women, and experts in areas of finance and accounting.14 The subcommittee interviews found the directors to have a wealth of sophisticated business and investment experience and considerable expertise in accounting, derivatives, and structured finance. Enron board members uniformly described internal board relations as harmonious. They said that board votes were generally unanimous and could recall 12 As part of its asset light strategy, during the summer of 2000, Enron worked on a transaction called Project Summer to sell $6 billion of its international assets to a single purchaser in the Middle East. Enrons directors indicated during their interviews that this deal fell through when the purchasers key decision maker became ill. Enron then pursued the asset sales on a piecemeal basis, using Whitewing, LJM, and others. 13 Senate Subcommittee Report, 7, 8. 14 Hearing Record at 34. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 64 Part One The Ethics Environment only two instances over the course of many years involving dissenting votes. The directors also described a good working relationship with Enron management. Several had close personal relationships with Board Chairman and Chief Executive Officer (CEO) Kenneth L. Lay. All indicated they had possessed great respect for senior Enron officers, trusting the integrity and competence of Mr. Lay; President and Chief Operating Officer (and later CEO) Jeffrey K. Skilling; Chief Financial Officer Andrew S. Fastow; Chief Accounting Officer Richard A. Causey; Chief Risk Officer Richard Buy; and the Treasurer Jeffrey McMahon and later Ben Glisan. Mr. Lay served as chairman of the board from 1986 until he resigned in 2002. Mr. Skilling was a board member from 1997 until August 2001, when he resigned from Enron. The Enron Board was organized into five committees: 1. The Executive Committee met on an as needed basis to handle urgent business matters between scheduled Board meetings. Its members in 2001 were Mr. Duncan, the Chairman; Mr. Lay, Mr. Skilling, Mr. Belfer, Dr. LeMaistre and Mr. Winokur. 2. The Finance Committee was responsible for approving major transactions which, in 2001, met or exceeded $75 million in value. It also reviewed transactions valued between $25 million and $75 million; oversaw Enrons risk management efforts; and provided guidance on the companys financial decisions and policies. Its members in 2001 were Mr. Winokur, the Chairman; Mr. Belfer, Mr. Blake, Mr. Chan, Mr. Pereira and Mr. Savage. 3. The Audit and Compliance Committee reviewed Enrons accounting and compliance programs, approved Enrons financial statements and reports, and was the primary liaison with Andersen. Its members in 2001 were Dr. Jaedicke, the Chairman; Mr. Chan, Dr. Gramm, Dr. Mendelsohn, Mr. Pereira, and Lord Wakeham. Dr. Jaedicke and Lord Wakeham had formal accounting training and professional experience. Dr. Mendelsohn was the only Committee member who appeared to have limited familiarity with complex accounting principles. 4. The Compensation Committee established and monitored Enrons compensation policies and plans for directors, officers and employees. Its members in 2001 were Dr. LeMaistre, the Chairman; Mr. Blake, Mr. Duncan, Dr. Jaedicke, and Mr. Savage. 5. The Nominating Committee nominated individuals to serve as Directors. Its members in 2001 were Lord Wakeham, the Chairman; Dr. Gramm, Dr. Mendelsohn and Mr. Meyer. The board normally held five regular meetings during the year, with additional special meetings as needed. Board meetings usually lasted two days, with the first day devoted to committee meetings and a board dinner and the second day devoted to a meeting of the full board. Committee meetings generally lasted between one and two hours and were arranged to allow board members, who typically sat on three committees, to attend all assigned committee meetings. Full board meetings also generally lasted between one and two hours. Special board meetings, as well as meetings of the Executive Committee, were typically conducted by telephone conference. Committee chairmen typically spoke with Enron management by telephone prior to committee meetings to develop the proposed committee meeting agenda. Board members said that Enron management provided them with these agendas as well as extensive background and briefing materials prior to Board meetings including, in the case of Finance Committee members, numerous deal approval Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 65 sheets (DASHs) for approval of major transactions. Board members varied in how much time they spent reading the materials and preparing for board meetings, with the reported preparation time for each meeting varying between two hours and two days. On some occasions, Enron provided a private plane to transport board members from various locations to a board meeting, and board members discussed company issues during the flight. Enron also organized occasional trips abroad which some board members attended to view company assets and operations. During the committee meetings, Enron management generally provided presentations on company performance, internal controls, new business ventures, specific transactions, or other topics of interest. The Finance Committee generally heard from Mr. Fastow, Mr. Causey, Mr. Buy, Mr. McMahon and, occasionally, Mr. Glisan. The Audit Committee generally heard from Mr. Causey, Mr. Buy, and Andersen personnel. The Compensation Committee generally heard from the companys top compensation official, Mary Joyce, and from the companys compensation consultant, Towers Perrin. On occasion, the committees heard from other senior Enron officers as well. At the full board meetings, board members typically received presentations from each committee chairman summarizing the committees work and recommendations, as well as from Enron management and, occasionally, Andersen or the companys chief outside legal counsel, Vinson & Elkins. Mr. Lay and Mr. Skilling usually attended Executive, Finance, and Audit Committee meetings, as well as the full board meetings. Mr. Lay attended many Compensation Committee meetings as well. The subcommittee interviews indicated that, altogether, board members appeared to have routine contact with less than a dozen senior officers at Enron. The board did not have a practice of meeting without Enron management present. Regular presentations on Enrons financial statements, accounting practices, and audit results were provided by Andersen to the Audit Committee. The Audit Committee chairman would then report on the presentation to the full board. On most occasions, three Andersen senior partners from Andersens Houston office attended Audit Committee meetings. They were D. Stephen Goddard, head of the Houston office; David Duncan, head of the Andersen engagement team that provided auditing, consulting and other services to Enron; and Thomas H. Bauer, another senior member of the Enron engagement team. Before becoming head of the Houston office, Mr. Goddard had led the Enron engagement team for Andersen. Mr. Duncan became the worldwide engagement partner for Enron in 1997, and from that point on typically made the Andersen presentations to the Audit Committee. The Audit Committee offered Andersen personnel an opportunity to present information to them without management present. Minutes summarizing Committee and Board meetings were kept by the corporate secretary, who often took handwritten notes on committee and board presentations during the boards deliberations and afterward developed and circulated draft minutes to Enron management, board members, and legal counsel. The draft minutes were formally presented to and approved by committee and board members at subsequent meetings. Outside of the formal committee and board meetings, the Enron directors described very little interaction or communication either among Board members or between Board members and Enron or Andersen personnel, until the company began experiencing severe problems in October 2001. From October until the companys bankruptcy on December 2, 2001, the board held numerous special meetings, at times on almost a daily basis. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 66 Part One The Ethics Environment Enron board members were compensated with cash, restricted stock, phantom stock units, and stock options.15 The total cash and equity compensation of Enron board members in 2000 was valued by Enron at about $350,000 or more than twice the national average for board compensation at a U.S. publicly traded corporation.16,17 Enrons Questionable Transactions An understanding of the nature of Enrons questionable transactions is fundamental to understanding why Enron failed. What follows is a very abbreviated overview of the essence of the major important transactions with the SPEs, including: Chewco, LJM1, LJM2 and the Raptors. A much more detailed, but still abbreviated, summary of these transactions is included in the Enrons Questionable Transactions Case at the end of the chapter. Enron had been using specially created companies called special purpose entities (SPEs) for joint ventures, partnerships, and the syndication of assets for some time. But a series of happenstance events lead to the realization by Enron personnel that SPEs could be used unethically and illegally to: Overstate revenue and profits Raise cash and hide the related debt or obligations to repay Offset losses in Enrons stock investments in other companies Circumvent accounting rules for valuation of Enrons treasury shares Improperly enrich several participating executives Manipulate Enrons stock price thus misleading investors and enriching Enron executives who held stock options In November 1997, Enron created an SPE called Chewco to raise funds or attract an investor to take over the interest of Enrons joint venture investment partner, CalPERS,18 in an SPE called Joint Energy Development Investment Partnership (JEDI). Using Chewco, Enron had bought out CalPERS interest in JEDI with Enron-guaranteed bridge financing, and tried to find another investor. Enrons objective was to find another investor, called a counterparty, that would: Be independent of Enron Invest at least 3 percent of the assets at risk Serve as the controlling shareholder in making decisions for Chewco Enron wanted a 3 percent, independent, controlling investor because U.S. accounting rules would allow Chewco to be considered an independent company, and any transactions between Enron and Chewco would be considered at 15 See Hearing Exhibits 35a and 35b on Enron board member compensation, prepared by the subcommittee based upon information in Enron filings with the Securities and Exchange Commission. Phantom stock units at Enron were deferred cash payments whose amounts were linked to the value of Enron stock. 16 See Director Compensation; Purposes, Principles, and Best Practices, Report of the Blue Ribbon Commission of the National Association of Corporate Directors (2001), page V (average total board compensation at top 200 U.S. public corporations in 2000 was $138,747). 17 Senate Subcommittee Report, 8-11. 18 The California Public Employees Retirement System. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 67 arms length. This would allow profit made on asset sales from Enron to Chewco to be included in Enrons profit even though Enron would own up to 97 percent of Chewco. Unfortunately, Enron was unable to find an independent investor willing to invest the required 3 percent before its December 31, 1997, year end. Because there was no outside investor in the JEDI-Chewco chain, Enron was considered to be dealing with itself, and U.S. accounting rules required that Enrons financial statements be restated to remove any profits made on transactions between Enron and JEDI. Otherwise, Enron would be able to report profit on deals with itself, which, of course, would undermine the integrity of Enrons audited financial statements because there would be no external, independent validation of transfer prices. Enron could set the prices to make whatever profit it desired and manipulate its financial statements at will. That, in fact, was exactly what happened. When no outside investor was found, Enrons CFO, Andrew Fastow, proposed that he be appointed to serve as Chewcos outside investor. Enrons lawyers pointed out that such involvement by a high-ranking Enron officer would need to be disclosed publicly, and one of Fastows financial staffa fact not shared with the boardMichael Kopper, who continued to be an Enron employee, was appointed as Chewcos 3 percent, independent, controlling investor, and the chicanery began. Enron was able to sell (transfer really) assets to Chewco at a manipulatively high profit. This allowed Enron to show profits on these asset sales and draw cash into Enron accounts without showing in Enrons financial statements that the cash stemmed from Chewco borrowings and would have to be repaid. Enrons obligations were understatedthey were hidden and not disclosed to investors. Duplicity is also evident in the way that Chewcos funding was arranged. CalPERS interest in JEDI was valued at $383 million; of that amount, Kopper and/or outside investors needed to be seen to provide 3 percent, or $11.5 million. The $383 million was arranged as follows: $240.0 132.0 0.1 11.4 $383.5 Barclays Bank PLCEnron would later guarantee this JEDI to Chewco under a revolving credit agreement Kopper and his friend Dodson ($125,000) Barclays Bank PLC loaned19 to Dodson/Kopper companies These financing arrangements are diagramed in Figure 2.3. Essentially, Enron as majority owner put no cash into the SPE. A bank provided virtually all of the cash, and in reality the so-called 3 percent, independent, controlling investor had very little investednot even close to the required 3 percent threshold. Nonetheless, Chewco was considered to qualify for treatment as an arms-length entity for accounting purposes by Enron and its auditors, Arthur Andersen. Enrons board, and presumably Arthur Andersen, were kept in the dark. A number of other issues in regard to Chewco transactions were noted in the Powers Report, including: Excessive management fees were paid to Kopper for little work.20 Excessive valuations were used upon winding-up thus transferring $10.5 million to Kopper. 19 20 Loaned through shell companies, and for certificates that would generate a yield. Fastows wife did most of the work. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 68 Part One The Ethics Environment FIGURE 2.3 Chewco Financing, in Millions Kopper & Dodsons Company Dodson Companies Enron $0.125 Jedi $132 Revolving Credit Source sBank Non-cash Investors $251.4 132.0 0.1 $11.4 $11.4 Loan* Chewco $240 Loan Barclays Bank Plc Kopper sought and received $2.6 million as indemnification from tax liability on the $10.5 million. Unsecured, nonrecourse loans totaling $15 million were made to Kopper and not recovered. Enron advance-booked revenues from Chewco. This pattern of financingno or low Enron cash invested, banks providing most of the funding, Enron employees masquerading as 3 percent, independent, controlling investorscontinued in other SPEs. Some of these SPEs, such as the LJM partnerships, were used to create buyers for Enron assets where Enron could keep control, but convert fixed assets into cash for growth at inflated prices, thus overstating cash and profits. Other SPEs, such as LJM1 and LJM2, provided illusionary hedge arrangements to protect Enron against losses in its merchant21 investment portfolio, thereby falsely protecting Enrons reported profits. In March 1998, Enron invested in Rhythms NetCommunications, Inc. (Rhythms), a business Internet service provider. Between March 1998 and May 1999, Enrons investment of $10 million in Rhythms stock soared to approximately $300 million. Enron recorded the increase in value as profit by increasing the value of its investment on its books. But Jeffrey K. Skilling, Enrons CEO, realized that the mark-to-market accounting procedure used would require continuous updating, and the change could have a significant negative affect on Enrons profits due to the volatility of Rhythms stock price. He also correctly foresaw that Rhythms stock price could plummet when the Internet bubble burst due to overcapacity. LJM1 (LJM Cayman LP), was created to hedge against future volatility and losses on Enrons investment in Rhythms. If Rhythms stock price fell, Enron 21 A merchant investment is an investment in a companys shares that are held for speculative purposes, not for control purposes. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 69 would have to record a loss in its investment. However, LJM1 was expected to pay Enron to offset the loss, so no net reduction would appear in overall Enron profit. As with Chewco, the company was funded with cash from other investors and banks based partly on promises of large guaranteed returns and yields. Enron invested its own shares, but no cash. In fact, LJM1 did have to pay cash to Enron as the price of Rhythms stock fell. This created a loss for LJM1 and reduced its equity. Moreover, at the same time as LJM1s cash was being paid to Enron, the market value of Enrons shares was also declining, thus reducing LJM1s equity even further. Ultimately, LJM1s effective equity eroded, as did the equity of the SPE (Swap Sub) Enron created as a 3 percent investment conduit. Swap Subs equity actually became negative. These erosions of cash and equity exposed that fact that the economic underpinning of the hedge of Rhythms stock was based on Enrons sharesin effect, Enrons profit was being hedged by Enrons own shares. Ultimately, hedging yourself against loss provides no economic security against loss at all. Enrons shareholders had been misled by $95 million profit in 1999 and $8 million in 2000. These were the restatements announced in November 2001, just before Enrons bankruptcy on December 2, 2001. Unfortunately for Enron, there were other flaws in the creation of LJM1 that ultimately rendered the arrangement useless, but by that time investors had been mislead for many years. For example, there was no 3 percent, independent, controlling investorAndrew Fastow sought special approval from Enrons chairman to suspend the conflict of interest provisions of Enrons Code of Conduct to become the sole managing/general partner of LJM1 and Swap Sub; and Swap Subs equity became negative and could not qualify for the 3 percent test unless Enron advanced more shares, which it did. Ultimately, as Enrons stock price fell, Fastow decided the whole arrangement was not sustainable, and it was wound up on March 22, 2000. Once again, the wind-up arrangements were not properly valued; $70 million more than required was transferred from Enron, and LJM1 was also allowed to retain Enron shares worth $251 million. Enrons shareholders were also misled by Enrons recording of profit on the treasury shares used to capitalize the LJM1 arrangement. Enron provided the initial capital for LJM1 arrangements in the form of Enrons own treasury stock, for which it received a promissory note. Enron recorded this transfer of shares at the existing market value, which was higher than the original value in its treasury, and therefore recorded a profit on the transaction. Since no cash had changed hands, the price of transfer was not validated, and accounting rules should not have allowed the recording of any profit. Initially, the LJM1 arrangements were thought to be so successful at generating profits on treasury shares, hedging against investment losses, and generating cash, that LJM2 Co-Investment LP (LJM2) was created in October 1999 to provide hedges for further Enron merchant investments in Enrons investment portfolio. LJM2 in turn created four SPEs, called Raptors, to carry out this strategy using similar methods of capitalization based on its own Treasury stock or options thereon. For a while, the Raptors looked like they would work. In October 2000, Fastow reported to LJM2 investors that the Raptors had brought returns of 193, 278, 2,500, and 125 percent, which was far in excess of the 30 percent annualized return described to the finance committee in May 2000. Of course, as we know now, Enron retained the economic risks. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 70 Part One The Ethics Environment Although nontransparent arrangements were used again, the flaws found in the LJM1 arrangements ultimately became apparent in the LJM2 arrangements, including: Enron was hedging itself, so no external economic hedges were created. Enrons falling stock price ultimately eroded the underlying equity and creditworthiness involved, and Enron had to advance more treasury shares or options to buy them at preferential rates22 or use them in costless collar23 arrangements, all of which were further dilutive to Enron earnings per share. Profits were improperly recorded on treasury shares used or sheltered by nonexistent hedges. Enron officers and their helpers benefited. In August 2001, matters became critical. Declining Enron share values, and the resulting reduction in Raptor creditworthiness, called for the delivery of so many Enron shares that the resulting dilution of Enrons earnings per share was realized to be too great to be sustainable. In September 2001, accountants at Arthur Andersen and Enron realized that the profits generated by recording Enron shares used for financing at market values was incorrect because no cash was received, and shareholders equity was overstated by at least $1 billion. The overall affect of the Raptors was to misleadingly inflate Enrons earnings during the middle period of 2000 to the end of the third quarter of 2001 (September 30) by $1,077 million, not including a September Raptor winding-up charge of $710 million. On December 2, 2001, Enron became the largest bankruptcy in the world, leaving investors ruined, stunned, and outragedand quite skeptical of the credibility of the corporate governance and accountability process. By that time, the Enron SPEs and related financial dealings had misled investors greatly. Almost 50 percent of the reported profits driving Enron stock up so dramatically were false. Table 2.1 summarizes the impacts of Enrons questionable transactions through key Enron SPEs. TABLE 2.1 Enrons Key Special Purpose Entities (SPEs) SPE SCH E M E PU R P OSE I M PACT Chewco/JEDI Syndicated investment LJM Provided market for assets Investment hedge Investment hedge LJM1/Rhythms LJM2/Raptors Off balance sheet liabilities hidden ($628 million), Revenues recognized early, Profits on own shares Artificial profits, Off balance sheet liabilities hidden Equity overstated ($1.2 billion) Unrecognized losses ($508 million) Unrecognized losses ($544 million) 22 23 Raptors III and IV were not fully utilized and/or used to shore up the equity of Raptors I and II. A costless collar is a two-step arrangement wherein Enron offered to contain LJM2s risk of Enrons stock price falling below a lower limit using its own Treasury shares, while at the same time making an offsetting arrangement for LJM2 to pay Enron if Enrons share price were to rise above a threshold. Since the arrangements offset one another in risk premium, and Treasury stock was to be used, the transaction was considered to be an equity transaction which did not affect the income statement of Enron. See page 110 of the Powers Report. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 71 TABLE 2.2 Payments to Fastow & Helpers R ETU R N, I N M I LLIONS OTH E R, I N M I LLIONS I NVESTM E NT A. Fastow M. Kopper B. Glisan K. Mordaunt $25,000 125,000 5,800 5,800 $ 4.5 in 2 mo. 10.0 incl. Dodson 1.0 1.0 $30 + stock options $2 in fees Enron Culture, Conflicts of Interest, and Whistle-Blowers How could the employees of Enron, Arthur Andersen, and Vinson & Elkins stand by when the returns to the Enron SPEs were so incredibly high at 193, 278, 2,500, and 125 percent? The returns to individuals involved were also spectacular even though they were already being paid by Enron, as Table 2.2 shows. Many Enron employees knew about the lack of integrity of the SPE dealings, but few came forward, and the ears of the board did not hear their stories. Perhaps more would have come forward, or made a more determined effort to contact the board, if conditions within Enron were different. Enrons culture was lacking in integrity to a surprising degree. For example, it is reported that a sham energy trading floor was created to mislead a group of stock analysts. The floor was complete with computers, desks, chairs, and traders. What employee would have thought that such an elaborate hoax could be created without the knowledge of the senior executives? And who would come forward with other tales of wrongdoing knowing that the senior officials encouraged or acquiesced to such outrageous behavior? A further example of major malfeasance is the reciprocal wash trading engaged in with other energy companies during the California energy crisis during the summer of 2000, which was designed to inflate demand and Enron revenues without generating any profits since there was no substantive transaction. An Enron employee would have to be an ethical hero to come forward to report ethical problems when Enrons culture and senior officers were apparently willing to go along with, or even lead in, the wrongdoing. Some employees did come forward, however. Not surprisingly, they made little impact on the minds and actions of senior Enron management, and none on Enrons directors. As Table 2.3 shows, some came to Andrew Fastow and others to Kenneth Lay. Fastow was clearly making himself wealthy and was not about to turn himself in, or change his ways. Lay consulted Enrons lawyers about Sherron Watkinss initially anonymous letter, but they had been paid as consultants to set up the SPE strategy and were not likely to report that they had made a mistake. Whether Lay did this purposely or not will probably never be known. In any event, the board of directors failed to pick up on many red flags, and apparently remained blissfully in the dark until too late. The board trusted Lay and Fastow to serve their interests and those of the shareholders, and the shareholders, pensioners, and employees paid the price. The Sherron Watkins letter, sent on August 15, 2001, and which is available, along with her Senate Subcommittee testimony of February 14, 2002, at www.thomsonedu.com/accounting/brooks is discussed at some length in the Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 72 Part One The Ethics Environment TABLE 2.3 Enron Whistle-Blowers B LEW TO ACTION SU BSEQU E NTLY Cliff Baxter, Vice Chair Lay None McMahon, Treasurer Kaminski, Risk Mgr. Sherron Watkins Fastow Fastow Lay None None None Exercised $32 million in stock options, just agreed to testify to Congress, found shot dead in his caran apparent suicideon Jan. 25, 2002 Reassigned, later returned as CEO Continued Discussed with Skilling and asked Vinson & Elkins to review Powers Report beginning on page 172. Sherron was a competent professional accountant who had worked for Arthur Andersen for many years before joining Enron. She complained that the aggressive accounting being practiced by Enron would implode, and it did. When Lay apparently did not change things because of her letter and their meetings, she was quite prepared to testify before investigating committees. If only a very few knowledgeable board members had heard her concerns, perhaps action could have been taken earlier. Sherron is a highly principled woman who knew what could happen and feared the worst. She realized the stakes were so high that she ultimately put her concerns for her own self-interest aside and came forward. Initially, however, she sent her letter anonymouslyan indication of her concern about the reception and treatment she expected. One of the unexplained Enron conundrums is why the following men who occupied senior positions at Enron, all of whom had continuous interaction with board members, apparently did not come forward with concerns: Richard Causey, Chief Accounting Officer Richard Buy, Chief Risk Officer Ben Glisan, Treasurer and senior accountant Why werent they loyal agents of Enron? Perhaps they were just too anxious to keep Andrew Fastow happy. Perhaps their lack of loyalty had something to do with the desire to please Fastow and Lay, who had a significant influence over Enrons stock option incentive plan. It was a particularly lucrative plan, as Table 2.4 shows. Startlingly, many boards of directors took the view that stock options were of no cost to the issuing companies because they were not recorded on the financial statements when earmarked for the recipient.24 Prevailing practice in the United States was to record stock options only when and if exercised, and then only at 24 In 2004, Warren Buffet championed a change in treatment by encouraging many companies to record stock options as compensation expense when granted rather than wait exercised. