Bob Jensen's Enron Quiz

Bob Jensen at Trinity University

Bob Jensen's threads on the Enron, Worldcom, and Andersen meltdowns can be found at http://www.trinity.edu/rjensen/FraudEnron.htm

Long-time subscribers to the AECM may remember my quips (years ago) about Michael Kopper ---
These inspired AECMers to write their own quips about Enron and about accounting in general.
You can read some of these AECM originals at http://www.trinity.edu/rjensen/FraudEnron.htm#Humor

Bob Jensen's Enron Updates are at http://www.trinity.edu/rjensen/FraudEnron.htm#EnronUpdates

Enron History --- http://en.wikipedia.org/wiki/Enron_scandal


A person can be a professional thief only if he is recognized and received as such by other professional thieves. Professional theft is a group way of life.
Edwin Sutherland

There will always be white collar crime as long as it pays big even when you get caught.
Bob Jensen --- http://www.trinity.edu/rjensen/FraudConclusion.htm#CrimePays

Enron's Timeline From Beginning to End --- http://www.trinity.edu/rjensen/FraudEnron.htm#EnronTimeline

Memorable quotations about Enron, Worldcom, and Andersen --- http://www.trinity.edu/rjensen/FraudEnron.htm#Quotations

Special Report on the Fall of Enron  --- http://www.chron.com/news/specials/enron/

Frontline (from PBS) videos on accounting and finance regulation and scandals in the U.S. --- http://www.pbs.org/wgbh/pages/frontline/shows/regulation/view/ Note that one of the Frontline videos in about the Enron scandal --- http://www.pbs.org/wgbh/pages/frontline/shows/regulation/view/

Enron Declared Bankruptcy in 2001
History of the Rise and Fall of Enron --- http://www.trinity.edu/rjensen/FraudEnron.htm
Bob Jensen's Enron Quiz --- http://www.trinity.edu/rjensen/FraudEnronQuiz.htm
And don't forget about the Enron home video starring some of the real players (including Jeff Skilling) before they got caught --- http://www.trinity.edu/rjensen/FraudEnron.htm#HFV

From Wikipedia --- http://en.wikipedia.org/wiki/Enron

Enron Creditors Recovery Corporation (formerly Enron Corporation) (former NYSE ticker symbol: ENE) was an American energy company based in Houston, Texas. Before its bankruptcy in late 2001, Enron employed around 22,000 people (McLean & Elkind, 2003) and was one of the world's leading electricity, natural gas, pulp and paper, and communications companies, with claimed revenues of $111 billion in 2000. Fortune named Enron "America's Most Innovative Company" for six consecutive years. At the end of 2001 it was revealed that its reported financial condition was sustained mostly by institutionalized, systematic, and creatively planned accounting fraud (see: Enron scandal). Enron has since become a popular symbol of willful corporate fraud and corruption.

Enron filed for bankruptcy protection in the Southern District of New York in late 2001 and selected Weil, Gotshal & Manges as their bankruptcy counsel. Enron still exists as an asset-less shell corporation, emerging from bankruptcy in November of 2004 after one of the biggest and most complex bankruptcy cases in U.S. history. On September 7, 2006, Enron sold Prisma Energy International Inc., its last remaining business, to Ashmore Energy International Ltd. Following the scandal, lawsuits against Enron's directors were notable because the directors settled the suits by paying very significant sums of money personally. The scandal also caused the dissolution of the Arthur Andersen accounting firm, affecting the wider business world.

Infectious Greed:  How Deceit and Risk Corrupted the Financial Markets  (Henry Holt and Company, 2003, Page 297, ISBN 0-8050-7510-0)

A close analysis of the dealings at Enron leads to three key conclusions, each counter to the prevailing wisdom about the company. First, Enron was, in reality, a derivatives-trading firm, not an energy firm, and it took much more risk than anyone realized. By the end, Enron was even more volatile than a highly leveraged Wall Street investment bank, although few investors realized it.

Second, Enron's core business of derivatives trading was actually highly profitable, so profitable, in fact, that Enron almost certainly would have survived if key parties had understood the details of its business. Instead, in late 2001, Enron was hoist with its own petard, collapsing --- not because it wasn't making money --- but because institutional investors and credit-rating agencies abandoned the company when they learned that Enron's executives had been using derivatives to hide the risky nature of their business.

 

March 31, 2008 message from rock musician larry@mightymoonmen.com

I just found your Enron links and stories from 2002...brings up bad memories
I wrote a song based loosely on Jeff skilling ... "Medicine Man"
You can listen to the song and read the lyrics ---
www.mightymoonmen.com 
thanx


Bob Jensen's Enron Quiz Questions

  1. What is the main temptation of white collar criminals?
    Why do auditors often lose professionalism?
    Click Here for Answer
     

  2. Who are the two richest Enron executives to emerge unscathed by Enron's scandal?
    Click Here for Answer
     

  3. What are some of the main lessons learned from the Enron scandal?
    Click Here for Answer
     

  4. How many facts at the height of Enron's success can your recite?  For example what were its 1999 sales, profits, and cash on hand (at least as reported in Enron's somewhat fictional 1999 financial statements)?  How big were the subsequent earnings and debt restatements?  Who held the most stock?  What was CEO Ken Lay's salary before other benefits? How many employees did Enron have on the payroll in 1999? 
    Click Here for Answers
     

  5. When was Enron formed and who founded it?
    Click Here for Answer
     

  6. When Enron's name became Enron, a consulting firm was paid over $1 million to recommend a name that turned into a laughing stock.  What was that absurd name that became an embarrassing joke?
    Click Here for Answer
     

  7. Who were the leading executives and Board of Director members and what did they eventually earn from their stock sales until paying fines or being forced to return money to Enron?
    Click Here for Answer
     

  8. What executive committed suicide by gunshot after Enron imploded?
    Click Here for Answer
     

  9. What are some of the leading books that have been written about Enron?
    Click Here for Answer
     

  10. What set Andy Fastow and Michael Kopper apart from most of the other Enron executives prior to the illegal self declarations of bonuses from a secret bank account set up just before Enron declared bankruptcy?
    Who were the phony versus the real female whistleblowers at Enron?
    Click Here for Answers
     

  11. How did energy deregulation became a tangled mess?
    What was the main source of the idea that Enron (before it was named Enron) should extend into the energy trading line of business in addition to its gas transmission line of business?  Who did this person work for at the time (it wasn't Enron)?
    Click Here for Answer

     

  12. In the simplest of terms, what is a special purpose entity (SPE) and why is it allowed by the SEC to remain off the accounting books (the FASB mainly went along with the SEC rule on these entities)?  Discuss the pros and cons of allowing SPEs to be unconsolidated in the books of the primary investor.
    Click Here for Answer
     

  13. What was the first SPE formed by Enron that was approved by the Board of Directors?  What did Andy Fastow promise the Board, a promise that he violated in the worst of possible terms?
    Click Here for Answer
     

  14. The first SPE was set up to hedge Enron's investment appreciation in Rhythms NetConnection.  A contractual obligation prevented sale of the investment at a time when its high value was volatile.  Andy Fastow proposed an SPE designed to hedge against a fall in the value of the Rhythms investment.  What type of derivative financial instrument was proposed to carry out this hedge?  Explain how the hedge would've worked optimally.
    Click Here for Answer
     

  15. What is most unusual and actually unethical about the way Enron's SPEs were managed?  How were these related party dealings disclosed and yet obscured in the infamous Footnote 16 of Enron's Year 2000 Annual Report?

    What did Professors Hartgraves and Benston conclude with respect to accounting fraud and failings of both Enron and the external auditors (Andersen) after a detailed analysis of the Powers Report commissioned by the former Chairman of the Board of Directors at Enron?
    Click Here for Answers
     

  16. Frank Partnoy presented the best testimony before the U.S. Senate about Enron's misuse of derivative financial instruments after Enron imploded and was being investigated.  Summarize Partnoy's major conclusions about these hedging activities and their accounting.
    Click Here for Answer
     

  17. In round numbers, what is the amount Andy Fastow ultimately admitted to skimming from over 3,000 SPEs he set up in Enron?  What is the best estimate of the actual amount he stole from his company?
    Click Here for Answer
     

  18. Was Andy Fastow considered a financial genius by financial experts within Enron?  Elaborate.
    Click Here for Answer
     

  19. Enron's auditing firm was Arthur Andersen (or just Andersen).  In the early 1990s, who was the managing partner on the Enron audit from the Houston Office?  What was Enron earning in audit billings to Enron per year?  What were the consulting fees per year paid to the Andersen's Houston office?
    Click Here for Answer
     

  20. David Duncan became Andersen's managing partner of the Enron audit in what year? Was Duncan a great accountant?  What were his credentials when Andersen made him the managing partner on the Enron audit?
    Click Here for Answer
     

  21. At one point in 1999 Duncan privately agreed with his Andersen colleague Carl Bass that Enron should take an added $______ charge to earnings, but that these were not material.  How much was this charge?  Why do you really think Duncan did not want to force Enron to make this charge?
    Click Here for Answers
     

  22. A WSJ reporter was the first to uncover Enron's secret "Related Party Transactions."  What reporter was this and what are those transactions that he/she investigated? 
    One time I posed a question to the, then, Editor of The Wall Street Journal Editorial Page (my former fraternity brother Bob Bartley) about why the WSJ on that very day was attacking Mike Milken as a felonious thief on Page 1 and praising Milken as a creative capitalist on the Editorial Page. Bob Bartley's truthful response was that the WSJ, more than any other newspaper, is really two newspapers bundled into one copy. The Editorial Page is an unabashed advocate of free-reining capital markets (Damn the Torpedoes). The rest of the newspaper reports the facts (and I think the WSJ reporters are among the best in the world, especially when they commenced to prickle Ken Lay and Jeff Skilling about hidden related party transactions at Enron). See Question 22 at http://www.trinity.edu/rjensen/FraudEnronQuiz.htm
    It's interesting that WSJ reporters discovered related party transactions when Enron's auditors pleaded ignorance about such fraudulent dealings. But then Andersen was becoming notorious at that time for bad audits.


    Click Here for Answer
     

  23. What is Chewco and why did it ultimately lead to a major split between Enron and Andersen?
    Click Here for Answer
     

  24. Virtually all of Enron's executives benefited from massive fraud just prior to the declaration of bankruptcy by Enron in December of 2001.  What was this fraud?
    Click Here for Answer
     

  25. What Time Magazine's Woman of the Year was noted for a very foul mouth?
    Hint: She's best known for her whistle blowing memo. She was an undervalued accounting executive without much to do. She finally took the trouble on her own to unravel the exceeding complexity of one of Andy Fastow's most complex SPEs that "had no skin."
    Click Here for Answer
     

  26. Did Rebecca Mark have a high level position in Enron?
    Was she competent?
    What famous accounting ratio could she just not comprehend?
    Click Here for Answer
     

  27. Aside from Andy Fastow's suggested use of SPEs for off-book transactions, who was the main instigator of accounting irregularities for items on the books of Enron? 
    What were some of the most typical types of accounting irregularities?
    Also mention some of Fastow's accounting irregularities.
    Click Here for Answer
     

  28. Who is Jay Cooke and what does he have, if anything, to do with the Enron scandal?
    Click Here for Answer  
     

  29. What was the total of Jeff Skilling's stock sales and how much was he eventually fined in 2006?
    What are Ken Lay's secret recipes for looting $184,494.426 from the corporation you manage?
    What was Ken Lay's defense?
    Answers to these questions can be found at
    http://www.trinity.edu/rjensen/FraudEnron.htm#SecretRecipes
    This includes Ken Lay's speech on December 13, 2005 ---
    http://www.trinity.edu/rjensen/FraudEnron.htm#KenLayDefense

     

  30. Will  Phil and Wendy Gramm forever go unpunished in the Enron scandal?
    Click Here for Answer  
     

  31. Was Enron really a loser or did outside forces bring it down?
    Click Here for Answer
     

  32. What did controversial change did Enron make in 1994?
    Click Here for Answer


Bob Jensen's Enron Updates are at http://www.trinity.edu/rjensen/FraudEnron.htm#EnronUpdates


 

 

Bob Jensen's Enron Quiz Answers



 

1. 
What is the main temptation of white collar criminals? 
Why do auditors often lose professionalism?

Jane Bryant Quinn once said something to the effect that, when corporate executives and bankers see billions of loose dollars swirling above there heads, it's just too tempting to hold up both hands and pocket a few millions.  I tell my students that it's possible to buy an "A" grade in my courses but none of them can possibly afford it.  The point is that, being human, most of us are vulnerable to some temptations in a weak moment.  Fortunately, none of you reading this have oak barrels of highly-aged whiskey in your cellars, the world's most beautiful women/men lined up outside your bedroom door, and billions of loose dollars swirling about like autumn leaves in a tornado.  Most corporate criminals that regret their actions later confess that the temptations went beyond what they could resist.  What amazes me in this era, however, is how they want to steal more and more after they already have $100 million stashed.  Why do they want more than they could possibly need?

See Bob Jensen's "Rotten to the Core" document at http://www.trinity.edu/rjensen/FraudRotten.htm
The exact quotation from Jane Bryant Quinn at http://www.trinity.edu/rjensen/FraudRotten.htm#MutualFunds


Question
So who are usually the master chefs cooking the accounting books and what is their main reason?

Answer:  The executives wanting fat bonuses

Question:
What is the typical ploy?

Answer
Get the fat bonus and then issue revised financial statements. Who ever heard of executives having to give back the cash bonuses received after the financial statements are revised?

Example
Besides Enron, look at big fat Fannie Mae
Investigators have uncovered new evidence that senior executives of Fannie Mae, the nation's largest buyer of home mortgages, manipulated its accounting in the 1990's to meet earnings projections so that top executives could receive more than $25 million in bonuses. In a 2,600-page report that was made public today, former Senator Warren Rudman and a team of lawyers and investigators concluded after an 18-month investigation that Fannie Mae's accounting practices "in virtually all of the areas that we reviewed were not consistent with" generally accepted accounting principles.
Stephen Labaton and Eric Dash, "
Report on Fannie Mae Cites Manipulation to Secure Bonuses," The New York Times, February 23, 2006 --- Click Here

Report protects the fannies of Fannie's Board of Directors: But executives are hit hard
They said the report criticizes Timothy Howard, the company's former chief financial officer, and Leanne G. Spencer, the former controller, for their roles in setting accounting policies. They added that the report focuses less criticism on Franklin D. Raines, the former chief executive, but says the company's management didn't keep the board adequately informed about accounting problems. (See related article)
James R. Hagerty, "
Fannie Report On Accounting Shields Board," February 23, 2006; Page A2 --- http://online.wsj.com/article/SB114066161292580888.html?mod=todays_us_page_one

Jensen Comment
Fannie Mae fired the KPMG auditing firm and is now spending over $140 million just to restate past financial statements. Most of the troubles center on FAS 133 rules for reporting derivative financial instrument hedges.

For a running account on Fanny Mae's accounting problems with FAS 133 see http://www.trinity.edu/rjensen/caseans/000index.htm


Examples of Book Cooking
Enron Corp. dipped into reserve accounts to illegally pad earnings in 2000 and improperly delayed reporting large losses in a retail energy operation the following year, former accountants testified yesterday. The testimony began the fifth week in the criminal conspiracy-and-fraud trial of former Enron Chairman Kenneth Lay and former President Jeffrey Skilling. The testimony provided new support for the Justice Department's accusations that the two top executives manipulated results at the company. Wesley Colwell, former accounting chief of Enron's wholesale energy unit, alleged he shifted a total of $14 million in July 2000 to create a two-cents-a-share boost to the company's second-quarter results. He testified that an Enron finance executive told him that month that Mr. Skilling was looking to "beat the Street" estimate of its second-quarter earnings. Mr. Colwell, who is testifying under a cooperation agreement with the government, paid a $500,000 fine to settle allegations by the Securities and Exchange Commission that he manipulated earnings. His agreement with the Justice Department requires that he testify to avoid criminal prosecution. Three previous government witnesses, all former Enron executives, pleaded guilty to crimes related to the energy giant. Mr. Colwell, who is testifying under a cooperation agreement with the government, paid a $500,000 fine to settle allegations by the Securities and Exchange Commission that he manipulated earnings. His agreement with the Justice Department requires that he testify to avoid criminal prosecution. Three previous government witnesses, all former Enron executives, pleaded guilty to crimes related to the energy giant.
Gary McWilliams and John R. Emshwiller, "Accountant Says Enron Dipped Into Reserves to Pad Earnings," The Wall Street Journal, February 28, 2006; Page C3 ---
http://online.wsj.com/article/SB114105814931084345.html?mod=todays_us_money_and_investing

"Testimony Links Skilling, Lay To Alleged Effort to Hide Losses," by John R. Emshwiller and Gary McWilliams, The Wall Street Journal, March 1, 2006; Page C2 ---
http://online.wsj.com/article/SB114114167255385382.html?mod=todays_us_money_and_investing

The former head of Enron Corp.'s retail-energy unit tied former President Jeffrey Skilling and former Chairman Kenneth Lay in testimony to an alleged effort to improperly hide hundreds of millions of dollars of losses in the division.

The testimony yesterday by David Delainey, who headed Enron Energy Services, or EES, was some of the most specific yet linking Messrs. Lay and Skilling to alleged wrongdoing. The former Enron president and chairman are in the fifth week of their federal fraud and conspiracy trial. Mr. Delainey has pleaded guilty to one count of insider trading and agreed to pay nearly $8 million in penalties. Like four previous witnesses, he is testifying for the government as part of a cooperation agreement.

Mr. Delainey took over the retail unit in early 2001 after having headed the company's profitable wholesale-energy trading operation. While Enron at the time was publicly portraying the retail unit as profitable and growing, Mr. Delainey contended yesterday that he found a problem-ridden unit burdened by hundreds of millions of dollars of losses. He said another senior executive had told him the unit's financial problems "could potentially bankrupt Enron."

At a March 29, 2001, meeting led by Mr. Skilling, Mr. Delainey testified, a decision was made to hide some of the big EES losses. Mr. Delainey said he argued the action, which involved moving some retail operations to the profitable wholesale unit, "lacked integrity" and shouldn't be done.

Continued in article

Bob Jensen's other Enron updates are at http://www.trinity.edu/rjensen/FraudEnron.htm#EnronUpdates


When trapped white collar criminals often cop a plea for some type of deal and then sit it out in Club Fed for a few months (e.g., Martha Stewart) or a few years (e.g., Andy Fastow) and then emerge to enjoy their stashed millions. In Andy Fastow's case it took slightly over two years for Enron's December 2001 collapse until Andy Fastow, in the face of overwhelming evidence, confessed on January 14, 2004.


Why white collar crime pays for Chief Financial Officer: 
Andy Fastow's fine for filing false Enron financial statements:  $30,000,000
Andy Fastow's stock sales benefiting from the false reports:     $33,675,004
Andy Fastow's estimated looting of Enron cash:                          $60,000,000
That averages out to winnings, after his court fines, of $10,612,500 per year for each of the six years he's expected to be in prison.
You can read what others got at http://www.trinity.edu/rjensen/FraudEnron.htm#StockSales 
Nice work if you can get it:  Club Fed's not so bad if you earn $29,075 per day plus all the accrued interest over the past 15 years.

The following is from Kurt Eichenwald's, Conspiracy of Fools (Broadway Books, 2005, pp. 671-672) --- http://www.bookreporter.com/reviews2/0767911784.asp 

Prosecutors informed Fastow that they would shelve plans to charge Lea (Fastow's wife)  if he would plead guilty.  Fastow refused and Lea was indicted.  Suddenly, the Fastows faced the prospect that their two young sons would have to be raised by others while they served lengthy prison terms.  The time had come for Fastow to admit the truth.

"All rise."

At 2:05 on the afternoon of January 14, 2004, U.S. District Judge Kenneth Hoyt walked past a marble slab on the wall as he made his way to the bench of courtroom 2025 in Houston's Federal District Courthouse.  Scores of spectators attended, seated in rows of benches.  In front of the bar, Leslie Caldwell, the head of the Enron Task Force, sat quietly watching the proceedings as members of her team readied themselves at the prosecutors' table.

Judge Hoyt looked out into the room.  To his right sat an array of defense lawyers surrounding their client, Andy Fastow, who was there to change his pleas.  Fastow, whose hair had grown markedly grayer in the past year and a half, sat in silence as he waited for the proceedings to begin.

Minutes later, under the high, regal ceiling of the courtroom, Fastow stepped before the bench, standing alongside his lawyers.

"I understand that you will be entering a plea of guilty this afternoon," Judge Hoyt asked.

"Yes, your honor," Fastow replied.

He began answering questions from the judge, giving his age as forty-two and saying that he had a graduate degree in business.  When he said the last word, he whistled slightly on the s, as he often did when his nerves were frayed.  He was taking medication for anxiety, Fastow said; it left him better equipped to deal with the proceedings.

Matt Friedrich, the prosecutor handling the hearing, spelled out the deal.  There were two conspiracy counts, involving wire fraud and securities fraud.  Under the deal, he said, Fastow had agreed to cooperate, serve ten years in prison, and surrender $23.8 million worth of assets.  Lea would be allowed to enter a plea and would eventually be sentenced to a year in prison on a misdemeanor tax charge.

Fastow stayed silent as another prosecutor, John Hemann, described the crimes he was confessing.  In a statement to prosecutors, Fastow acknowledged his roles in the Southampton and Raptor frauds and provided details of the secret Global Galactic agreement that illegally protected his LJM funds against losses in their biggest dealings with Enron.

Hemann finished the summary, and Hoyt looked at Fastow.  "Are those facts true?"

"Yes, your honor," Fastow said, his voice even.

"Did you in fact engage in the conspiratorious conduct as alleged?"

"Yes, your honor."

Fastow was asked for his plea.  Twice he said guilty.

"Based on your pleas," Hoyt said, "the court finds you guilty."

The hearing soon ended.  Fastow returned to his seat at the defense table.  He reached for a paper cup of water and took a sip.  Sitting in silence, he stared off at nothing, suddenly looking very frail.


Why white collar crime pays for Chief Enron Accountant: 
Rick Causey's fine for filing false Enron financial statements:    $1,250,000
Rick Causey's stock sales benefiting from the false reports:     $13,386,896
That averages out to winnings of $2,427,379 per year for each of the five years he's expected to be in prison
You can read what others got at http://www.trinity.edu/rjensen/FraudEnron.htm#StockSales 
Nice work if you can get it:  Club Fed's not so bad if you earn $6,650 per day plus all the accrued interest over the past 15 years.

The Causey of It All --- At Long Last

Of all the Enron accounting executives (Fastow was the CFO who knew epsilon about accounting) I wanted Rick Causey sent up river. Causey was the Chief Accounting Officer who worked out most of the accounting fraud and was the closest conspirator with David Duncan, Andersen's manager of the less-than-independent audit. Causey mysteriously was not called on to testify in the trials of Lay and Skilling, purportedly because he was "not a rat." It appears that he was a bit more of a rat than previously reported.

"Ex-Enron Officer Given 5½ Years in Prison," The New York Times, November 16, 2006 --- http://www.nytimes.com/2006/11/16/business/16enron.html

Richard A. Causey, the last of the top Enron executives to learn his punishment, was sentenced Wednesday to five and a half years in prison for his role in the corporate accounting scandal.

Mr. Causey, 46, the company’s former chief accounting officer, pleaded guilty in December to securities fraud, two weeks before he was to be tried along with the founder of Enron, Kenneth L. Lay, and the former chief executive, Jeffrey K. Skilling, on conspiracy, fraud and other charges related to the company’s collapse.

Mr. Causey had agreed to serve seven years in prison. Prosecutors said they could have recommended it be reduced to five if they were pleased with his cooperation.

Mr. Causey also agreed to pay $1.25 million to the government and to forfeit a claim to about $250,000 in deferred compensation as part of his plea deal. Unlike some others at Enron, he did not skim millions of dollars for himself.

Prosecutors dropped their plan to seize Mr. Causey’s home, a $950,000 two-story red-brick house in a Houston suburb.

Mr. Causey had faced more than 30 counts of conspiracy, fraud, insider trading, lying to auditors and money laundering.

In his guilty plea, made in Federal District Court, he admitted making false public findings and statements.

He did not testify in the Lay-Skilling trial this year, though he was on the defense witness list.

Mr. Skilling and Mr. Lay were convicted in May of conspiracy and fraud. Mr. Lay’s convictions were wiped out with his July death from heart disease. Mr. Skilling was sentenced last month to more than 24 years in prison.

Andrew S. Fastow, Enron’s former chief financial officer, whose schemes helped doom the company, was sentenced in September to six years.

Mark E. Koenig, Enron’s former director of investor relations, and Michael J. Kopper, an Enron managing director and Mr. Fastow’s top aide, are scheduled to be sentenced Friday.

Enron collapsed into bankruptcy in December 2001 after years of accounting tricks could no longer hide billions in debt or make failing ventures appear profitable.

Bob Jensen's threads on Rick Causey are at http://www.trinity.edu/rjensen/FraudEnronQuiz.htm


"Ex-Enron Accountant Pleads Guilty to Fraud," Kristen Hays, Yahoo News, December 28, 2005 --- http://news.yahoo.com/s/ap/20051228/ap_on_bi_ge/enron_causey

A former top accountant at Enron Corp. sealed his plea deal with prosecutors Wednesday, becoming a key potential witness in the upcoming fraud trial of former CEOs Kenneth Lay and Jeffrey Skilling.

Lay and Skilling were granted two extra weeks to adjust to the setback before their much anticipated trial, the last and biggest of a string of corporate scandal cases, starts at the end of January.

The accountant, Richard Causey, pleaded guilty to securities fraud Wednesday in return for a seven-year prison term — which could be shortened to five years if prosecutors are satisfied with his cooperation in the trial. He also must forfeit $1.25 million to the government, according to the plea deal.

Causey's arrangement included a five-page statement of fact in which he admitted that he and other senior Enron managers made various false public filings and statements.

"Did you intend in these false public filings and false public statements, intend to deceive the investing public?" U.S. District Judge Sim Lake asked.

"Yes, your honor," replied Causey, who said little during the short hearing, appearing calm, whispering to his attorneys and answering questions politely.

Continued in article

Jensen Comment
I forgot to mention the millions that Fastow and Causey will probably make on the lecture circuit after they are released from prison.  Scott alludes to this below:

January 3, 2005 reply from Scott Bonacker [aecm@BONACKER.US]

Was someone asking about ZZZZ Best?

"Morze created 10,000+ phony documents, and no one caught it. He teaches his course Fraud: Taught by the Perpetrator many times each year for the Federal Reserve, bar associations, Institute of Internal Auditors, CPA and law firms.

Public speaking does seem to benefit the speakers. Guys in Gary's group are dealing better than other white-collar criminals, says Mark Morze, one of Mr. Zeune's speakers, who served more than four years in jail for his role in ZZZZ Best Co., the carpet-cleaning enterprise that bilked banks and investors for some $100 million back in the 1980s. Guys who are in denial pay the price forever, Mr. Morze says. Source: The Wall Street Journal, May 25, 1999"

See http://www.theprosandthecons.com/cons.htm 

Scott Bonacker, CPA
Springfield, Missouri


Question
Would you like to sift through millions of Enron email messages?

Enron's E-mail (Email) messages are now part of the public record --- http://www.trinity.edu/rjensen/FraudEnron.htm#Email


"10 Enron Players: Where They Landed After the Fall," The New York Times, January 29, 2006 --- http://www.nytimes.com/2006/01/29/business/businessspecial3/29profiles.html


Bob Jensen's threads on how white collar crime pays even if you get caught --- http://www.trinity.edu/rjensen/FraudConclusion.htm#CrimePays

Bob Jensen's threads on the Enron/Andersen frauds --- http://www.trinity.edu/rjensen/FraudEnron.htm

 

Many big-time white collar criminals have enough stashed to make their crimes worthwhile even in the unlikely event that they get caught --- http://www.trinity.edu/rjensen/FraudConclusion.htm#CrimePays

 

Ed Ketz sums it up pessimistically at http://accounting.smartpros.com/x50181.xml

Accounting frauds are here to stay. When the prophet said "the heart is deceitful above all things," he included the hearts of corporate managers. Whatever one's religious beliefs, one has to admit that the empirical evidence in the world of corporate accounting confirms Jeremiah's insight. Managers don't employ accounting; they bend, twist, and distort it to display the set of numbers that helps them look good. Who cares about truth?

Continued in article

Enron Investors and Their Lawyers Aiming at Deep Investment Banking Pockets
Andersen Coughs Up $72.5 More Millions for Enron's Investors
Lawyers representing Enron investors have already won settlements for $7.3 billion of the $40 billion shareholders claim they lost in Enron’s 2001 collapse. On Nov. 1, the latest settlement — an agreement by Arthur Andersen, Enron’s former accounting firm, to pay $72.5 million — was disclosed. But it is far from clear whether the testimony of Mr. Fastow, a convicted felon who masterminded some of the fraudulent transactions that hid the company’s poor financial health, will be enough to push the seven banks that have not settled to the negotiating table.
Lexei Barrionuevo, "Fastow Gets His Moment in the Sun," The New York Times, November 10, 2006 --- Click Here

Jensen Comment
The investment bankers, including Merrill Lynch, in the high rolling days of Enron succumbed to CFO Andy Fastow's extortion threats of taking Enron's business away if these investment bankers did not play ball his (corrupt) way. Now it's ironic how he's returning to make the banks restore millions to investors he destroyed.

Update on October 2007

Then how come Merrill Lynch is on the verge of escaping the wrath of investors because of its involvement in some of Enron's corporate and accounting frauds? The Securities and Exchange Commission lays out the facts in various documents such as Litigation Release No. 20159 and Accounting and Auditing Enforcement Release No. 2619, and in the related Complaint in the U.S. District Court.
"The Accounting Cycle:  The Merrill Lynch-Enron-Government Conspiracy," by: J. Edward Ketz, SmartPros, October 2007 --- http://accounting.smartpros.com/x59129.xml 

In a 2004 trial, a jury found these four Merrill executives guilty of participating in a fraudulent scheme. The former Merrill managers appealed the verdicts, and amazingly the Fifth Circuit tossed them out. The appellate court held that those bankers provided "honest services" and that they did not personally profit from the deal.

That argument assumes that getaway drivers supply honest services to bank robbers; after all, an oral agreement to repurchase the investment at 22 percent return is a strong signal that something is amiss with the transaction. The argument also shows a lack of understanding how managers profit in the real world. Investment bankers advance their careers by bringing in business that generates income for the bank; Merrill Lynch's executives did that with the Enron barge transaction, thereby promoting their careers, their promotions, and their salaries and bonuses, even if in an indirect fashion.

Why do auditors often lose professionalism?

For auditors the problem is more complicated, especially for those in charge of major local-office audits or those in charge of their entire firms of tens of thousands of employees around the world.  Think of David Duncan who had the honor as a relatively young man to take charge of Andersen's audit of the huge Enron Corporation in 1997.  David was not a shareholder in Enron and, unlike Andy Fastow, did not have greedy hands in the air while Enron's billions were swirling over his head. 

David Duncan was torn apart by classical auditor conflicting responsibilities.  On one side he had a huge responsibility to see that Enron abided by Generally Accepted Accounting Principles (GAAP) intended for fairness of information released to the investing public.  He also was responsible for maintaining both internal and external public perceptions of Andersen's professionalism.  On the other side he inherited hundreds of Andersen's Houston Office auditors and consultants working on Enron, some of whom were my former students.  David Duncan was responsible for meeting the huge monthly payroll of his audit and consulting teams.  Enron was a problematic client because there were higher than usual threats about taking Enron's business elsewhere if Andersen became too problematic in Enron's eyes.  I might add that financial institutions like Citibank and Merrill Lynch faced similar problems of losing enormous cash flows from Enron if they did not overlook some of Andy Fastow's financial misdeeds.

Hundreds upon hundreds of Andersen's Houston Office professionals would've been fired if David Duncan lost Enron as a client.  And these people were much closer to Duncan than unknown faces in the investing public.  David Duncan violated GAAP responsibilities in favor of keeping Enron as a client.  Not all Andersen auditors would've done the same.  Carl Bass, who worked at a high level on the Enron audit,  most certainly paid more homage to GAAP than David Duncan.   But the buck stopped at Duncan's desk, and this is why Duncan forced Bass off the Enron audit.

What is discouraging is how the CEOs at both Enron and Andersen preferred to remain in the dark about accounting irregularities instigated by executives beneath themselves.  Ken Lay at Enron preferred not to hear about accounting book cooking that helped to keep Enron share prices soaring.   Several succeeding CEOs at Andersen resisted putting in quality controls on large audits around the world --- even when there were signs of bad auditing dating back to audit failures such as Waste Management.  Art Wyatt, a former high-level executive partner with Andersen, captured the sentiment in his paper entitled "ACCOUNTING PROFESSIONALISM --- THEY JUST DON'T GET IT" --- http://aaahq.org/AM2003/WyattSpeech.pdf

I attribute many audit failures in every large large CPA firm to the growth in size of the clients themselves.  The U.S. auditing process is flawed in design by having CPA auditors both responsible to the public and beholding to fees paid to them by clients being audited.  The potential for conflict of interest is self evident since huge clients can destroy local offices of large CPA firms by changing auditors.

The problem was not so huge years ago when firms had many small clients and could afford to lose a client in favor of standing on principles of professional responsibility.  The problem is huge today because local offices of these firms often have a single enormous client like Enron, Exxon, Fannie Mae, or General Electric upon which the future of the entire office resides.  Enron was paying Andersen's Houston office $1 million per week for auditing and consulting services.  Imagine any single local office losing cash flow of $1 million per week!

Many theorists claim that the U.S. auditing model is so flawed that auditing should be put in the hands of the government.  My response is that this would be even worse given the track record as U.S. government being the source of the biggest frauds in world history. 

No auditing system will ever be perfect.  All we can do is struggle to constantly make our profession better and increasingly ethical.  We do have some help from the tort lawyers nipping at our heels (actually our heads).  You can read more about the Future of Auditing at http://www.trinity.edu/rjensen/FraudConclusion.htm#FutureOfAuditing

The day Arthur Andersen loses the public's trust is the day we are out of business.
Steve Samek, Country Managing Partner, United States, on Andersen's Independence and Ethical Standards CD-Rom, 1999.

When the Securities and Exchange Commission found evidence in e-mail messages that a senior partner at Andersen had participated in the fraud at Waste Management, Andersen did not fire him. Instead, it put him to work revising the firm's document-retention policy. Unsurprisingly, the new policy emphasized the need to destroy documents and did not specify that should stop if an S.E.C. investigation was threatened. It was that policy David Duncan, the Andersen partner in charge of Enron audits, claimed to be following when he shredded Andersen's reputation.
Floyd Norris, "Will Big Four Audit Firms Survive in a World of Unlimited Liability?," The New York Times, September 10, 2004

Kurt Eichenwald, Conspiracy of Fools (Broadway Books, 2005, pp. 666-667) --- http://www.bookreporter.com/reviews2/0767911784.asp 
 

Andersen sought to settle but fumbled.  The government demanded an admission of criminal liability, and at one point the two sides seemed close to a deal.  But in the end Andersen balked, and the government walked away from the negotiating table.

By that time a top prosecutor on the Enron Task Force, Andrew Weissmann, had secured a secret weapon: David Duncan.  After mulling the matter for months, Duncan acknowledged that he must have destroyed documents with the knowledge that he would be keeping them away from the SEC.  He agreed to plead guilty to one count of obstruction, and to serve as the chief witness against his former employer.

The Andersen indictment for obstruction of justice ended the company's last hope of survival.  Clients fled in droves, unwilling to allow a firm charged with a crime to serve as their financial watchdog.  Around the globe, Andersen partners jumped to competing firms.  By the time of Andersen's conviction in June, only a small shell of the once great firm remained, and it announced that it would cease auditing public companies.
 

"Last of 15 Enron Defendants Sentenced:  Former Broadband Chief Gets Lesser Prison Term After Aiding Prosecutors," by Carrie Johnson, The Washington Post, June 19, 2007 --- Click Here

The former chief of Enron's Internet business unit was sentenced to 27 months in prison yesterday, closing what could be the final chapter in the Houston energy trader's downfall.

Kenneth D. Rice, 48, is the 15th and final Enron official to face punishment for his role in the company's bankruptcy more than five years ago. Under federal guidelines, he must serve nearly two years, or 85 percent, of the sentence handed down by U.S. District Judge Vanessa D. Gilmore yesterday in a Houston courtroom.

Kenneth D. Rice, shown with daughter Kirsten Rice, got a 27-month sentence. His testimony helped win the conviction of Enron's top two executives. (By F. Carter Smith -- Bloomberg News)

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"What got me here is, I lied over about a two-year period, on a number of occasions, to the investing community," Rice said yesterday, according to Bloomberg News. "I wasn't raised that way, and I'm ashamed of that."

Rice told the jury in last year's criminal trial of Enron's two top executives that he and others misrepresented the financial health of Enron Broadband Services, a highly touted division that posted billions of dollars in losses. His testimony helped prosecutors win the conviction of former chief executive Jeffrey K. Skilling, who is serving a prison term of 24 1/3 years. Company founder Kenneth L. Lay died in July 2006 before he could be sentenced.