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 73 TABLE 2.4 Enron Stock Proceeds, October 1998 to November 2001, Over $30 Million Lou Pal Ken Lay Rebecca Mark-Jusbasche Ken Harrison Kenneth Rice Jeffrey Skilling Mark Frevert Stanley Horton Joseph Sutton J. Clifford Baxter Joseph Hirco Andrew Fastow Chairman, Enron Accelerator Chairman Director Director, Portland General Electrics Chairman, Enron Broadband Director (former CEO) Vice Chairman Global Chairman Vice Chairman Vice Chairman CEO, Enron Broadband Chief Financial Officer $353.7 million 101.3 79.5 75.2 72.8 66.9 50.3 45.5 40.1 35.2 35.2 30.5 Source: 2002 Washington Post. Reprinted with permission. the exercise price, not at market price. The chairman of Enrons compensation committee implied this during his Senate Subcommittee testimony on the subject of Lays overall compensation of $141 million for 2001, the stock option portion of which was approximately $130 million.25 Arthur Andersens Role Arthur Andersen (AA) was, as Enrons auditor, supposed to be a professional fiduciary looking out for the interests of Enrons shareholders and their representatives, Enrons board of directors. That they did not do so because they missed or ignored huge manipulationsand then were caught shredding Enron audit documents, added significantly to the outrage felt by investors, pensioners, media, and politicians. Confidence in financial markets, in corporate governance and financial statements that underlay investor decisions, and in the audit profession eroded dramatically. Ultimately, AAs ability to audit SEC registrant companies was suspended by the SEC because of repeated difficulties, such as were found with the Enron audit, in the audits of Sunbeam, Waste Management, Inc., and, later, WorldCom. Clients left for other firms. AA was found shredding Enron audit working papers, and found guilty of obstructing justice as a result. Partners and staff left to join other firms. Essentially, a firm of 24,000 employees in the United States and 85,000 worldwide vaporized in less than a year. Details of AAs deficiencies are outlined more fully in the accompanying case, Arthur Andersens Troubles. The once-proud firm that defined the standard for integrity occupied the following roles with regard to Enron: Auditor Consultant on accounting and other matters, including SPE transactions 25 Testimony of Charles Lemaistre on May 7, 2002, at http://www.senate.gov/~gov_affairs/ 050702lemaistre.htm Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 74 Part One The Ethics Environment Internal auditor, since this function was contracted out by Enron to AA Advisor on tax matters Advisor, reviewer of financial disclosure For the year 2000, AA is said to have received fees of approximately $52 million: $25 million for audit work and $27 million for other services. There is little doubt that Enron was one of AAs largest clients, and was growing. AAs internal culture was reportedly driven by the desire for revenue, so Enron was one of AAs prize possessions. Given these facts, AA and its personnel were confronted by several conflicts of interest, which may have impinged upon and weakened their resolve to act in their fiduciary relationship as auditors, including: Auditing their own work as SPE consultants, leading to a lack of objectivity Self-interest versus the publics interest, leading to wishing not to upset Enron management and thus: I I I Losing a very large, prestigious audit and a huge audit fee Partners not liked by Enron were removed from the audit Noncompliance with company policies and codes was not brought to the attention of the board AAs internal debates over Enrons questionable accounting treatments and business risks were not aired with the audit committee to ensure that the members were knowledgeable Public disclosures were not satisfactory to inform investors I I Audit staff wishing to leave AA and join Enron. Of course, AAs shortcomings may be due, in part, to: A lack of competence, such as displayed in the Rhythms decisions A failure of AAs internal policies whereby the concerns of a Quality Control or Practice Standards partner could be and were overruled by the audit partner in charge of the Enron account. AA was the only one of the Big 5 accounting firms to have this flaw, and it left the entire firm vulnerable to the decision of the person with the most to lose by saying no to a client Lack of information caused by Enron staff not providing critical information, or failure on the part of AA personnel to ferret it out A misunderstanding of the fiduciary role required by auditors Regardless of the causes, AA did not live up to the expectations of the public, the board, current shareholders, the accounting profession, and regulators. Ultimately, AA was indicted and convicted in 2002 for the obstruction of justice because personnel in several cities shredded Enron audit papers. AA claimed these were not important, but this lacked credibility and could not be substantiated since the shredding had taken place. The impact of this conviction was that AAs ability to audit companies that were SEC registrants (required for share listing and trading on the New York Stock Exchange or NASDAQ) was initially in doubt, and finally withdrawn. The reputation and ability of the firm to function was eroded. AA personnel joined other accounting firms in the United States and around the world. AA was finished as a firm, and the Big 5 firms became the Big 4. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 75 The fact that AAs conviction was overruled by the U.S. Supreme Court in 2005 because of faulty jury instructions came too late to change the course of history.26 The accounting profession was altered forever in the United States, and received a wake up call in other parts of the world.27 Independence, objectivity, fiduciary duty, and the primacy of the public interest came into sharper focus. Enrons Governance and Control System was Short-Circuited In view of the conflicts of interest of Fastow and his helpers, of the rest of the senior management team, of Enrons lawyers, and particularly those of Arthur Andersen, it is quite clear that Enrons directors were unable to rely on the information they were receiving, or upon Enrons company policies being followed. Enrons management was out of control. This was the directors own fault. They failed to understand their role included a challenge and compliance cycle, and trusted too much when there were many red flags warning that questions should have been pressed. Figure 2.4 shows the elements of Enrons system that were short-circuited and therefore not reliable for the governance of Enron in the shareholders best interests. FIGURE 2.4 Enrons Governance and Control Structure Was Short-Circuited Board Ken Lay: Committees: Financial Reports Chair; Co-chair ZZZ Audit and Compliance Compensation, Finance, Nominating Outside Law Firm SPEs Management CEO: Lay, Skilling CFO: Fastow CAO: Causey CRO: Buy Others: Kopper, McMahon, Glisan Watkins, Kaminsky Internal Audit AA Company Policies Code of Conduct Whistle-blowers Legend Auditor Arthur Andersen Missing Guidance Missing Compliance Suspended Guidance Consultant: Arthur Andersen 26 Supreme Court overrules jurybut too late to save Andersen, Barry McKenna, Globe & Mail, Report on Business, June 1, 2005, B1, B11. 27 In Canada, for example, a Canadian Public Accountability Board (CPAB) was created. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 76 Part One The Ethics Environment Banks Were Willing Accomplices in Enron SPES and Prepays Many of the schemes used by Fastow to mislead investors and strip money out of Enron relied upon the participation of large financial institutions like Barclays Bank in the Rhythms hedge transaction. Many bank personnel knew that the deals they were being called to finance were not serving a wholesome economic purpose. They knew that bank funds were being passed through to finance Enron in off-balance sheet schemes that would mislead investors. Enrons banks were knowledgeable accomplicesaiding and abettingin the schemes to defraud Enrons investors, and have since faced sanctions and lawsuits from the SEC, the State of New York and others. The Senate Investigations Committee has undertaken a review of some of these arrangements, known as prepays, to see if there is evidence that the banks knew that the transactions involved had no economic substance.28 The report of investigator Roach identified two banks, JPMorgan Chase (twelve deals worth $3.7 billion) and Citigroup (fourteen deals worth $4.8 billion), as the primary sources of Enron prepay funding, and concludes that the parties involved in the Enron prepays were aware of the entire structure and its accounting purpose.29 Enrons prepays were mechanisms for Enron to record prepayments for future energy delivery as current operating earnings and cash flow rather than as cash flow from financing operations. The Roach Report states: Under the Enron prepay structure, a participating bank would send cash (the money destined for Enron) to the third party, in exchange for the future delivery of a fixed amount of a commodity. The third party, in turn, would enter into an identical arrangement with Enron, and effectively serve as a pass through for the bank funding to get to Enron. Enron would repay the funding in a fixed amount of the commodities, which would pass through the third party en route to the bank. Up to this point this appears to be a real trade because all three parties bear the risk that the price of the underlying commodity will change. This is called price risk and it is an essential element in a true trading transaction. But, Enron prepays also entailed a transaction known as a swap in order to mitigate price risk. Under a swap agreement, Enron exchanged (with the bank) the floating price of the commodity for the fixed price of the commodity. The net effect is to cancel out any price risk to all parties in the trade. . . . the third party was not independent and the terms of the prepay were predetermined based on Enrons decision as to how much operating cash flow it needed to report. . .30 The linked structure used by Enron did not comply with AAs internal criteria that were established to distinguish true trading activity from loans.31 An AA June 1999 audit memo found by Roach clearly shows that AA recognized the problem and how it needed to be rectified. The Roach Report does not state whether the AA memo was followed by Enron. 28 29 See the testimony of Senior Investigator Roach on July 23, 2002. Roach Report, Appendix A, A-8. 30 Ibid., A-8. 31 Roach Report, Appendix A, A-7. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 77 An additional complication has arisen. One bank that has reinsured their loans to Enron is finding that the reinsurors are refusing to pay up, arguing that the banks knew that the underlying transactions were a sham. Therefore, they argue that the reinsurance arrangements were not made in good faith, that risks were beyond the norm, and therefore that the reinsurance for subsequent loss is void.32 Table 2.5 presents the huge lawsuit settlement payments that Enrons accomplice banks have agreed to up to December 31, 2005. Direct lawsuits for complicity, and the possibility that reinsurance will be declared void, have had a sobering effect on the participation of banks in such schemes in the future. Banks are screening partners and deals much more carefully and are less ready to participate in arrangements that may look legal, but are probably unethical. This is one of the most significant outcomes of the Enron debacle. TABLE 2.5 Enrons Accomplice Banks Lawsuit Settlements To December 31, 2005 $ COM M E NT Merrill Lynch 80m JP Morgan Chase 2.2bn 135m Citigroup 2bn 120m Canadian Imperial Bank of Commerce 2.8bn 80m Toronto Dominion Bank Royal Bank of Canada Royal Bank of Scotland 130m 25m 42m March 2003 Fine imposed by the SEC. Four of the Banks executives were found guilty of fraud and conspiracy, facing sentences of up to 15 years in prison (Daniel Bayly, Robert Furst, William Fuhs, and James Brown). August 2005. First Enron-related U.S. Bank settlement. The bank denied wrongdoing. August 2003. Fine imposed by the SEC. JP Morgans Q2/Q3 profits were $1.83bn. June 2005. Citigroup did not admit liability, and said money already set aside for legal costs would cover the payment. August 2003. Fine imposed by the SEC. Citigroups Q2/Q3 profits were $4.3bn. June 2005. More than annual profit yr 2005. December 2003. Fine imposed by the SEC. Two CIBC executives also will pay fines totaling $600,000. August 2005 August 2005 August 2005 Sources: SEC files, newspaper articles, and Enrons website at http://www.enron.com/corp/pressroom/releases/ 2005/ene2005.html for Megaclaims settlements. 32 The Royal Bank of Canada sued Rabobank, a reinsuror, seeking to recover a $500 million loan, but ended up settlingin a confidential agreementfor a lesser amount that produced an after-tax reduction in net income of $74 million. See Feb. 16, 2004 news release by The Royal Bank of Canada. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 78 Part One The Ethics Environment Enrons Tax Avoidance Enrons banks were not the only willing accomplices in the companys questionable transactions. Several accounting firms, investment bankers, and law firms allegedly provided highly questionable advice on twelve large structured transactions that sheltered over $2 billion in tax from 1995 until its bankruptcy on December 2, 2001. While these transactions may barely adhere to the letter of the law, they have been branded as unethical by members of the Senate Committee on Finance. According to the Senate Committees Report,33 Enrons management discovered that tax transactions could not only save tax, but could be used to generate financial statement earnings. Thereafter, Enrons tax department was looked upon as a profit center.34 Generally, four strategies were used in the structured transactions: Duplication of a single economic loss (i.e., deduction of the same loss twice) Shifting of tax basis from a nondepreciable asset (nontaxable) to a depreciable asset (taxable) with little or no outlay Generation of tax deductions for the repayment of principal (which is highly questionable) Generation of fees for serving as an accommodation party for another taxpayer35 Enron recorded the credits arising from the first two strategies as financial income. Unfortunately, the Senates analysis of Enrons structured transactions (summarized on Table 3 of the Senate Report) revealed a pattern of behavior showing that Enron deliberately engaged in transactions that had little or no business purpose in order to obtain favorable tax and accounting treatment.36 Although a proper business purpose is a fundamental prerequisite for such tax benefits, according to the Senate Report, Enron represented the business purpose of the transaction, and Enrons counsel did not bother to look beyond the representation.37 Most proposed transactions received a Should comply with technical tax law requirements assurance opinion from advisers or counsel.38 Moreover, the Senate Report indicates that the transactions were exceedingly complicated, thus precluding a meaningful review by tax auditors. This complexity was engineered with the advice of a small pool of sophisticated outside advisers. Sometimes these advisers counseled Enron directly, and sometimes each other. The following tax advisers names appeared as promoters and/or primary tax opinion providers on the twelve structured transactions: Arthur Andersen Bankers Trust Vinson & Elkins 33 4 times 5 3 Report of the Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations, Volume 1: Report, U.S. Senate Committee on Finance, February 2003, released 2/22/03, http://www.house.gov/jct/s-3-03-vol1.pdf. 34 Ibid., 8. 35 Ibid., 8. 36 Ibid., 16. 37 Ibid., 16. 38 Ibid., 16. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 79 Deloitte & Touche Akin, Gump, Strauss, ... 6 others 2 2 1 incl. Chase Manhattan, Deutsche Bank, Ernst & Young The Senate Report comments39 that: A critical component of many of Enrons transactions was the involvement of an accommodation party such as an Enron employee or the party promoting the transaction. Enrons activities show that, in general, when transactions can be structured by parties that have the shared goal of obtaining favorable tax treatment, the tax rules do not function as intended and may produce undesirable results. Enrons aggressive interpretation of business purpose, the cooperation of accommodation parties, the protections provided by tax opinions, the complex design of transactions, advantages over IRSall were factors that contributed to Enrons ability to engage in tax-motivated transactions. Until the costs of participating in tax-motivated transactions are substantially increased, corporations such as Enron will continue to engage in transactions that violate the letter or the spirit of the law. Time will tell whether the exposure generated by the Senate Report proposed, or the proposed tightening of loopholes and increases in sanctions and penalties, will change the practice of these and other tax advisers permanently in the future. Their actions may be legal, but in the case of Enron, not considered ethical because they offended the public interest. The short-term evidencebad press, lawsuits and settlements from Deloitte & Touche and Ernst & Young, and the transition of tax advice from aggressive tax opportunism to a more responsible, conservative naturesuggest that a change is underway. Enron Prosecutors and Prosecutions Enron executives have faced criminal, civil, and administrative proceedings, which can lead to jail terms, fines, and agreements not to act in the future as directors or officers of companies whose shares are publicly traded. Prosecutionsoften been initiated by the SEChave led to increased expectations of performance and for prosecutorial aggressiveness where miscreant executives are suspected. Eliot Spitzer, Attorney General for New York, and Patrick J. Fitzgerald, U.S. Attorney for the Northern District of Illinois, have emerged as the iconic attack-dog-like public prosecutors who have begun to go after corporate criminals with gusto. It is suspected that Spitzer, in particular, is intent upon going after miscreant celebrities and senior executives quickly to set an example for others, particularly where the SEC has been slow to act. Both Spitzer and Fitzgerald have utilized the practice of offering lower-penalty deals to less senior executivesparticularly to CFOsin return for information and testimony that can be used against more senior executives. Table 2.6 shows the status of key Enron prosecutions. 39 Senate Report, 16. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 80 Part One The Ethics Environment Enron Reference Materials TABLE 2.6 Enron Key Executive IndictmentsTo December 31, 2005 INDICTED BY FOR PLEA/COOPERATE RESULT Ken Lay, Chair, Chair and CEO Jeffrey Skilling, CEO Jul 2004 Feb 2004 Andrew Fastow, CFO Lea Fastow, Assistant Treasurer Richard Causey, CAO Michael Kopper Jan 2004 Unnamed Charges 35 counts of Fraud and insider trading Securities fraud Tax fraud Not guilty Not guilty Trial pending Jan 2006. Trial pending Jan 2006. Plea agreement (guilty) Plea agreement (guilty) May 2004 10yr sentence Forfeit $23.8 million 1yr sentence Dec 2005 Securities fraud Fraud and money laundering Securities fraud Plea agreement (guilty) 7yr sentence Forfeit $1.25 million Forfeit $12 million Serve a 10yr sentence Forfeit $1.49 million Forfeit $625,000. Guilty 5yr sentence 10yr sentence Forfeit $29.4 million Guilty 5yr sentence Forfeit $250,000 5yr sentence, released on $100,000 bail Settlement $168 million; $155 million covered by insurance Aug 2002 Plea agreement (guilty) Mark Koenig Investor Relations Ben Glisan, Treasurer Kenneth Rice, CEO Broadband Services Kevin Hannon Aug 2004 Plea agreement (guilty) Dec 2002 Sep 2003 Apr 2005 Fraud Fraud Securities fraud Securities fraud Denied wrongdoing Plea agreement (guilty) Sep 2005 Timothy Despain Assistant Treasurer Enron Board of Directors (18 members) Apr 2004 Securities fraud Breach of Fiduciary Duty Plea agreement (guilty) Jan 2005 Source: SEC Files, newspaper articles. = Cooperates with prosecutors Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 81 TABLE 2.7 Selected Enron Financial Statement Details 2000 1999 1998 Summary Income Statement (millions) Revenues $101,789 $40,112 Operating income 1,953 802 IBIT 2,482 1,995 Net income before Cumulative Accounting Changes 979 1,024 Net Income 979 893 EPS (in dollars)- basic 1.22 1.17 - diluted 1.12 1.10 Detail of IBIT (millions) Transport & distribution Trans. Services Portland General Wholesale Services Retail Energy Services Broadband Services Exploration & prod. Corporate and other IBIT $ 391 341 2,260 165 (60) (615) 2,482 $ 380 305 1,317 (68) 65 (4) 1,995 $ 7.3 15.4 10.7 33.4 6.8 7.2 6.5 9.6 33.4 $31,260 1,378 1,582 703 703 1.07 1.01 $ 351 286 968 (119) 128 (32) 1,582 Summary Balance Sheet (billions) Current assets $ 30.4 Investments, other 23.4 Property, plant, equip, net 11.7 Total Assets 65.5 Current liabilities 28.4 Long-term debt 8.6 Deferred credits and other 13.8 Shareholders Equity 11.5 Total Liabilities & Shareholders Equity 65.5 The Aftermath The aftermath for Arthur Andersen and the accounting profession are dealt with in the previous sections and in the accompanying case, Arthur Andersens Troubles. The Senate Investigations Committee deliberations were previously noted with regard to the role of Enrons management and directors. Their report appeared on July 8, 2002. Prior to this, the Enron bankruptcy and the Senate Hearings had raised the awareness of the public, politicians, and regulators to governance failures and their impact. As noted in the earlier discussion of the governance timeline, many groups had brought forward changes in governance structures. On June 26, 2002, WorldCom announced that it had discovered a $4.3 billion manipulation of earnings. The resulting outrage galvanized the construction and Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 82 Part One The Ethics Environment passage of the Sarbanes-Oxley Act on July 30, 2002, which provided the blueprint for a new framework for governance to be developed in the United States and which will inform developments around the world. Not surprisingly, the key concepts included accountability, transparency, independence, objectivity, fiduciary duty, and the primacy of the public interest. As Enron executives and accomplices are indicted, settled with, or convicted, and as the SEC and other regulators respond to the Sarbanes-Oxley Act, the long-run changes in corporate governance and practice and the accounting profession will continue to emerge. Downloadable Enron Case Source Document Files To assist readers of this case, the following downloadable files are available at www.thomsonedu.com/accounting/brooks. The Powers Report The Senates Permanent Subcommittee on Investigations Report on The Role of the Board of Directors in the Collapse of Enron Senate Subcommittee Testimony of Robert Roach, Appendices Sarbanes-Oxley Act of 2002 Governance and Accountability Changes up to WorldCom Even before the Enron scandal appeared and resulted in a filing for bankruptcy protection on December 2, 2001, there had been some recognition that governance and accounting changes were desirable. After Enron, there was turmoil and growing outrage over the cavalier way that Enron executives claimed ignorance, bad memories, or pleaded the Fifth Amendment. Arthur Andersen representatives did not help in their testimony, and there was a growing concern that no one was being brought to justice. There seemed to be no accountability, or little will on the part of justice officials to get tough with the culprits that had caused so much anxiety and loss, and had enriched themselves so handsomely in the process. Even though there were some attempts to strengthen corporate governance and accountability before Enron, it is almost impossible to convey the growing sense of investor and public outrage throughout December 2001 and into the early summer of 2002. President Bush promised further reforms to restore confidence in the financial markets, but failed to slow the market slide. Then, on June 25, 2002, came the shocking news that the giant corporation, WorldCom, was also in financial difficulty. This progression of disasters galvanized two U.S. lawmakers, Paul Sarbanes and Michael Oxley, to merge their efforts and bring forward the landmark governance reform legislation known as the Sarbanes-Oxley Act of 2002. Table 2.8 is a partial list of key guideline and regulatory changes that had been brought into being before and after the Enron fiasco, and before the WorldCom bankruptcy announcement on July 21, 2002. WorldCom: The Final Catalyst WorldCom, Inc., the second largest U.S. telecommunications giant and almost 70 percent larger than Enron in assets, announced on June 25, 2002, that it had Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 83 TABLE 2.8 Key Changes in Governance Guidelines and Regulations SOU RCE OF CHANG E AN NOU NCE D 1994 1999 May 2000 2000 Nov. 21, 2001 Apr. 26, 2002 Apr. 4, 2002 2002 Various June 6, 2002 June 28, 2002 July 9, 2002 The Dey Report, Where Were the Directors? Toronto Stock Exchange To review corporate governance and make recommendations for best practice. Five Years to the Dey, Report on Corporate Governance, Toronto Stock Exchange and The Institute of Corporate Directors To survey and analyze governance procedures at TSE companies. The Combined Code: Principles of Good Governance and Principles of Best Practice Based on the Hempel (1998), the Cadbury (1992) and Greenbury Reports (1995), used by companies listed on the London Stock Exchange. Guidance for Directors on the Combined Code, The Turnbull Report See Combined Code purpose. The Saucier Report, Beyond Compliance: Building a Governance Culture, Joint Committee on Corporate Governance, CICA/TSE To review the current state of corporate governance in Canada, compare Canadian and international best practices, and make recommendations for changes that will ensure Canadian corporate governance is among the best in the world. Toronto Stock Exchange (TSX) Guidelines, Amended Revisions effective Dec. 31, 2002, to adopt some Saucier Report recommendations. SEC Blue Ribbon Committee Discussions Business Roundtablevarious statements NYSE Corporate Governance Listing Requirements, Effective Aug. 2002, after SEC approval A review at the request of Harvey Pitt, SEC Chairman, to enhance the accountability, integrity, and transparency of companies listed on the NYSE. SEC Order effective Aug. 14, 2002 CEO and CFO to certify 8-K, quarterly, and annual financial reports President George Bushs Proposals Speech Notes: A synthesis of the 2002 proposals of the SEC, NYSE, and NASDAQ is available at www.torys.com as publication No. 200216T. More recent regulations are also reviewed. Visit www.thomsonedu.com/accounting/ brooks for links to key governance organizations Websites. overstated cash flow by $3.8 billion.40 Then WorldCom applied for bankruptcy protection on July 21, 2002, and subsequently eclipsed Enron as the worlds largest bankruptcy. This came as a staggering blow to the credibility of capital markets. It occurred in the middle of the furor caused by: The Enron bankruptcy on December 2, 2001, and the related Congress and Senate hearings and Fifth Amendment testimony by Enron executives The depression of the stock markets The pleas by business leaders and President Bush for restoration of credibility and trust to corporate governance, reporting, and the financial markets 40 Simon Romero and Alex Berenson, WorldCom says it hid expenses, inflating cash flow $3.8 billion, New York Times, June 26, 2002. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 84 Part One The Ethics Environment Responsive introduction of governance guidelines by stock exchanges and the Securities and Exchange Commission Debate by the U.S. Congress and Senate of separate bills to improve governance and accountability Arthur Andersens conviction for obstruction of justice on June 15, 2002 WorldCom failed because of bad business judgments that were hidden from investors by accounting manipulations and executive skullduggery, which are explained more fully in the case, WorldCom: The Final Catalyst, located at the end of the chapter. Arthur Andersen LLP was WorldComs auditor. WorldComs accounting manipulations involved very basic, easy-to spot types of fraud.41 Overstatements of cash flow and income were created because one of WorldComs major expenses, line costs, or fees paid to third party telecommunication network providers for the right to access the third parties networks,42 were accounted for improperly. Essentially, line costs that should have been expensed, thus lowering reporting income, were offset by capital transfers or charged against capital accounts, thus placing their impact on the balance sheet rather than the income statement. In addition, WorldCom created excess reserves or provisions for future expenses, which they later released or reduced, thereby adding to profits. The manipulation of profit through reserves or provisions is known as cookie jar accounting. The aggregate overstatement of income quickly rose to more than $9 billion43 by September 19, 2002, for the following reasons: $3.85 billion for improperly capitalized expenses, announced June 25, 200244 $3.83 billion for more improperly capitalized expenses in 1999, 2000, 2001, and the first quarter of 2002, announced on August 8, 200245 $2.0 billion for manipulations of profit through previously established reserves, dating back to 1999 Ultimately, the WorldCom fraud totaled $11 billion. Key senior personnel involved in the manipulations at WorldCom included: Bernard J. Ebbers, CEO; Scott D. Sullivan, CFO; Buford Yates, Jr., Director of General Accounting; David F. Myers, Controller; Betty L. Vinson, Director of Management Reporting, from January 2002; Troy M. Normand, Director of Legal Entity Accounting, from January 2002. Their motivation and mechanism for these manipulations is evident from the SECs description of what happened at the end of each quarter, after the draft quarterly statements were reviewed. Steps were taken by top management to hide WorldComs problems and boost or protect the companys stock price in order to profit from stock options, maintain collateral requirements for personal loans, and keep their jobs. These steps were required, in part, to offset the downward pressure on 41 42 Bruce Myerson, A WorldCom primer, the Associated Press, June 26, 2001. Complaint: SEC v. WorldCom, Inc., U.S. Securities and Exchange Commission, June 26, 2002, para. 5, www.sec.gov/litigation/complaints/complr17588.htm. 43 WorldCom to reveal more bogus accounting, the Associated Press, September 19, 2002; David E. Royella and WorldCom faces two new charges, misstatement grows, David E. Royella, Financial Post, November 6, 2002, FP4. 