Rice faced as much as a decade in prison and agreed to forfeit cash, sports cars and jewelry worth $14.7 million under the terms of his 2004 plea agreement. Between February 2000 and June 2001, Rice sold $53 million worth of Enron stock, some at a time when he later said he had access to secret information about its high debt burdens.

Once among Skilling's closest confidants and companions on off-road adventure tours, Rice ultimately turned against him. Rice was known within Enron's gleaming office towers as a risk taker who collected motorcycles and fast cars, including a Ferrari and a Shelby he turned over to the government as part of his plea deal.

Federal prosecutors Ben Campbell and Jonathan E. Lopez argued that Rice should receive a reduced prison term in exchange for his testimony against his former colleagues.

"Mr. Skilling would simply say . . . 'this is the number, this is what the number is going to be,' " Rice told jurors in February 2006 about the process of generating financial projections.

 

See the Future of Auditing at http://www.trinity.edu/rjensen/FraudConclusion.htm#FutureOfAuditing







 

2.
Who are the two richest Enron executives to emerge unscathed by Enron's scandal?

If you care to know what Enron officials (the Cast of Characters) received in stock sales, you can see a listing at http://www.trinity.edu/rjensen/FraudEnron.htm#StockSales

Lou Pai
First there's the soap opera of Lou Pai, his strip tease dancers, his Colorado ranch bigger than Rhode Island, and the mountain he named after himself.

An obscure and incompetent trading executive named Lou Pai is the biggest Enron stock sale winner (over $270 million) but that was sheer luck because he was sued for divorce by his wife while Enron's share prices were still soaring.  Lou had an addiction for strippers to a point where he brought dancers back to Enron HQ to prove that he really was a wealthy executive.

He didn't particularly want to sell his Enron stock at that time, but when he got a strip tease dancer pregnant Lou's wife demanded a cash settlement in the divorce.  That turned out to be the luckiest timing in her or his life.  I don't know how much the dancer got in the end, but she did marry Lou immediately after his divorce.
 

Rich Kinder
A former head of Enron's accounting area, Rich Kinder, left the company in 1996 long before the scandal broke in 2001.  Actually he lost his CEO position to Jeff Skilling. Kinder since has become a billionaire in his own company Kinder Morgan.  Little of his vast wealth arose from ill-gotten gains from Enron.  However, Enron's accounting books got cooked early on under his watch while Andersen's auditors turned a blind eye. 

And a lesser executive named Lou Pai cashed in his stock early on due to the luck of being divorced by his wife.  The fortuitous timing of the sale back when Enron's stock was soaring could not be attributed to insider trading by investigators.  He's the luckiest sinner (I literally mean sinner) on the planet.

Let me add a bit more about Rich Kinder that appears as follows at http://www.fool.com/news/foth/2003/foth030131.htm
 

Once upon a time, a company named Enron Liquids Pipeline, L.P., owned and operated the pipelines that shipped the fuel Enron sold to itself, while pretending to provide an energy marketplace. Even in Enron's heyday, fuel eventually transferred across those pipelines and went to customers to heat homes, cook food, and power automobiles and factories.

Despite Enron's fraud and deceit, the pipeline company still exists today as Kinder Morgan Energy Partners (NYSE: KMP). The name changed when owners Rich Kinder and Bill Morgan bought it from Enron in 1996. This, of course, was well before the big E's ultimate undoing. And though Kinder was an Enron executive until joining Morgan, the companies' corporate governance practices were far afield from one another.

To wit, Kinder Morgan still exists as a public company, while its more famous cousin does not. In fact, it has a history of growth in earnings, operational cash flow, and cash distributions. It also has decent prospects for continued growth and a solid business model that make its current, longer-term 11% profit-growth projections seem achievable. While fuel prices are volatile -- rising and falling in response to everything from the weather to Middle East tensions -- Kinder Morgan isn't in the fuel business; it's in the fuel distribution business. Big difference. It makes money based on the amount of fuel that passes through its pipelines. The price of that fuel, while a concern to the buyers and sellers at each end of the pipeline, is of no concern whatsoever to Kinder Morgan.

The company has four distinct units: natural gas pipeline, products (liquid petroleum) pipelines, carbon dioxide pipelines, and terminals (coal and other dry materials). Diversification protects it from being slammed by relative price swings among differing energy sources. A price hike in coal that causes more people to shift from electric to natural gas heat, for example, would likely shift revenues from Kinder Morgan's terminals unit to its natural gas pipelines unit. The biggest risk for the company would be a wholesale decrease in energy usage across its portfolio of transport offerings. It has happened, but there's a greater tendency to cycle among fuel stocks.

Kinder Morgan is the largest pipeline company in the U.S., and the business offers significant barriers for new entrants that help protect it from competition. Pipeline construction costs are significant, as are right-of-way acquisitions (ROWs), and the latter of the two is a decreasing resource. Once ROWs are granted, alternate sites have declining value and increasing cost of acquisition.

Pipeline construction also requires political capital, particularly if the construction comes close to populated areas. Pipelines have statutory minimal maintenance standards to protect against catastrophes, regardless of the revenue generated by the pipeline. In other words, the ramp up of a new pipeline or a new pipeline company can get expensive in a hurry, before the pipeline has generated the first penny of revenue. Kinder Morgan's infrastructure is already in place, and it has sufficient volume through its pipelines to cover the maintenance charges. Why would a new competitor try to compete against that?

The huge infrastructure costs required for pipelines also act as financial leverage for the company. A substantial part of Kinder Morgan's costs are static and must be paid regardless of business levels. Once those costs are covered, however, the incremental margins in the company's businesses become incredibly high. As more goods travel across the company's pipelines, a large fraction of that additional revenue travels straight to the bottom line. In the company's second quarter of 2002, for example, it had an 87% boost in its natural gas pipelines' operating income. Half of that income growth came from internal growth, such as higher pipeline utilization.

The other half came through acquisitions. In the past, the partnership has benefited from acquiring assets from its affiliated company, Kinder Morgan Inc. (NYSE: KMI). There's also a third financial component company that's also publicly traded, Kinder Morgan Management (NYSE: KMR). Future acquisitions will need to take place in a more competitive environment, however. The field of possible acquisitions that would make substantial difference to Kinder Morgan's bottom line has narrowed as the company has grown. Were Kinder Morgan a smaller company, the tougher acquisition climate would look like a difficult obstacle to overcome. Since it leads the industry, however, the company can negotiate competitive deals from a position of strength.

Kinder Morgan carries some Enron baggage due to its shared heritage and similar core business model -- both being pipeline companies at their bases. However, upon closer look, Kinder Morgan bears little resemblance to the Enron that collapsed. As Enron's fraud fed on itself, its reported profits grew much faster than the money it paid to its shareholders. As a limited partnership, Kinder Morgan has an extremely high distribution payment, and thus any attempt to fraudulently boost profits would ultimately be self-defeating. Higher reported profits would inevitably lead to higher cash payments to its partners, and if these reported profits were fraudulent, the company would quickly knife through its available cash.

The Master Limited Partnership structure taken on by Kinder Morgan requires federal tax liabilities to pass through to the partners, who then pay tax on them. As such, to attract investors, the partnership must pay out high dividends (currently Kinder Morgan's yield sits at 6.8%). This eliminates the double taxation on dividends, but not without risk.

Most public companies have limited liability protection; investors cannot lose more than they invest. In this type of partnership, however, there are two classes of partners: general and limited. The general partner has unlimited liability and can lose even unrelated assets, while the limited partners have standard limited liability protections. In Kinder Morgan's case, the general partner is owned by Kinder Morgan Inc., so owners of Kinder Morgan Energy units are protected from unlimited risk.

Continued in article

 

1996: Rich Kinder loses his CEO position to Jeff Skilling
         Enron's accounting books got cooked early on under his watch while Andersen's auditors turned a blind eye. 

You can download Enron's Infamous Home Video
Although it has nothing to do with the above professional movie, Jim Borden sent me a copy of the amateur video recording of Rich Kinder's departure from Enron (Kinder preceded Skilling as President of Enron).  This 1996 video features nearly half an hour of absurd skits, songs and testimonials by company executives.  It features CEO Jeff Skilling proposing Hypothetical Future Value (HPV) accounting with in retrospect is too true to be funny during the subsequent melt down of Enron.  George W. Bush (then Texas Governor Bush and his father) appear in the video.  You can download parts of it at  http://www.cs.trinity.edu/~rjensen/video/windowsmedia/enron3.wmv

Footnote:  Rich Kinder left Enron, formed his own energy company, and became a billionaire --- http://www.mcdep.com/MR11231.PDF

Bob Jensen's threads on HPV Accounting are at http://www.trinity.edu/rjensen/theory01.htm#FairValue




 


  1. How did Enron really lose so much money?
    What are some of the main lessons learned from the Enron scandal? 
    What major problems remain?

     

    Accounting Standard Setters Are Making Some Dangerous Mistakes in the Wake of Enron
    From a short seller who made a fortune at the expense of Enron shareholders
    From an investor who is not in favor of "principles-based standards" relative to "rule-based standards"

    "Short-Lived Lessons From an Enron Short," by Jim Chanos, The Wall Street Journal, May 30, 2006; Page A14 --- http://online.wsj.com/article/SB114894232503965715.html?mod=todays_us_opinion

    The convictions of Ken Lay and Jeff Skilling are less than a week old, and yet conclusions are already being drawn about whether "corporate wrongdoing" is a thing of the past. As someone with more than a passing interest in the Enron story -- I was, to quote Ken Lay's bizarre testimony, one of the "short-sellers that were organized and working together and conspiring together" against Enron -- I feel a need to examine what lessons those of us who slog it out daily in the corporate trenches might gain from Enron's spectacular collapse. I propose to offer the top 10 lessons from Enron that executives, investors and lawyers will soon forget:

    1. The Enron scandal shows a need for a standards-based accounting system, rather than a rules-based one.

    Wait a minute, you must be saying -- in the wake of Enron, don't we need more accounting rules to cover every possible situation, not some mushy "standards"-based guidelines?

    No. It is precisely our "check-the-box" accounting rules that get written for every type of transaction that helped create the financial monster that was Enron. By having armies of clever bankers and lawyers pretzel-twist uneconomic deals into profit sources that conformed to GAAP ("Generally Accepted Accounting Principles," or "Good As Actual Profits" as it's sometimes known), dishonest management teams always hide behind the disclaimer that their accounting has been blessed by their auditors. The problem is, I can think of no major financial fraud in the 25 years I've been on Wall Street that did not have audited financials that conformed to GAAP! Yet reasonable independent auditors and audit committees, using the "standard" of economic common sense, would have unmasked most of the financial chicanery that became apparent at these companies only after their collapse.

    2. Mark-to-Market accounting was not the problem at Enron, Mark-to-Model was.

    Many casual observers of the Enron saga have pointed to the shortcomings of the Mark-to-Market (MTM) method of accounting that Enron used for its trading assets (i.e., the act of recording the price or value of a security, portfolio or account to reflect its current market value rather than its book value). But MTM is entirely appropriate -- and necessary -- for trading assets held at financial firms. How else would one handle valuation for assets that trade on verifiable exchanges and/or electronic networks?

    In Enron's case, however, non-exchange traded assets and illiquid private deals were treated similarly, with today's "prices" derived by computer models that estimated future prices and volatility. The "estimates" in these models were helpfully provided by . . . Enron itself! As any capable financial economist will point out, today's market prices offer only a starting point for estimating future prices and volatility, which are, by definition, unknowable. In an MTM system with no independent source of current prices, when one feeds the "unknowables" of future prices and volatility, and the "probable" of time, into a computer, a "certain" current price is calculated! Neat, huh?

    3. Off-balance-sheet deals and entities are "off" the balance sheet for a reason.

    One would think that this concept would be pretty obvious, given the LJM, Jedi, Chewco, Deathstar, Jabba the Hut (OK, I made that last one up) monikers used to describe off-balance-sheet entities at Enron. One would be wrong. Yet it is my experience, pre- and post-Enron, that such accounting is used by companies to hide things they don't want investors to see. Pre-Enron saw silliness such as the Coca-Cola/Coca-Cola Enterprises "two-step," while today one can ponder the off-balance-sheet "land banking" that exists at the publicly traded U.S. homebuilders. If a company is determined to keep a significant aspect of its business off its books, investors should simply ask why.

    4. Wall Street analysts don't "do" complex.

    Isn't that what securities analysts are for, you might ask? Silly reader . . . analysis is for kids! Literally. At most large Wall Street firms, the tedious job of constructing financial models and answering client accounting queries is handled by the junior analyst on the team. It still shocks me today that when meeting with a team of "sell-side" Wall Street analysts from a firm to discuss a particular company, the senior analyst invariably concedes the answer to a complex financial question to a junior analyst working for him.

    In a post-Eliot Spitzer world, how can this be? Simple. Senior analysts still spend most of their time on the road making client presentations. That is, of course, if they aren't playing golf with the CEO or organizing the menu at the next investor conference in Las Vegas. The recent attempts by certain companies to discourage hard-hitting independent research will only serve to maintain the chasm between those that "do the numbers" and those with, hopefully, the experience to know what the numbers mean.

    5. The rating agency system breaks down when most needed. Rely on it at your own peril.

    Time and again, when confronted with negative financial "surprises" by corporate issuers during the last decade, the "independent" ratings agencies fell down on the job. This kept slow-on-the-uptake investors dancing on the decks of numerous financial Titanics, while those heeding other signals (such as the burgeoning market for credit-default derivatives) prepared to man the lifeboats.

    Whether it was the hubris of not wanting to precipitate a run on the bank (as if it wasn't happening already!), or the incompetence of one ratings agency analyst admitting to not having read the company's SEC filings, the shortcomings of an analyst-based ratings agency system became apparent in the Enron fiasco. Market-based price-discovery agents, such as short sellers in the equity market and purchasers of credit-default insurance in the bond/derivative markets, supplanted the Big Three ratings agencies as accurate predictors of Enron's financial distress.

    6. Beware of, and question, unexpected executive resignations.

    This lesson should seem obvious, but cognitive dissonance assures that it isn't. When Jeff Skilling resigned abruptly after six months as Enron's CEO, alarm bells should have been going off on Wall Street, as they were in Houston. But mindful of the still-bountiful fees Enron promised the Street, virtually every analyst covering Enron told his/her clients "all was well"! Didn't anyone find it disconcerting that despite claiming (the still undisclosed) "personal reasons" for his resignation, Mr. Skilling admitted on the front page of this newspaper the next day that if Enron's stock price had stayed up, "I don't think that I would have felt the pressure to leave"?

    By asking the right questions, investors in August 2001 (with Enron's stock still at $40) might have been able to deduce that Enron's stock was not just a barometer of its financial health, but was also an actual component (through the investor-guarantee mechanism in the Fastow partnerships) of its health, as this newspaper's reporters would so convincingly point out two months later. Mr. Skilling hid the road map to Enron's future collapse on the front page of The Wall Street Journal, but few noticed.

    7. Whistleblowers aren't whistleblowers if they blow their whistles inside the company walls.

    Someone should inform Time magazine's Person-of-the-Year Department that writing a "cover-your-behind" memo to your boss about financial irregularities within the firm is not "whistleblowing." Having the guts to risk your job and reputation, by bringing evidence of those irregularities to the proper financial authorities, is. Enough said.

    8. Special investigations by corporate boards are almost always a waste of time/money, and often prove highly misleading.

    As a corollary to Lesson No. 7, when questions are raised internally about possible financial improprieties, corporate boards often hire counsel to conduct investigations on their behalf. This is done foremost for their own protection ("We investigated once we knew!"), and only incidentally to uncover unpleasant facts that such boards, charged with oversight as a duty, should've known about already. Many boards, in a wonderful example of willful blindness, simply don't want to know. In fact, one well-regarded Washington law firm forensic accounting SWAT team, headed by a former SEC enforcement director, managed to not find much wrong at either Enron or Tyco, despite abundant internal documents at their disposal. Such incompetence is highly rewarded in future corporate assignments. Rely on these reports at your own risk.

    9. Character cannot be compartmentalized.

    This lesson may be the most important of all. Investors and outside advisors often seem preoccupied with analyzing the formal propriety of specific corporate transactions, and the associated financial accounting. Questionable deals and disclosures are analyzed discretely, and not as part of any disturbing pattern of dubious corporate policies. Yet one had only to read the history of Ken Lay's involvement in the Valhalla energy-trading scandal at Enron in 1987 to detect a harbinger of scandals yet to come. That bad guys have a pattern of dishonest behavior should seem obvious, but it's not.

    And, finally, 10: Friends do not let (possibly guilty) friends take the stand in criminal trials.

    Let's face it, the Enron trials of Lay and Skilling had it all; greed, arrogance, an incompetent defense strategy (oh, how I wish short sellers had the power that Enron's defense team claimed we have!) and, of course, larger-than-life corporate villains. One would assume the high profile nature of the trial itself might underscore this observer's list of lessons learned from Enron's spectacular collapse. But thankfully, I'm pretty confident that they will be forgotten soon.

    Mr. Chanos is managing partner of Kynikos Associates.

    Bob Jensen's Enron Updates are at http://www.trinity.edu/rjensen/FraudEnron.htm#EnronUpdates

    Bob Jensen's threads on the Enron/Andersen scandals are at http://www.trinity.edu/rjensen/FraudEnron.htm






    3.
    Main Lessons Learned from Enron

    Enron lost a lot of money on various ventures (especially most of its huge international ventures) that were dreamed up by young and inexperienced cowboy-type executives hired more for their supposed creativity than for experience and understanding of how to make sustained profits in business ventures. 

    However, the main reason Enron went under is that it departed from its fundamental lines of business and became good (at times) and very bad (at other times) in trades of derivative financial instruments that can be used (for hedging) and abused (for speculation). The executives in this line of business ran the operation poorly and sometimes illegally.  For a time they got away with covering up their mistakes with creative accounting.

    Testimony of Frank Partnoy Professor of Law, University of San Diego School of Law Hearings before the United States Senate Committee on Governmental Affairs, January 24, 2002 --- http://www.senate.gov/~gov_affairs/012402partnoy.htm 
     

    How did Enron lose so much money? 
    That question has dumbfounded investors and experts in recent months.  But the basic answer is now apparent: Enron was a derivatives trading firm; it made billions trading derivatives, but it lost billions on virtually everything else it did, including projects in fiber-optic bandwidth, retail gas and power, water systems, and even technology stocks.  Enron used its expertise in derivatives to hide these losses.  For most people, the fact that Enron had transformed itself from an energy company into a derivatives trading firm is a surprise.