44 WorldCom Inc., Form 8-K, Current Report Pursuant to Section 13 or 15(D) of the Securities Exchange Act of 1934, August 14, 2002, para. 2, www.sec.gov/archives/edgar/. 45 Ibid., para. 3. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 85 WorldComs share price caused by U.S. and European regulators rejection of WorldComs US $115 billion bid for Sprint Communications.46 Ebbers company had been using takeovers rather than organic growth to prop up earnings, and the financial markets began to realize this would be increasingly difficult. According to the SEC: Specifically, after reviewing the consolidated financial statements for the third quarter of 2000, WorldCom senior management determined that WorldCom had failed to meet analysts expectations. WorldComs senior management then instructed Myers, and his subordinates, including Yates, VINSON and NORMAND, to make improper and false entries in WorldComs general ledger reducing its line cost expense accounts, and reducingin amounts corresponding to the improper and false line cost expense amountsvarious reserve accounts. . . . There was no documentation supporting these entries, and no proper business rationale for them, and they were not in conformity with GAAP.47 Manipulations followed the same pattern for the fourth quarter of 2000, but a change in technique was required for the first quarter of 2001 for fear of discovery by the auditors. Senior management instructed that line cost expenses be fraudulently reclassified . . . . . . to a variety of capital asset accounts without any supporting documentation or proper business rationale and in a manner that did not conform with GAAP. . . . In particular, . . . NORMAND telephoned WorldComs Director of Property Accounting (the DPA) and instructed him to adjust the schedules he maintained for certain Property, Plant & Equipment capital expenditure accounts (the PP&E Roll-Forward) by increasing certain capital accounts for prepaid capacity.48 In future periods, the increase of certain accounts for prepaid capacity remained the manipulation of choice. It should be noted that Ebbers was not an accountant. He was, however, ably assisted in these manipulations by Scott Sullivan, his chief financial officer, and David Myers, his controller. Both Sullivan and Myers had worked for Arthur Andersen before joining WorldCom. Other fascinating revelations offer a glimpse behind the scenes at WorldCom: 1. WorldCom also announced that it might write off $50.6 billion in goodwill or other intangible assets when restating for the accounting errors noted above. Apparently WorldCom acquisition decisions had been faulty. 2. Investigation revealed that Bernard Ebbers had been loaned $408.2 million. He was supposed to use the loans to buy WorldCom stock or for margin calls as the stock price fell. Instead, he used it partly for the purchase of the largest cattle ranch in Canada, construction of a new home, personal expenses of a family member, and loans to family and friends.49 46 47 Ebbers became symbol of scandals, Financial Post, July 14, 2005, FP1, FP3. Complaint: SEC v. Betty L. Vinson, and Troy M. Normand, U.S. Securities and Exchange Commission, modified October 31, 2002, www.sec.gov/litigation/complaints/comp17783.htm. 48 Ibid., para. 4, 5, and 6. 49 Royella, WorldCom faces two new charges. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 86 Part One The Ethics Environment 3. When . . . asked whether he was afraid of Ebbers, he (Sullivan) said: At times, at times I wasnt. He can be very intimidating.50 Former Attorney-General Richard Thornburgh51 was appointed by the U.S. Justice Department to investigate the collapse and bankruptcy of WorldCom. In his Report to the U.S. Bankruptcy Court in Manhattan on November 5, 2002, he said: One person, Bernard Ebbers, appears to have dominated the companys growth, as well as the agenda, discussions and decisions of the board of directors, . . . A picture is clearly emerging of a company that had a number of troubling and serious issues . . . relating to culture, internal controls, management, integrity, disclosure and financial statements. While Mr. Ebbers received more than US $77 million in cash and benefits from the company, shareholders lost in excess of US $140 billion in value.52 The WorldCom saga continues as the companys new management tries to restore trust in its activities. As part of this effort, the company changed its name to MCI. On August 26, 2003, Richard Breeden, the Corporate Monitor appointed by the U.S. District Court for the Southern District of New York, issued a report outlining the steps the Company will take to re-build itself into model of strong corporate governance, ethics and integrity . . . (to) foster MCIs new company culture of integrity in everything we do.53 The company is moving deliberately to reestablish the trust and integrity it requires to compete effectively for resources, capital, and personnel in the future. The SEC has filed complaints, which are on its website against the company, and its executives. The court has granted the injunctive relief the SEC sought. The executives have been enjoined from further such fraudulent actions, and subsequently banned by the SEC from practising before it, and some have been banned by the court from acting as officers or directors in the future. WorldCom, as a company, consented to a judgement imposing everything the Commission wanted, including extensive reviews and provision of: Governance systems, policies, plans and practices. Internal accounting control structure and policies. Training and education to minimize future securities laws violations. Civil fines.54 Ebbers and Sullivan were each indicted on nine charges: one count of conspiracy, one count of securities fraud, and seven counts of false regulatory findings.55 50 51 Ex-WorldCom CFO implicates Ebbers, Toronto Star, February 8, 2005, D9. Richard Thornburgh issued two reports on WorldCom problems. These can be found at www. thomsonedu.com/accounting/brooks. 52 Don Stancavish, WorldCom dominated by Ebbers, Bloomberg News, in Financial Post, November 5, 2002, FP13. 53 MCI website, Governance: Restoring the Trust, http:/ /global.mci.com/about/governance/ restoringtrust/, (accessed January 3, 2006). 54 SEC Litigation Release No. 17883/ December 6, 2002, http://www.sec.gov/litigation/litreleases/ lr17883.htm. 55 Jury convicts Ebbers on all counts in fraud case, MSNBC, March 15, 2005, http://www.msnbc. msn.com/id/7139448/. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 87 Sullivan pled guilty on the same day he was indicted, and later cooperated with prosecutors and testified against Bernie Ebbers in the hopes of receiving a lighter sentence.56 Early in 2002, Ebbers stood up in church to address the congregation saying: I just want you to know that youre not going to church with a crook.57 Ebbers took the stand and argued that he didnt know anything about WorldComs shady accounting, that he left much of the minutiae of running the company to underlings.58 But after eight days of deliberations, on March 15, 2005, a federal jury in Manhattan didnt buy his aw shucks, hands-off, or ostrich-in-thesand defense. They believed Sullivan, who told the jury that Ebbers repeatedly told Sullivan to hit his numbersa command . . . to falsify the books to meet Wall Street expectations.59 On July 13, 2005, Ebbers was sentenced to twenty-five years in a federal prison.60 Once a billionaire, he also lost his house, property, yacht, and fortune. At 63 years of age, in January 2006, Ebbers appealed his sentence. Sullivans reduced sentence was for five years in a federal prison, forfeiture of his house, ill-gotten gains, and a fine. Investors lost over $180 million in WorldComs collapse,61 and they lost more in other companies as well as confidence in credibility of the financial markets, governance mechanisms, and financial statements continued to deteriorate. Governance ReformThe Sarbanes-Oxley Act of 2002 The announcement by WorldCom of their massive accounting earnings manipulation fraud struck the capital markets, media, and politicians like a lightening bolt. Senator Paul Sarbanes, a Democrat, was trying to push forward a bill of governance and accounting reforms through the U.S. Senate. Congressman Michael Oxley, a Republican, was trying to do the same through the U.S. House of Representatives. Opposition was stiff to both bills, but immediately after the WorldCom announcement, the two men joined forces and the Sarbanes-Oxley Act of 2002 was passed through both the Congress and the Senate and became law on July 30, 2002. It was an amazing galvanization and an unexpected but hoped for outcome. Sarbanes-Oxley Act (SOX): New Governance for Corporations and the Accounting Profession SOX is the most far-reaching U.S. security law enacted since the Securities Act of 1933 and the Securities Exchange Act of 1934, which spawned the Securities and Exchange Commission (SEC) in 1934 to administer the acts. Many of the provisions 56 57 Crawford, Ex-WorldCom CEO Ebbers guilty. Ebbers became symbol of scandals, Financial Post, July 14, 2005, FP1, FP3. 58 Crawford, Ex-WorldCom CEO Ebbers guilty. 59 Jury convicts Ebbers on all counts in fraud case. 60 Ebbers became symbol of scandals. 61 Ibid., Ebbers became symbol of scandals. Also Richard J. Newman estimated investor losses to as much as $200 million in Time for payback, in Stern in the News, NYU Stern, at http://w4.stern. nyu.edu/news/news/2003/october/1027usnews.htm. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 88 Part One The Ethics Environment of SOX required SEC action for implementation, and future studies to access the best path for future guidance. SOX has created an international regulatory framework for corporations seeking access to the U.S. capital markets and their auditors. SOX sets new standards for governance that will apply to all SEC registrant companies those listed on U.S. stock exchangesincluding those large foreign companies that are listed on the U.S. exchanges. Over 200 of Canadas largest companies, and many other large international enterprises, will therefore have to comply with any new rules. Also, SOX establishes a new framework for the U.S. accounting profession that replaces self-regulation by the profession with a Public Company Accounting Oversight Board (PCAOB). The PCAOB will oversee all accounting firmsU.S. and foreignthat audit SEC registrants, as well as the accounting and disclosure rules those companies follow. Prior financial disasters, including the Enron, Arthur Andersen, and WorldCom governance debacles, raised the awareness in the United States, Canada, Australia, and the United Kingdom that the governance frameworks had to be improved. Specifically, in order to deal with the governance credibility crisis and restore confidence in the current corporate capital markets system, action was needed to meet public expectations in regard to the following matters: Clarification of the roles, responsibilities, and accountabilities of the board of directors, its subcommittees, of the directors themselves, and of the auditors. Reduction of the conflicts of interest influencing the directors, executives, and auditors so that they would exercise loyalty, independent judgment, and objectivity in the best interest of the shareholders or the company; or in the case of the auditor, in the public interest. Ensure that the directors were sufficiently informed on corporate plans and activities, the adequacy of company policies and internal controls to ensure compliance, and actual compliance, including whistle-blowers concerns. Ensure that directors possess adequate financial competence and other expertise where required. Ensure that financial reports were accurate, complete, understandable and transparent. Ensure that accounting standards are adequate to protect investors interests. Ensure that the regulation and oversight of auditors of public companies, as well as their appointment and operating parameters, are adequate and appropriate to serve the public interest. The developments proposed in SOX to remedy these problem areas are discussed next within the context of the new governance frameworks for corporations and for the auditing profession, as well as other matters. A .PDF version of SOX is available at www.thomsonedu.com/accounting/brooks together with a summary of certain SOX provisions relevant to oversight of the accounting profession. For reference, SOX is organized as indicated in Table 2.9. New SOX Corporate Governance Framework The new SOX framework takes the perspective that honest and full accountability to shareholders, and therefore to the public, is of paramount importance. Such accountability is identified as a prime responsibility of corporate directors to ensure and senior corporate officers to deliver, and that they are free from bias Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 89 TABLE 2.9 Organization of the Sarbanes-Oxley Act of 2002 SECTIONS TITLE 1,2,3 101-109 201-209 301-308 301 I II III 401-409 404 406 501 601-604 701-705 801-807 901-906 1001 1001-1007 IV V VI VII VIII IX X XI Short Title,Definitions, Table of Contents Public Company Oversight Board Auditor Independence Corporate Responsibility Public Company Audit Committees (including whistle-blower encouragement) Corporate Responsibility for Financial Statements (including CEO and CFO certification) Enhanced Financial Disclosures Management Assessment of Internal Controls Code of Ethics for Senior Financial Officers Analyst Conflicts of Interest Commission Resources and Authority Studies and Reports Corporate Criminal Fraud Accountability White Collar Crime Penalty Enhancements Corporate Tax Returns Corporate Fraud and Accountability in doing so. In addition, since the accuracy and integrity of such an accountability regime depends upon the independent scrutiny of auditors, directors are charged with ensuring that, through the audit subcommittee of the board, the auditors are free from conflicts of interest, have access to and report to the board, and so on. These matters are provided for in SOX through the introduction of specific provisions related to: Clarification of the responsibility of directors and officers for public accountability and its integrity. Enhanced conflict of interest provisions designed to ensure sufficient directors are independent from management. Clarification of the role, responsibility and membership of audit subcommittees of the board, so that: I I The audit subcommittee: Is directly responsible for the appointment, compensation, and oversight of any public accounting firm employed by that issuer. . .62 including the resolution of any disputes with management. Must establish procedures to receive and address complaints regarding accounting, auditing, and internal controls, including establishing procedures to allow employees to submit anonymous complaints.63 I 62 63 SOX, Section 301 (2), p. 33. Ibid., Section 301(4), p. 34. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 90 Part One The Ethics Environment I I I I Must approve any non-audit services to be provided by the auditors. Only independent64 directors can serve on the audit subcommittee, All must be financially competent. One must be, and be identified to be, a financial expert.65 Auditors report to the audit subcommittee, and are to be met without management present, and vice versa. The subcommittee must be given adequate budget and time to complete its work, including the right to hire and consult outside experts. Additional disclosures: I I To allow scrutiny of transactions between principal stockholders and management. To report upon the corporations internal controls, including the managements responsibility for establishing, maintaining, and assessing their effectiveness. Accelerated reporting of corporate disclosures and stock trades. Management assessment and signed certification by the CEO and CFO to the board and SEC of the integrity of: I I Quarterly and annual financial reports, and SEC forms. Systems of internal control underlying and ensuring that integrity.66 Requirement for a code of ethics and compliance thereto for senior financial officers. The illegality of exercising any undue influence on the conduct of audits. Proper action by insiders for stock trading and dealing with stock analysts. Sanctions for wrongdoing, including forfeiture of bonuses and profits, officer and director bars from service, and penalties. New SOX Framework for the U.S. Accounting Profession Auditors, as noted previously, will be more responsive to the audit subcommittee of the board, who will arrange their appointment, reappointment, fees, and settle disputes; and they will be much less responsive to senior management who often played a dominant role in these matters. In this regard, auditors will be working with financially competent, independent directors whose interests should be more directed than they may have been toward clear, comprehensive public reports. Auditors must report directly to audit committees on the following matters: All critical accounting policies and practices to be used. All alternative treatments of financial information under GAAP that have been discussed with management. 64 SOX, Section 310 (3), p. 33 states that independence requires that a member of an audit committee may not, other than in his capacity as a member of the audit committee, the board of directors, or any other board committee(i) accept any consulting, advisory, or other compensatory fee from the issuer; or (ii) be an affiliated person of the issuer or any subsidiary thereof. 65 A financial expert is defined in SOX, SEC 407 (b), p. 47, as a person who has (1) an understanding of GAAP and financial statements, (2) experience in (A) the preparation or auditing of financial statements of generally comparable issuers, and (B) the application of such principles in connection with the accounting for estimates, accruals and reserves; and (3) experience with internal accounting controls; and (4) an understanding of audit committee functions. 66 This is known as Section 404 review compliance work. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 91 The ramifications of the use of the alternative treatments and disclosures and the treatment preferred by the auditor. All other material written communications between the auditor and management, including any management letter and schedule of unadjusted differences. Their review of and attestation on managements assessment of the companys internal controls, including: I . . . whether the internal control structure and procedures include maintenance of records that accurately and fairly reflect the companys transactions and disposition of assets; whether there is reasonable assurance that the transactions are recorded as necessary to permit the preparation of financial statements in accordance with GAAP and made in accordance with proper authorization by management and directors; and a description of material weaknesses in internal controls found on the basis of testing done and material non-compliance.67 I I In addition, SOX establishes a Public Company Accounting Oversight Board (PCAOB) that will: Consist of five members (only two of which can be CPAs) with five-year staggered terms. Inspect, discipline, and write rules governing accounting firms that audit public companies. Establish auditing and attestation standards, including quality control and independence standards for the audit of public companies. Maintain a register of foreign firms that audit SEC registrants, and who will be subject to PCAOB regulations and discipline. In order to stop auditors from auditing results of their own non-audit services, auditors will be prohibited from offering the non-audit services listed below, and may offer other non-audit services such as tax services to SEC registrants only if permitted by the clients Audit Subcommittee: . . . bookkeeping and other services related to the accounting records or financial statements of the client; financial information system design and implementation; appraisal or valuation services; fairness opinions, or contribution-in-kind reports; actuarial services; internal audit outsourcing services; management functions or human resources; broker or dealer, investment adviser, or investment banking services; legal services and expert services unrelated to the audit; and any other service the PCAOB determines by regulation is not permissible.68 Finally, an audit partner cannot serve as the engagement partner or the concurring partner for over five concurrent years. 67 68 The Sarbanes-Oxley Act, Financial Reporting Release, PricewaterhouseCoopers, August 2002, 3. Ibid., 4. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 92 Part One The Ethics Environment New SOX Frameworks for Other Matters SOX has provisions covering/requiring the need for a code of conduct for attorneys serving registrants, the treatment of analyst conflicts of interest, and penalties for fraud and white collar crime. In addition, SOX required the following studies to chart the best course ahead: U.S. General Accounting Office (GAO)problems associated with the consolidation of major accounting firms Comptroller Generalmandatory rotation of audit firms SECadoption of principles-based accounting system; role and function of credit rating agencies; actions of violators and violations; enforcement actions; possible complicit earnings manipulation activities of investment banks and financial advisers Finally, SOX states that it is a crime to knowingly destroy, alter, or falsify records needed in federal investigations and bankruptcy proceedings, with such crime to be punishable by a fine and/or imprisonment of up to twenty years.69 Implementation by the SEC The SEC was charged with introducing new regulations or changes in its regulations to implement the proposed SOX frameworks within defined time frames, subject to research studies where appropriate. It should be noted, however, that while the proposed SOX frameworks push governance and accountability reform a long way, the SEC might push the reforms even further. One such case is the proposed SEC rule for lawyers that discover a violation. As the proposal stands, lawyers would have to report any material violation of securities laws, or fiduciary duty, or similar material violation found to their clients chief legal counsel or to the CEO. If there is no appropriate response the attorney must report to the audit committee, the board, or a committee of outside directors. If this up-the-ladder reporting does not generate an appropriate response, and the violation would likely result in substantial injury to the financial interest or property of the issuer or of investors, the outside attorney would have to make a noisy exit, which would involve withdrawal from representation of the issuer, notification to the SEC of the withdrawal, and repudiation of any submission to the SEC that the lawyer believes is tainted. Law firms argued that the proposed rule goes further than the SOX intended and proposes to make them into whistle-blowers, and that the noisy withdrawal provision is inconsistent with fundamental rights, such as attorneyclient privilege and confidentiality. Time will tell whether outside lawyers have responsibilities worthy of noisy exit disclosure to those outside the SEC and client.70 69 70 SOX, Section 802 (a), p. 57. SEC aims to make lawyers whistle-blowers, Torys LLP, December 19, 2002, www.torys.com. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 93 Impact on Governance, Accountability and Reporting, and Management Practice The new SOX governance framework will focus the attention of directors and management on issues that are of critical importance to the proper governance and reporting process. In particular, the following developments will bring positive and long-overdue changes: New and specific focus on improved accountability and reporting to public shareholders, and related internal control and whistle-blower systems, and upon the related certification by CEO and CFOwhere false certification will be considered a criminal offense. Strengthening of the role of the audit committee, the full independence of serving directors, information flow, and the ability of auditors to report on and engage the committee in meaningful discussion. Clarification of roles, responsibilities, and competencies of directors and board subcommittees. Definition of and emphasis on avoiding conflict of interest situations, as well as codes of conduct for the CFO and others. Increased penalties for wrongdoing. However, finding enough financial experts to serve as directors, and as identified directors on audit committees, will be a challenge. Time requirements and legal risk have escalated, forcing the reduction of the number of boards on which one can sit, and much higher board fees and special fees for sitting on audit committees. Training in director competencies is growing and will become the norm. It is unlikely that smaller companies and foreign companies will voluntarily fully adopt the new governance regime due to its time-consuming nature and cost. This may create a two-tier governance system that may not favor some investors. Some corporations will resign their SEC registration and remove themselves from the U.S. capital markets, as Porsche has already done. In the end, if the proposed SOX governance system had been in place, would the Enron, WorldCom, and other financial disasters have been avoided? Certainly the probability of avoidance would have been much higher. Impact on the Accounting Profession and Auditing Practice The U.S. accounting profession has lost its relatively unfettered ability to offer non-audit service to clients based solely on the judgment and self-regulation of accountants. Non-audit services offered have been circumcised, and since they must usually be provided by firms not performing the companys audit, are less efficient or more costly to provide to audit clients. Audit service fee margins have increased dramatically due to the extremely large demands for Section 404 compliance work assisting with the review of the integrity of corporate internal controls and the accuracy of financial statements. The surge in demand has precipitated a shortage of qualified audit personnel. There was such an outcry against the cost of compliance with Section 404estimated at Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 94 Part One The Ethics Environment $7.8 million in 2004 for each of the Fortune 1000 companies71that the SEC responded by indicating that it never intended that the work should be absolutely exhaustive, but based on judgment72. This produced some relief from the paranoia of some CEOs and CFOs worried about jail terms, and from lawyers and auditors who were advising an ultraconservative approach. Nonetheless, the cost of Section 404 work has been enormous. Is the cost worth the extra protection? According to one informed observer, Lynn Turner,73 who is a former chief accountant at the SEC, the aggregate cost of the Section 404 compliance work for all U.S. registrants is less (which he estimated at $5 billion) than the amount lost by Enron investors alone ($90 billion). The benefitcost relationship is even more extremely favorable if losses from any other corporate scandals are avoided in the future. Ongoing annual costs of Section 404 compliance should fall as systems are put in place, improved, and documented. Better internal control systems should also moderate increased annual audit costs that appear to have risen up to 16 percent in the two years following the Enron debacle.74 In U.S. and foreign jurisdictions, it is probable that some smaller professional accounting firms will forego auditing SEC or stock market registrants because they will want to avoid dealing with the PCAOB, and wish to maintain the nature and margins of their current integrated practices. This may mean that a two-tier system of auditors develops throughout the worldone for the large corporations and another for the small. A two-tier system for GAAP for big or small corporations may also become more attractive. The full impact of SOX continues to unfold, but the strengthening of accountability, and of independence standards and the relationship of the auditor to the audit subcommittee, will help the auditor serve the public interest. Impact on Business Ethics Trends There is no doubt that the Enron, Arthur Andersen, and WorldCom cases have produced much greater awareness of ethical issues and trends that were underway, including conflicts of interest and the control of self-interest, fiduciary duty of directors to shareholders/company and of auditors to the public interest, and the general good business sense of developing an ethical culture. That ethical culture should be based upon honesty, fairness, compassion, integrity, predictability, and responsibility, and focused on the development of trust and the respect for stakeholder interests. In fact, U.S. and foreign corporations that have good governance and accountability do embrace these, and have indicated that they have already been doing, in substance, what SOX recommends. The infamous corporate debacles have also produced a new awareness that ethics and reputation are linked much more directly than earlier thought to be the case. Moreover, as in most product liability cases, the fine for Arthur Andersen of $500,000 (or the largest earlier fine of $7 million) proved to be insignificant compared to the loss of future revenue. Most importantly, the concept of franchise risk75 Sarbanes-Oxley Section 404 Costs and Remediation of Deficiencies: Estimates from a Sample of Fortune 1000 Companies, Charles River Associates, Washington, April 2005, 2. 72 Commission Statement on Implementation of Internal Control Reporting Requirements, 2005-74, U.S. Securities and Exchange Commission, Washington, D.C., May 16, 2005. 73 Remarks by Lynn Turner on August 9, 2004, at the 2004 Annual Meeting of the American Accounting Association. 74 Ibid. 75 The risk of losing the franchise to operate. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 71 Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 95 has taken on an entirely new reality since Arthur Andersen, a firm of vaunted reputation and 85,000 employees, has essentially disappeared in less than one year, and two of the worlds most highly regarded corporations are in bankruptcy proceedings. Comprehensive risk management must include ethics risks and higher estimates for franchise risk. Modern strategic, risk-oriented audit approaches will have to incorporate ethics risks and higher estimates for franchise risk as well. Corporate internal control systems should include ethics risk monitoring, and new systems should be developed to do so. Professional accountants tended to subjugate fiduciary values to revenue generation considerations until AAs debacle. Will professional accounting bodies and firms consolidate the learning from AA, rather than put their own business concerns before quality? Will the switch from self-regulation in the United States be beneficial if applied around the world, or will a two- or multitier regime emerge that will leave the public interest at risk? Finally, the need for business and professional ethics education, which illustrates through cases like Enron, Arthur Andersen, and WorldCom how important ethics are to corporate and to professional accounting firm culture and performance, has never been more evident. QU ESTIONS 1. What were the common aspects that were necessary for the Enron and WorldCom debacles to occur? 2. What actions by directors, executives, and professional accountants could have prevented the Enron and WorldCom debacles? 3. Was the enactment of the Sarbanes-Oxley Act (SOX) necessary? Why or why not? 4. What are the three most important improvements in the governance structure that could result from SOX? 5. What were the common elements in Arthur Andersens approach that appeared to allow the disasters at Enron, WorldCom, Waste Management, and Sunbeam? 6. What is wrong with Enrons banks financing transactions they knew were without economic substance? 7. How should boards of directors change incentive remuneration schemes for executives to lessen the risk of motivating executives to risk manipulations to enrich themselves? 8. What lessons should be learned from reviewing the events described in this chapter? CASE I NSIG HTS The cases that follow, Enron, Arthur Andersen, and WorldCom, Waste Management, and Sunbeam have become icons in the history of governance and accountability. Taken together, they reflect the greed of fraud-intent management, the failure of conflicted governance systems and the integrity of the Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 96 Part One The Ethics Environment corporate reporting systems, and the misunderstanding of the fiduciary duties of directors and professional accountants. The seeds of Arthur Andersens downfall are evident throughout. The first three cases are more detailed accounts of material summarized in Chapter 2. Enrons Questionable Transactionsa detailed account of the questionable transactions underlying the massive fraud made possible by flaws in corporate and professional accounting governance. Arthur Andersens Troublesthe story of the once revered, but systemically flawed, auditor of all these companies that forgot to whom fiduciary duty was owed. WorldCom: The Final Catalystthe timely and massive fraud that triggered meaningful reform of corporate and professional accounting governance. Waste Management, Inc.one of Arthur Andersens early audit failures where the accounting manipulations of management and a dominated corporate governance system led to bankruptcy. Sunbeam CorporationArthur Andersen failed to stop Chainsaw Al Dunlap, who hoodwinked his board and intimidated his accounting staff into manipulating financial reports. PR I NCI PAL R E FE R E NCES Available at www.thomsonedu.com/accounting/brooks Sarbanes-Oxley Act of 2002. SEC Reports, Press Releases, and Complaints, regarding Enron, Arthur Andersen, and WorldCom. Testimony of Robert Roach, Appendices, U.S. Senate Permanent Subcommittee on Investigations. The Powers Report, 2001. The Role of the Board of Directors in the Collapse of Enron, The U.S. Senates Permanent Subcommittee on Investigations Report, 2002. ETH ICS CASE Enrons Questionable Transactions An understanding of the nature of Enrons questionable transactions is fundamental to understanding why Enron failed. What follows is a summary of the essence of the major important transactions with the SPEs, including Chewco, LJM1, LJM2, and the Raptors. This summary extends the comments presented in Chapter 2, beginning on page 66. Chewco Transactions Chewco Investments LP1 was created in November 1997 to buy the 50 percent interest owned by CalPERS, the California Public Employees 1 Chewco was named for Chewbacca, the Star Wars character. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 97 Continued Retirement System, in a joint venture investment partnership called Joint Energy Development Investment Limited Partnership (JEDI). JEDI had operated since 1993 as a nonconsolidated SPE. Enron wanted to create a larger unit with capital of $1 billion, and CalPERS asked to be bought out. Chewco was created as a vehicle to attract a replacement for CalPERS and to buy out CalPERS interest in JEDI. Originally, Andrew Fastow proposed that he be appointed to manage Chewco temporarily until an outside investor, or counterparty, could be found. According to the Powers Report, Enron lawyers advised against this since his senior officer status would have required proxy disclosure. Instead, Michael Kopper, who worked at Enron for Fastow, a fact known only to Jeffrey K. Skilling on the board of directors,2 was appointed. Enron planned to guarantee loans for bridge financing to buy out CalPERS interest in JEDI, which had been valued at $383 million. The intention was to replace the bridge financing with the investment of an outside investor, but none was found. Enrons financial year end passed on December 31, 1997; without an independent, controlling outside investor with at least 3 percent of the capital at risk, $11.5 million in this case (3 percent of $383 million), the activities of both JEDI and Chewco had to be consolidated into Enrons financial statements and on a retroactive basis. Whether through negligence or inability to find a proper counterparty, the accounts of Enron had to be restated to include the dealings of JEDI. In November and December of 1997, Enron and Kopper created a new capital structure for Chewco, which had three elements: $240 million unsecured subordinated loan to Chewco from Barclays Bank PLC, which Enron would guarantee; $132 million advance from JEDI to Chewco under a revolving credit agreement; and $11.5 million in equity (representing approximately 3% of total capital) from Chewcos general and limited partners.3 These financing arrangements are diagrammed in Figure 1. Essentially, Enronas majority ownerput no cash into the SPE. A bank provided virtually all of the cash, FIGURE 1 Chewco Financing, in Millions Enron Kopper & Dodsons Company Dodson Companies $0.125 Jedi $132 Revolving Credit Source sBank Non-cash Investors $251.4 132.0 0.1 $11.4 $11.4 Loan* Chewco $240 Loan Barclays Bank Plc 2 Powers Report, 41. 3 Powers Report, 49. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 98 Part One The Ethics Environment Continued and in reality the so-called 3 percent independent, controlling investor had very little investednot even close to the required 3 percent threshold. Nonetheless, Chewco was considered to qualify for treatment as an armslength entity for accounting purposes by Enron and its auditors, Arthur Andersen. Enrons board, and presumably Arthur Andersen, was kept in the dark. Kopper invested approximately $115,000 in Chewcos general partner and approximately $10,000 in its limited partner before transferring his limited partnership interest to William Dodson [Koppers domestic partner].4 The rest of the $11.5 million $11.4, to be exactwas loaned by Barclays Bank to Kopper/Dodson, although the original wording was unusual in that it implied that the monies were for certificates that would generate a yield.5 Ultimately, Kopper and Dodson created a series of limited partnerships (LLPs) and limited companies (LLCs) through which to operate their interests, but Kopper was de facto the managing general partner of Chewco. This meant there was no outside investor with 3 percent of equity at risk. Moreover, Barclays asked that $6.6 million be reserved against the $11.4, and the $6.6 million was pledged/deposited with them, so that the resulting net of $4.8 million did not satisfy the 3 percent rule for nonconsolidation. According to the Powers Report, the existence of the $6.6 million reserve was well known at Enron.6 However, in Congressional Committee testimony, the CEO of Arthur Andersen stated that they had reviewed and approved the financial arrangement as qualifying under the 3 percent rule, and received $80,000 for this advice.7 The $6.6 million reserve was created as part of a transfer of $16.6 million from JEDI through Chewco to two of the limited partnerships controlled by Kopper and Dodson, namely Big River Funding LLC and Little River Funding LLC. The entire complicated structure created for the Chewco financing transaction can be viewed on page 51 of the Powers Report. The Powers Report goes on to detail several subsequent transactions that took place before Enron unraveled in late 2001 that appear not to have been in the best interests of Enron, including: Management and other fees paid through to Kopper amounted to $2 million for essentially little work, some of which was done by Fastows wife; most of 4 5 the rest of the work was on time that Kopper was being paid as an Enron employee. The fee for Enron guaranteeing the Barclays loan was under that called for by the market risk assumed. When it was decided to liquidate JEDI, the buyout of Chewcos interest was valued at a premium of $1 million by Jeffrey McMahon (then senior vice president, finance and treasurer of enron). He told Fastow, who undertook to negotiate with Kopper, and came back indicating that Skilling had approved a $10 million payment.8 Fastow denied this to the Powers committee but declined to comment on a handwritten note from Kopper that confirmed Fastows participation. Ultimately, a premium of $10.5 million was paid. This represented a return of 360 percent. Kopper demanded later and received $2.6 million in September 2001 as an indemnification against the tax consequences of the $10.5 million premium. Enrons in-house counsel had originally declined this request, but was overruled by Fastow, who told them that Skilling had approved. Upon closing the repurchase of JEDI, Chewco was not required to repay the $15 million it had loaned on an unsecured and non-recourse basis to Kopper and Dodson for them to invest in Osprey trust certificates. Osprey was a limited partner in Whitewing Associates, another related company that will be discussed later. The Powers Report also noted that from December 1997, Enron began to incorrectly pre-book revenue for services not yet provided in regard to the Barclays guarantee fee and the JEDI management fee arrangement that Chewco assumed, in the amounts of $10 million and $25.7 million respectively. When Enrons affairs began to unravel in public, the board started an investigation that led to the bankruptcy filing on December 2, 2001. The Powers Report states: In late October 2001, the Enron Board (responding to media reports) requested a briefing by Management on Chewco. Glisan [Ben F. Glisan, Jr., the Enron transaction support employee with principal responsibility for accounting matters in the Chewco transaction, signed many of the documents on Enrons behalf] was responsible for presenting the briefing at a Board meeting on short notice. Powers Report, 49. Ibid., 50. 6 Ibid., 52. 7 Ibid., 53. 8 Powers Report, 61. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 99 Continued Following the briefing, Enron accounting and legal personnel (as well as Vinson & Elkins) undertook to review documents relating to Chewco. This review identified the documents relating to the finding of the Big River and Little River reserve accounts in December 1997 through the $16.6 million distribution from JEDI. Enron brought those documents to the attention of Andersen, and consulted with Andersen concerning the accounting implications of the funded reserve accounts. After being shown the documents by Enron and discussing the accounting issues with Enron personnel, Andersen provided the notice of possible illegal acts that Andersens CEO highlighted in his Congressional testimony on December 12, 2001. Enrons accounting personnel and Andersen both concluded that, in light of the funded reserve accounts, Chewco lacked sufficient outside equity at risk and should have been consolidated in November 1997. In addition, because JEDIs nonconsolidation depended on Chewcos status, Enron and Andersen concluded that JEDI also should have been consolidated in November 1997. In a Current Report on Form 8-K filed on November 8, 2001, Enron announced that it would restate its prior period financials to reflect the consolidation of those entities as of November 1997.9 partners, ERNB Ltd. . . . and Campsie Ltd. A diagram of the financing of LJM1 can be found on page 70 of the Powers Report. LJM1 ultimately entered into three transactions with Enron: (1) the effort to hedge Enrons position in Rhythms NetConnections stock, (2) the purchase of a portion of Enrons interest in a Brazilian power project (Cuiaba), and (3) a purchase of certificates of an SPE called Osprey Trust.11 The Rhythms hedge transaction is significant because it introduces the basic form future for hedge transactions. Per the Powers Report on page 77: In March 1998, Enron invested $10 million in the stock of Rhythms NetConnections, Inc. (Rhythms), a privately-held internet service provider for businesses using digital subscriber line technology, by purchasing 5.4 million shares of stock at $1.85 per share. On April 7, 1999, Rhythms went public at $21 per share. By the close of the trading day, the stock price reached $69. By May 1999, Enrons investment in Rhythms was worth approximately $300 million, but Enron was prohibited (by a lock-up agreement) from selling its shares before the end of 1999. Because Enron accounted for the investment as part of its merchant portfolio, it marked the Rhythms position to market, meaning that increases and decreases in the value of Rhythms stock were reflected on Enrons income statement. LJM Partnerships and The Raptors: LJM1 On June 28, 1999, the Enron board approved Fastows proposal that he invest $1 million and become the sole managing/general partner of LJM1 (LJM Cayman LP), which would raise funds from outside investors that could be used to hedge the possible loss of market value of Enrons investment in Rhythms NetConnections, Inc. (Rhythms for short). Fastow said that he would receive fees, that the Enron Code of Conduct would require special action (suspension of the code) by the chairman, and that his participation would not adversely affect the interests of Enron.10 The Powers Report continues: LJM1 was formed in June 1999. Fastow became the sole and managing member of LJM Partners, LLC, which was the general partner of LJM Partners, L.P. This, in turn, was the general partner of LJM1. Fastow raised $15 million from two limited Skilling was concerned about mitigating the volatility caused by these mark-to-market increases and decreases, and Fastow and Glisan devised a hedging transaction to do so. The arrangement also resulted in Enron recognizing the appreciation in value of Enrons own stocka recognition that GAAP does not normally permit except under strict conditions where cash is received for the stock confirming the market value. Their proposal was to capitalize an SPE with Enron stock, and have the SPE hedge the value of the Rhythms investment so that the SPE would pay Enron if the Rhythms investment decreased. This payment would be shown as revenue by Enron and offset the loss in the Rhythms investment on Enrons books. Ultimately, $95 million in lost Rhythms value was offset and Enrons income was higher as a result. In addition, Enron recorded profit on the Enron shares transferred. Unfortunately, LJM1 did not 9 10 Powers Report, 66, 67. Ibid., 69. 11 Ibid., 70. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 100 Part One The Ethics Environment Continued qualify as having 3 percent invested by an independent, controlling general partner (since Fastow was not independent), and the Enron stock was paid for by a promissory note, not cash. Moreover, it became clear that the creditworthiness of the SPE depended upon the Enron shares transferred, and since the value of Enron shares declined in 2000 and 2001, that creditworthiness was eroded below the level required to pay Enron its offsets. Enron, it became obvious, was attempting to hedge itself largely a game of smoke and mirrors in the absence of outside investment to absorb the economic risk. In spite of these problems, Arthur Andersen and Enrons law firm, Vinson & Elkins, indicated that the hedge was reasonable, and that it could go ahead as Fastow and Glisan intended. Ultimately, however, upon reexamination by Arthur Andersen, it was determined (in October 2001) that the financial statements for 19992001 had to be restated. In November, Enron announced that it would restate prior period financial statements to reflect the consolidation retroactive to 1999, which would have the effect of decreasing Enrons net income by $95 million in 1999 and $8 million in 2000.12 The Powers Report describes the Rhythms transaction beginning on page 79, with a diagram on page 81 and a discussion of the hedge beginning on page 82. It is noted on page 83 that the equity of the SPE used for the transaction (Swap Sub, of which LJM1 owned part) was negative and thus the transaction could not have qualified for the 3 percent nonconsolidation rule. This sprung from the fact that: At its formation on June 30, 1999, Swap Sub had negative equity because its liability (the Rhythms put, valued at $104 million) greatly exceeded its assets ($3.75 million in cash plus $80 million in restricted Enron stock).13 This was what Arthur Andersen found upon reexamination in October 2001. Arthur Andersens CEO said: In evaluating the 3 percent residual equity level required to qualify for non-consolidation, there were some complex issues concerning the valuation of various assets and liabilities. When we reviewed this transaction again in October 2001, we determined that our teams initial judgment that the 3 percent test was met was in error. We promptly told Enron to correct it.14 Within two weeks after the transaction closed on June 30, 1999, it was realized that the volatility of earnings had not improved to the degree desired,15 and four more derivative actions were entered into to make the hedge act more like a swap. These did not cure the problem sufficiently, and due to the continuing concern for the erosion of creditworthiness, the decision was made to liquidate the hedge. In February or March 2000, Vince Kaminski estimated that there was a 68 percent probability that the structure would default, and he claims he relayed this to the accounting group.16 In early March 2000, negotiations to unwind Swap Sub were begun between Causey and Fastow with Fastow giving the impression that he had no personal interest in the outcomewhich he was just negotiating for the limited partners of LJM1. On March 8, 2000, Enron gave Swap Sub a put on 3.1 million shares of Enron at $71.31 per share, which was $4.12 over the closing price, thus conveying approximately $12.8 million in value to Swap Sub. Perhaps this was by mistake. Subsequently, Fastow proposed that Swap Sub receive $30 million from Enron for the unwind, and this was agreed to. The unwind was completed per an agreement dated March 22, 2000, which was not subjected to an independent fairness examination, nor was the board advised, nor DASH sheets executed. Arthur Andersen reviewed the deal, but said nothing. Not until later was it realized that the value ascribed to the shares reacquired by Enron was as unrestricted shares, and no discounting was employed to reflect that they were restricted. As a result, an estimated $70 million more than what was required was transferred to Swap Sub, and ultimately to Fastow and his associates.17 In addition, LJM1 was allowed to retain 3.6 million postsplit Enron shares related to the original transaction, which, on April 28, 2000, had an undiscounted value of $251 million at closing price.18 Many of Enrons employees were involved in these transactions, but none were approved to benefit as 15 12 13 Powers Report, 84. Powers Report, 83. 14 Ibid., 84. Ibid., 85. See Footnote 30 of the Powers Report. Because the put provided one-sided protection, Enron was exposed to income statement volatility when Rhythms price increased and subsequently decreased. In addition, Enron was subject to income statement volatility from the time value component of the put option. 16 Ibid., 87. 17 Ibid., 91. 18 Ibid., 91. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 101 Continued required by the Enron Code of Conduct, and the board apparently did not know of their involvement. However, the employees benefited mightily, as is detailed later. In May, as noted earlier, McMahon expressed his reservations about Enron accounting and deals to Fastow and was reassigned. Glisan became the new treasurer of Enron. were Fastow and, at some point after the creation of LJM2, an entity named Big Doe LLC. Kopper was the managing member of Big Doe. (In July 2001, Kopper resigned from Enron and purchased Fastows interest in LJM2.)20 A diagram of this structure is on page 74 of the Powers Report. Subsequently, a management agreement was executed between Enron and LJM2 that specified which full-time Enron employees were to work on LJM2 matters. Once again, the issue arises of whether LJM2 qualified for nonconsolidation. A series of transactions were entered into that created profit on Enrons earnings statement based upon the assumption that LJM2 was not to be consolidated under the 3 percent rule. Fastow was not a completely independent third party who possessed the risks and rewards of ownership. However, he could be removed by a 75 percent (and later 66 percent) vote of the limited partners. Were these restrictions enough? Initially Arthur Andersen and Enrons lawyers, Vinson & Elkins, thought so, but the Powers Committee was not so certain.21 LJM Partnerships and The Raptors: LJM2 In October 1999, Fastow proposed a second LJM partnership, LJM2 Co-Investment LP (LJM2), where he would serve as a general partner through intermediaries to encourage up to $200 million of outside investment that could be used to purchase assets that Enron wanted to syndicate. This, Fastow said, would provide Enron the funds needed to grow quickly and at less cost than by other means. This was not done blindly, as the following shows: The minutes and our interviews reflect that the Finance Committee discussed this proposal, including the conflict of interest presented by Fastows dual roles as CFO of Enron and general partner of LJM2. Fastow proposed as a control that all transactions between Enron and LJM2 be subject to the approval of both Causey, Enrons Chief Accounting Officer, and Buy, Enrons Chief Risk Officer. In addition, the Audit and Compliance Committee would annually review all transactions completed in the prior year. Based on this discussion, the Committee voted to recommend to the Board that the Board find that Fastows participation in LJM2 would not adversely affect the best interests of Enron.19 LJM2 and The Raptors In aggregate, the Raptors, which were Rhythms-like hedging arrangements for several of Enrons other merchant investments, had a huge impact on Enrons financial results. Unfortunately, three of the four were modeled after the ill-fated Rhythms, and they had the same shortcomings, so that their impact had to be reversed when their lack of creditworthiness was exposed. They acted as dampeners of the accounting volatility related to earnings, but they were not useful hedges of economic risk. The termination of the Raptor arrangements in the third quarter of 2001 was one of the mighty blows that undermined investor confidence in Enron. The following table showing the impact of the Raptors appears on page 133 of the Powers Report. The Report also discloses that shareholders equity was overstated by $1.2 billion due to improper accounting for Enron stock transferred as stock sold in the following excerpt: The transactions between Enron and LJM2 that had the greatest impact on Enrons financial statements Later, the board reviewed the discussion, and gave their approval. LJM2 was formed in October 1999, and its general partner was LJM2 Capital Management, LP. Limited solicitation developed approximately fifty limited partners raising $394 million including the contributions of the general partner. Again, Fastow arranged a series of intermediaries as follows: The general partner, LJM2 Capital Management, LP, itself had a general partner and two limited partners. The general partner was LJM2 Capital Management, LLC, of which Fastow was the managing member. The limited partners 20 21 Ibid., 73. Powers Report, 76. 19 Powers Report, 71. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 102 Part One The Ethics Environment Continued TABLE 1 Impact of the Raptors on Earnings, in Millions QUARTE R 3Q 2000 4Q 2000 1Q 2001 2Q 2001 3Q 2001 TOTAL R E P ORTE D EAR N I NGS $364 $286 $536 $530 ($210) $1506 EAR N I NGS WITHOUT RAPTORS $295 ($176) $281 $490 ($461) $429 RAPTORS CONTR I B UTION TO EAR N I NGS $69 $462 $255 $40 $251 $1,077 *Third quarter 2001 figures exclude the $710 million pre-tax charge to earnings related to the termination of the Raptors. involved four SPEs known as the Raptors. Expanding on the concepts underlying the Rhythms transaction (described above), Enron sought to use the embedded value of its own equity to counteract declines in the value of certain of its merchant investments. Enron used the extremely complex Raptor structured finance vehicles to avoid reflecting losses in the value of some merchant investments in its income statement. Enron did this by entering into derivative transactions with the Raptors that functioned as accounting hedges. If the value of the merchant investment declined, the value of the corresponding hedge would increase by an equal amount. Consequently, the declinewhich was recorded each quarter on Enrons income statementwould be offset by an increase of income from the hedge. As with the Rhythms hedge, these transactions were not true economic hedges. Had Enron hedged its merchant investments with a creditworthy, independent outside party, it may have been able successfully to transfer the economic risk of a decline in the investments. But it did not do this. Instead, Enron and LJM2 created counter-parties for these accounting hedges the Raptorsbut Enron still bore virtually all of the economic risk. In effect, Enron was hedging risk with itself. In three of the four Raptors, the vehicles financial ability to hedge was created by Enrons transferring its own stock (or contracts to receive Enron stock) to the entity, at a discount to the market price. This accounting hedge would work, and the Raptors would be able to pay Enron on the hedge, as long as Enrons stock price remained strong and especially if it increased. . . . When the value of many of Enrons merchant investments fell in late 2000 and early 2001, the Raptors hedging obligations to Enron grew. At the same time, however, the value of Enrons stock declined, decreasing the ability of the Raptors to meet those obligations. These two factors combined to create the very real possibility that Enron would have to record at the end of first quarter 2001 a $500 million impairment of the Raptors obligations to it. Without bringing this issue to the attention of the Board, and with the design and effect of avoiding a massive credit reserve, Enron Management restructured the vehicles in the first quarter of 2001. In the third quarter of 2001, however, as the merchant investments and Enrons stock price continued to decline, Enron finally terminated the vehicles. In doing so, it incurred the after-tax charge of $544 million ($710 million pre-tax) that Enron disclosed on October 16, 2001 in its initial third quarter earnings release. Enron also reported that same day that it would reduce shareholder equity by $1.2 billion. One billion of that $1.2 billion involved the correction of accounting errors relating to Enrons prior issuance of Enron common stock (and stock contracts) to the Raptors in the second quarter of 2000 and the first quarter of 2001; the other $200 million related to termination of the Raptors.22 Details of these activities are available in the Powers Report on pages 98133. The following table is provided for reference purposes. Raptors I and II were capitalized in almost identical manners. For Raptor I (Talon), in April 2000, 22 Powers Report, 97, 98. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 103 Continued TABLE 2 Enrons RaptorsSelected Details NAM E Raptor Raptor Raptor Raptor I II III IV Talon Timberwolf Porcupine Bobcat APPROVE D IN 2001 May June 2 Not Aug.7 DIAG RAM ON 101 116 CAPITAL (M I L) FROM LJ M2 $30 $30 $30 $30 R EQU I R E D (M I L) LJ M2 R ETU R N $41 $41 $39.5 $41 EXPECTE D (M I L) H E DG E CAP. USE D $500 $513 Only TNPC Nil LJM2 contributed $30 million cash. Enron contributed (through a wholly owned subsidiary) $1,000 cash, a $50 million promissory note, and Enron shares, or rights to shares, worth $537 million, which could not be sold, pledged, or hedged for three years. The value of the shares was therefore discounted by 35 percent, which agreed with a fairness evaluation by PricewaterhouseCoopers (PwC). Enron received a promissory note from Talon in the amount of $400 million. An interesting arrangement apparently was not reflected in the setup documents seen by the board, but was understood by those working on the deal, namely that Talon could not write any derivatives until LJM2 received at least its capital back plus $11 million ($41 million) or 11 percent annualized return. If this return was not received in six months, Enron could be forced to buy back its shares at their unrestricted value. Enron was to get any return after the $41 million was paid. These arrangements were very generous to LJM2. In addition, however, $41 million in profit was created for Talon by Enron purchasing from Talon a put option that would require Talon to purchase Enron shares in six months at a $41 million premium. This was strange and generous because Enron was betting its own stock would go down, and the terms of the put did not reflect the lack of creditworthiness of Talon.23 The option was settled early, on August 3, 2000, by Causey on behalf of Enron and Fastow, and since Enron stock had gone up, only $4 million of the $41 million was returned to Enron. Talon paid $41 million 23 to LJM2, which earned 193 percent, plus Enron paid its accounting fees and a management fee of $250,000 per year. Talon was free to start hedging, which it did. Unfortunately, the capacity of Talon to hedge Enrons merchant investments was limited by Talons ability to pay Enron in the value of the merchant investment(s) declined. This ability, or creditworthiness, depended in turn upon Talons assets, which included some cash but mostly shares of Enron. As the market price of those Enron shares declined in the fall of 2000, the possibility that Talon could not paythus forcing Enron to record losses grew so large that Enron sought to shore up Talons creditworthiness by using a costless collar arrangement. The Powers Report describes the arrangement as follows: To protect Talon against a possible decline in Enron stock price-which would decrease the value of Talons principal asset, and thereby decrease its credit capacity on October 30, 2000, Enron entered into a costless collar on the approximately 7.6 million Enron shares and stock contracts in Talon. The collar provided that, if Enron stock fell below $81, Enron would pay Talon the amount of any loss. If Enron stock increased above $116 per share, Talon would pay Enron the amount of any gain. If the stock price was between the floor and ceiling, neither party was obligated to the other. This protected Talons credit capacity against possible future declines in Enron stock.24 24 Ibid., 110. Powers Report, 103, 104. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 104 Part One The Ethics Environment Continued Unfortunately, the protection was only designed to protect within a narrow range, and Enrons stock was destined to fall below the $81 level. Based on Talons revised contract, its creditworthiness would only protect Enron for about another $10 per share fall below the $81 level. If Enrons share price was to fall below $71, Talon could not pay off and Enron would have to record net losses on its merchant investments. In addition, the costless collar dealt with Talons Enron shares as if they were not restricted, thus not honoring the 35 percent discount for the three-year restriction period that underlay the original fairness valuation and setup calculations. To make the costless collar arrangements legal, Causey signed a waiver of the three-year restrictions (worth $187 million), thus conveying even more value to Talon than was originally expected.25 Before there were any hedge transactions between Talon (Raptor I) and Enron, Fastow told Enrons Executive Committee that there had been tremendous utilization by the business units of Raptor I,26 and asked for the establishment of Raptor II on June 22, 2000. The presentation requesting the establishment of Raptor IV was made on August 7, 2000, by Ben Glison, who noted that Raptor I was almost completely utilized and that Raptor II would not be available for utilization until later in the year.27 This deferred availability of Raptor II reflects the need to repay LJM2 its $41 million similar to the Raptor I arrangements before hedging could start. The arrangements to capitalize Raptors II and IV were indeed similar to that used for Raptor I, as the Powers Report states: Just as it had done with Talon in Raptor I, Enron paid Raptor lIs SPE, Timberwolf, and Raptor IVs SPE, Bobcat, $41 million each for share-settled put options. As in Raptor I, the put options were settled early, and each of the entities then distributed approximately $41 million to LJM2. Although these distributions meant that both Timberwolf and Bobcat were available to engage in derivative transactions with Enron, Enron engaged in derivative transactions only with Timberwolf. These transactions, entered into as of September 22, 2000 and December 28, 2000, had a total notional value of $513 million.28 25 26 Powers Report, 111. Ibid., 112. 27 Ibid., 112. 28 Ibid., 113, 114. Raptor II did enter into merchant investment hedge transactions with Enron. Raptor IV never did because, due to the continued erosion of both merchant investment values and Enron share prices, on March 26, 2001, Raptor IVs creditworthiness had to be combined with that of the other Raptors to shore up the entire Raptor program. However, prior to the creation of a combined Raptor credit pool, for the same reasons as noted for Raptor I, Enron arranged costless collars for Raptors II and IV on November 27, 2000, and January 24, 2001, respectively. Again, the impact of the collars was limited, and the restricted share shares values factored into the setup transfer valuations was waived. Raptor III was different from the other Raptors because it was intended to hedge only the merchant investment in The New Power Company (TNCP), and it did not hold Enron shares or rights to Enron shares as assets. Instead, Enron provided it warrants or rights to purchase TNCP shares at a very low value, which essentially amounted to the same thing as holding shares. This avoided seeking board approval to use Enron shares, and avoided the dilutive effect on Enrons EPS (earnings per share) that using such shares would have produced. On September 27, 2000, Enron (through a subsidiary named Pronghorn) and LJM2 created the Raptor III SPE Porcupine as shown in the diagram on page 116 of the Powers Report. Once again, Enrons contribution followed the earlier Raptor framework except for the substitution of TNCP shares/rights, and LJM2 contributed $30 million. This left the Raptor III hedge in the position of having to pay Enron for declines in the value of TNCP from assets largely consisting of TNCP shares or rights. If the shares of TNCP declined, the need to pay would rise and the means to pay decreased. This doubling of the importance of TNCP meant that the risk of default was higher than for other Raptors, and certainly more sensitive to declines in the share values of Enrons TNCP merchant investment. Arthur Andersen and Enrons lawyers Vinson & Elkins both received fees for pre-clearing the Raptor III arrangements. Enrons board did not appear to have approved the creation of Raptor III, and no DASH sheets were prepared. LJM2s return was set at the $39.5 million or 30 percent per year, and LJM2 received the $39.5 million in one weekyielding a return of 2,500 percent. By mid-December 2000, the assets of Raptors I and III had declined, and their liabilities increased so much that both had negative equity and therefore Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 105 Continued did not have the ability to pay off Enron in regard to the hedges undertaken. Unless something was done quickly, Enron would have had to reflect significant losses on the year-end statement for 2000 due to this lack of creditworthiness. Therefore, according to the Powers Report, . . . Enrons accountants, working with Andersen, decided to use the excess credit capacity in Raptors II and IV to shore up the credit capacity in Raptors I and III. A 45-day cross-guarantee agreement, dated December 22, 2000, essentially merged the credit capacity of all four Raptors. The effect was that Enron would not, for year end, record a credit reserve loss unless there was negative credit capacity on a combined basis. Enron paid LJM2 $50,000 to enter into this agreement, even though the crossguarantee had no effect on LJM2s economic interests. We have seen no evidence that Enrons Board was informed of either the credit capacity problem or the solution selected to resolve that problem. Enron did not record a reserve for the year ending December 31, 2000.29 It is noteworthy that the Powers Report goes on to say in a footnote that: At the time, Andersen agreed with Enrons view that the 45-day cross-guarantee among the Raptors to avoid a credit reserve loss was permissible from an accounting perspective. The workpapers that Andersen made available included a memorandum dated December 28, 2000, by Andersens local audit team, which states that it consulted two partners in Andersens Chicago office on the 45-day cross-guarantee. The workpapers also include an amended version of the December 28, 2000 memorandum, dated October 12, 2001, stating that the partners in the Chicago office advised that the 45-day cross-guarantee was not a permissible means to avoid a credit reserve loss.30 tected by the creditworthiness of all the Raptors taken together. However, the credit problems of Raptors I and III were too great for Raptors II and IV to carry, and (1) in return for notes receivable totaling $260 million, Enron had to agree to advance Raptors II and IV up to 18 million Enron shares that could not be sold, pledged or hedged for four years (necessitating a 23 percent discount); (2) to increase credit capacity, Enron sold 12 million shares of Enrons stock to Raptors II and IV in exchange for notes receivable totaling $568 million; and (3) Enron hedged any restricted shares held by the Raptors. This last hedging, however, overtook the 23 percent discount calculations for the notes receivable, a fact that was brought forward to the auditors and Enrons accountants by Kaminski. Restructuring the Raptors allowed Enron to avoid reflecting the $504 million credit reserve loss in its first quarter financial statements. Instead, it recorded only a $36.6 million credit reserve loss.31 Ultimately, in the late summer of 2001, the continuing decline of Enron and TNCP share values caused a further large deficiency of Raptor creditworthiness. In addition: The collaring arrangements Enron had with the Raptors aggravated the situation, because Enron now faced the prospect of having to deliver so many shares of its stock to the Raptors that its reported earnings per share would be diluted significantly. At the same time, an unrelated, but extraordinarily serious, Raptor accounting problem emerged. In August 2001, Andersen and Enron accountants realized that the accounting treatment for the Enron stock and stock contracts contributed to Raptors I, II and IV was wrong. Enron had accounted for the Enron shares sold in April 2000 to Talon (Raptor I), in exchange for a $172 million promissory note, as an increase to notes receivable and to shareholders equity. This increased shareholders equity by $172 million in Enrons second, third and fourth quarter 2000 financial reports. Enron made similar entries when it sold Enron stock contracts in March 2001 to Timberwolf and Bobcat (Raptors II and IV) for notes totaling $828 million. This accounting treatment increased shareholders equity by a total of $1 billion in Enrons first and second quarter 2001 financial reports. Enron accountants told us that Andersen was aware of, and approved, the accounting treatment for In early 2001, Enrons stock price continued to decline as did its merchant investments. As a result the cross-quarantee proved to be insufficient and a more permanent solution was sought. On March 26, 2001, the Raptor arrangements were restructured by a cross-collateralization of the Raptors, and by the infusion of more Enron shares. Essentially, Enron assigned its interest in hedge payments from any Raptor to any other Raptor that could not pay for its hedge commitments. Consequently, Enron was pro- 31 29 Powers Report, 120. 30 Ibid., 120. Powers Report, 125. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 106 Part One The Ethics Environment Continued the Enron stock contracts sold to the Raptors in the first quarter of 2001. Andersen did not permit us to interview any of the Andersen personnel involved. In September 2001, Andersen and Enron concluded that the prior accounting entries were wrong, and the proper accounting for these transactions would have been to show the notes receivable as a reduction to shareholders equity. This would have had no net effect on Enrons equity balance. Enron decided to correct these mistaken entries in its third quarter 2001 financial statements. At the time, Enron accounting personnel and Andersen concluded (using a qualitative analysis) that the error was not material and a restatement was not necessary. But when Enron announced on November 8, 2001 that it would restate its prior financials (for other reasons), it included the reduction of shareholders equity. The correction of the error in Enrons third quarter financial statements resulted in a reduction of $1 billion ($172 million plus $828 million) to its previously overstated equity balance. In mid-September, with the quarter-end approaching, Causey met with Lay (who had just recently reassumed the position of CEO because of Skillings resignation) and Greg Whalley (Enrons COO) to discuss problems with the Raptors. Causey presented a series of options, including leaving the vehicles in place as they were, transactions to ameliorate the situation, and terminating the Raptors. Lay and Whalley directed Causey to terminate the Raptors. Enron did so on September 28, 2001, paying LJM2 approximately $35 million. This purchase price apparently was the result of a private negotiation between Fastow (who had sold his interest in LJM2 to Kopper in July), on behalf of Enron, and Kopper, on behalf of LJM2. This figure apparently reflected a calculation that LJM2s residual interest in the Raptors was $61 million. Enron accounted for the buy-out of the Raptors under typical business combination accounting, in which the assets and liabilities of the acquired entity are recorded at their fair value, and any excess cost typically is recorded as goodwill. However, Andersen told Enron to record the excess as a charge to income. As of September 28, 2001, Enron calculated that the Raptors combined assets were approximately $2.5 billion, and their combined liabilities were approximately $3.2 billion. The difference between the Raptors assets and liabilities, plus the $35 million payment to LJM2, resulted in a charge of approximately $710 million ($544 million after taxes) reflected in Enrons third quarter 2001 financial statements. It is unclear whether the accounting treatment of the termination was correct. Enrons transactions with the Raptors had resulted in the recognition of earnings of $532 million during 2000, and $545 million during the first nine months of 2001, for a total of almost $1.1 billion. After taking the unwind charge of $710 million, Enron had still recognized pre-tax earnings from its transactions with the Raptors of $367 million. Thus, it may have been more appropriate for Enron to have reversed the full $1.1 billion of previously recorded pre-tax earnings when it bought back the Raptors.32 Unbelievably, Fastow reported to the LJM2 investors in October 2000 that the Raptors had brought returns of 193 percent, 278 percent, 2,500 percent, and 125 percent, which were far in excess of the 30 percent annualized returns described to the Finance Committee in May 2000. Moreover, since Enron retained the economic risks involved, these returns are evidently for something else. The Powers Report concludes by identifying seven accounting issues raised by the Raptors that are alleged to be questionable.33 Questions Answers should be based on the case as presented, and relevant sections of Chapter 2. 1. Which segment of its operations got Enron into difficulties? 2. How were profits made in that segment of operations (i.e., what was the business model)? 3. Did Enrons directors understand how profits were being made in this segment? Why or why not? 4. Enrons directors realized that Enrons conflict of interests policy would be violated by Fastows proposed SPE management and operating arrangements because they proposed alternative oversight measures. What was wrong with their alternatives? 5. Ken Lay was the chair of the board and the CEO for much of the time. How did this probably contribute to the lack of proper governance? 6. What aspects of the Enron governance system failed to work properly, and why? 7. Why didnt more whistle-blowers come forward, and why didnt some make a significant difference? How could whistle-blowers have been encouraged? 32 33 Powers Report, 125128. Ibid., 129132. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 107 Continued 8. What should the internal auditors have done that might have assisted the directors? 9. Identify conflicts of interests in: SPE activities Arthur Andersens activities Executive activities 10. How much time should a director of Enron have been spending on Enron matters each month? How many large company boards should a director serve on? 11. How would you characterize Enrons corporate culture? How did it contribute to the disaster? ETH ICS CASE Arthur Andersens Troubles Once the largest professional services firm in the world, and arguably the most respected, Arthur Andersen LLP (AA) has disappeared. The Big 5 accounting firms are now the Big 4. Why did this happen? How did it happen? What are the lessons to be learned? Arthur Andersen, a 28-year-old Northwestern University accounting professor, co-founded the firm in 1913. Tales of his integrity are legendary, and the culture of the firm was very much in his image. For example, Just months after [Andersen] set up shop in Chicago, the president of a local railroad insisted that he approve a transaction that would have inflated earnings. Andersen told the executive there was not enough money in the City of Chicago to make him do it.1 In 1954, consulting services began with the installation of the first mainframe computer at General Electric to automate its payroll systems. By 1978, AA became the largest professional services firm in the world with revenues of $546 million, and by 1984 consulting brought in more profit than auditing. In 1989, the consulting operation, wanting more control and a larger share of profit, became a separate part of a Swiss partnership from the audit operation. In 2000, following an arbitrators ruling that a break fee of $1 billion be paid, Andersen Consulting split completely and changed its name to Accenture. AA, the audit practice, continued to offer a limited set of related services, such as tax advice.2 Changing Personalities and Culture Throughout most of its history, AA stood for integrity and technical competence. The firm invested heavily in training programs and a training facility in St. Charles, a small town south of Chicago, and developed it until it had over 3,000 residence beds and outstanding computer and classroom facilities. AA personnel from all over the world were brought to St. Charles for training sessions on an ongoing basis. Even after the consulting and audit operations split, both continued to use the facility. Ironically, AA was the first firm to recognize the need for professional accountants to study business and professional accounting formally. In the late 1980s, AA undertook a number of programs to stimulate that formal education, including the development of ethics cases, the creation of an approach to the resolution of professional ethical problems, and the hosting of groups of 100 accounting academics to get them started in the area. Most had no formal ethics training and were uncertain how to begin ethics teaching, or even if they should. It is likely that AAs farsighted policies are responsible for the genesis of much of the professional ethics education and research in accounting that is going on today. What happened to the AA culture that focused on integrity and technical competence? What changed that would account for AAs involvement in the following major financial scandals as the audit firm that failed to discover the underlying problems? Some observers have argued that a change in AAs culture was responsible. Over the period when the consulting practice was surpassing the audit practice Continued 1 2 Fall from Grace, Business Week, August 12, 2002, 54. Ibid., see table on page 53. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 108 Part One The Ethics Environment Continued TABLE 1 Arthur Andersens Problem Audits CLI E NT WorldCom PROB LE M M ISSE D, DATE $4.3 billion overstatement of earnings announced on June 25, 2002 Inflation of income, assets, etc., bankrupt Dec. 2, 2001 Candidate for bankruptcy LOSSES TO SHAR E HOLDE RS JOB LOSSES AA FI N E $179.3 billion 17,000 N.A. Enron $66.4 billion 6,100 $.5 million (for shredding) Global Crossing Waste Management* Sunbeam* $26.6 billion Overstatement of income by $1.1 billion, 19921996 Overstatement of 1997 income by $71.1 million, then bankruptcy Books cooked, largest nonprofit bankruptcy ever $20.5 billion 8,700 11,000 $7 million $4.4 billion 1,700 Baptist Foundation of Arizona $570 million 165 *Cases are at the end of the chapter Source: Fall from Grace, Business Week, August 12, 2002, 54. as the most profitable aspect of the firm, a natural competitiveness grew up between the two rivals. The generation of revenue became more and more desirable, and the key to merit and promotion decisions. The retention of audit clients took on an increasingly greater significance as part of this program, and since clients were so large, auditors tended to become identified with them. Many audit personnel even looked forward to joining their clients. In any event, the loss of a major client would sideline the career of the auditors involved at least temporarily, if not permanently. For many reasons, taking a stand against the management of a major client required a keen understanding of the auditors role, the backing of senior partners in your firm, and courage. The pressure for profit was felt throughout the rest of the audit profession, not just at Arthur Andersen. Audit techniques were modified to require higher levels of analysis, and lower investment of time. Judgment sampling gave way to statistical sampling, and then to strategic risk auditing. While each was considered better than its predeces- sor, the trend was toward tighter time budgets, and the focus of the audit broadened to include to development of value-added non-audit outcomes, suggestions, or services for clients. Such non-audit services could include advice on the structuring of transactions for desired disclosure outcomes and other work upon which the auditor would later have to give an audit opinion. According to discussions in the business and professional press, many audit professionals did not see the conflicts of interest involved as a problem. The conflict between maximizing audit profit for the firm and providing adequate audit quality so that the investing public would be protected was considered to be manageable so that no one would be harmed. The conflict between auditing in the public interest with integrity and objectivity that could lead to the need to roundly criticize mistakes that your firm or you had made in earlier advice was considered not to present a worry. In addition, the conflict between the growing complexity Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 109 Continued of transactions, particularly those involving derivative financial instruments, hedges, swaps, and so on, and the desire to restrain audit time in the interest of profit was thought to be within the capacity of auditors and firms to resolve. The growing conflict for auditors between serving the interests of the management team that was often instrumental in making the appointment of auditors, and the interests of shareholders was recognized but did not draw reinforcing statements from firms or professional accounting bodies. Some professional accountants did not understand whether they should be serving the interests of current shareholders or future shareholders, or what serving the public interest had to do with serving their client. They did not understand the difference between a profession and a business. Ethical behavior in an organization is guided by the ethical culture of that organization, by any relevant professional norms and codes, and particularly by the tone at the top3 and the example set by the top executives. Also, presumably the selection of the CEO is based partly on the choice of the values that an organization should be led toward. Joe Berardino was elected AAs CEO on January 10, 2001, but he had been partner-in-charge of the AAs U.S. audit practice for almost three years before. He was the leader whose values drove the firm from 1998 onward, and probably continued those of his predecessor. What were his values? Barbara Ley Toffler, a former Andersen partner during this period and before, has provided the following insight: When Berardino would get up at a partners meeting, all that was ever reported in terms of success was dollars. Quality wasnt discussed. Content wasnt discussed. Everything was measured in terms of the buck. . . . Joe was blind to the conflict. He was the most aggressive pursuer of revenue that I ever met.4 Arthur Andersens Internal Control Flaw Given this tone at the top, it is reasonable to assume that AA partners were going to be motivated by revenue generation. But if too many risks are taken in the pursuit of revenue, the probability of a series of audit problems leading to increasingly unfavorable consequences becomes greater. That is 3 exactly what happened. Unfortunately, the leaders of AA failed to recognize the cumulative degree to which the public, the politicians, and the SEC were angered by the progression of AA audit failures. If they had recognized the precarious position they were in, the AA leadership might have corrected the flaw in the AA internal control that allowed the Enron audit failures to happen. AA was the only one of the Big 5 to allow the partner in charge of the audit to override a ruling of the quality control partner. This meant that at AA, the most sensitive decisions were taken by the person who was most concerned with the potential loss of revenue from the client in question, and who was most likely to be subject to the influence of the client. In all of the other Big 5 firms, the most sensitive decisions are taken by the person whose primary interest is the compliance with GAAP, the protection of the public interest, and the reputation of the firm. On April 2, 2002, the U.S. House Energy and Commerce Committee 5 released a memo dated December 18, 1999, from Carl Bass, a partner in AAs Professional Services Group in Chicago, to David Duncan, the AA partner in charge of the Enron account. That memo asked for an accounting change (believed to be in regard to SPE transactions) that would have resulted in a $30$50 million charge to Enrons earnings. In February 2000, Bass emailed Duncan to object to the setting up of an LJM partnership because he indicated that this whole deal looks like there is no substance.6 On March 4, 2001, Bass wrote that then-chief financial officer Andrew Fastows role as manager of special partnerships compromised deals Enron made with the entities.7 Duncan overruled Bass on the first issue, and Bass was removed from Enron audit oversight on March 17, 2001, less than two weeks after he questioned Fastows role in Enrons SPEs. In any other Big 5 firm, Duncan would not have been able to overrule a quality control partner on his own. History might have been different if a quality-focused internal control procedure had been in place at AA, rather than one that was revenue focused. 