                    Enron is to blame for much of this, of course.  The temptations associated with derivatives have proved too great for many companies, and Enron is no exception.  The conflicts of interest among Enron’s officers have been widely reported.  Nevertheless, it remains unclear how much top officials knew about the various misdeeds at Enron.  They should and will be asked.  At least some officers must have been aware of how deeply derivatives penetrated Enron’s businesses; Enron even distributed thick multi-volume Derivatives Training Manuals to new employees.  (The Committee should ask to see these manuals.)

                    Enron’s directors likely have some regrets.  Enron’s Audit Committee in particular failed to uncover a range of external and internal financial gimmickry.  However, it remains unclear how much of the inner workings at Enron were hidden from the outside directors; some directors may very well have learned a great deal from recent media accounts, or even perhaps from this testimony.  Enron’s general counsel, on the other hand, will have some questions to answer.

                    But too much focus on Enron misses the mark.  As long as ownership of companies is separated from their control – and in the U.S. securities market it almost always will be – managers of companies will have incentives to be aggressive in reporting financial data.  The securities laws recognize this fact of life, and create and subsidize “gatekeeper” institutions to monitor this conflict between managers and shareholders. 

                    The collapse of Enron makes it plain that the key gatekeeper institutions that support our system of market capitalism have failed.  The institutions sharing the blame include auditors, law firms, banks, securities analysts, independent directors, and credit rating agencies.

                    All of the facts I have described in my testimony were available to the gatekeepers.  I obtained this information in a matter of weeks by sitting at a computer in my office in San Diego, and by picking up a telephone.  The gatekeepers’ failure to discover this information, and to communicate it effectively to investors, is simply inexcusable.

                    The difficult question is what to do about the gatekeepers.  They occupy a special place in securities regulation, and receive great benefits as a result.  Employees at gatekeeper firms are among the most highly-paid people in the world.  They have access to superior information and supposedly have greater expertise than average investors at deciphering that information.  Yet, with respect to Enron, the gatekeepers clearly did not do their job. 

                    One potential answer is to eliminate the legal requirements that companies use particular gatekeepers (especially credit rating agencies), while expanding the scope of securities fraud liability and enforcement to make it clear that all gatekeepers will be liable for assisting companies in transactions designed to distort the economic reality of financial statements.  A good starting point before considering such legislation would be to call the key gatekeeper employees to testify.

                    Congress also must decide whether, after ten years of steady deregulation, the post-Enron derivatives markets should remain exempt from the regulation that covers all other investment contracts.  In my view, the answer is no. 

                    A headline in Enron’s 2000 annual report states, “In Volatile Markets, Everything Changes But Us.”  Sadly, Enron got it wrong.  In volatile markets, everything changes, and the laws should change, too.  It is time for Congress to act to ensure that this motto does not apply to U.S. financial market regulation.

     


    The choice of taking on or keeping a risky client may increase all clients' cost of capital.

    Loss of Reputation is a Kiss of Death for One Public Accounting Firm:  An Empirical Study
    Andersen Audits Increased Clients' Cost of Capital Relative to Clients of Other Auditing Firms

    "The Demise of Arthur Andersen," by Clifford F. Thies, Ludwig Von Mises Institute, April 12, 2002 --- http://www.mises.org/fullstory.asp?control=932&FS=The+Demise+of+Arthur+Andersen

    From Yahoo.com, Andrew and I downloaded the daily adjusted closing prices of the stocks of these companies (the adjustment taking into account splits and dividends). I then constructed portfolios based on an equal dollar investment in the stocks of each of the companies and tracked the performance of the two portfolios from August 1, 2001, to March 1, 2002. Indexes of the values of these portfolios are juxtaposed in Figure 1.

    From August 1, 2001, to November 30, 2001, the values of the two portfolios are very highly correlated. In particular, the values of the two portfolios fell following the September 11 terrorist attack on our country and then quickly recovered. You would expect a very high correlation in the values of truly matched portfolios. Then, two deviations stand out.

    In early December 2001, a wedge temporarily opened up between the values of the two portfolios. This followed the SEC subpoena. Then, in early February, a second and persistent wedge opened. This followed the news of the coming DOJ indictment. It appears that an Andersen signature (relative to a "Final Four" signature) costs a company 6 percent of its market capitalization. No wonder corporate clients--including several of the companies that were in the Andersen-audited portfolio Andrew and I constructed--are leaving Andersen.

    Prior to the demise of Arthur Andersen, the Big 5 firms seemed to have a "lock" on reputation. It is possible that these firms may have felt free to trade on their names in search of additional sources of revenue. If that is what happened at Andersen, it was a big mistake. In a free market, nobody has a lock on anything. Every day that you don’t earn your reputation afresh by serving your customers well is a day you risk losing your reputation. And, in a service-oriented economy, losing your reputation is the kiss of death.

     

    On July 14, 2006, Greg Wilson inquired about what the implications of poor auditing are to investors and clients?

    July 14, 2006 reply from Bob Jensen

    Empirical evidence suggests that when an auditing firm begins to get a reputation for incompetence and/or lack of independence its clients’ cost of capital rises. This in fact was the case for the Arthur Andersen firm even before it imploded. The firm’s reputation for bad audits and lack of independence from Andersen Consulting, especially after the Waste Management auditing scandal, was becoming so well known that some of its major clients had already changed to another auditing firm in order to lower their cost of capital.

    Bob Jensen

    Bob Jensen's threads on fraudulent and incompetent auditing are at http://www.trinity.edu/rjensen/FraudConclusion.htm#IncompetentAudits

    Bob Jensen's threads on accounting and auditing theory are at
    http://www.trinity.edu/rjensen//theory/00overview/theory01.htm

    Bob Jensen's threads on the Andersen/Enron/Worldcom scandals are at http://www.trinity.edu/rjensen//theory/00overview/theory01.htm

    July 14, 2006 reply from Ed Scribner [escribne@NMSU.EDU]

    I think the conventional wisdom is that poor audits reduce the ability of information to reduce uncertainty, so investors charge companies for this in the form of lower security prices.

    In a footnote on p. 276 of the Watts and Zimmerman "Market for Excuses" paper in the April 79 Accounting Review, WZ asserted the following:

    ***
    Share prices are unbiased estimates of the extent to which the auditor monitors management and reduces agency costs... . The larger the reduction in agency costs effected by an auditor (net of the auditor's fees), the higher the value of the corporation's shares and bonds and, ceteris paribus, the greater the demand for that auditor's services. If the market observes the auditor failing to monitor management, it will adjust downwards the share price of all firms who engage this auditor... .
    ***

    Sometime in the 1980s, Mike Kennelley tested this assertion on the then-recent SEC censure of Peat Marwick. (I think his article appeared in the Journal of Accounting and Economics, but I can't find it at the moment.) The Watts/Zimmerman footnote suggests a negative effect on all of Peat Marwick's client stock prices, but Mike, as I recall, found a small positive effect.

    Because agency theory seems to permit arguing any side of any argument, a possible explanation was that the market interpreted this adverse publicity as a wakeup call for Peat Marwick, causing it to clean up its act so that its audits would be impeccable.

    A couple of other examples of the empirical research:

    (1) Journal of Empirical Legal Studies Volume 1 Page 263 - July 2004 doi:10.1111/j.1740-1461.2004.00008.x Volume 1 Issue 2

    Was Arthur Andersen Different? An Empirical Examination of Major Accounting Firm Audits of Large Clients Theodore Eisenberg1 and Jonathan R. Macey2

    Enron and other corporate financial scandals focused attention on the accounting industry in general and on Arthur Andersen in particular. Part of the policy response to Enron, the criminal prosecution of Andersen eliminated one of the few major audit firms capable of auditing many large public corporations. This article explores whether Andersen's performance, as measured by frequency of financial restatements, measurably differed from that of other large auditors. Financial restatements trigger significant negative market reactions and their frequency can be viewed as a measure of accounting performance. We analyze the financial restatement activity of approximately 1,000 large public firms from 1997 through 2001. After controlling for client size, region, time, and industry, we find no evidence that Andersen's performance significantly differed from that of other large accounting firms.

    ... Hiring an auditor, at least in theory, allows the client company to "rent" the reputation of the accounting firm, which rents its reputation for care, honesty, and integrity to its clients.

    ... From the perspective of audit firms' clients, good audits are good investments because they reduce the cost of capital and increase shareholder wealth. Good audits also increase management's credibility among the investment community. In theory, the capital markets audit the auditors.

    ------------------------------------
    (2) Journal of Accounting Research Volume 40 Page 1221 - September 2002 doi:10.1111/1475-679X.00087 Volume 40 Issue 4

    Corporate Financial Reporting and the Market for Independent Auditing: Contemporary Research Shredded Reputation: The Cost of Audit Failure Paul K. Chaney & Kirk L. Philipich In this article we investigate the impact of the Enron audit failure on auditor reputation. Specifically, we examine Arthur Andersen's clients' stock market impact surrounding various dates on which Andersen's audit procedures and independence were under severe scrutiny. On the three days following Andersen's admission that a significant number of documents had been shredded, we find that Andersen's other clients experienced a statistically negative market reaction, suggesting that investors downgraded the quality of the audits performed by Andersen. We also find that audits performed by Andersen's Houston office suffered a more severe decline in abnormal returns on this date. We are not able to show that Andersen's independence was questioned by the amount of non-audit fees charged to its clients.

    Ed Scribner
    New Mexico State University, USA


     


    Top Enron Executives are now convicted felons

    "Lay, Skilling Are Convicted of Fraud:  Jurors Reject Defense Claim That Enron Was Clean; Question of Credibility Two 'Very Controlling People'," by John R. Emshwiller, Gary McWilliams, and Ann Davis, The Wall Street Journal, May 26, 2006; Page A1 ---  http://www.trinity.edu/rjensen/FraudEnron.htm#EnronUpdates

    The convictions of former Enron Corp. chairman Kenneth Lay and former president Jeffrey Skilling decimated their high-stakes argument that Enron was a law-abiding company done in by newspaper reports, short-sellers and market panic. The jury's decision cemented the once-highflying energy company's legacy as one of the most egregious corporate offenders of the 1990s.

    The verdicts yesterday against both men on numerous federal fraud and conspiracy charges cap a string of prosecutions in which hundreds of senior corporate executives at numerous companies have been held accountable for wrongdoing on their watches.

    Once viewed as one of the biggest business success stories of the 1990s, Enron collapsed in 2001, the first of a string of corporate scandals. Its fall marked a dramatic end to the stock-market boom and the beginning of a wave of corporate and regulatory reforms, including the 2002 Sarbanes-Oxley law.

    Juror Kathy Harrison, an elementary-school teacher, said after the verdicts that she hoped executives at other companies would realize that "those in charge have responsibility. There's too much hurt here. If something good can come out, companies can be aware that they must be conscientious." (Read more reactions to the verdicts.)

    After delivering their verdicts, the Enron jurors said they had focused partly on the credibility of the two former executives. In a risky legal strategy, both men had argued that no crimes were committed at Enron, apart from a few largely irrelevant ones involving former Chief Financial Officer Andrew Fastow. Messrs. Lay and Skilling both testified during the trial, and both faced withering cross-examinations by prosecutors.

    Judge Sim Lake read the string of guilty verdicts in a packed courtroom. Both defendants stood calmly as family members gasped and some began to sob.

    Mr. Skilling, 52 years old, was convicted on 19 of 28 counts of conspiracy, fraud and insider trading. He was acquitted on nine counts of insider trading. Mr. Lay, 64, was convicted on all six conspiracy and fraud counts he faced. After reading the jury verdicts, Judge Lake also found Mr. Lay guilty of all four counts in a separate banking-fraud case heard by the judge while the jury was deliberating.

    After the verdicts were announced, Mr. Lay joined more than a dozen friends and family members in a circle in one corner of the courtroom to pray. One of Mr. Lay's supporters, Rev. Bill Lawson, could be heard invoking the story of Jesus, "who was convicted and even executed," he said.

    "We'll all come through this stronger," said Mr. Lay, occasionally tugging at the hand of his wife, Linda, who had sat through the entire four-month trial. Later, Mr. Lawson said he advised Mr. Lay "to hang in there and trust God."

    In a telephone interview last night, Mr. Skilling said that when he was pronounced guilty on the first count of conspiracy, "that floored me. God, there was no conspiracy." He said that the relatively short jury deliberations had raised his hopes. But "we were just on a tilted football field," he said, referring to going on trial in Enron's headquarters city.

    The convictions came despite Messrs. Lay and Skilling putting on one of the most expensive criminal defenses ever, spending an estimated $60 million. Both men remain free pending sentencing, which is set for Sept. 11. Each faces many years in prison.

    Attorneys for both men said they would appeal the verdicts, which came on the sixth day of jury deliberations that many observers had expected to stretch for weeks. The verdict "doesn't change our view of what happened at Enron, or of Jeff Skilling's innocence," said a clearly upset Daniel Petrocelli, Mr. Skilling's lead lawyer. "We told our story and the jury disagreed with it."

    At a press conference after the verdicts, several jurors said that government witnesses, many of them former Enron executives testifying as part of plea bargains, had convinced them that illegal activities had occurred at Enron, and that the defendants were responsible.

    Defense lawyers had decided to put both Mr. Skilling and Mr. Lay on the stand. "I wanted badly to believe what they were saying," said juror Wendy Vaughan, a small-business owner. But "there were places in their testimony where I felt their character was questioned," she said.

    "Both men said they had their hands firmly on the wheel" of the company, said another juror, elementary-school principal Freddy Delgado. For the two executives to later claim they didn't know about wrongdoing, said Mr. Delgado, was "not the right thing."

    Continued in article


     

    What are some of the main lessons learned from the Enron scandal? 
    I especially like "Suggestions for Reform" listed at http://www.citizenworks.org/corp/reforms.php

    A pretty good summary of lessons learned is provided at http://www.law.northwestern.edu/professionaled/documents/Ruder_Lessons_Enron.pdf
     


    "Enron’s Lasting Influence," AccountingWeb, January 10, 2006 ---
    http://www.accountingweb.com/cgi-bin/item.cgi?id=101647

    With the former Enron executives finally coming to trial, we are reminded again of the long shadow cast by the implosion of the company that helped enact the Sarbanes-Oxley (SOX) Act of 2002. Section 404 has added teeth to SOX, making regulation more expensive and staff intensive and the Public Company Accounting Oversight Board (PCAOB) has been created to aid in the governance and enforcement of the accounting industry. Audit committees have attained more important positions in corporate structures and are more attuned to avoid the conflicts of being both auditor and consultant for the same company. At the same time, with the collapse of Arthur Andersen, the consolidation of the Big Five to the Big Four now have four accounting firms doing the work for more than 90 percent of publicly traded companies, according to the New York Times.

    “We certainly have seen some improvements in governance, but we’ve also seen some areas of no improvement, and some areas where things have gone backwards,” said Lynn E. Turner, speaking to the New York Times. Turner is the former chief accountant at the Securities and Exchange Commission (SEC) and now managing director of research at Glass, Lewis & Company.

    The outright accounting scandals of WorldCom, Tyco, and Adelphia have now morphed into companies making financial restatements. Glass, Lewis & Company reports that earnings restatements numbered 1,031 through the end of October 2005, compared with 650 for 2004 and 270 in 2001, according to the New York Times. John C. Coffee, speaking in the Los Angeles Times, said the restatements were not necessarily evidence of fraud but shows the tighter focus of accountants.

    Also, more than 1,250 public companies, out of around 15,000 in total, reported material weaknesses in their internal corporate controls in October 2005. Some 232 other companies reported less serious, but significant deficiencies in their internal controls, according to the New York Times.

    In contrast, a new study shows that the number of securities class-action suites has come down 17 percent in 2005. The 176 filed in 2005 is the lowest since 1997, according to Cornerstone Research and Stanford Law School. 1998 saw 239 suites, the highest number in recent years, according to the Los Angeles Times.

    Christopher Cox, chairman of the SEC, said in a late December interview with the New York Times, that he agreed that more should be done, disclosing his intention to lead a commission effort to rewrite rules forcing companies to provide more financial details concerning executive pay.

    Tighter accounting and disclosure rules enacted to enhance the transparency of financial information have lead to an industry-lead backlash. Cox said to the New York Times that it “would be a mistake” to retract major provisions of SOX.

    “The shocks were so big that no director could miss the lesson and if they did miss somehow, the significant changes in the law made it absolutely certain that they are now more focused,” Cox added. “With just a few years of Sarbanes-Oxley under their belts, most companies are begrudgingly admitting that the exercise is producing benefits.”

    SOX has sincere proponents though, institutional and pension investor groups being the most vocal. Alan G. Hevesi, New York comptroller of one of the nation’s largest institutional investors, has been leading the effort to increase corporate accountability. Speaking with the New York Times, Hevesi said, “We’ve had some successes in corporate governance reform. In other words – such as giving a greater voice to shareholders to elect independent directors and curbing excessive executive compensation – we haven’t been as successful. I worry about whether the necessary reforms have really been institutionalized.”

    Executives say that restatements are healthy signs of change according to the New York Times although, “The general impression of the public is that accounting rules are black and white. They are often anything but that, and in many instances the changes in earnings came after new interpretations by the chief accountant of the S.E.C.," said Steve Odland, Office Depot’s CEO and head of a corporate governance task force at the Business Roundtable.

    Accounting scandals are more often settled with the SEC or actions filed by the agency now. For example, AcAfee, the Internet security company, has agreed to settle charges made by the SEC that they inflated revenues by some $622 million between 1998 and 2000. Their penalty will be $50 million. The settlement is awaiting court approval.

    The SEC filed a civil lawsuit against six former executives then employed by an unnamed transfer-agent unit of Putnam Investments last week. They allegedly defrauded mutual funds and clients out of some $4 million in 2001. Also the judge has ruled that SEC testimony will be allowed into the trials of former Enron executives Jeffrey Skilling and Kenneth Lay.

    Bob Jensen's threads on reforms are at http://www.trinity.edu/rjensen/FraudProposedReforms.htm

    Bob Jensen's threads on the Enron/Andersen scandals are at http://www.trinity.edu/rjensen/FraudEnron.htm


    What major problems remain?

    Some of the remaining problems are mentioned at
    http://www.s-ox.com/news/detail.cfm?articleID=225

    Frank Partnoy thinks problems will remain as long as the over-the -counter (OTC) markets in derivatives continue to operate in a nearly unregulated market where insiders can exploit investors.  For a review of his books on this, and a summary of worldwide derivatives frauds in general, go to http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds






     

4.
How many facts at the height of Enron's success can your recite?  For example what were its 1999 sales, profits, and cash on hand (at least as reported in Enron's somewhat fictional 1999 financial statements?  How big were the subsequent earnings and debt restatements? Who held the most stock?  What was CEO Ken Lay's salary before other benefits? How many employees did Enron have on the payroll in 1999? 


Sales in 1999: $40,112,000,000
Net Income: $893,000,000
Cash on hand at end of 1999: $288,000,000

In 2001 Enron had slightly over 10,000 full-time employees, about half of which worked out at its headquarters in Houston.  Some writers place this number at 20,000 but I've never been able to confirm such a high number.

When Enron declared bankruptcy in December 2001 it was the seventh largest corporation in the United States and once dreamed of world domination in the energy market --- http://news.bbc.co.uk/2/hi/business/3400201.stm

There were subsequent restatements after accounting fraud was detected. You can read about the impacts of these restatements at http://www.law.northwestern.edu/professionaled/documents/Ruder_Lessons_Enron.pdf
 

1997 earnings of $105 million were reduced by $28 million,
1998 earnings of $703 million were reduced by $133 million,
1999 earnings of $893 million were reduced by $153 million,
2000 earnings of $979 million were reduced by $91 million.

Reported debt was increased by over $500 million for each of the
years 1997 through 2000, as follows:

1997 - $711 million
1998 - $561 million
1999 - $685 million
2000 - $628 million

The announced restatements of earnings, increased debt, and reduction of shareholder equity caused third parties in the trading community to lose confidence in Enron and to cease trading with the company. The result was a collapse of Enron’s ability to trade in the energy markets. Some have described this loss of confidence as the equivalent of a run on the bank. Others have described Enron’s collapse as due to market reaction to the disclosures regarding Enron’s earnings and balance sheet.

In any event, Enron’s stock collapsed and the company filed for bankruptcy in mid-December of 2001.
 



You can read the following at http://www.corpwatch.org/article.php?id=457

Top Individual Stock Holders

BELFER, ROBERT A., 1.18% (PRX 03-21-2000) Common Stock
BELFER, ROBERT A., 17.02% (PRX 03-21-2000) Preferred Convertible Stock
Office Address: Belco Petro. Corp. 67 5th Ave., 46th Fl. New York, New York 10153-0002
Age: 64
Director since 1983 Mr. Belfer's principal occupation is Chairman and Chief Executive Officer of Belco Oil & Gas Corp., a company formed in 1992. Prior to his resignation in April, 1986 from Belco Petroleum Corporation ("BPC"), a wholly owned subsidiary of Enron, Mr. Belfer served as President and then Chairman of BPC. (Proxy Statement, March 21, 2000)

RUBEN, LAWRENCE, JR., ET AL, 1.43% (PRX 03-21-2000) Common Stock
RUBEN, LAWRENCE, JR., ET AL, 22.06% (PRX 03-21-2000) Preferred Convertible Stock
Married to Selma Belfer (see above)
Office Address: 600 Madison Ave, New York, NY, 10022-1615

Chairman and CEO

Kenneth L. Lay
Age: 57
Pay: $5,200,000

US Political Connections

As of June 2000, Enron had contributed $10,265 to Sen. Slade Gorton 's Campaign (Center for Responsive Politics)

As of January 2000, Enron had contributed $99,750 to George W. Bush's Presidential Campaign - the 11th largest contributor to Bush's campaign (Center for Responsive Politics)

Kenneth Lay contributed a total of more than $100,000 to Bush's gubernatorial campaigns of 1994 and 1998, this made Lay's Bush top 21st individual donor (Associated Press, April 7, 2000)

Kenneth Lay and his wife, Linda contributed $76,000 to the Republican National State Elections Committee since 1997 (Associated Press, April 7, 2000)

Enron's total lobbying expenditures for 1998 were $1,600,000.  Of this, $200,000 was lobbying expenditures for Enron Wind Corp. (Center for Responsive Politics)

Enron hired former members of Pres. George Bush's Cabinet, Secretary of State James Baker and Commerce Secretary Robert Mosbacher in 1993 to help develop overseas projects. Mosbacher had served on the board of Enron in the 1980's (The New York Times, February 23, 1993)

New Jersey State Attorney General is accusing Enron of violating state laws that prohibit some energy providers from making donations to politicians (Megawatt Daily, March 27, 2000)

Foreign Political Involvement

In order to get approval from the British Government to purchase one of Britain's largest public water utilities, Enron funneled "Labour almost pounds 30,000 in the last two years" (The Independent (London), September 11, 1998)

Shortly after his father won the US Presidency in 1988, George W. Bush called the Argentine Minister of Public Works, Rodolfo Torragno to pressure him to accept Enron's "laughable" bid for a large pipeline project. (Mother Jones, March 1, 2000; The Nation, November 21, 1994)

There were accusations in Panama that Enron was using it's influence with Energy Minister Luis Carlos Valenzuela to force the state oil company to sign a "sweetheart deal" with Enron to export natural gas to Central American (Latin America Energy Alert, December 8, 1999; The Nation, May 22, 2000)

"Gas giant Enron Corp.'s plan to develop Mozambique's Pande natural gas field appears to have been saved from cancellation last month by a blunt threat from the U.S. National Security Council to cut off future U.S. aid to the country." (The Oil Daily, December 1, 1995) Enron beat out South Africa's state petroleum company, Sasal to build the pipeline in 1995 and recently sold the gas and oil rights to Sasal.

Enron and Native Peoples in the United States

Manager of Enron's American Indian Affairs is Roger Fragua.
Fragua was formerly the Jemez Tribe Administrator in New Mexico (Las Vegas Review-Journal, September 27, 1997)

In 1997, Confederated Tribes of Warms Springs, Oregon, expressed their wish to gain control over the three Portland General Electric Co. hydropower dams on the Tribes' land in order to restore abandoned fish ladders. Enron owned PGE and "intended to keep the license". (Engineering News-Record, August 4, 1997) In early 2000, Enron Corp.'s Portland General Electric Co. agreed to sell stakes in its hydroelectric system over four decades to the Tribes, (Houston Chronicle, February 2, 2000).  At the same time, Enron is in the process of selling it's interests in PGE to Sierra Pacific Resources. (Inside F.E.R.C.'s Gas Market Report, March 17, 2000)

Activists challenging Enron's wind farm on the Columbia River Gorge "maintain that Enron has been unresponsive to tribal and environmental concerns, refusing to reply to repeated invitations to visit the site or meet with elders." (Indian Country Today (Lakota Times) April 12, 2000) In testimony to the US Congress in 1999, Enron's manager of American Indian Affairs stated, "We seek Tribal partners that are motivated in seeking "for-profit" energy projects that are culturally, environmentally and economically sound Enron has a long history of responsibly working with many American Indian Tribes...". (Federal Document Clearing House Congressional Testimony, July 1, 1999)

Kenneth L. Lay, CEO and Chairman of Enron, received the American Spirit Award from the Council of Energy Resource Tribes in 1988. The award is "given to a corporate executive who has supported CERT and its efforts to enhance higher education opportunities for American Indian students in the fields of science, engineering and business". (Coal, March 1988)

Enron and the Environment

In 1996, Enron received the Corporate Conscience Award for Environmental Stewardship sponsored by the Council on Economic Priorities. (PR Newswire, June4, 1996)

Patagonia, Inc, an outdoor clothing and equipment company committed to environmentally friendly business decisions, purchases all of its electricity from Enron Wind, the first company in California to do so. (The Energy Report, July 13, 1998)

Enron's pipeline project with Florida Gas Transmission Co, was found in violation 109 times regarding wetlands destruction and improper land clearing and damaging waterways in 1994. It paid $575,400 in fines. (Oregonian, August 6, 1996 and Southeast Energy Power Report, December 16, 1994)

Enron and Dutch Shell's pipeline in Bolivia ruptured on January, 2000, and spilled 29,000 barrels of crude petroleum. This contaminated "hundreds of acres of organic farmland, killing fish and birds in the Andes' lake Poopo, and destroying the livelihood of a 5,000 year old native tribe, Uru Morato". Enron and it's Bolivian partner, Transredes has spent $ 10-mil so far on the oil spill, and clean-up has not yet been completed, a spokesman for Enron Corp, which owns 50% of Transredes, said late Mar 21. (Friends of the Poopo and the Uru Morato, Vermont, USA and Platt's Oilgram News, March 23, 2000)

Enron, Shell and Transredes are building a 390 mile pipeline in Bolivia that has "brought serious environmental and social problems " to local communities living along its path. They have so far experienced, "pollution of local water resources, degradation of local roads, soil and air pollution". (A World Class Disaster: The Case of the Bolivia-Cuiaba Pipeline, A Report on the Failures of Enron International to Comply with Bolivian Environmental Laws and OPIC Loan Conditions in the Construction of the Lateral Ipias-Cuiaba Gas Pipeline, December 8, 1999) Activist have been pressuring the US Overseas Private Investment Corporation to pull it's support of the Cuiaba Pipeline Project, however, Enron has stated that it will proceed with the project, whether or not it gets OPIC funding. (Financial Times (London) July 15, 1999)

International Violations

Enron's activities with their Dabhol Power project in India has been documented by Human Rights Watch as violating the human rights of locals protesting the project, the largest power plant in the world. "The Dabhol Power Corporation and it's parent company, Enron, are complicit in these human rights violations. Enron's local entity, the Dabhol Power Corp. benefited directly from an official policy of suppressing dissent through misuse of the law, harassment of anti-Enron protest leaders and prominent environmental activists, and police practices ranging from arbitrary to brutal". (The Enron Corporation: Corporate Complicity in Human Rights Violations, Jan 1999, Human Rights Watch)

Enron's water division, Azurix Corp, is the city water supply company for the community of Bahia Blanca in Buenos Aires. In April, 2000, the water supply was laced with toxic bacteria that caused skin irritation and possible neurological damage. (Reuters, April 25, 2000)

The World Bank is objecting to the terms of a power purchase agreement between Enron and the state of Lagos (Nigeria) in December of 1999. The terms are too favorable to Enron: they acquired a long-term right to sell power to Lagos without competitive bidding; can charge a high price for the fuel used by its power plant; cannot be penalized for the poor performance of its plants; does not fully bear the completion risks for the plants under its control; benefits from generous arrangements for payment security; and would receive excessive contract termination payments. (EIU Views Wire, May 25, 2000)

Enron Wind

13000 Jameson Rd.
Tehachapi, CA 93581

Telephone: 661-823-6700
Fax: 661-822-7880
wind@enron.com

In 1999, Enron Wind agreed to relocate a proposed wind farm away from endangered California Condor flight patterns after The National Audubon Society and Tejan Ranch began a public campaign targeting Enron Wind after the California Energy Commission approved development of the project. (Global Power Report, November 12, 1999)

Enron's Board of Directors (Proxy, March 23, 2000)

NORMAN P. BLAKE, JR., 58 Director since 1993 Mr. Blake is the Chief Executive Officer and Secretary General of the United States Olympic Committee. Mr. Blake served as Chairman, President and Chief Executive Officer of the Promus Hotel Corporation from December, 1998 until November, 1999 when it merged with the Hilton Hotels Corporation. From November, 1990 until May, 1998, he served as Chairman, President and Chief Executive Officer of USF&G Corporation until its merger with the St. Paul Companies. He is also a director of Owens-Corning Corporation.

RONNIE C. CHAN, 50 Director since 1996 For over nine years, Mr. Chan has been Chairman of Hang Lung Development Limited, a publicly traded Hong Kong company involved in property development and investment as well as hotel development and management. Mr. Chan also co-founded and is a director of various companies within Morningside/Springfield Group, which invests in private industrial companies internationally and he is also a director of Standard Chartered Bank PLC and Motorola, Inc.

JOHN H. DUNCAN, 72 Director since 1985 Mr. Duncan's principal occupation has been investments since 1990. Mr. Duncan is also a director of EOTT Energy Corp. (the general partner of EOTT Energy Partners, L.P.), Azurix Corp. and Group I Automotive Inc.

WENDY L. GRAMM, 55 Director since 1993 Dr. Gramm is an economist and Director of the Regulatory Studies Program of the Mercatus Center at George Mason University. From February, 1988 until January, 1993, Dr. Gramm served as Chairman of the Commodity Futures Trading Commission in Washington, D.C. Dr. Gramm is also a director of IBP, Inc., State Farm Insurance Co. and Invesco Funds. Dr. Gramm was also a director of the Chicago Mercantile Exchange until December 31, 1999.

KEN L. HARRISON, 57 OTO Director since 1997 Mr. Harrison has served as Chairman of the Board and Chief Executive Officer of Portland General Electric Company since 1988. He plans to retire on March 31, 2000. Additionally, Mr. Harrison served as Chairman of Enron Communications, Inc. from its inception in 1996 through November, 1999, and as a Vice Chairman of Enron from July, 1997 to July, 1999.

ROBERT K. JAEDICKE, 71 Director since 1985 Dr. Jaedicke is Professor (Emeritus) of Accounting at the Stanford University Graduate School of Business in Stanford, California. He has been on the Stanford University faculty since 1961 and served as Dean from 1983 until 1990. Dr. Jaedicke is also a director of Boise Cascade Corporation, California Water Service Company and GenCorp, Inc. Dr. Jaedicke was also a director of State Farm Insurance Co. until June, 1999.

KENNETH L. LAY, 57 Director since 1985 For over fourteen years, Mr. Lay has been Chairman of the Board and Chief Executive Officer of Enron. Mr. Lay is also a director of Eli Lilly and Company, Compaq Computer Corporation, Azurix Corp., EOTT Energy Corp. (the general partner of EOTT Energy Partners, L.P.), Questia Media, Inc. and Trust Company of the West.

CHARLES A. LEMAISTRE, 76 Director since 1985 For 18 years, Dr. LeMaistre served as President of the University of Texas M. D. Anderson Cancer Center in Houston, Texas and now holds the position of President Emeritus.

REBECCA MARK-JUSBASCHE, 45 Director since 1999 Since July, 1998, Ms. Mark-Jusbasche has served as Chairman and Chief Executive Officer of Azurix Corp., a global water company formed by Enron in 1998. From May, 1998, until July,1999, Ms. Mark-Jusbasche served as a Vice Chairman of Enron. From January, 1996, until March, 1999, Ms. Mark-Jusbasche served as Chairman of Enron International Inc. From January, 1996 until May, 1998, Ms. Mark-Jusbasche served as Chief Executive Officer of Enron International Inc. From July, 1991 until March, 1998, she served as Chairman and Chief Executive Officer of Enron Development Corp. Ms. Mark-Jusbasche is a member of the Council on Foreign Relations and The Chase Manhattan Corp. National Advisory Board.

JOHN MENDELSOHN, 63 Director since 1999 Since July, 1996, Dr. Mendelsohn has served as President of the University of Texas M.D. Anderson Cancer Center. Prior to 1996, Dr. Mendelsohn was Chairman of the Department of Medicine at Memorial Sloan-Kettering Cancer Center in New York. Dr. Mendelsohn is a director of ImClone Systems, Inc.

JEROME J. MEYER, 62 Director since 1997 For over eight years, Mr. Meyer served as Chairman and Chief Executive Officer of Tektronix, Inc., an electronics manufacturer located in Wilsonville, Oregon. Currently, Mr. Meyer serves as Chairman and as a director of Tektronix, Inc. He is also a director of Standard Insurance Corp. and Centerspan Communications, Inc.

PAULO V. FERRAZ PEREIRA, 45 Director since 1999 For over five years, Mr. Pereira has served as President and Chief Operating Officer of Meridional Financial Group and Managing Director of Group Bozano. Mr. Pereira is the former President and Chief Executive Officer of the State Bank of Rio de Janeiro.

FRANK SAVAGE, 61 Director since 1999 Since 1995, Mr. Savage has served as Chairman of Alliance Capital Management International (a division of Alliance Capital Management L.P.). Mr. Savage is also a director of Lockheed Martin Corporation, Alliance Capital Management L.P., Lyondell Chemical Corp. and Qualcomm Corp.

JEFFREY K. SKILLING, 46 Director since 1997 Since January, 1997, Mr. Skilling has served as President and Chief Operating Officer of Enron. From January, 1991until December, 1996, he served as Chairman and Chief Executive Officer of Enron North America Corp. and its predecessor companies. Mr. Skilling is also a director of Azurix Corp. and the Houston Branch of the Federal Reserve Bank of Dallas.

JOHN A. URQUHART, 71 Director since 1990 Mr. Urquhart serves as Senior Advisor to the Chairman of Enron. From 1991 to 1998, Mr. Urquhart was a Vice Chairman of Enron. Since August, 1991, Mr. Urquhart has also been President of John A. Urquhart Associates, a management consulting firm in Fairfield, Connecticut. He also serves as a director of TECO Energy, Inc., Hubbell, Inc., The Weir Group, PLC and Catalytica Inc.

JOHN WAKEHAM, 67 Director since 1994 Lord Wakeham is a retired former U.K. Secretary of State for Energy and Leader of the Houses of Commons and Lords. He served as a Member of Parliament from 1974 until his retirement from the House of Commons in April, 1992. Prior to his government service, Lord Wakeham managed a large private practice as a chartered accountant. He is currently Chairman of the Press Complaints Commission in the U.K. and chairman or director of a number of publicly traded U.K. companies. Lord Wakeham is also a director of Azurix Corp.

HERBERT S. WINOKUR, JR., 56 Director since 1985 Mr. Winokur is Chairman and Chief Executive Officer of Capricorn Holdings, Inc. (a private investment company) and Managing General Partner of Capricorn Investors, L.P., Capricorn Investors II, L.P. and Capricorn Investors III, L.P., partnerships concentrating on investments in restructure situations, organized by Mr. Winokur in 1987, 1994, and 1999, respectively. Prior to his current appointment, Mr. Winokur was Senior Executive Vice President and a director of Penn Central Corporation. Mr. Winokur is also a director of Azurix Corp., The WMF Group, Ltd., Mrs. Fields' Holding Company, Inc., CCC Information Services Group, Inc. and DynCorp.

Top Ten Institutional Stock Holders as of June 15, 2000 (Vicker's Stock Research)
INST CODE INSTITUTION NAME INCORP SHARES VALUE($000) PORTFOLIO VALUE($000) %PORT
MM JANUS CAPITAL US 67,127,310 4,891,903 226,957,100 2.15
MF JANUS FUND US 26,118,310 1,903,372 29,979,300 6.34
BA BARCLAYS BK PLC FN 20,533,076 1,496,348 448,821,000 .33
MM FMR CORP US 17,520,864 1,276,833 626,451,900 .20
MM CITIGROUP INC. US 16,623,620 1,211,446 191,045,900 .63
MM AMER CENT INVT US 13,686,800 997,426 89,791,300 1.11
MM MSDW & CO US 13,281,745 967,907 192,401,600 .50
MM TAUNUS CORP US 12,938,627 942,902 203,497,200 .46
MM STATE STR CORP US 12,804,149 933,102 322,063,600 .28
MM PUTNAM INV MGT. US 11,347,292 826,934 275,420,100 .30

Source:
ImpactResearch: A Program of the DataCenter
1904 Franklin Street, Suite 900, Oakland, CA 94612 USA
Tel: 1 510-835-4692 Fax: 1 510 835 3017
Email: lkleven@datacenter.org

 




 







 

5. 
When was Enron formed and who founded it?

Ken Lay founded Enron in July 1985 as a result of the merger of Houston Natural Gas and InterNorth of Omaha, Nebraska.  Its main assets were natural gas pipelines.