5 This is a concept emerging in new governance standards that boards of directors are to monitor. 4 Fall from Grace, 55, 56. Andersen under fire over memos: Carl Bass Documents, Financial Post, April 4, 2002, FP1, FP10. 6 Andersen partner warned on Enron in 99: Questioned Partnerships, Financial Post, April 3, 2002, FP9. 7 Andersen under fire, FP1. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 110 Part One The Ethics Environment Continued Arthur Andersens Apparent Enron Mistakes The previously presented Enron Debacle discussion covers in detail many of the questionable accounting transactions, legal structures, and related disclosures that AA reviewed as auditors of and consultants to Enron. Without repeating these in detail, it is possible to provide the following summary of significant issues that AA could be questioned about in court proceedings: AA apparently approved as auditors and consultants (and collected fees for the consulting advice) the structure of many Special Purpose Entities (SPE) that were used to generate false profits, hide losses, keep financing off Enrons consolidated financial statements, and failed to meet the required outsider 3 percent equity-at-risk, and decision control criteria for nonconsolidation. AA failed to recognize the Generally Accepted Accounting Principle (GAAP) that prohibits the recording of shares issued as an increase in shareholders equity unless they are issued for cash (not for notes receivable). AA did not advise Enrons audit committee that Andrew Fastow, Enrons CFO, and his helpers were involved in significant conflict of interest situations without adequate alternative means of managing these conflicts. AA did not advise the Enron Audit Committee that Enrons policies and internal control were not adequate to protect the shareholders interests even though AA had assumed Enrons internal audit function. Many transactions between Enron and the SPEs were not in the interest of Enron shareholders since: I I Side deals between Enron and banks removing the banks risk from transactions such as the: Chewco SPE Rhythms hedge. Numerous prepay deals for energy futures even though AA made a presentation to Enron on the GAAP and AA requirements that precluded such arrangements.8 Why Did Arthur Andersen Make These Apparent Mistakes? The term apparent is used because AAs side of the story has not been heard. The so-called mistakes may have logical, reasonable explanations, and may be supportable by other accounting and auditing experts. That stated, these apparent mistakes may have been made for several reasons, including: Incompetence, as displayed and admitted in the Rhythms case Judgment errors as to the significance of each of the audit findings, or of the aggregate impact in any fiscal year Lack of information caused by Enron staff not providing critical information, or failure on the part of AA personnel to ferret it out Time pressures related to revenue generation and budget pressures that prevented adequate audit work and the full consideration of complex SPE and prepay financial arrangements A desire not to confront Enron management or advise the Enron board in order not to upset management, and particularly Fastow, Skilling, and Lay A failure of AAs internal policies whereby the concerns of a quality control or practice standards partner can and was overruled by the audit partner in charge of the Enron account. AA was the only one of the Big 5 accounting firms to have this flaw, and it left the entire firm vulnerable to the decision of the person with the most to lose by saying no to a client A misunderstanding of the fiduciary role required by auditors Enron profits and cash flow were manipulated and grossly inflated, misleading investors and falsely boosting management bonus arrangements. Extraordinarily overgenerous deals, fees, and liquidation arrangements were made by Fastow, or under his influence, with SPEs owned by Fastow, his family, and Kopper, who was also an employee of Enron. I AA apparently did not adequately consider the advice of its quality control partner, Carl Bass. AA apparently did not find significant audit evidence, or did not act upon evidence found, related to the: I Since AA has now disintegrated, it is unlikely that the cause of specific audit deficiencies will ever be Erroneous valuation of shares or share rights transferred to SPEs. 8 Testimony of Robert Roach to the Senate Permanent Subcommittee on Investigations, July 23, 2002, Appendix A, A-6. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 111 Continued known. However, it is reasonable to assume that all of the causes listed played some part in the apparent mistakes that were made. A review of additional cases of failure where Arthur Andersen was the auditor, such as the Waste Management and Sunbeam failures that appear at the end of the chapter, reveal that AAs behavior was strikingly similar to that in the Enron debacle. In each case, AA appears to have been so interested in revenue generation that they were willing not to take a hard line with their clients. AA personnel apparently believed that there was no serious risk of default and that, over time, accounting problems could be worked out. At the very least, AAs riskassessment process was seriously flawed. Also, when AAs client had a combined chairman of the board and CEO who intimidated or was willingly helped by his CFO, neither additional professional accountants working for the corporations nor other nonaccounting personnel who knew of the accounting manipulations raised their concerns sufficiently with AA or the Audit Committee of their board of directors to stimulate corrective action. This lack of courage and understanding of the need and means to stimulate action left AA, the board, and the public vulnerable. deficiencies, particularly in view of the earlier similar cases involving the AA audits of Waste Management and Sunbeam. In regard to the Waste Management debacle, The commission argued that not only did Andersen knowingly and recklessly issue materially false and misleading statements, it failed to enforce its own guidelines to bring the company in line with minimally accepted accounting standards.10 As a condition of the $7 million fine paid in June 2001 settling AAs Waste Management audit deficiencies, AA had agreed to rectify its audit inadequacies, and the SEC believed that AA had not honored this undertaking. Consequently, since AAs behavior in the Enron debacle was so similar, the SEC provided only a temporary and conditional waiver,11 pending the outcome of the trial. The conviction was announced on Saturday, June 15, 2002, but many large clients had already transferred their work to other large audit firms. Some boards of directors and CEOs thought that AAs reputation was so damaged by the Enron fiasco that they no longer wanted to be associated with AA, or that such an association might weaken their companys ability to attract financing at the lowest rates. The outrage of the public was so intense that other boards could not face the lack of credibility that continuing with AA would have produced with their shareholders. Still other boards realized that if AA were convicted, there would be a stampede to other firms, and their company might not be able to make a smooth transition to another SEC-certified audit firm if they waited to switch. By the time the conviction was announced, only a small percentage of AAs largest clients remained. Even though AAs chances of acquittal upon appeal were considered by some observers to be good, AA was a shell of its former self and was essentially finished as a firm in the United States, and ultimately around the world. The chain of events that led to the shredding of some of AAs Enron audit documents begins before Enron decided to announce a $618 million restatement of earnings and a $1.2 billion reduction of equity on October 16, 2001. An SEC investigation was launched into Enrons accounting on October 17, and AA was advised on October 19. However, AA Shredding Enron Audit Documents: Obstruction of Justice The final disintegration of AA was not caused directly by the Enron audit deficiencies, but by a related decision to shred Enron audit documents, and the conviction on the charge of obstruction of justice that resulted. This charge, filed on March 7, 2002, raised the prospect that if AA were convicted, the Securities and Exchange Commission (SEC) would withdraw AAs certification to audit SEC registrant companies.9 That would preclude those large public companies that needed to be registered with the SEC to have their shares traded on U.S. stock exchanges (the NYSE and NASDAQ) or raise significant amounts of capital in the United States. Since these clients represented the bulk of AAs U.S. and foreign accounting practices, if convicted AA would be effectively reduced to insignificance unless a waiver could be arranged from the SEC. The SEC, however, was very angry about the Enron audit 9 10 AA could also face probation for up to five years and a $500,000 fine as well as fines for up to twice any gains or damages the court determines were caused by the firms action. Back time may catch Andersen, Toronto Star, March 21, 2002, D11. 11 SEC Announces Actions for Issuers in Light of Indictment of Arthur Andersen LLP, SEC Release 2002-37. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 112 Part One The Ethics Environment Continued had advised Enron that such an announcement was necessary to correct its accounting for SPEs and, on October 9 as the eight-page indictment states, retained an experienced New York law firm to handle further Enron-related litigation.12 Eleven days later, the subject of shredding was discussed as part of an emergency conference call to AA partners, and shredding began three days after that.10 Shredding was undertaken in AAs Houston office, as well as in London, Chicago and Portland. . . . according to the U.S. government, . . . the destruction was wholesale, with workers putting in overtime in order to get the job done. Tonnes of paper relating to the Enron audit were promptly shredded as part of the orchestrated document destruction. The shredder at the Andersen office at the Enron building was used virtually constantly and to handle the overload, dozens of large trunks filled with Enron documents were sent to Andersens Houston office to be shredded.13 At the trial, AA argued differently. AAs lawyer attempted to clarify the purpose of Chicago-based AA lawyer Nancy Temples email of October 10 to Michael Odom of AAs Houston office. In that email she wrote that it might be useful to consider reminding the (Enron audit) team that it would be helpful to make sure that we have complied with the policy14 which calls for destruction of extraneous and redundant material.15 This lack of relevance, of course, was difficult to prove after the documents in question had been destroyed. Essentially, AA contended that the order to follow the document retention policy was an innocent effort to organize papers, e-mails and computer files and eliminate extraneous material.16 David Duncan, however, testified against AA. He had been fired from AA (where he had been the partner in charge of the Enron audit) on January 15, one day after he met with the U.S. Justice Department. He said: I obstructed justice . . . I instructed people on the (Enron audit) team to follow the document retention policy, which I knew would result in the destruction of documents.17 The jury deliberated for many days, emerged, and was sent back for additional deliberations. Ultimately, AA was declared guilty. Although AA planned to appeal, it agreed to cease all audits of public companies by the end of August. Ironically, AAs conviction turned upon the jurys view that the shredding was part of a broad conspiracy, and that rested on testimony that was re-read to the jury, indicating that an AA memo (or memos) was altered. The acts of shredding alone were not enough for conviction. The jury was reported as concluding that: Duncan eventually pleaded guilty to one count of obstruction and testified on the governments behalf, but jurors said afterwards that they didnt believe his testimony. Instead, the jury agreed that Andersen in-house attorney Nancy Temple had acted corruptly in order to impede the SECs pending investigation. Speaking to reporters, juror Jack Gallo said that one of Temples memos was critical in helping the jury reach its verdict. The memo, from last October, was a response to an email from Duncan about Enrons third quarter earnings statement. Enron wanted to describe a massive earnings loss as non-recurring, but Duncan advised Enron against using that phrase. Temples memo advised Duncan to delete any language that might suggest that Andersen disagreed with Enron, and further advised Duncan to remove her own name from his correspondence, since she did not want to be called as a witness in any future litigation stemming from Enrons earnings announcements.18 On October 16, 2002, AA was fined the maximum of $500,000 and placed on five years probation. AA appealed out of principle, even though only 1,000 employees remained. Interestingly, on May 31, 2005, the U.S. Supreme Court overturned the conviction on the grounds that the jury instructions failed to convey the requisite consciousness of wrongdoing19that AA personnel needed to think they were doing wrong rather than right to be convicted. The 17 12 Grand Jury Indictment on the Charge of Obstruction of Justice, United States of America against Arthur Andersen, LLP, filed in the United Sates District Court Southern District of Texas on March 7, 2002, 5. 13 Ibid., D11. 14 Auditor evidence attacked, Toronto Star, May 22, 2002, E12. 15 Ibid., E12. 16 Ibid., E12. Andersen partner admits wrongdoing, Toronto Star, May 14, 2002, D3. 18 Greg Farrell, Arthur Andersen convicted of obstruction of justice, USA TODAY, June 15, 2002. 19 Barry McKenna, Supreme Court overrules jurybut too late to save Andersen, Globe & Mail, Report on Business, June 1, 2005, B1, B11. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 113 Continued U.S. government must decide whether to retry the case. Unfortunately, the Supreme Courts ruling came too late for AA. mation events tested. The other events were November 8, 2001, when Enron announced its restatements, December 12, 2001, when AAs CEO admitted AA made an error, and February 3, 2002, the day following the release of the Powers Report, when AA hired former Federal Reserve Chairman Paul Volcker to chair an independent oversight board to shore up AAs credibility. Volcker later resigned when it became evident that AA was unwilling to embrace significant changes. Additional research studies have examined many aspects of the conduct of the directors, executives, lawyers, and accountants involved in the Enron, Arthur Andersen, and WorldCom tragedies. In addition, the roles of regulators, of directors, and of professional independence have come under scrutiny. These studies are to be found in many academic and professional journals as well as the popular business press. In particular, useful articles can be found in the Journal of Business Ethics, Business Ethics Quarterly, Journal of Accounting Research, Contemporary Accounting Research, Journal of Research in Accounting Ethics, and Business Week. Lingering Questions Within a few months, arrangements had been made for the AA units around the world to join other firms, but not before many staff had left, and not all those remaining were hired by the new employers. A firm of 85,000 people worldwide, including 24,000 in the United States, was virtually gone. Was this an appropriate outcome? Perhaps only 100 AA people were responsible for the Enron tragedy, but 85,000 paid a price. Will the reduced selection of large accounting firms, the Big 4, be able to serve the public interest better than the Big 5? What if another Big 4 firm has difficulty. Will we have the Big 3, or are we now facing the Final Four? Will fate await other individual AA partners and personnel beyond David Duncan, or by the AICPA through the exercise of its code of conduct? Will a similar tragedy occur again? Emerging Research These questions, and others, have stimulated the accounting research community to investigate them. Conferences are being held, and research articles are appearing. One of the early studies, by Paul R. Chaney and Kirk L. Philipich entitled Shredded Reputation: The Cost of Audit Failure,20 provided insights into the impact of AAs problems on its other corporate clients and their investors. On January 10, 2002, AA admitted shredding Enrons documents, and in the ensuing three days the stock prices of most of AAs 284 other large clients that were part of the Standard & Poors 1,500 Index fell. Over that time, these stocks dropped an average of 2.05 percent and lost more than $37 million in market value. This was the largest movement observed for the four critical infor- Questions 1. What did Arthur Andersen contribute to the Enron disaster? 2. Which Arthur Andersen decisions were faulty? 3. What was the prime motivation behind the decisions of Arthur Andersens audit partners on the Enron, WorldCom, Waste Management, and Sunbeam audits: the public interest or something else? Cite examples that reveal this motivation. 4. Why should an auditor make decisions in the public interest rather than in the interest of management or current shareholders? 5. Why didnt the Arthur Andersen partners responsible for quality control stop the flawed decisions of the audit partners? 6. Should all of Arthur Andersen have suffered for the actions or inactions of fewer than 100 people? Which of Arthur Andersens personnel should have been prosecuted? 7. Under what circumstances should audit firms shred or destroy audit working papers? 8. Answer the Lingering Questions on page 113. 20 Paul R. Chaney and Kirk L. Philipich, Shredded reputation: The cost of audit failure, Journal of Accounting Research, Vol. 40 No. 4, September 2002, 12351240. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 114 Part One The Ethics Environment ETH ICS CASE WorldCom: The Final Catalyst This case presents, with additional information, the WorldCom saga included in Chapter 2. Questions specific to WorldCom activities are located at the end of the case. Worldcom Lights the Fire WorldCom, Inc., the second largest U.S. telecommunications giant and almost 70 percent larger than Enron in assets, announced on June 25, 2002, that it had overstated its cash flow by $3.8 billion.1 This came as a staggering blow to the credibility of capital markets. It occurred in the middle of the furor caused by: The Enron bankruptcy on December 2, 2001, and the related Congress and Senate hearings and Fifth Amendment testimony by Enron executives The depression of the stock markets The pleas by business leaders and President Bush for restoration of credibility and trust to corporate governance, reporting, and the financial markets Responsive introduction of governance guidelines by stock exchanges and the Securities and Exchange Commission Debate by the U.S. Congress and Senate of separate bills to improve governance and accountability The conviction of Arthur Andersen, auditor of both Enron and WorldCom, for obstruction of justice on June 15, 2002 charged against capital accounts, thus placing their impact on the balance sheet rather than the income statement. In addition, WorldCom created excess reserves or provisions for future expenses, which they later released or reduced, thereby adding to profits. The manipulation of profit through reserves or provisions is known as cookie jar accounting. The aggregate overstatement of income quickly rose to more than $9 billion4 by September 19, 2002, for the following reasons: $3.85 billion for improperly capitalized expenses, announced June 25, 20025 $3.83 billion for more improperly capitalized expenses in 1999, 2000, 2001, and the first quarter of 2002, announced on August 8, 20026 $2.0 billion for manipulations of profit through previously established reserves, dating back to 1999 Ultimately, the WorldCom fraud totaled $11 billion. Key senior personnel involved in the manipulations at WorldCom included: Bernard J. Ebbers, CEO Scott D. Sullivan, CFO Buford Yates, Jr., Director of General Accounting David F. Myers, Controller Betty L. Vinson, Director of Management Reporting, from January 2002 Troy M. Normand, Director of Legal Entity Accounting, from January 2002 Worldcoms Accounting Manipulations WorldComs accounting manipulations involved very basic, easy-to-spot types of fraud.2 Overstatements of cash flow and income were created because one of WorldComs major expenses, line costs, or fees paid to third party telecommunication network providers for the right to access the third parties networks,3 were accounted for improperly. Essentially, line costs that should have been expensed, thus lowering reporting income, were offset by capital transfers or 1 According to SECs complaint against Vinson and Normand:7 4. WorldCom fraudulently manipulated its financial results in a number of respects, including by improperly reducing its operating expenses in at least two 4 Simon Romero and Alex Berenson, WorldCom says it hid expenses, inflating cash flow $3.8 billion, New York Times, June 26, 2002. 2 Bruce Myerson, A WorldCom primer, the Associated Press, June 26, 2001. 3 Complaint: SEC v. WorldCom, Inc., U.S. Securities and Exchange Commission, June 26, 2002, para. 5, www.sec. gov/litigation/complaints/complr17588.htm. WorldCom to reveal more bogus accounting, Associated Press, September 19, 2002; David E. Royella, WorldCom faces two new charges, misstatement grows, Financial Post, November 6, 2002, FP4. 5 WorldCom Inc., Form 8-K, Current Report Pursuant To Section 13 Or 15(D) Of The Securities Exchange Act Of 1934, August 14, 2002, para. 2, www.sec.gov/archives/edgar/. 6 Ibid., para. 3. 7 Complaint: SEC v. Betty L. Vinson, and Troy M. Normand, U.S. Securities and Exchange Commission, modified October 31, 2002, para. 4, 5, 6, www.sec.gov/litigation/complaints/ comp17783.htm. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 115 Continued ways. First, WorldCom improperly released certain reserves held against operating expenses. Second, WorldCom improperly recharacterized certain operating costs as capital assets. Neither practice was in conformity with generally accepted accounting principles (GAAP). Neither practice was disclosed to WorldComs investors, despite the fact that both practices constituted changes from WorldComs previous accounting practices. Both practices artificially and materially inflated the income WorldCom reported to the public in its financial statements from 1999 through the first quarter of 2002. 5. Many of the improper accounting entries related to WorldComs expenses for accessing the networks of other telecommunications companies (line costs), which were among WorldComs major operating expenses. From at least the third quarter of 2000 through the first quarter of 2002, in a scheme directed and approved by senior management, and participated in by VINSON, NORMAND and others, including Yates and Myers, WorldCom concealed the true magnitude of its line costs. By improperly reducing reserves held against line costs, and thenafter effectively exhausting its reservesby recharacterizing certain line costs as capital assets, WorldCom falsely portrayed itself as a profitable business when it was not, and concealed the large losses it suffered. WorldComs fraudulent accounting practices with respect to line costs were designed to and did falsely and fraudulently inflate its income to correspond with estimates by Wall Street analysts and to support the price of WorldComs common stock and other securities. 6. More specifically, in the third and fourth quarters of 2000, at the direction and with the knowledge of WorldComs senior management, VINSON, NORMAND and others, by making and causing to be made entries in WorldComs books which improperly decreased certain reserves to reduce WorldComs line costs, caused WorldCom to overstate pretax earnings by $828 million and at least $407 million respectively. Then, after WorldCom had drawn down WorldComs reserves so far that the reserves could not be drawn down further without taking what senior management believed was an unacceptable risk of discovery, VINSON, NORMAND and others, again at the direction and with the knowledge of senior management, made and caused to be made entries in WorldComs books which improperly capitalized certain line costs for the next five quarters, from the first quarter 2001 through the first quarter 2002. This accounting gimmick resulted in an overstatement of WorldComs pretax earnings by approximately $3.8 billion for those five quarters. The motivation and mechanism for these manipulations is evident from the SECs description of what happened at the end of each quarter, after the draft quarterly statements were reviewed. Steps were taken by top management to hide WorldComs problems and boost or protect the companys stock price in order to profit from stock options, maintain collateral requirements for personal loans, and keep their jobs. These steps were required, in part, to offset the downward pressure on WorldComs share price caused by U.S. and European regulators rejection of WorldComs US $115 billion bid for Sprint Communications.8 Ebbers company had been using takeovers rather than organic growth to prop up earnings, and the financial markets began to realize this would be increasingly difficult. According to the SEC: 27. In or around October 2000, at the direction and with the knowledge of WorldCom senior management, VINSON, NORMAND and others, including Yates and Myers, caused the making of certain improper entries in the companys general ledger for the third quarter of 2000. Specifically, after reviewing the consolidated financial statements for the third quarter of 2000, WorldCom senior management determined that WorldCom had failed to meet analysts expectations. WorldComs senior management then instructed Myers, and his subordinates, including Yates, VINSON and NORMAND, to make improper and false entries in WorldComs general ledger reducing its line cost expense accounts, and reducingin amounts corresponding to the improper and false line cost expense amountsvarious reserve accounts. After receiving instructions through Yates, VINSON and NORMAND ensured that these entries were made. There was no documentation supporting these entries, and no proper business rationale for them, and they were not in conformity with GAAP. These entries had the effect of reducing third quarter 2000 line costs by approximately $828 million, thereby increasing WorldComs publicly reported pretax income by that amount for the third quarter of 2000.9 Manipulations followed the same pattern for the fourth quarter of 2000, but a change was required for the first quarter of 2001 for fear of discovery. 8 Ebbers became symbol of scandals Financial Post, July 14, 2005, FP1, FP3. 