 


 
 

 

6. 
When Enron's name became Enron, a consulting firm was paid over $1 million to recommend a name that turned into a laughing stock.  What was that absurd name that became an embarrassing joke?
 

Perhaps the fallout from the first major decision of the Enron Corporation should have served as a warning for the company's future. As Ken Lay, Jeff Skilling and others laid the groundwork for a new energy giant, they consulted with a New York firm to suggest a name for their company. Several months and millions of dollars later, "Enteron" was the suggestion. It combined both the international and energy aspects of the new enterprise. Everyone seemed to love the new name. Unfortunately no one bothered to check Webster's. "Enteron" is also a word for the (entrails) digestive tube running from the mouth to the anus. Given that one of "Enteron's" major products was natural gas, the choice of names made the new company a laughingstock. "Enteron" quickly became "Enron."

For more on this see --- http://www.bookreporter.com/reviews2/0767911784.asp








 


7. 
Who were the leading executives and Board of Director members and what did they eventually earn from their stock sales until paying fines or being forced to return money to Enron?


See Enron's Cast of Characters and Their Stock Sales at http://www.trinity.edu/rjensen/FraudEnron.htm#StockSales

"10 Enron Players: Where They Landed After the Fall," The New York Times, January 29, 2006 --- http://www.nytimes.com/2006/01/29/business/businessspecial3/29profiles.html


 


8.
What executive committed suicide by gunshot after Enron declared bankruptcy?

Without anything that can be called a serious investigation, local authorities in a wealthy Houston suburb have whitewashed the death of former Enron vice chairman J. Clifford Baxter, calling it a suicide. Baxter, 43, was found shot to death in his Mercedes Benz in the early hours of Friday morning, January 25, near his home in Sugar Land. Baxter’s body was discovered inside his Mercedes Benz, which was parked in a turnaround on a street near his home. Officials in Sugar Land moved swiftly to label Baxter’s death a suicide. Local Justice of the Peace Jim Richard initially declared that Baxter died of a self-inflicted gunshot wound and no further inquiry was required. But within hours he reversed himself, citing the intense public interest in the death, and ordered an autopsy.
"The strange and convenient death of J. Clifford Baxter—Enron executive found shot to death," by Patrick Martin, World Specialist Web Site, January 22, 2002 ---a http://www.wsws.org/articles/2002/jan2002/enro-j28.shtml







 


9.
What are some of the leading books that have been written about Enron?

See the references at http://www.trinity.edu/rjensen/FraudEnron.htm#References






 



 

10
What set Andy Fastow and Michael Kopper apart from most of the other Enron executives prior to the illegal self declarations of bonuses from a secret bank account set up just before Enron declared bankruptcy?

Fastow and Kopper were the most dastardly criminals who repeatedly conspired to steal millions from Enron itself and got away with it due to amazing luck and/or cowardice of other executives, bankers, and auditors who suspected bad things were being engineered by Fastow but were afraid to ask.  In particular, Fastow openly promised Ken Lay, Jeff Skilling, and Enron's entire Board that he would not take fees for managing the SPEs they allowed him to set up for purposes of hedging and keeping debt off the books.  Subsequently, Fastow with the aid of Kopper managed to secretly skim off something over $60 million dollars into their hidden bank accounts.  And much of what they achieved while running the funds was obtained from insider information.  Having Fastow run these funds was a blatant conflict of interest that never should've been allowed by Enron's CEO, Enron's Board, or Enron's auditor (Andersen).

The charges against Fastow are outlined at http://www.findarticles.com/p/articles/mi_pjus/is_200210/ai_1616198674

The SEC's complaint is at http://www.sec.gov/litigation/complaints/comp17762.htm

Michael Kopper eventually confessed.  You can read part of his testimony summarized at http://www.signonsandiego.com/uniontrib/20040928/news_1b28enron.html

Long-time subscribers to the AECM may remember my quips (years ago) about Michael Kopper ---
These inspired AECMers to write their own quips about Enron and about accounting in general.
You can read some of these AECM originals at http://www.trinity.edu/rjensen/FraudEnron.htm#Humor

And don't forget about the Enron home video starring some of the real players (including Jeff Skilling) befpre they got caught --- http://www.trinity.edu/rjensen/FraudEnron.htm#HFV

Tales from the Enron trial got you down? Like Andrew Fastow's testimony of how he laundered $10,000 as a tax-free gift to his own sons? So after work you stumble home, seeking refuge from the workaday sludge in the stark competitive world of Sports Illustrated, which this week is awash in the details of the doping case against Barry Bonds, an Icarus, legend has it, who flew toward baseball heaven on wax wings made from human growth hormone. For perspective on the Bonds myth, I called Gary Wadler, a physician who has seen it all as a member of the World Anti-Doping Agency. "Bonds and Fastow were both into cooking," Dr. Wadler offered. "Bonds cooked the record books and Fastow cooked the financial books."
Daniel Henninger, "Barry Bonds, Meet Andrew Fastow, The Wall Street Journal, March 17, 2006 --- http://www.opinionjournal.com/columnists/dhenninger/?id=110008100

At last we hear from the master criminal himself --- Andy Fastow
"Excerpts from Testimony By Former Enron CFO Fastow," The Wall Street Journal, March 8, 2006 --- http://online.wsj.com/article/SB114174916581991546.html?mod=todays_us_money_and_investing 

Former Enron CFO Andy Fastow, the prosecution's star witness, testified at the Lay-Skilling trial that he ran financial partnerships designed to help Enron meet earnings targets and mask huge losses. Mr. Fastow, who hasn't spoken publicly since October 2001, is among the most highly anticipated witnesses in this trial. Following are excerpts from his testimony.

Wednesday, March 8 LAY KNEW: Fastow testified that former chairman Ken Lay was at a meeting in August 2001 in which he heard about a "hole in earnings" at Enron, just days before he gave a BusinessWeek interview claiming Enron was in its "best shape" ever. Fastow said of the Lay interview, "I think most of the statements in there are false."

* * * ON GREED: In a heated cross-examination by Skilling lawyer Daniel Petrocelli, Fastow admitted, "I believe I was extremely greedy, and that I lost my moral compass, and I've done terrible things that I very much regret."

INSIDE-OUT: Steady growth and bright prospects "was the outside view of Enron," Fastow testified. "The inside view of Enron was very different."

* * * RECURRING DREAM: Lay opted to characterize a loss on an investment in the third quarter of 2001 as "nonrecurring," even though a gain on the same holding was earlier characterized as "recurring," Fastow testified, adding, "I thought that was an incorrect accounting treatment."

* * * DEATH SPIRAL: By October 2001, Enron's suppliers refused to trade with the company and Fastow testified that he feared the company would collapse and that he and an aide went to Lay to warn him. "I said I thought this was a death spiral, a serious risk of bankruptcy. I said the majority of trades being done were to unwind positions."

* * * MORE HEROICS: "Within the culture of corruption Enron had, a culture that rewarded financial reporting rather than rewarding economic value, I believed I was being a hero. I was not. It was not a good thing. That's why I'm here today."

Tuesday, March 7 THE PROFIT PROBLEM: One of Enron's off-balance-sheet partnerships, LJM1, was designed to help the company "solve a problem," Fastow testified. "We were doing this to inflate our earnings, and I don't think we wanted to show people what we were doing.''

* * * MORE DEALS: Fastow quoted Skilling as saying, " 'Get me as much of that juice as you can,' '' after Fastow informed him that more money would need to be raised to continue making deals like LJM1. In such deals, these so-called outside entities would purchase underperforming assets from Enron to get debt off its balance sheet and boost earnings.

* * * RISKY BUSINESS: Fastow testified that partnerships like the LJMs were willing to do deals that Enron "just couldn't do with others" because they were too risky or didn't make economic sense.

* * * SKILLING'S WORD: Fastow testified about pressure from Skilling to have one of the LJMs buy a minority stake in a Brazilian power plant owned by Enron because Enron's South American unit was struggling to meet its earnings target. "I told him it was a piece of s--t, and no one would buy it,'' Fastow said, adding that he relented, in part, because Skilling assured him he wouldn't lose money on the deal. Fastow testified that there were many more "bear-hug" guarantees like this from Skilling in mid-2000.

* * * BREAKING THE LAW: Fastow testified that the LJMs were legal and did many legal deals, but "certain things I did as general partner of LJM were illegal."

* * * BELIEVE IT OR NOT: In his first day of testimony, Fastow repeatedly said that he thought he was "a hero for Enron," for coming up with these unique business deals to help the company meet Wall Street targets even when it was financially in trouble. "I thought the foundation was crumbling and we were doing everything we could to prop it up as long as we could … We were in pretty bad shape."

* * * WORRIES ABOUT PUBLICITY: Skilling was concerned, Fastow testified, that off-balance-sheet deals like the LJMs would "attract attention, and if dissected, people would see what the purpose of the partnership was, which was to mask potentially hundreds of millions of dollars of losses."

* * * FALSE TAX RETURN: Fastow tearfully admitted that he "misled" his wife about some of the money the couple earned from Enron-related deals. "She would not, in my opinion, have signed a fraudulent tax return," Fastow said. Lea Fastow served one year in federal prison for filing a false tax return.

* * * A FAMILY AFFAIR: Fastow also admitted that he had one of his top aides send $10,000 checks to each of his sons. The checks were portrayed as gifts to the boys, but really they were proceeds from a business deal. "I shouldn't have. It was the wrong thing to do."

Jensen Comment
It comes as some relief to accountants that Fastow has not yet mentioned collusion with the Andersen Auditors led by David Duncan. CFO Fastow worked in secrecy ripping off Enron itself. CAO Rick Causey worked more closely with Duncan to issue false financial statements. Rick Causey's fine for filing false Enron financial statements was $1,250,000.

From The Wall Street Journal Accounting Weekly Review on September 29, 2006

TITLE: Fastow Gets 6 Years as Judge Cites Need for Mercy
REPORTER: John R. Emshwiller and John M. Biers
DATE: Sep 27, 2006
PAGE: A3
LINK: http://online.wsj.com/article/SB115927466992074204.html?mod=djem_jiewr_ac 
TOPICS: Accounting, Accounting Fraud, Auditing

SUMMARY: In a Houston federal court, Andrew Fastow received a sentence of 6 years in prison followed by two years of community service, "significantly less than the 10 years of imprisonment that had been envisioned in the 2004 plea agreement between Mr. Fastow and federal prosecutors....'I was very surprised,' said Leslie Caldwell, the original director of the special Justice Department task force that investigated the Enron scandal."

QUESTIONS:
1.) Of what criminal actions did Andrew Fastow plead guilty? What impact did these actions have on shareholders and employees (including both current employment and retirement plans)?

2.) Access the 175 page declaration by Andrew Fastow linked through the on-line version of this article. What two accounting standards are specifically referred to on the bottom of page 2 of the declaration (page 5 of the pdf file itself)? Provide their titles and a brief statement of the topics covered by these standards.

3.) Again refer to Fastow's declaration. What financial ratios were specific targets at Enron? How might transactions that would be subject to the requirements of Statements of Financial Accounting Standards 125 and 140, as well as assistance of investment bankers, contribute to meeting those operational targets?

4.) One Enron employee, Sherron Watkins, initially wrote to Chairman and Chief Executive Kenneth Lay in protest of the financing transactions and financial reporting she observed. How difficult do you think it was for her to take an ethical action in the Enron environment at the time? What personal and professional well being did she face losing by taking her stance in the matter?

Reviewed By: Judy Beckman, University of Rhode Island

Bob Jensen's Enron Updates are at http://www.trinity.edu/rjensen/FraudEnron.htm#EnronUpdates


 

Lynn Brewer versus Sherron Watkins Whistleblowers at Enron

October 14, 2007 message from dberesfo@uga.edu

Bob,

There was a terrific story in Friday's edition of USA that unmasks a phony whistle blower at Enron who has established an "ethics institute." Sorry I'm out of town and don't have the link but I'm sure you can find it easily. Cynthia Cooper, who was a real hero in uncovering the WorldCom fraud, is coming out with a book in early December that is a grat read.

Denny

October 15. 2007 reply from Bob Jensen

Thanks Denny.

Lynn Brewer was never enough of a player to even mention in my threads on the Enron scandal --- http://www.trinity.edu/rjensen/FraudEnron.htm

I’m glad Brewer and her book are being discredited --- http://www.trinity.edu/rjensen/FraudEnronBrewer.htm
Fortunately she was not a fourth woman on the cover of Time Magazine in 2002 (see below)
Here's what USA Today did to Lynn Brewer:
          Halloween Hangman (interactive video, hit the buttons)  --- http://www.dedge.com/flash/hangman/hangman.swf

I hope Lynn Brewer is added to Jude Werra's "Liars Index" (See Below for “Executives Making It by Faking It”)
But then again Lynn Brewer even lied about being an executive at Enron

 I’m sure you know that Sherron Watkins was an executive VP whistleblower at Enron who had more dirty words in her vocabulary than a rap star. The failure of Arthur Andersen’s top brass to act on her disclosures about Fastow’s SPE frauds became a huge embarrassment all the way to the top of Andersen.

"Time Names Whistle-Blowers as Persons of the Year 2002", Reuters, December 22, 2002 --- http://www.reuters.com/newsArticle.jhtml?type=topNews&storyID=1948721 

Time Magazine named a trio of women whistle-blowers as its Persons of the Year on Sunday, praising their roles in unearthing malfeasance that eroded public confidence in their institutions.

Two of the women, Sherron Watkins, a vice president at Enron Corp., and Cynthia Cooper of WorldCom Inc., uncovered massive accounting fraud at their respective companies, which both went bankrupt.

The third, Coleen Rowley, is an agent for the Federal Bureau of Investigation. In May, she wrote a scathing 13-page memo to FBI Director Robert Muller detailing how supervisors at a Minneapolis, Minnesota field office brushed aside her requests to investigate Zacarias Moussaoui, the so-called "20th hijacker" in the Sept. 11th attacks, weeks before the attacks occurred.

"It came down to did we want to recognize a phenomenon that helped correct some of the problems we've had over the last year and celebrate three ordinary people that did extraordinary things," said Time managing editor Jim Kelly.

Other people considered by the magazine, which hits stores on Monday, included President Bush, al Qaeda leader Osama bin Laden, Vice President Dick Cheney and New York attorney general Eliot Spitzer.

Bush was seen by some as the front-runner, especially after he led his party to a mid-term electoral upset in November that cemented the party's majority in Congress.

However, Kelly said "some of (Bush's) own goals: the capture of Osama bin Laden, the unseating of Saddam Hussein, the revival of a sluggish economy, haven't happened yet. There was a sense of bigger things to come, and it might be wise to see how things played out," he added.

Watkins, 43, is a former accountant best known for a blunt, prescient 7-page memo to Enron chairman Kenneth Lay in 2001 that uncovered questionable accounting and warned that the company could "implode in a wave of accounting scandals."

Her letter came to light during a post-mortem inquiry conducted by Congress after the company declared bankruptcy.

Cooper undertook a one-woman crusade inside telecommunications behemoth WorldCom, when she discovered that the company had disguised $3.8 billion in losses through improper accounting.

When the scandal came to light in June after the company declared bankruptcy, jittery investors laid siege to global stock markets.

FBI agent and lawyer Rowley's secret memo was leaked to the press in May. Weeks before Sept. 11, Rowley suspected Moussaoui might have ties to radical activities and bin Laden, and she asked supervisors for clearance to search his computer.

Her letter sharply criticized the agency's hidebound culture and its decision-makers, and gave rise to new inquiries over the intelligence-gathering failures of Sept. 11.

Bob Jensen's threads on the Enron and Worldcom scandals are at --- http://www.trinity.edu/rjensen/FraudEnron.htm 

Bob Jensen's threads on whistle blowing are at http://www.trinity.edu/rjensen/FraudConclusion.htm#WhistleBlowing


"Executives: Making It by Faking It:  Wisconsin headhunter Jude Werra's "Liars Index" of faked résumé claims hit a five-year high in the first half of 2007," Business Week, by Joseph Daniel McCool, Business Week, October 4, 2007 --- Click Here 

. . . Jude Werra. The president of Brookfield (Wis.)-based Jude M. Werra & Associates has spent the better part of 25 years documenting executive résumé fraud, credentials inflation, and the misrepresentation of executive educational credentials. It's something that has kept Werra pretty busy over the years, given the prevalence of such management-level chicanery and the fact that so many ambitious and transition-minded individuals have convinced themselves that it's their credentials—real or otherwise—that matter most.

Stopping at Nothing to Get to the Top Werra's semiannual barometer of executive résumé deception—his very own "Liars Index"—hit a five-year high, based on his review of résumés he received during the first half of 2007. He figures that about 16% of executive résumés contain false academic claims and/or material omissions relating to educational experience. That was up five percentage points from the levels he witnessed between July and December of last year.

And when you account for the fudging of claims of experience unrelated to academic degrees earned, it's easy to see why executive headhunters generally acknowledge that as many as one-third of management-level résumés contain errors, exaggerations, material omissions, and/or blatant falsehoods.

Some people will stop at almost nothing to get to where they want in their career. Still, Werra wonders why otherwise experienced executives would inflate their credentials or otherwise mislead with their résumé, in light of the potential career-ending consequences.

Checking References Isn't Enough Given the alarming levels to which they do attempt to mislead, he constantly reminds hiring organizations that it's critical that they verify what they read on résumés, even at the executive level. What's even more alarming—and more prevalent than people falsifying their backgrounds and qualifications—is the number of hiring organizations who fail to conduct a rigorous background check on their new management recruits. Far too many organizations figure that checking a few references is enough.

And even the most thorough reference checks won't uncover false claims that predate those references' own professional interactions with the individual executive. It's quite possible that a fabrication of one's education, certifications, and experience is what got the executive his first management job many years ago, leaving the trail cold unless it's reopened during the course of a diligent background check.

When it comes to executive-level hiring that's going to cost the organization into the high six figures, at minimum, when you factor in headhunting fees, the new executive's salary, and benefits, it becomes a matter of caveat emptor.