9 Complaint: SEC v. Betty L. Vinson, and Troy M. Normand, U.S. Securities and Exchange Commission, modified October 31, 2002, www.sec.gov/litigation/complaints/comp17783.htm Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 116 Part One The Ethics Environment Continued 29. In or around April 2001, after reviewing the preliminary consolidated financial statements for the first quarter of 2001, WorldComs senior management determined that WorldCom had again failed to meet analysts expectations. Because WorldComs senior management determined that the company could not continue to draw down its reserve accounts to offset line costs without taking what they believed to be unacceptable risks of discovery by the companys auditors, WorldCom changed its method of fraudulently inflating its income. WorldComs senior management then instructed Myers, and his subordinates, including Yates, VINSON and NORMAND, to make entries in WorldComs general ledger for the first quarter of 2001 which fraudulently reclassified line cost expenses to a variety of capital asset accounts without any supporting documentation or proper business rationale and in a manner that did not conform with GAAP. 30. Specifically, in or around April 2001, at the direction and with the knowledge of World Coms senior management, defendants VINSON, NORMAND and others, including Yates and Myers, fraudulently reduced first quarter 2001 line cost expenses by approximately $771 million and correspondingly increased capital asset accounts, thereby fraudulently increasing publicly reported pretax income for the first quarter of 2001 by the same amount. In particular, in or about April 2001, NORMAND telephoned WorldComs Director of Property Accounting (the DPA) and instructed him to adjust the schedules he maintained for certain Property, Plant & Equipment capital expenditure accounts (the PP&E RollForward) by increasing certain capital accounts for prepaid capacity. NORMAND advised the DPA that these entries had been ordered by WorldComs senior management. Correspondingly, a subordinate of NORMAND made journal entries in WorldComs general ledger, transferring approximately $771 million from certain line cost expense accounts to certain PP&E capital expenditure accounts.10 owner before he entered the Telcom business,11 where his sixty acquisitions and style earned him the nickname the Telcom Cowboy. However, he was ably assisted in these manipulations by Scott Sullivan, his Chief Financial Officer, and David Myers, his Controller. Both Sullivan and Myers had worked for Arthur Andersen before joining WorldCom. Other spectacular revelations offer a glimpse behind the scenes at WorldCom. The company, which applied for bankruptcy protection in July 21, 2002, also announced that it might write off $50.6 billion in goodwill or other intangible assets when restating for the accounting errors previously noted. apparently other WorldCom decisions had been faulty. The revelations were not yet complete. Investigation revealed that Bernard Ebbers, the CEO, had been loaned $408.2 million. He was supposed to use the loans to buy WorldCom stock or for margin calls as the stock price fell. Instead, he used it partly for the purchase of the largest cattle ranch in Canada, construction of a new home, personal expenses of a family member, and loans to family and friends.12 Finally, it is noteworthy that: At the time of its scandal, WorldCom did not possess a code of ethics. According to WorldComs Board of Directors Investigative Report, the only mention of ethics was contained in a section in WorldComs Employee Handbook that simply stated that . . . fraud and dishonesty would not be tolerated (WorldCom 2003, p. 289). When a draft version of a formal code was presented to Bernie Ebbers . . . for his approval before the fraud was discovered in 2001, his response was reportedly that the code of ethics was a . . . colossal waste of time (WorldCom 2003, 289).13 Why Did They Do it? According to U.S. Attorney General John Ashcroft: the alleged Sullivan-Myers scheme was designed to conceal five straight quarterly net losses and create the illusion that the company was profitable.14 11 In future periods, the increase of certain accounts for prepaid capacity remained the manipulation of choice. Worldcoms Other Revelations It should be noted that Ebbers was not an accountanthe began as a milkman and bouncer, and became a basketball coach and then a Best Western Hotel 10 Complaint: SEC v. Betty L. Vinson, and Troy M. Normand, U.S. Securities and Exchange Commission, modified October 31, 2002, www.sec.gov/litigation/complaints/comp17783.htm. Krysten Crawford, Ex-WorldCom CEO Ebbers guilty, CNN/Money, March 15, 2005, http://money.cnn.com/ 2005/03/15/news/newsmakers/ebbers/?cnn=yes 12 Royella, WorldCom faces two new charges, FP4. 13 Mark S. Schwartz, Effective Corporate Codes of Ethics: Perceptions of Code Users, Journal of Business Ethics, 55:323343, 2004, p. 324, and WorldCom 2003, Report of the Investigation by the Special Investigative Committee of the Board of Directors June 9, 2003. 14 WorldCom accounting fraud rises to $7 billion, The Baltimore Sun, August 9, 2002. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 117 Continued In view of Ebbers $408.2 million in loans, which were largely to buy or pay margin calls on WorldCom stock and which were secured by WorldCom stock, he would be loathe to see further deterioration of the WorldCom stock price. In short, he could not afford the price decline that would follow from lower WorldCom earnings. In addition, according to the WorldComs 2002 Annual Meeting Proxy Statement,15 at December 31, 2001, Ebbers had been allocated exercisable stock options on 8,616.365 shares and Sullivan on 2,811,927. In order to capitalize on the options, Ebbers and Sullivan (and other senior employees) needed the stock price to rise. A rising or at least stable stock price was also essential if WorldCom stock was to be used to acquire more companies. Finally, if the reported results became losses rather than profits, the tenure of senior management would have been shortened significantly. In that event, the personal loans outstanding would be called and stock option gravy train would stop. In 2000, Ebbers and Sullivan had each received retention bonuses of $10 million so they would stay for two years after September 2000. In 1999, Ebbers received a performance bonus allocation of $11,539,387, but he accepted only $7,500,000 of the award.16 The Continuing Saga The WorldCom saga continues as the companys new management try to restore trust it its activities. As part of this effort, the company changed its name to MCI. On August 26, 2003, Richard Breeden, the Corporate Monitor appointed by the U.S. District Court for the Southern District of New York, issued a report outlining the steps the Company will take to re-build itself into a model of strong corporate governance, ethics and integrity . . . (to) foster MCIs new company culture of integrity in everything we do.18 The company is moving deliberately to reestablish the trust and integrity it requires to compete effectively for resources, capital, and personnel in the future. The SEC has filed complaints, which are on its website, against the company and its executives. The court has granted the injunctive relief the SEC sought. The executives have been enjoined from further such fraudulent actions, and subsequently banned by the SEC from practising before it, and some have been banned by the court from acting as officers or directors in the future. WorldCom, as a company, consented to a judgment: . . . imposing the full injunctive relief sought by the Commission; ordering an extensive review of the companys corporate governance systems, policies, plans, and practices; ordering a review of WorldComs internal accounting control structure and policies; ordering that WorldCom provide reasonable training and education to certain officers and employees to minimize the possibility of future violations of the federal securities laws; and providing that civil money penalties, if any, will be decided by the Court at a later date.19 An Experts Insights Former Attorney General Richard Thornburgh was appointed by the U.S. Justice Department to investigate the collapse and bankruptcy of WorldCom. In his Report to the U.S. Bankruptcy Court in Manhattan on November 5, 2002, he said: One person, Bernard Ebbers, appears to have dominated the companys growth, as well as the agenda, discussions and decisions of the board of directors, . . . A picture is clearly emerging of a company that had a number of troubling and serious issues . . . [relating to] culture, internal controls, management, integrity, disclosure and financial statements. While Mr. Ebbers received more than US $77 million in cash and benefits from the company, shareholders lost in excess of US $140 billion in value.17 18 15 Bernie Ebbers and Scott Sullivan were each indicted on nine charges: one count of conspiracy, one count of securities fraud, and seven counts of false regulatory findings20. Sullivan pleaded guilty on the same day he was indicted and later cooperated WorldComs 2002 Annual Meeting Proxy Statement, SEC Edgar File, April 22, 2002, www.sec.gov/Archives/ edgar/data/723527/000091205702015985/0000912057-02015985.txt. 16 Ibid. 17 Don Stancavish, WorldCom dominated by Ebbers, Bloomberg News, in Financial Post, November 5, 2002, FP13. MCI website, Governance: Restoring the Trust, http:// global.mci.com/about/governance/restoringtrust/, (accessed January 3, 2006). 19 SEC Litigation Release No. 17883/ December 6, 2002, http://www.sec.gov/litigation/litreleases/lr17883.htm. 20 Jury convicts Ebbers on all counts in fraud case, MSNBC, March 15, 2005, http://www.msnbc.msn.com/id/7139448/. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 118 Part One The Ethics Environment Continued with prosecutors and testified against Bernie Ebbers in the hopes of receiving a lighter sentence.21 Early in 2002, Ebbers stood up in church to address the congregation saying: I just want you to know that youre not going to church with a crook.22 Ebbers took the stand and argued that he didnt know anything about WorldComs shady accounting, that he left much of the minutiae of running the company to underlings.23 But after eight days of deliberations, on March 15, 2005, a federal jury in Manhattan didnt buy his aw shucks, hands-off, or ostrich-in-the-sand defense. The jury believed Sullivan, who told the jury that Ebbers repeatedly told him to hit his numbersa command . . . to falsify the books to meet Wall Street expectations. 24 They did not buy Ebbers I know what I dont know argument, especially after the prosecutor portrayed a man who obsessed over detail and went ballistic over a US $18,000 cost overrun in a US $3-billion budget item while failing to pick up on the bookkeeping claim that telephone line costs often fluctuated fraudulentlyby up to US $900-million a month. At other times, he replaced bottled water with tap water at WorldComs offices, saying employees would not know the difference.25 On July 13, 2005, Ebbers was sentenced to twentyfive years in a federal prison26. Once a billionaire, he also lost his house, property, yacht, and fortune. At 63 years of age, he is appealing his sentence. Sullivans reduced sentence was for five years in a federal prison, forfeiture of his house, ill-gotten gains, and a fine. Investors lost over $180 million in WorldComs collapse27, and more in other companies as the confidence in credibility of the financial markets, governance mechanisms and financial statements continued to deteriorate. Questions 1. Describe the mechanisms that WorldComs management used to transfer profit from other time periods to inflate the current period. 2. Why did Arthur Andersen go along with each of these mechanisms? 3. How should WorldComs board of directors have prevented the manipulations that management used? 4. Bernie Ebbers was not an accountant, so he needed the cooperation of accountants to make his manipulations work. Why did WorldComs accountants go along? 5. Why would a board of directors approve giving its Chair and CEO loans of over $408 million? 6. How can a board ensure that whistle-blowers will come forward to tell them about questionable activities? 21 22 Crawford, Ex-WorldCom CEO Ebbers guilty. Ebbers became symbol of scandals, FP1, FP3. 23 Crawford, Ex-WorldCom CEO Ebbers guilty. 24 Jury Convicts Ebbers on all counts in fraud case. 25 Ebbers became symbol of scandals. 26 27 Ibid. Ibid. ETH ICS CASE Waste Management, Inc. Waste Management, Inc. (WMI), founded by cousins Dean Buntrock and Wayne Huizenga, first came to public attention in 1971 when the founders began to buy up many small family-owned waste haulers in a successful effort to consolidate the waste disposal industry in the United States. By 1990, as a result of strong growth through acquisitions and operations, WMI had become the largest waste management Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 119 Continued company in the United States. Wayne Huizenga left WMI in 1984 to found his Blockbuster empire.1 Unfortunately, real growth was bolstered by aggressive accounting policies and, when profitability and real growth slowed in the early 1990s, 2 Dean Buntrock and his associates began to manipulate the companys financial reports to keep to its appearance of success.3 Without this successful appearance, the companys stock price would have fallen, making WMI stock far less useful in acquiring additional haulers, as well as making executive stock options worth far less. Ultimately, the lack of real growth came to light, management was changed, and investigations began. In February 1998, WMI announced the restatement of its 19921996 reported earnings, acknowledging that profits had been overstated by $3.54 billion pre-tax. The impact on WMIs share price was not favorable, and although steep declines did not emerge until the second half of 1998, the stocks growth trend was broken. The U.S. Securities and Exchange Commission investigated and laid charges citing massive fraud against former WMI officials; Arthur Andersen, WMIs auditor; and several of Arthur Andersens partners. Significant fines and sanctions were applied. Arthur Andersen paid a fine of $7 million, and key partners were fined and banned from practicing before the SEC. In order to settle two class action lawsuits with irate shareholders, WMI paid $677 million, with Arthur Andersen contributing $95 million. WMI refused to pay pensions and severance to the senior officers implicated in the scandal. Arthur Andersen was the companys auditor throughout this period, and the firm was well aware of WMIs accounting practices. Why didnt they stand up to their client? What could they have done? What should they have done? Did this experience change their approach to risk management? Waste Management Stock Chart, Weekly Prices,19982003 Reprinted courtesy of NAQ, Inc. Discovery Dean Buntrock retired as CEO in June 1996, but continued as the chairman of WMIs board of directors. He appointed his longtime second-in-command 1 Can waste management climb out of the muck? Business Week, March 23, 1998. 2 Ibid. The decline was due to a surplus of dump space and declining prices, and a slowing of stock-based acquisitions due to low attractiveness of company stock. 3 Actually, the use of aggressive or liberal accounting policies and questionable disclosure probably began prior to 1992. Burying trash in big holeson the balance sheet, Business Week, May 11, 1992. Phillip B. Rooney, the companys president and chief operating officer, as CEO, but Rooney resigned in February 1997 due to pressure from unhappy WMI shareholders, and Buntrock was pressed back into service. In July 1997, Buntrock turned over his chairmans title to Ronald T. Lemay, who was formerly an executive at Sprint Corp. However, on October 29, after only three months, Lemay resigned and went back to Sprint. A former Chrysler vice chairman, newly named director and turn-around expert, Robert S. Miller, was appointed interim chairman and CEO. According to Miller, LeMay got a whiff of the accounting problems and He left because it was deep enough and he hadnt hit bottom yet. 4 Nonetheless, LeMay had initiated an investigation into the accounting manipulations that subsequently became the starting point for recognizing the 19921996 financial reports needed restatement to correct numerous overstatements, and the point of departure for the ensuing SEC investigation. According to the SECs information release of March 26, 2002, the defendants, WMIs senior officers (Buntrock; Rooney; James E. Koenig, executive vice president and CFO; Thomas C. Hau, vice president, corporate controller, and chief accounting officer; 4 Where it hurts: An accounting scandal endangers big payout for a retired CEOWaste Managements board withholds $40 million from Buntrock, othersAlma mater loses $3 Million, Jeff Bailey, The Wall Street Journal, May 19, 1999. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 120 Part One The Ethics Environment Continued Herbert Getz, senior vice president general counsel, and secretary; and Bruce D. Tobecksen, vice president of finance), aided by Arthur Andersen and its partners, perpetrated a massive financial fraud lasting more than five years.5 The information release goes on to state that in its related complaint the SEC alleges the following: Defendants fraudulently manipulated the Companys financial results to meet predetermined earnings targets. The Companys revenues and profits were not growing fast enough to meet these targets, so defendants instead resorted to improperly eliminating and deferring current period expenses to inflate earnings. They employed a multitude of improper accounting practices to achieve this objective. Among other things, defendants: expenses, and failed to establish sufficient reserves (liabilities) to pay for income taxes and other expenses.6 The Impact These manipulations gave rise to the following aggregated amounts over the period from 19921996, as indicated by the cumulative restatement announced in early 1998, as reported in the SEC complaint: The RestatementThen the Largest in Corporate History 293. The accounting review started in mid-July by Buntrocks successor continued through the end of the year, with the same long-time Company controllers conducting the review. AA continued as the Companys auditor, but a new engagement team was assembled to audit the Companys restated financial statements. The audit committee oversaw the work on the Restatement and engaged another big 5 accounting firm to shadow the audit work of AA and advise the committee regarding the various accounting issues. avoided depreciation expenses on their garbage trucks by both assigning unsupported and inflated salvage values and extending their useful lives, assigned arbitrary salvage values to other assets that previously had no salvage value, failed to record expenses for decreases in the value of landfills as they were filled with waste, CU M U LATIVE R ESTATE M E NTS OF refused to record PR E-TAX I NCOM E (TH ROUG H 12/31/96) expenses necessary to write off the costs of Vehicle, equipment and container depreciation expense unsuccessful and Capitalized interest abandoned landfill Environmental and closure/post-closure liabilities development projPurchase accounting related to remediation reserves ects, Asset impairment losses established inflated Software impairment reversal environmental reserves (liabilities) in Other connection with Pre-tax subtotal acquisitions so that Restatements of Pre-Tax Income the excess reserves (1/1/97 through 9/30/97) could be used to avoid Income Tax Expense Restatement recording unrelated (through 9/30/97) operating expenses, Total Restated items improperly capitalized a variety of 5 (I N M I LLIONS) $509 192 173 128 214 (85) 301 $1,432 $250 $190 $1,872 Waste Management, Inc. Founder and Five Other Former Top Officers Sued for Massive Earnings Management Fraud, Litigation Release No. 17435/ March 26, 2002, Accounting and Auditing Enforcement Release No. 1532, U.S. Securities and Exchange Commission (see www. thomsonedu.com/accounting/brooks.). 294. The details of the massive Restatement finally came in early 1998. In February 1998, Waste Management 6 Ibid. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 121 Continued announced that it was restating its financial statements for the period 1992 through 1996 and the first three quarters of 1997. At the time, the Restatement was the largest in history. In the Restatement, the Company admitted that, through the first three quarters of 1997, it had materially overstated its reported pre-tax earnings by approximately $1.7 billion and understated certain elements of its tax expense by $190 million. See table below. 295. Additionally, contemporaneous to the Restatement, the Company also recorded approximately $1.7 billion in impairment losses and other charges. The total amount of the Restatement and fourth quarter charges was approximately $3.6 billion.7 material misstatements and omissions. In the process, the . . . defendants received the following estimated illgotten gains, from their bonuses, retirement benefits, trading and charitable giving alone: Ill-gotten Gains Buntrock Rooney Koenig Hau Getz Tobecksen $16,917,761 $9,286,124 $951,005 $640,100 $472,500 $403,7799 The WMI restatement acknowledged that its reported net after-tax income had been misstated by the following amounts in each of the years from 1992 to 1996 inclusive, as reported in the SEC complaint: 14. In the Restatement, the Company acknowledged that its original financial statements had misstated its net after-tax income as in the table below. The Company acknowledged that, in total, it had overstated its net after-tax income by over $1 billion.8 For these wrongdoings, the SEC made the following claims against all or some of the defendants: securities fraud, filing false periodic reports, falsification of books and records, and lying to auditors.10 In summary, the SEC sought: a final judgment as to each defendant that permanently enjoins him, orders the disgorgement of illgotten gains plus prejudgment interest, imposes civil penalties as a lesson to him and to others, and prohibits him from serving as an officer or director of a public company.11 Who Did It, and Why? The complaint goes on to explain each defendants participation in the fraud, essentially indicating that Buntrock masterminded the fraud, and that the other defendants actively participated in and/or knew or recklessly disregarded facts indicating that WMIs financial statements or disclosures contained Arthur Andersens Role The SECs Litigation Release does not mince words about the role of Arthur Andersens partners. It states: YEAR 1992 1993 1994 1995 1996 Q1Q3 1997 OR IG I NALLY R E P ORTE D (THOUSAN DS) $850,036 $452,776 $784,381 $603,899 $192,085 $417,600 Defendants were aided in their fraud by the Companys long-time auditor Arthur Andersen LLP (Andersen), which repeatedly issued unqualified audit reports on the Companys materially false and misleading AS annual financial stateR ESTATE D PE RCE NT ments. At the outset of (THOUSAN DS) OVE RSTATE D the fraud, management capped Andersens audit $739,686 15 fees and advised the $288,707 57 Andersen engagement $627,508 25 partner that the firm $340,097 78 could earn additional fees $(39,307) 100+ through special work. $236,700 76 Andersen nevertheless identified the Companys improper accounting practices and quantified much of the impact of those Ibid., 5. Ibid., 7981. 11 Ibid., 6. 10 9 7 Complaint: SEC v. Dean Buntrock, Phillip B. Rooney, James E. Koenig, Thomas C. Hau, Herbert A. Getz, and Bruce D. Tobecksen, No. 02C 2180, U.S. Securities and Exchange Commission, March 26, 2002, 6465 (see www.thomsonedu. com/accounting/brooks. 8 Ibid., 45. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 122 Part One The Ethics Environment Continued practices on the Companys financial statements. Andersen annually presented Company management with what it called Proposed Adjusting Journal Entries (PAJEs) to correct errors that understated expenses and overstated earnings in the Companys financial statements. Management consistently refused to make the adjustments called for by the PAJEs. Instead, defendants secretly entered into an agreement with Andersen fraudulently to write off the accumulated errors over periods of up to ten years and to change the underlying accounting practices, but to do so only in future periods. That signed, four-page agreement, known as the Summary of Action Steps (attached to the Commissions complaint), identified improper accounting practices that went to the core of the companys operations and prescribed thirty-two must do steps for the company to follow to change those practices. The Action Steps thus constituted an agreement between the company and its outside auditor to cover up past frauds by committing additional frauds in the future. Defendants could not even comply with the Action Steps agreement. Writing off the errors and changing the underlying accounting practices as prescribed in the agreement would have prevented the company from meeting earnings targets and defendants from enriching themselves.12 The SEC findings as detailed beginning on page 3 of the June 19 Litigation Release, or in the longer Administrative Proceedings of the same date,15 provide an interesting year-by-year expansion of the summary noted above. In addition, the Litigation Release makes the following salient points: As reported to the audit committee, between 1991 and 1997, Andersen billed Waste Management corporate headquarters approximately $7.5 million in audit fees. Over this seven-year period, while Andersens corporate audit fees remained capped, Andersen also billed Waste Management corporate headquarters $11.8 million in other fees, much of which related to tax, attest work unrelated to financial statement audits or reviews, regulatory issues, and consulting services. A related entity, Andersen Consulting, also billed Waste Management corporate headquarters approximately $6 million in additional non-audit fees. Of the $6 million in Andersen Consulting fees, $3.7 million related to a Strategic Review that analyzed the overall business structure of the Company and ultimately made recommendations on implementing a new operating model designed to increase shareholder value. Allgyer was a member of the Steering Committee that oversaw the Strategic Review, and Andersen Consulting billed his time for these services to the Company. In setting Allgyers compensation, Andersen took into account, among other things, the Firms billings to the Company for audit and nonaudit services. As the Commission stated in its Order as to Andersen, I In a separate announcement13 of settlements reached on June 19, 2001, the SEC detailed its findings against Arthur Andersen and the following of its partners: Robert E. Allgyer, partner responsible for the audit, who was known as the rainmaker inside Andersen for his skill at winning business by pitching consulting, tax and other non-audit services.14 Edward G. Maier, the risk management partner for Andersens Chicago office. Walter Cercavschi, the concurring partner on the WMI audit. Robert Kutsenda, then Central Region audit practice director for Andersen. [u]nless the auditor stands up to management as soon as it knows that management is unwilling to correct material misstatements, the auditor ultimately will find itself in an untenable position: it either must continue issuing unqualified audit reports on materially misstated financial statements and hope that its conduct will not be discovered or it must force a restatement or qualify its report and thereby subject itself to the liability that likely will result from the exposure of its role in the 15 12 SEC Litigation Release No. 17435, 3. 13 Arthur Andersen . . . and Partners Settle . . ., Litigation Release No. 17039/ June 19, 2001, Accounting and Auditing Enforcement Release No. 1410/ June 19, 2001, U.S. Securities and Exchange Commission (see www.thomsonedu.com/ accounting/brooks). 14 David Ward and Loren Steffy, How Andersen went wrong, Bloomberg Markets, May 2002. Order Instituting Public Administrative Proceedings, Making Findings and Imposing Remedial Sanctions Pursuant to the Commissions Rules of Practice, Securities Exchange Act of 1934, Release No. 44444/June 19, 2001, Accounting and Auditing Enforcement Release No. 1405/June 19, 2001, Administrative Proceeding File No. 3-10513, Securities and Exchange Commission (see www.thomsonedu.com/accounting/brooks.). Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 123 Continued prior issuance of the materially misstated financial statements. The Commission in this case found that I where the bones are buried, . . . youve got to use the dog.17 Andersen failed to stand up to management to prevent the issuance of materially misstated financial statements. Instead, Andersen allowed the Company to establishand then continue for many yearsa series of improper accounting practices. As a result, Andersen found itself in 1998 in the position of auditing the Restatement and issuing an unqualified audit report in which it acknowledged that the prior financial statements on which it had issued unqualified audit reports were materially misstated. Other Impacts Arthur Andersen and Waste Management, Inc., have been sued in numerous class actions by irate shareholders. To date they have paid out the following amounts: Regarding the restatement of earnings: $220 million (Andersen $75 mil.)18 Securities violations: $457 million (Andersen $20 mil.)19 The Commission ultimately found in its Order as to Andersen that I the circumstances of this case, including the positions within the Firm of the partners who were consulted by the engagement team, the gravity and duration of the misconduct, and the nature and magnitude of the misstatements mandate that the Firm be held responsible for the acts of its partners in causing the Firm to issue false and misleading audit reports in the Firms name. The Commissions Complaint alleges and the Commissions Order found that Andersen knew or was reckless in not knowing that the unqualified audit reports that it issued for the years 1993 through 1996 were materially false and misleading because the audits were not conducted in accordance with GAAS and the financial statements did not conform to GAAP. The Complaint further alleges that Andersen violated section 10(b) of the Exchange Act and rule 10b-5 thereunder. The Commissions Order as to Andersen finds that Andersen engaged in improper professional conduct within the meaning of rule 102(e)(1)(ii) of the Commissions Rules of Practice.16 Not surprisingly, the confidence that shareholders were willing to place in WMI management and future earnings announcements was severely eroded. On a personal level, Mr. Buntrock and other senior executives discovered in May 1999 that the approximately $40 million due them for pension and deferred compensation was withheld by the WMI board until the accounting investigation was completed. This followed the precedent set in the case of the former Sunbeam CEO, Albert J. Dunlap, who expected $5.5 million. Cendant Corp., however, which found its pretax profits were overstated by $500 million, paid retiring CEO, Walter A. Forbes, the full $35 million in severance due in July 1998.20 Now that the precedent appears to have shifted, the question arises as to whether executives found to have knowingly or unknowingly, but negligently, contributed to a financial scandal should be forced to pay towards class action settlements reached. Questions 1. Why didnt Arthur Andersen stand up to WMI management? 2. What aspects of their risk management model did the Arthur Andersen partners incorrectly consider? As a result of the Commissions complaint, and without admitting or denying the allegations or findings in the Commissions complaint and orders, Arthur Andersen and the partners consented to the actions in the accompanying table. Surprisingly, Arthur Andersen was not fired as WMIs auditor until 2001. According to audit committee members, Arthur Andersen was kept on to help with the accounting probe. If you want to find 17 18 Where It Hurts. Ibid. 19 Calmetta Coleman, Waste Management to pay $457 million to settle shareholder class-action lawsuit, The Wall Street Journal, November 8, 2001. 20 Where It Hurts. 16 Arthur Andersen . . . and Partners Settle. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 124 Part One The Ethics Environment Continued SEC SANCTIONS R E LATE D TO I M PROPE R AU DIT PRACTICES WITH R EGAR D TO TH E AU DITS F OR 19921997 O F WASTE MANAG E M E NT, I NC. Permanent Injunction Enjoining From Future Violations of Sections or Rules of the Securities Exchange Act Arthur Andersen Robert Allgyer Edward Maier Walter Cercavschi Robert Kutsenda Section 10(b) [1934] Rule 10b-5 [1934] Section 10(b) [1934] Rule 10b-5 [1934] Section 17(a) [1933] Section 10(b) [1934] Rule 10b-5 [1934] Section 17(a) [1933] Section 10(b) [1934] Rule 10b-5 [1934] Section 17(a) [1933] Civil Penalty (Fine) Censure under Rule 102(e) for improper professional conduct Denial of right to appear or practice before the SEC as an accountant, with the right to request reinstatement after . . . Censure Censure Denial, 5 years Censure Denial, 3 years Censure Denial, 3 years Censure Denial, 1 year $7 million $50,000 $40,000 $30,000 - 3. To whom should Arthur Andersen have complained if WMI management was acting improperly? 4. Did the WMI board and audit committee do their jobs? 5. Were the fines levied high enough? 6. Should you use the same dog to discover the bones in an accounting scandal? ETH ICS CASE Sunbeam Corporation and Chainsaw Al In July 1996, Albert J. Dunlap was hired as CEO and Chairman by Sunbeams board of directors to revive the company from a period of lagging sales and profits, and make it an attractive acquisition target. Chainsaw Al, as he was known for his staff- and cost-cutting style as a turn-around expert, had a reputation for results that immediately propelled the price of Sunbeam stock upward by 60 percent to $18.63.1 By 1997, he planned to eliminate half of 1 Sunbeams 6,000 employees and 87 percent of its products.2 According to Sunbeam managers, it . . . resulted in near-total chaos. 3 However, 1997 reported sales rose by $184 million or 18.7 percent.4 In March 1998, Sunbeam paid $2.5 billion to buy the companies manufacturing Coleman stoves, 2 3 Chainsaw Al: He anointed himself americas best CEO. But Al Dunlap drove Sunbeam into the ground, Business Week, October 18, 1999. Ibid. Ibid. 4 Sunbeam Corporations 1997 Annual Report, SEC 10-K Filing, March 2, 1998 (see www.thomsonedu.com/accounting/brooks). Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 125 Continued FIGURE 1 60 50 Price per Share ($) 40 30 20 10 0 Jul-96 Mr. Dunlap appointed Nov-96 Sale of non-core businesses Earnings announced - 97 Restructuring Charge Stock Price Movement During the Stewardship of Mr. Dunlap Q3 earnings announced New acquisitions announced Q1 estimates below projections Q1 earnings announced Barrons article published Mr. Dunlap terminated Mr. Dunlaps new compensation plan Mar-97 Jul-97 Nov-97 Mar-98 Jul-98 Reprinted with permission of Shyam V. Sunder, from Working Paper Series ACC-99-07 Sunbeam, Inc, stern School of Business, NYU. Mr. Coffee coffee makers, and First Alert smoke detectors. Dunlap was rewarded with a $2 million annual salary and stock options worth millions.5 Sunbeams stock peaked at $52. Unfortunately, Chainsaw had used manipulative accounting techniques to inflate Sunbeams financial results. When properly restated, for example, Sunbeams reported net income for 1997 was reduced from $109.4 million to $38.3 million.6 In early 1998, the lack of real success in the selling of Sunbeams products could no longer be easily masked and the manipulations had to offset the lowered sales and be larger than earlier manipulations in order to create an attractive percentage gain in sales and profits. Moreover, since some of the manipulations used in 1996 and 1997 had recorded future sales too early, there were even fewer sales to count in 1998, and using the same manipulative techniques at ever larger levels raised issues of credibility. Interestingly, at least two people were not fooled: Deidra DenDanto, a 26-year-old, recently hired member of Sunbeams internal audit staff, and Andrew Shore, a stock analyst at Paine Weber, Inc.7 Deidra challenged the manipulative practices from the start, but got little support from her superiors. She finally resigned on April 3 after sending a letter to the board of directors.8 Shore became wary of the high inventory and accounts receivable levels Dunlap was creating as early as the second quarter of 1997. On April 3, 1998, Sunbeam had to announce that revenue and orders would be 5 percent lower than expected. Chainsaw Al did not put forward a credible front during the conference call. In addition, Andrew Shore had just found that two senior officers had left Rich Goudis, chief of investor relations, resigned on April 3,9 and Donald Uzzi, executive vice president for worldwide consumer products, had been fired earlier10and Shore had downgraded his rating of the companys shares. The companys share price fell by almost 25 percent to $34.375.11 The accounting manipulations used were unraveling, and stories began to appear in the press. The most damaging appeared in Barrons, and an impromptu board meeting was held on June 9 during which Dunlap, Russell A. Kersh, the CFO; and Robert J. Gluck, the controller, refuted the charges.12 Kersh did, however, reveal that it would be tough to make 1998 projections. At the end of the meeting, Dunlap demanded the boards support or he (and Kersh) 5 Sunbeam 1999 Annual Meeting Proxy Statement, SEC Edgar Filing, May 14, 1999 (see www.thomsonedu.com/accounting/ brooks). 6 Andersens other headache: Sunbeam, BusinessWeek, January 29, 2002. 7 Chainsaw Al. Ibid. Ibid. 10 How Al Dunlap self-destructed, BusinessWeek, July 6, 1998. 11 Ibid. 12 Ibid. 9 8 Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 126 Part One The Ethics Environment Continued would leave the company. The directors were stunned and incredulous. They did some checking with other executives including David C. Fannin, Sunbeams executive vice president and chief counsel. They met again with Fannin on June 13 and Chainsaw Al was fired by phone later that day along with the CFO.13 He asked for, but was given no explanation. Sunbeam then announced that its prior financial statements could not be relied upon. In the same month, the Securities and Exchange Commission began their investigation into Sunbeams accounting practices. A new management team was hired, but the fundamental weaknesses of Sunbeam products in their markets were tough to remedy. In November 1998, Sunbeam issued restated financial statements for the fourth quarter of 1996, all quarters of 1997, and the first quarter of 1998. As a result, Sunbeams stock price declined to approximately $7 from $52 in March, eight months earlier. On February 5, 2001, Sunbeam filed for protection while reorganizing under Chapter 11 of the U.S. Bankruptcy Code.14 On May 15, 2001, the SEC charged Dunlap, former CFO Russell A. Kersh, controller Robert J. Gluck, and vice presidents Donald R. Uzzi and Lee B. Griffin, as well as Arthur Andersen LLP partner Phillip Harlow, with fraud. The SEC also announced the settlement of similar charges against Sunbeams former counsel, David Fannin.15 of a successful restructuring of Sunbeam in order to inflate its stock price and thus improve its value as an acquisition target. To this end, management employed numerous improper earnings management techniques to falsify the Companys results and conceal its deteriorating financial condition. Specifically, senior management created $35 million in improper restructuring reserves and other cookie jar reserves as part of a year-end 1996 restructuring, which were reversed into income the following year. Also in 1997, Sunbeams management engaged in guaranteed sales, improper bill and hold sales, and other fraudulent practices. At year-end 1997, at least $62 million of Sunbeams reported income of $189 million came from accounting fraud. The undisclosed or inadequately disclosed acceleration of sales through channel-stuffing also materially distorted the Companys reported results of operations and contributed to the inaccurate picture of a successful turnaround. When these measures did not lead to a sale of the Company by year-end 1997, senior management took increasingly desperate measures to conceal Sunbeams mounting financial problems, meanwhile attempting to finance the acquisition of three other companies in part through the public sale of debt securities. Management engaged in additional accelerated sales and sales for which revenue was improperly recognized, deleted certain corporate records to conceal pending returns of merchandise, and misrepresented the Companys performance and future prospects in press releases and in meetings with analysts and lenders. In June 1998, negative statements in the press about the Companys sales practices prompted Sunbeams Board of Directors to begin an internal investigation. This resulted in the termination of certain members of senior management, including Sunbeams chief executive officer and chief financial officer, and, eventually, in an extensive restatement of the Companys financial statements from the fourth quarter of 1996 through the first quarter of 1998. As a result, Sunbeams restated 1997 income was approximately one-half of the amount previously reported.16 SEC Findings The SEC based its fraud charges on the following summary of its findings: From the last quarter of 1996 until June 1998, Sunbeam Corporations senior management created the illusion 13 14 Ibid. Order Instituting Public Administrative Proceedings, Pursuant to Section 8A of the Securities Act of 1933 and Section 21A of the Securities Exchange Act of 1934, Making Findings, and Imposing a Cease-And-Desist Order, Securities Act of 1933 Release No. 7976/May 15, 2001, Securities Exchange Act of 1934 Release No. 44305/May 15, 2001, Accounting and Auditing Enforcement Release No. 1393/May 15, 2001, Administrative Proceeding File No. 3-10481, Securities and Exchange Commission, May 15, 2001, (SEC Litigation Release) (see www.thomsonedu.com/ accounting/brooks). 15 SEC sues former CEO, CFO, other top officers of Sunbeam Corporation in massive fraud, SEC News Headline Report 2001-49, May 15, 2001 (see www.thomsonedu.com/accounting/ brooks). The details17 of the manipulative techniques that were uncovered by the SEC are of particular interest, as follows: Overstatement of 1996 restructuring charges, thus creating inflated or cookie jar reserves to be reversed 16 17 SEC Litigation Release, op. cit. Ibid. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 127 Continued later to bolster future profits. This overstatement of restructuring charges by a newly installed management team is known as the big bath approach because of the attribution of large losses to ousted management, leaving it clean for the new group. At least $35 million of the total restructuring charge of $337.6 million was improperly created, including: I tomers to place orders before they would otherwise have done so. This practice was not disclosed so investors were unaware of lowered margins and future sales would be jeopardized. I $18.7 million of overstated restructuring costs not in conformity with generally accepted accounting principles (GAAP). $6 million overstatement of a $12 million reserve against a future environmental litigation/remediation (this litigation was settled late in 1997 for $3 million). $2.1 million overstatement of inventory loss by erroneously considering some good inventory as bad, and then selling it at inflated margins in 1997. $2.3 million overstatement of 1996 advertising expenses for service to be rendered in 1997. Overstatement of part of the $21.8 million reserve for cooperative advertising for local retailers. I I Bill and hold sales began to be used in the second quarter of 1997. If customers would order goods before they needed them, Sunbeam offered to hold the goods in Sunbeams warehouse until they requested later delivery. Sunbeam would pay all storage, shipment, and insurance expense. Unsold goods could be returned for full credit. The SEC considered these transactions little more than projected orders disguised as sales. The preceding three techniques would be considered channel-stuffingthe overloading of distribution channels by inducing or forcing the channel members (i.e., wholesalers, distributors, retailers, etc.) to acquire goods before they would otherwise order them. This practice causes the goods ordered prematurely to clog up the channel and delay further orders until the backlog is sold. For example, according to an internal Sunbeam memo, by May 1998, Wal-Mart Stores, . . . which prefers four weeks inventory, was loaded with 23.6 weeks of Sunbeam appliances.18 Obviously there will be a delay before a company can attain normal sales levelsunless the channel is stuffed to a greater degree. Recording of rebates from suppliers for purchases in later periods as income in the period the rebate was received or negotiated. $2.75 million was falsely recorded in the second quarter of 1997 as early sales instead of reductions in the cost of I I I These cookie jar reserves were drawn down through-out 1997, having an effect on reported figures. (See table.) Nondisclosure of unusual or infrequent sales: I $19.6 million of deeply discounted products (a onetime sale) were sold in the first quarter of 1997 without disclosure, thus conveying to investors a false picture of sustainable sales. Contingent sales I Recording of accelerated and false sales, through: I In March 1997, Sunbeam booked QUARTE R as a sale $1.5 milOF 1997 lion revenue from an arrangement Q1 where a wholesaler held barbeque grills over Q2 the quarter end but could return all unsold grills Q3 for credit after the quarter end Q4 with Sunbeam paying all costs of shipment and storage. No risks of ownership were assumed by the wholesaler. COOKI E JAR R ESE RVE I M PROVE M E NT OF I NCOM E $4.3 million non-GAAP $2.1 million inventory $330,000 advertising expense $8.2 million non-GAAP $5.6 million coop advertising $2.9 million non-GAAP $663,000 advertising expense $1.5 million non-GAAP $9.0 million litigation 13% 6% I Early-buy incentives, including offering excessive discounts and other incentives to induce cus- 18 Chainsaw Al. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 128 Part One The Ethics Environment Continued goods sold in later periods. An additional $1.9 million was recorded in the third quarter. I Purported sale of spare parts inventory to a company that had serviced Sunbeam products for a fixed fee per unit. $11 million in revenue and $5 million in income was recorded. However, Arthur Andersen, Sunbeams auditor, found that Sunbeam had guaranteed a five percent profit margin to the customer on resale of the inventory, and a fee for service of an indeterminate value, and indicated that Sunbeams revenue recognition was improper. Sunbeam reserved $3 million against the value of the transaction, but refused to reverse it. Arthur Andersen regarded the restated net transaction as not material and therefore did not qualify their opinion for it. Improper deletion from Sunbeams computer system of all product return authorizations in the first quarter of 1998. Although Sunbeam had to honor their agreements, many returns were delayed past the quarter end so that the companys reserve for returns appeared to be adequate when, in fact, it was understated and income correspondingly overstated. At the end of 1997, Sunbeam reduced its reserve from $6.5 million to $2.5 million without reasonable justification. At the end of January 1998, Sunbeam further reduced it by another $1 million when, in fact, there was approximately $18 million in impending returns and the companys established approach should have called for a reserve of $4.5 million. Extending the first quarter of 1998 from March 29 to March 31 to capture more sales in the quarter. The SECs claim, in summary, was that these manipulations accounted for an overstatement of Sunbeams income by 50 percent during 1997, and that this fraudulent misrepresentation was significant to the decisions of the investing public. How Did They Do It? According to published reports, soon after Chainsaw Al was hired, he recruited Russell Kersh, with whom he had worked before, to be his CFO. Then he gave huge stock options to 250 of the 300 top officers at Sunbeamso significant that many would have had to forego gains of $1 million or more if they resigned before the three-year vesting period. This potential gain was obviously why these senior executives endured Dunlaps intimidating performance review sessions, which were referred to as Hair Spray Days due to the stream of air from Dunlaps mouth that blew back the executives hair. It was like a dog barking for hours, . . . He just yelled, ranted and raved. He was condescending, belligerent, and disrespectful.19 Dunlaps cost-cutting measures resulted in the firing of so many people that normal functions could not be carried out. At one stage, the Sunbeam computer system broke down during an upgrade and couldnt be fixed for months due to lack of technicians that had been fired. During this period Sunbeam reportedly lost track of shipments, could not bill customers properly, and could not collect accounts receivable.20 Making the projected quarterly numbers was always a difficult exercise. But in the fourth quarter [of 1997], however, no amount of game playing or beating up on people could produce the numbers Dunlap had promised investors. So he turned to his longtime ally and CFO, Russell Kersh, who had been with him through his stints at Lily Cup and Scott Paper. In the often esoteric interpretations that are made in accounting, Kersh was rarely conservative or bashful about his creative competence during his tenure as Sunbeams CFO. In a self-congratulatory tone, he would point to his chest and boast to fellow executives that he was the biggest profit center the company had. Dunlap knew it as well. At meetings, I I The SEC further claims that no acquisitor had surfaced for Sunbeam, and the financial picture was so grave in early 1998 that Chainsaw Al negotiated the purchase of three companiesColeman, First Alert, and Signature Brandswith the view of creating another restructuring or cookie jar reserve. The 1998 manipulations described above, and others, were intended to maintain the illusion of favorable momentum to facilitate the placement of $700 million of zero coupon bonds and raise a sufficient revolving line of credit ($1.7 billion) to complete the purchases. Sunbeam completed the acquisition on March 30, 1998, but never disclosed that the increase in gross sales for the two extended days, March 30 and 31, amounted to $38 million. While Sunbeam executives were manipulating the companys financial reports, they were also making a continuous stream of misleading statements to financial analysts, the SEC, and to the investing public. These are detailed in the SECs Litigation Release. 19 20 Chainsaw Al. Ibid. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 129 Continued executives recalled, Dunlap would say: If it werent for Russ and the accounting team, wed be nowhere. Several executives heard Dunlap shout at subordinates: Make the goddamn number. And Russ, you cover it with your ditty bag.21 To investors who made millions by following him, Dunlap was, if not a god, certainly a savior. He parachuted into poorly performing companies and made tough decisions that quickly brought shareholders sizable profits. Were all seduced by the possibility of big wins, says Paine Webber Inc. analyst Andrew Shore.22 Whether Arthur Andersen knew about Sunbeams problems, and how much they knew, will probably never be known with certainty. In their defense against the SEC claims, Andersen claimed that revisions found in the restatement were purely the result of changes in approach mandated by Sunbeams new management.25 Lawyers and Sunbeam executives regarded this position as Andersen doing anything to evade blame.26 Board of Directors Role Given this defense, however, it is possible that Andersen did not review all accounting, internal control, and other concerns with the audit committee of the board or the board of directors itself or, if it did, Andersen may not have branded them as material.27 One reason for this could be that Chainsaw Al was both the CEO and chair of the board, so open discussion and questioning of management may not have been encouraged. Another reason could be that Andersen wanted to protect its audit and nonaudit fees. Nonetheless, the board of directors is not supposed to accept what the external auditors say without any probing or discussion. If issues were raised, questions about the nature of the transactions and the auditors judgments about materiality should have been posed by board members. These might have surfaced information on the companys practices or the auditors judgments that required further investigation. In addition, the board is expected to ensure that the company has proper policies and internal controls so that the policies are followed. This area is the specific mandate of the controller and internal audit group. Although Deidra DenDanto had made numerous reports about her concerns, these do not appear to have reached the board, except perhaps too late in March or early April 1998. Perhaps a whistle-blowing program reporting to the audit committee might have assisted the Sunbeam board. The board seems to have been out of touch with the reality of Sunbeams operations. One matter the board did not handle properly was the investigation of Chainsaw Als resume and Arthur Andersens Role With all this going on, it is reasonable to ask how Arthur Andersen staff members could not have known about the poor internal controls on sales, accounts receivable, and inventory associated with the computer system breakdown. Did they not review internal audit reports? If their audit procedures were more strategic or analytical than procedural, why did they not identify the abnormal growth of inventory and accounts receivable that Andrew Shore did? Perhaps the auditors did not exercise sufficient professional skepticism23 in recognizing the abnormality or, if they recognized it, in exploring the explanations received from Sunbeams management. Deidra DenDanto, one of Sunbeams internal auditors and formerly of Arthur Andersen, knew of the accounting manipulations. Why didnt Arthur Andersen? Perhaps Arthur Andersen recognized many of the problems discussed above (as the SEC claims), but regarded them as not material. In one instance the SEC notes that the auditor may have regarded a partially adjusted matter (the recording as revenue of the purported sale of Sunbeams spare parts inventory) as not material in relation to Sunbeams reported figures, but implies that this was too simplistic an analysis. The comparisons necessary for a proper assessment of materiality should be based on the clients adjusted figures, and on many more factors than most would expect.24 21 22 Ibid. How Al Dunlap self-destructed. 23 See Auditor scepticism and revenue transactions, Jimmy W. Martin, The CPA Journal, New York, August 2002. 24 See FASB, Concepts Statement No. 2, p. 125, and SEC Staff Accounting Bulletin: No. 99Materiality, August 12, 1999, p. 4. 25 26 Andersens other headache: Sunbeam. Ibid. 27 Ibid.; SEC Litigation Release. Continued Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western 130 Part One The Ethics Environment Continued background before it hired him. Apparently, there were several years missing from his resume, thus hiding a period a quarter century ago [when] he was also fired from Nitec Paper Corp. amid similar allegations; in both cases, amazingly high profits were reported and used to justify huge payouts to Dunlap, only to have auditors later conclude that profits were fictitious.28 Dunlap denied any wrongdoing. Neither Dunlap nor Kersh sold Sunbeam stock or received performance-based bonuses during the relevant period. The Commissions action against three other former officers of Sunbeam, Robert J. Gluck, Donald R. Uzzi and Lee B. Griffith, and against Phillip Harlow, the audit partner on the Arthur Andersen engagements to audit Sunbeams 1996, 1997 and 1998 year-end financial statements, remains pending. Trial is scheduled for January 2003. Results of the SEC Charges In April 2001, Arthur Andersen agreed to pay Sunbeam shareholders $110 million to settle a class action lawsuit.29 On September 4, 2002, the SEC announced30 that, without admitting or denying the SECs allegations, Dunlap and Kersh consented to the entry of judgments before the court: (1) permanently enjoining each of them from violating the antifraud, reporting, books and records, and internal controls provisions of the federal securities laws; (2) permanently barring each of them from serving as officers or directors of any public company, and (3) requiring Dunlap to pay a civil penalty of $500,000 and Kersh to pay a civil penalty of $200,000. Questions 1. Explain how Chainsaw Al used cookie jar reserves to inflate Sunbeams profit. 2. Can bill and hold practices ever be considered sales that should be recorded in the period in which the goods are initially held? 3. Why didnt Sunbeams board of directors catch on to the manipulations? 4. How should a board make sure that it gets the information it needs to monitor management actions and accounting policies? 5. If you are a professional accountant who reports an ethical problem to your superior who does nothing, what more should you do? 6. What problems can you identify with Arthur Andersens work as auditor of Sunbeam? 7. How should a board assess the performance of their companys auditors? 8. While it is attractive to have a CEO that is a strong person with a high profile, how should a board manage or keep track of such a person without demotivating them? 9. Can a board effectively monitor a CEO who is also the chair of the board? The Release further notes that: Dunlap paid $15,000,000 and Kersh $250,000 out of their own funds to settle a related class action. 28 The incomplete resume: A special report; An executives missing years: Papering over past problems, Floyd Norris, New York Times, July 16, 2001. 29 Andersens other headache: Sunbeam. 30 Former Top Officers of Sunbeam Corp. Settle SEC Charges . . ., SEC Litigation Release No. 17710/ September 4, 2002, Accounting and Auditing Enforcement Release No. 1623/September 4, 2002. Business & Professional Ethics for Directors, Executives, & Accountants, 4e, Brooks - 2007 Thomson South-Western

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