Let the Hiring Company Beware And while it may be tempting to believe that an executive recruiter will uncover any issues during the courtship process, it's ultimately up to the hiring organization to know exactly who it is that's being hired. Sure, misrepresentation will cost the unscrupulous executive, but it can also wreak havoc on a company's brand, workforce, and external relations teams.

Beyond the boundaries of checking claims made by an individual on his or her résumé, the hiring organization can trust that engaging the services of a professional background-screening consultant will pay off. These consultants often come with significant experience in law enforcement, and they can help uncover such things as criminal convictions, unpaid child support, and other hidden issues that should influence the hiring decision.

A thorough background check is an important insurance policy for the recruiting process, and headhunters will tell you that your organization risks getting burned if an executive it hires has, at any time in his or her past, decided to assume the risks of playing with fire.

Given the high cost of a bad executive hire, today's organizations simply can't afford not to do their homework.

 

 




 


11.
What was the main source of the idea that Enron (before it was named Enron) should extend into the energy trading line of business in addition to its gas transmission line of business?  Who did this person work for at the time (it wasn't Enron)?

Jeff Skilling, a brilliant Harvard MBA, had the seminal idea while he was employed at the famous management consulting firm called McKinsey & Company --- http://bodurtha.georgetown.edu/enron/jeff_skilling_enrons_missing_man.htm 

Kurt Eichenwald, Conspiracy of Fools (Broadway Books, 2005, pp. 40-42) --- http://www.bookreporter.com/reviews2/0767911784.asp 

Skilling reached a large, open area lined with empty offices.  His was the first on the right; a large conference table filled the room, piled high with stacks of paper--reports, memos, and other remnants of dozens of rejected strategies.  He sat, reaching for a pad of quadrille paper.  Something was tugging at the back of his mind--an idea, a thought, something Skilling had ruminated about for years.  Maybe if he wrote it down, it would become clearer.

Pulling a pen out of his shirt pocket, Skilling sketched an axis, then drew a declining curve.  He divided the curve into sections--at five years, ten years, twenty.  He tore off the sheet and scribbled calculations on the next page.  After about thirty minutes, he set down his pen and studied what he had written.

This is fucking brilliant.

Could it be this simple?  Here, on a couple of pages, was the answer to Enron's problems--hell, to the industry's problems.  Over the years, Skilling had often been electrified by his own ideas, but this one, this one was a gold mine.  It was so elegant.  It had to work.

Tearing the second sheet off the pad, Skilling scrambled out of the office in search of Rich Kinder, who was just moving up to the job of Enron's vice chairman.  As a consultant, Skilling couldn't just take an idea and run with it; somebody at Enron needed to give the green light.  He figured Kinder not only would understand his brainstorm but would have the guts to get it done.

On the other side of the building, Skilling rode a small executive elevator to fifty, then walked past the boardroom into Kinder's office.

"Rich..."

"Jeff.  What's up?"

Skilling laid his quadrille paper on a small conference table.  "Look at this."

Kinder strode over to the table and skimmed the page.  A bunch of numbers.  He shrugged. So?

"Let's say we go out and buy gas reserves," Skilling said.  "Give me a number, Rich.  How much is it going to cost to buy gas reserves?"

"I don't know, one dollar per mef."

A dollar for every thousand cubic feet of gas.  Just as Skilling had figured.  "Okay," Skilling said.  "So if we bought reserves at a dollar, we could take them and carve them up, send them to different term markets."

Kinder didn't know where this was going.

"Different contract terms," Skilling continued.  "Twenty years, ten years, five years, it doesn't matter.  And then we lock in their price with the contracts."

Skilling scribbled his graph again.  Kinder recognized it as a standard gas-production curve.  Gas wells are a lot like a shaken-up bottle of soda; when they are first tapped, built-up pressure pushes out fuel, but over time that force--and the volume of gas coming out--drop.  That was reflected in the curve Skilling sketched, showing declining production over many years.  But, he said, if Enron owned reserves with a production curve of two decades, it could calculate a fixed price for gas sales over periods of years.  The longer the term of contract--the further out on the production curve--the more expensive the price.  The market movement for gas prices wouldn't matter, since Enron would already have locked in its cost at one dollar.

Kinder understood the implications immediately.  With deregulation, the old world of fixed gas rates was gone, and prices were now dictated by the open market--meaning a cold snap, a shortage, anything could drive them up rapidly.  Suddenly industrial customers couldn't anticipate fuel costs, pipelines couldn't be sure they could guarantee delivery on a long-term contract, and producers were only as good as their last well.  The uncertainty was already driving industry toward dirtier fuels--coal, oil--with more reliable pricing.  This Skilling idea might change all that.  Enron could transform cleaner natural gas into a dependable choice, buying it at fixed, rock-bottom prices, selling it for more, and pocketing the difference.

It would be like a bank, Skilling said, but instead of taking in and sending out money, Enron would traffic in gas.  Producers would be depositors, gas customers would be borrowers, and Enron would be rich.  To attract the business, he said, Enron would need a marketing division, but from there everything should come together.

"Rich," Skilling said.  "What if I told you that I can construct a twenty-year contract, right now, at $2.20."

Kinder stood back.  "You're fucking kidding me."

"No, I'm not fucking kidding you."

It was one of those rare eureka moments.  Industrial customers were having enough trouble obtaining twenty-year contracts, and finding one at less than four dollars per thousand cubic feet was thought to be impossible.  A guaranteed fixed price from Enron of just over two dollars would bring every customer to the company's doorstep.

"If that's true," Kinder said, "then we will own the power-generation market in North America."

Skilling beamed.  "Yep," he said nodding.

Word of some gangbuster new McKinsey idea crackled though Enron, and soon everyone wanted to hear the details.  Within days, a group of about twenty Enron executives gathered in conference room 49C1 for their own briefing from Skilling.  Most were ready to give up much of their afternoon; typically, McKinsey reports ran on for as long as a hundred pages and took hours to review.

 


 

By now we all know how energy deregulation allowed Enron energy traders to conduct fraud, especially in the states of California and Washington. Below is a nice piece on how deregulation works and, sometimes, does not work.

Question
How did energy deregulation became a tangled mess?

"Short-Circuited," by Jerry Taylor and Peter Van Doren, The Wall Street Journal, August 30, 2007; Page A11 --- http://online.wsj.com/article/SB118843421064212958.html?apl=y 

After a pretty good 30-year run, deregulation is on the political ropes. Although loosening the shackles on banking, trucking and airlines delivered lower prices, robust competition and political applause, it hasn't worked for electricity. California and Virginia have already abandoned the project and other states are contemplating a similar retreat. For the first time in decades, Americans are inclined to think that regulation is the thin blue line between defenseless consumers and predatory capitalists.

So did free market reformers take deregulation too far? Yes and no.

Yes, because they promised rate reductions they had no business promising. No, because deregulation of some parts of the system was offset by more ambitious regulations elsewhere. The end result is even more economically artificial than the one we started with.

Many of the states that undertook utility restructuring in the late 1990s rolled back retail electricity prices and then froze them in place for years during the "transition" to retail competition. The headline-grabbing rate increases this year in Maryland (50% in Baltimore) and Illinois (24% in Chicago) occurred because the period of regulated prices ended -- while during the freeze period the prices of the fuels used for generation (coal and natural gas) increased significantly.

The states sticking to the old regulatory regime had no rate freezes, instead passing on higher fuel costs to consumers through gradual price increases. The average increase in rates in the regulated states from 1990 through 2006 (one cent per kWh) is not statistically different from the increase in deregulated states (1.6 cents per kWh).

Still, electricity rates increased under deregulation, while rates decreased in deregulated industries like airlines, banking and trucking. Why?

Under the old regulatory regime, electricity generators received their costs plus an allowed return on capital. If generators' costs differed, they received differing revenues. Prices were then established by a "weighted average" of all producer costs. Under deregulation, however, generators receive revenues based on the price charged by the most expensive generator whose output is necessary to meet demand in each hour.

While some may find such pricing to be odd, it is found in all commodity markets. Potatoes, for example, sell at the same price even though the cost of production varies across farmers. The supermarket does not price potatoes based on the "weighted average" of their acquisition costs, and producers do not sell at cost plus a modest mark-up. They sell at what the market will bear, and the market will bear the highest cost source of potatoes necessary to meet consumer demand.

Thus, in a regulatory regime, rising natural gas prices affect electricity prices only according to the percentage of electricity generated by natural gas (about 18.7% of supply nationwide in 2005). But in deregulated markets, all generators get revenues based on the price charged by the most expensive (often natural gas) plant in operation.

Does this mean that consumers are always worse off under market (marginal-cost) prices rather than regulated (weighted average) prices? Well, regulation certainly delivers lower prices than the market during shortages. But regulation delivers higher prices during times of relative abundance.

Few remember that the impetus for deregulation was the discrepancy between higher-priced "regulated" power (predominantly coal and nuclear) and lower-priced spot market power (predominantly from gas-fired power plants) when natural gas costs were low in the 1990s. The owners of coal and nuclear generation resisted market pricing because they believed (correctly at that time) that in a market-price regime they would not recover the capital costs of their much more capital-intensive generation.

Thus rate freezes in states "deregulating" electricity markets were not designed to protect consumers. They were meant to protect high-cost producers, and kept retail prices from falling, if the new markets were driven by marginal-cost pricing.

Still, markets appear to be worse than regulation because generators whose costs are lower than the most expensive players in the market will get "excess" revenues. But excess profits aren't forever. Once returns are predictably higher than normal, entry will occur to dissipate them.

Consider Texas. Unlike other deregulated states, utilities in Texas were allowed to pass fuel-cost increases on to consumers on a yearly basis during the transition to full deregulation. There was no provision, however, for passing through fuel-cost decreases. Post-Katrina, natural-gas prices pushed the cost of electricity to between 15 cents and 19 cents per kWh. But electricity prices did not adjust down when natural gas prices fell.

Those high prices, which result in large profits for coal-fired plants, induced TXU, the largest generator in Texas, to announce plans to build 11 more coal plants. Ironically, the much-praised plan by Kohlberg Kravis Roberts & Co. to take over TXU and build only three coal-fired power plants will keep power costs higher than otherwise. Environmentalists and plant owners win while ratepayers lose.

A final worry is that deregulation means sky-high prices during peak demand periods, typically hot summer afternoons. True. But they would be more than offset by lower off-peak prices. That's because in a regulatory regime ratepayers must still pay off, through higher rates, the capital costs of power plants sitting idle during off-peak demand periods. And there's a lot of idle generating capacity. MIT economist Paul Joskow, for example, reports that in New England during 2001, 45% of the generating capacity produced only 7% of the total electricity.

In sum, allowing markets to dictate electricity prices is a good thing for consumers, even if they are sometimes higher than under regulation. Unfortunately -- and here is the fly in the ointment -- price deregulation has been accompanied by rules encouraging the legal separation of generation from transmission and the purchase of wholesale power through organized spot markets.

This approach is based on the belief that, while the generating sector is potentially quite competitive, the electricity transmission business is not. Thus, the argument goes, deregulation, in order to work properly, must sever the vertical integration of electricity generation, transmission, and distribution under a single corporate umbrella.

While this seems reasonable, there are good reasons why vertical integration makes sense in the electric power business. Unfortunately, none of those reasons have been given much of a hearing.

First, vertical integration is an efficient response to the so-called "holdup" problem. Investors in generating plants worry that, because the assets are costly, dedicated and immobile, they can be "held up" by transmission line owners. Investors in transmission lines fear being held up by generators. Vertical integration ends the fight.

Second, transmission and generation are substitutes for one another -- and the right amount of investment in either is an economic, not an engineering, puzzle. Efficient investment in both may not be possible through decentralized arrangements (prices and contracts) between separately owned assets. In contrast, an organization that owns both generation and transmission assets is more likely to invest optimally in both.

Third and finally, vertical integration minimizes risk in the real-time operation of the system. The better coordinated are generation and transmission, the less chance there is of cascading blackouts and other problems. Coordination is far easier when there is one actor rather than hundreds.

These considerations largely explain why 10 of the 11 published studies on this issue conclude that vertical integration is the most efficient corporate organizational form for electricity providers. Unfortunately, the debate about utility restructuring has almost completely ignored those studies -- assuming rather that vertical integration serves no useful purpose other than facilitating the market power of incumbent electricity providers.

Interestingly enough, the deregulators are trying to create a world that would probably never arise in a totally free electricity market. In a world of deregulated vertically integrated firms, both producers and consumers would almost certainly resist spot market relationships. During gluts, firms would not recover the cost of capital; and during shortages, electricity consumers would be vulnerable to economic extortion, as competitive entry and rivalry can't happen overnight. Both firms and consumers would likely prefer long-term contracts, an arrangement that meets consumers' interest in price protection and firms' interest in cost recovery.

Accordingly, the equilibrium relationship between firms and consumers in a totally unregulated world might resemble that of the old regulatory regime, albeit an equilibrium achieved through contract. The only (unanswerable) question is how different the specifics of such hypothetical contracts would be from current regulatory practices.

True deregulation involves allowing market actors to run their businesses in whatever manner they like, price what the market will bear, and discover for themselves how best to deliver goods and services without government influencing those decisions with carrots and sticks. The faux deregulation we have in the electricity market unfortunately falls short on most of those counts. And that -- rather than the rate increases -- is the real problem.

Mr. Van Doren is editor of Regulation magazine, published by the Cato Institute, where Mr. Taylor is a senior fellow and director of natural resource studies.








 

12.
In the simplest of terms, what is a special purpose entity (SPE) and why is it allowed by the SEC to remain off the accounting books (the FASB mainly went along with the SEC rule on these entities)?  Discuss the pros and cons of allowing SPEs to be unconsolidated in the books of the primary investor.

In the simplest of terms a SPE is an entity that operates like its own separate fund or business apart from its main beneficiary like Enron that created it.  Unlike typical subsidiary corporations, SPEs do not have to be consolidated in the financial statements of the beneficiary. 

The SEC is the accounting standard setter that first allowed SPE accounting off the books.  The main reason is that this allows certain types of ventures that might not otherwise be entered into cases where the ventures make economic sense.  The key theoretical condition of an SPE is that the current liquidation value of its assets should exceed its debt.  The idea is that nobody gets hurt badly if the SPE is liquidated. 

A very confusing requirement was imposed that an outside investor (independent of the beneficiary) must put up at least 3% of the value of the SPE, thereby cushioning the blow if an SPE is liquidated somewhat below its debt obligations.  After the Enron fiasco, the FASB accounting standard setter raised this limit to 10% but did not go so far as to ban off-book SPE entities.  Entire industries were formed because the SEC allowed SPEs to keep debt off the books, especially the entire industry of synthetic leasing.  Harsher actions by the SEC or the FASB would destroy these entire industries.

The abuse of SPEs arises when the assets of the SPE are not genuine assets, not sufficiently liquid, and/or are overvalued relative to debt obligations.  Having volatile financial instruments and/or derivative financial instruments may be problematic as assets if they are subject to huge value fluctuations in the markets.  Andy Fastow violated the SPE rules by having Enron (in a complicated way) becoming its own sham "outside" investor and in having Enron's own common stock as the main asset of Enron's SPEs hedging its own stock value.

Enron's very complex, actually unfathomable, SPEs are summarized at http://news.findlaw.com/hdocs/docs/enron/sicreport/chapter1.pdf

You can read more about the technical aspects of SPEs at http://www.trinity.edu/rjensen/theory/00overview/speOverview.htm








 


13.
What was the first SPE formed by Enron that was approved by the Board of Directors?  What did Andy Fastow promise the Board, a promise that he violated in the worst of possible terms?  Who gave Andy the idea of using SPE's to dress up Enron's financial statements?

Enron mistakenly allowed Andy Fastow to form a SPE called LJM with an obvious conflict of interest since Fastow then had the dual role of representing the LJM Partnership in negotiations with Enron itself.  It was a role that he badly abused using insider information.

You can read details of LJM and its offspring at http://news.findlaw.com/hdocs/docs/enron/sicreport/chapter3.pdf

Andy Fastow didn't know the first thing about SPEs to begin with or what their advantage might be for dressing up financial statements.  He'd only had one accounting course in his life and knew almost nothing about accounting.   Apparently David Duncan instigated these ideas in Fastow's head.

From Eichenwald's Conspiracy of Fools, Page143
(Note that " Lea" is Andy Fastow's wife who inherited a fortune before she met Andy):

The idea was so delicious, so simple it was breathtaking.  Somebody was going to make money on the wind farms; why shouldn't it be Andy Fastow and his family?

The deal Fastow and Kopper were cobbling together was a structured transaction, where outside investors provide three percent of the deal's capital.  A company could provide 97 percent of the capital to an off-books partnership, find 3 percent somewhere else, stir in some legal legerdemain, and--poof!--an "independent" buyer was created.  The company could then legally "sell" an asset to the partnership--even if most of the payment originated from its own pockets.  The round-trip of cash complete, the company had converted an asset on its balance sheet into revenue.  When Andersen accountants first laid out the rules, Fastow had ridiculed them, saying the three percent could come from anybody--even his gardener or his family.  Now he was ready to put that thought into action.

With Kopper's help, he constructed an entity called Alpine Investors to make the purchase.  It would cost about $17 million, far more money than Fastow had in his bank account.  But with the magic of structured finance, he didn't have to worry about that.  Almost $16.5 million would come in a loan to Alpine from Enron.  Then Fastow--along with his wife's wealthy family, the Weingartens, and friends like Patty Melcher, a wealthy Houstonian close to Lea--would kick in $510,000.  Fastow would run the partnership, with Enron's friends as investors.

Fastow sang the praises of the deal to Kopper.  "Enron keeps control, without the burdens of legal ownership," he said.  "It's perfect."









 


14.
The first SPE was set up to hedge Enron's investment appreciation in Rhythms NetConnection.  A contractual obligation prevented sale of the investment at a time when its high value was volatile.  Andy Fastow proposed an SPE designed to hedge against a fall in the value of the Rhythms investment.  What type of derivative financial instrument was proposed to carry out this hedge?  Explain how the hedge would've worked optimally.

Enron had in investment in Rhythms NetConnection IPO that had appreciated in value from $28 million to around $400 million, an enormous gain that Ken Lay wanted to both capture and report in current earnings.  The problem was that Enron had to wait another six months due to a sales restriction on its IPO shares.  Much of the gain might be lost in six months.  So a hedge was set up in the first LJM SPE. 

Newly-promoted CFO Andy Fastow used a long put option to hedge Enron's profit in the IPO.  One problem, however, is that the market value of long put options may vary significantly from the value of its underlying (in this case the daily value of common shares of Rhythms and Enron shares).  This is the first time Fastow, in clear violation of his fiduciary responsibility, used Enron's share values to hedge Enron's asset value.

Other "arms-length" problems are discussed in greater detail at http://news.findlaw.com/hdocs/docs/enron/sicreport/chapter4.pdf






 


15. What is most unusual and actually unethical about the way Enron's SPEs were managed?  How were these related party dealings disclosed and yet obscured in the infamous Footnote 16 of Enron's Year 2000 Annual Report?

What did Professors Hartgraves and Benston conclude with respect to accounting fraud and failings of both Enron and the external auditors (Andersen) after a detailed analysis of the Powers Report commissioned by the former Chairman of the Board of Directors at Enron?

Answers

While representing Enron in the dealings of the SPE partnerships, Andy Fastow was investing his own (and his wife's) money along with money from partner banks in dealings where he could take advantage of insider information at Enron and essentially steal from Enron for the benefit of himself and his SPE partners. 

What is really sad is the way Andy managed to obscure is related party dealings in a terribly sad and infamous Footnote 16 in Enron's Year 2000 Annual Report --- http://www.trinity.edu/rjensen/FraudEnron.htm#Senator

For details of Enron's infamous Footnote 16 go to http://www.trinity.edu/rjensen/FraudEnron.htm#Senator

Also see how Enron kept its LJM secret with Facade Theatre, until the "Rhythm" created its own tempo and chaos took over --- http://cbae.nmsu.edu/~dboje/enron/rhythms.htm

Much of the information about conflicts of interest are detailed in the Powers Report commissioned by the former Chairman of the Board of Directors of Enron.

"Web of Details Did Enron In as Warnings Went Unheeded," by Kurt Eichenwald and Diana Henriques," The New York Times, February 10, 2002
The article by Eichenwald and Henriques is the best summary of the 200+ page Powers report that I have seen to date

 

"Enron Trial to Start Its Final Chapter:  Defense and Prosecution Rest Without Calling New Experts; Closing to Start Next Week," by Gary McWilliams, The Wall Street Journal, May 9, 2006; Page C5 --- http://online.wsj.com/article/SB114709862484846620.html?mod=todays_us_money_and_investing

With 52 days of sometimes teary, sometimes bitter testimonies completed, the conspiracy-and-fraud trial of two former top Enron Corp. executives is set to move into its final phase next week.

Yesterday, the defense and prosecution unexpectedly rested without calling further experts, paving the way for closing arguments to begin Monday. The eight-woman, four-man jury thereafter will consider six counts against former Enron Chairman Kenneth Lay and 28 counts against former President Jeffrey Skilling.

The prosecution has sought to paint the two men as using guile and bluff to improperly pad profits and deceive investors on the state of key Enron operations from 1999 through the company's collapse in 2001. The two men insist that they did nothing wrong, blaming a market panic for toppling the onetime energy giant.

U.S. District Judge Sim Lake again yesterday denied defense motions for acquittal and for immunity for former Enron executives who have refused to testify without it. The latter motion asked the judge to bar the prosecution from arguing that Mr. Skilling's version of events was contradicted by numerous government witnesses.

Allowing the prosecution's closing argument to cite the government witnesses, "would increase the unfair prejudice" that resulted from the government's refusal to offer immunity, according to Mr. Skilling's attorneys. The motion seemed designed to buttress any appeal.

The defense rested after hearing from two final defense witnesses, including a former Enron manager who contracted with a small Internet company that Messrs. Lay and Skilling had invested in personally. The prosecution had used the pair's investments in PhotoFete.com Inc. to attack their credibility, arguing they failed to comply with Enron's code of conduct.

Margaret Nadasky, a former Enron branding manager, testified she hired PhotoFete.com without knowledge of the investments. She testified that although Mr. Lay's office in September 2001 asked her to explain why she was then ending the PhotoFete.com contract, she never heard any further from Mr. Lay or his office.

The prosecution's last witness was an employee with former Enron-owned utility Portland General Electric Co. who testified that she was stunned when Enron in the fall of 2001 reported a $1 billion charge to earnings and a $1.2 billion reduction in stockholder equity. Patti Klein said the report seemed to contradict Mr. Lay's assurances that Enron would hit its earnings targets for the quarter. Enron bought the utility in 1997 and spun it off to creditors last month.

She said the disclosure wasn't what she expected from his public comments. "He promised us he would be forthcoming with information and very transparent," said Ms. Klein. Under questioning by the defense, she conceded she wasn't aware of what information Mr. Lay was receiving. Mr. Lay has maintained he was repeating information given to him by advisers and subordinates.

Meanwhile, Mr. Lay's lead defense attorney appeared in the courtroom for the first time since late March, when he underwent the first of two surgeries to clear arterial blockages. Attorney Michael Ramsey said he expects to share closing arguments with others on the defense team next week.

 

Benston & Hartgraves versus Rush & Arnold

In the testimony below, defense witnesses for Skilling and Lay (Walter Rush and Jerry Arnold) "attribute Enron's descent into bankruptcy proceedings to a combination of bad publicity and lost market confidence" rather than accounting fraud. This places the Professor Arnold's opinion in conflict with that of Professors Hartgraves and Benston earlier analyses based upon the lengthy Powers Report commissioned by the former Chairman of the Board of Enron.

The 208 Page February 2, 2002 Special Investigative Committee of the Board of Directors (Powers) Report--- http://news.findlaw.com/hdocs/docs/enron/sicreport/ 
Alternative 2:  http://nytimes.com/images/2002/02/03/business/03powers.pdf 
Alternative 3:  http://i.cnn.net/cnn/2002/LAW/02/02/enron.report/powers.report.pdf 
Alternative 4:  Part One | Part Two
| Part Three | Part Four

Hartgraves and Benston arrive at more negative conclusions than Jerry Arnold who was paid $1 million by the defense team to express an opinion below: "Accountants: Enron Financials Correct."

In any event, Andersen does not appear to have applied the GAAP requirement to recognize asset impairment (FAS 121). From our reading of the Powers Report, the put-options written by the SPEs that, presumably, offset Enron's losses on its merchant investment, were not collectible, because the SPEs did not have sufficient net assets.
"ENRON: what happened and what we can learn from it," by George J. Benston and Al L. Hartgraves, Journal of Accounting and Public Policy, 2002, pp. 125-137:

3.3 Independent public accountants (CPAs)

The highly respected firm of Arthur Andersen audited and unqualifiedly signed Enron's financial statements since 1985.  According to the Powers Report, Andersen was consulted on and participated with Fastow in setting up the SPEs described above.  Together, they crafted the SPEs to conform to the letter of the GAAP requirement that the ownership of outside, presumably independent, investors must be at least 3% of the SPE assets.  At this time, it is very difficult to understand why they determined that Fastow was an independent investor.  Kopper's independence also is questionable, because he worked for Fastow.  In any event, Andersen appears, at best, to have accepted as sufficient Enron's conformance with the minimum specified requirements of codified GAAP.  They do not appear to have realized or been concerned that the substance of GAAP was violated, particularly with respect to the independence of the SPEs that permitted their activities to be excluded from Enron's financial statements and the recording of mark-to-market-based gains on assets and sales that could not be supported with trustworthy numbers (because these did not exist).  They either did not examine or were not concerned that the put obligations from the SPEs that presumably offset declines in Enron's investments (e.g., Rhythms) were of no or little economic value.  Nor did they require Enron to record as a liability or reveal as a contingent liability its guarantees made by or though SPEs. Andersen also violated the letter of GAAP and GAAS by allowing Enron to record issuance of its stock for other than cash as an increase in equity.  Andersen also did not have Enron adequately report, as required, related-party dealings with Fastow, an executive officer of Enron, and the consequences to stockholders of his conflict of interest.

4.1 GAAP

We believe that two important shortcomings have been revealed.  First, the US model of specifying rules that must be followed appears to have allowed or required Andersen to accept procedures that accord with the letter of the rules, even though they violate the basic objectives of GAAP accounting.  Whereas most of the SPEs in question appeared to have the minimum-required 3% of assets of independent ownership, the evidence outlined above indicates that Enron in fact bore most of the risk.  In several important situations, Enron very quickly transferred funds in the form of fees that permitted the 3% independent owners to retrieve their investments, and Enron guaranteed the SPEs liabilities.  Second, the fair-value requirement for financial instruments adopted by the FASB permitted Enron to increase its reported assets and net income and thereby, to hide losses.  Andersen appears to have accepted these valuations (which, rather quickly, proved to be substantially incorrect), because Enron was following the specific GAAP rules.

Andersen, though, appears to have violated some important GAAP and GAAS requirements.  There is no doubt that Andersen knew that the SPEs were managed by a senior officer of Enron, Fastow, and that he profited from his management and partial ownership of the SPEs he structured.  On that basis alone, it seems that Andersen should have required Enron to consolidate the Fastow SPEs with its financial statements and eliminate the financial transactions between those entities and Enron.  Furthermore, it seems that the SPEs established by Fastow were unlikely to be able to fulfill the role of closing put options written to offset losses in Enron's merchant investments.  If this were the purpose, the options should and would have been purchased from an existing institution that could meet its obligations.

Andersen also seems to have allowed Enron to violate the requirement specified in FASB Statement 5 that guarantees of indebtedness and other loss contingencies that in substance have the same characteristics, should be disclosed even if the possibility of loss is remote.  The disclosure shall include the nature and the amount of the guarantee.  Even if Andersen were correct in following the letter, if not the spirit of GAAP in allowing Enron to not consolidate those SPEs in which independent parties held equity equal to at least 3% of assets, Enron's contingent liabilities resulting from its loan guarantees should have been disclosed and described.

In any event, Andersen does not appear to have applied the GAAP requirement to recognize asset impairment (FAS 121).  From our reading of the Powers Report, the put-options written by the SPEs that, presumably, offset Enron's losses on its merchant investment, were not collectible, because the SPEs did not have sufficient net assets.  (Details on the SPEs' financial situations should have been available to Andersen.)  GAAP (FAS 5) also requires a liability to be recorded when it is probable that an obligation has been incurred and the amount of the related loss can reasonable be estimated.  The information presently available indicates that Enron's guarantees on the SPEs and Kopper's debt had become liabilities to Enron.  It does not appear that they were reported as such.

GAAP (FAS 57) specifies that relationships with related parties "cannot be presumed to be carried out on an arm's-length basis, as the requisite conditions be competitive, free-market dealings may not exist".  As Executive Vice President and CFO, Fastow clearly was a "related party".  SEC Regulation S-K (Reg. §229.404. Item 404) requires disclosure of details of transactions with management, including the amount and remuneration of the managers from the transactions.  Andersen does not appear to have required Enron to meet this obligation.  Perhaps more importantly, Andersen did not reveal the extent to which Fastow profited at the expense of Enron's shareholders, who could only have obtained this information if Andersen had insisted on its inclusion in Enron's financial statements.

4.2 GAAS

SAS 85 warns auditors not to rely on management representations about onset values, liabilities, and related-party transactions, among other important items.  Appendix B to SAS 85 illustrates the information that should be obtained by the auditor to review how management determined the fair values of significant assets that do not have readily determined market values.  We do not have access to Andersen's working papers to examine whether or not they followed this GAAS requirement.  In the light of the Wall Street Journal report presented above of Enron's recording a fair value for the Braveheart project with Blockbuster Inc., though, we find it difficult to believe that Andersen followed the spirit and possibly not even the letter of this GAAS requirement.

SAS 45 and AICPA, Professional Standards, vol. 1, AU sec. 334 specify audit requirements and disclosures for transactions with related parties.  As indicated above, this requirement does not appear to have been followed.

An additional lesson that should be derived from the Enron debacle is that auditors should be aware of the ability of opportunistic managers to use financial engineering methods, to get around the requirements of GAAP.  For example, derivatives used as hedges can be structured to have gains on one side recorded at market or fair values while offsetting losses are not recorded, because they do not qualify for restatement to fair-value.  Another example is a loan disguised as a sale of a corporation's stock with guaranteed repurchase from the buyer at a higher price.  If this subterfuge were not discovered, liabilities and interest expense would be understated.  Thus, as auditors have learned to become familiar with computer systems, they must become aware of the means by which modern finance techniques can be used to subvert GAAP.


The above findings from the Powers Report appear to be inconsistent with the testimony of four years later. Here’s a summary just released by SmartPros. I hate the title "Accountants: Enron Financials Correct" and the inferences made that Enron’s accounting was above board. There was accounting fraud at Enron and auditing fraud at Andersen. Both the Chief Accounting Officer (Causey) and the Chief Financial Officer (Fastow) have confessed to accounting fraud and are now serving time in prison. To imply that Enron’s financial statements were “correct” is very deceiving.

"Accountants: Enron Financials Correct ," by Michael Graczyk (Associated Press Writer), SmartPros, May 4, 2006 --- http://accounting.smartpros.com/x52873.xml 

May 4, 2006 (Associated Press) — Last-minute changes to quarterly earnings reports prosecutors contend were ordered by Enron Corp. Chief Executive Jeffrey Skilling to improve the company's reputation on Wall Street were accurate, and not the result of improper tapping of company reserves, a defense expert testified Wednesday.

"The whole process of financial reporting, in a company as large as Enron, to get financial statements out ... is an enormous undertaking," said Walter Rush, an accounting expert hired by Skilling. "And people are scrambling, trying to get these estimates put together.

"There are changes going on up to the very last second. It is universal. Every company goes through this."

Rush was the second consecutive accounting expert to take the stand, following University of Southern California professor Jerry Arnold, who testified for Enron founder and former CEO Kenneth Lay.

They are among the last defense witnesses, as lawyers for the two top chiefs at Enron expect to conclude their case early next week, the 15th week of their federal fraud trial.

Mark Koenig, former head of investor relations at Enron, testified early in the trial that he believed top Enron executives were so bent on meeting or beating earnings expectations to keep analysts bullish on the company's stock that they made or knew of overnight changes to estimates. Paula Rieker, Koenig's former top lieutenant, said Koenig told her Skilling ordered abrupt last-minute changes to two quarterly earnings reports to please analysts and investors.

"They could have just had a bad number," Rush said, referring to Koenig's and Rieker's testimony about a late-night change in a fourth-quarter 1999 report that boosted earnings per share from 30 cents to 31 cents.

Arthur Andersen, Enron's outside accounting firm, already had the 31-cent number days earlier, Rush said.

"They could have been a couple steps behind the way the process was evolving," he said of Koenig and Rieker.

In addition, Rush said the intention to "beat the street," a phrase attributed to Skilling, was typical in business.

"Companies set goals and forecasts for themselves all the time," Rush said.

Prosecutors also contend Enron achieved its rosy earnings by drawing improperly from reserves. But Rush, responding specifically to second-quarter earnings in 2000, said a transfer from one reserve was not material since Enron had another, underreported reserve.

"That number had the effect of understating Enron's profits," he said.

He also disputed government contentions Enron executives improperly moved parts of the company's retail operation into its highly profitable wholesale business unit to hide financial problems under the guise of an accounting process called "resegmentation."

"I do believe it was properly disclosed and properly accounted for," Rush said, adding that he believed Enron went beyond the rules in disclosing particulars about the resegmentation.

"The rules only require we tell we have made a resegmentation. You just merely need to alert the reader there has been a change."

Earlier Wednesday, Arnold repeated his sentiment that Lay did not mislead investors about the company's financial health in the weeks before it filed for bankruptcy protection in December 2001.

Arnold said third-quarter 2001 financial statements cited by Lay in discussions with investors complied with Securities and Exchange Commission rules.

"That is my view," he said, answering repeated questions about the quarter when Enron reported $638 million in losses and a $1.2 billion reduction in shareholder equity.

The government contends Lay knew many Enron assets were overvalued and that losses were coming and misrepresented this to the public.

Several former high-ranking Enron executives have testified Lay misled investors when he said the losses were one-time events.

"I disagree with their interpretation," Arnold said, who noted his company had been paid $1 million for his work on the Enron defense.

Only 10 minutes into his testimony Wednesday, U.S. District Judge Sim Lake grew impatient when Arnold and prosecutor Andrew Stolter repeatedly went round and round on the same question.

"I'm not going to have sparring over minor, uncontroverted issues," a clearly irritated Lake barked.

Skilling, who testified earlier, and Lay, who wrapped up six days on the witness stand Tuesday, are accused of repeatedly lying to investors and employees about Enron when prosecutors say they knew the company's success stemmed from accounting tricks.

Skilling faces 28 counts of fraud, conspiracy, insider trading and lying to auditors, while Lay faces six counts of fraud and conspiracy.

The two men counter no fraud occurred at Enron other than that committed by a few executives, like Fastow, who stole money through secret side deals. They attribute Enron's descent into bankruptcy proceedings to a combination of bad publicity and lost market confidence.


Here's a summary of what USC Professor Jerry Arnold said on the stand

"Accountant Says Enron's Moves Were Routine," The New York Times, May 4, 2006 --- http://www.nytimes.com/2006/05/04/business/businessspecial3/04enron.html

Defense lawyers in the Enron trial called on two accounting specialists on Wednesday to refute prosecution claims that the company had falsified its books.

One accounting specialist told jurors yesterday that last-minute changes to quarterly earnings reports were routine at many companies, and were not an indication of accounting fraud.

Prosecutors had contended that the chief executive of Enron, Jeffrey K. Skilling, had ordered the changes to enhance the company's standing on Wall Street, but Walter Rush, an accounting expert hired by Mr. Skilling's defense team, said that changes "going on up to the very last second" were commonplace.

"It is universal," Mr. Rush said. "Every company goes through this."

Mr. Rush was the second accounting expert to take the stand, following Prof. Jerry Arnold of the University of Southern California, who testified for the Enron founder and former chief executive, Kenneth L. Lay, in the 14th week of their fraud trial.

The judge overseeing the trial, Judge Simeon T. Lake III of Federal District Court, said late Wednesday he wanted testimony and rebuttal witnesses finished no later than the end of next week, and he tentatively set the reading of his charge to the jury and the start of closing arguments for May 15.

With the trial in the home stretch, Mr. Lay's lead lawyer, Michael W. Ramsey, was returned to a hospital on Tuesday. Mr. Ramsey, 66, underwent a two-hour medical procedure six weeks ago to clear an artery with a stent and was recovering, but felt worse this week. He was absent during Mr. Lay's testimony earlier this week and last week.

The accounting specialists were called to refute the testimony of Mark Koenig, former head of investor relations at Enron, and others. Mr. Koenig testified that he believed that Enron executives were so bent on meeting or beating earnings expectations to keep analysts bullish that they made or knew of overnight changes to estimates.

Paula Rieker, Mr. Koenig's former top lieutenant, said Mr. Koenig told her Mr. Skilling ordered abrupt last-minute changes to two quarterly earnings reports to please analysts and investors.

Mr. Rush also disputed government contentions that Enron executives improperly moved parts of the company's retail operation into its highly profitable wholesale business unit in 2001 to hide financial problems under the guise of an accounting process called resegmentation.

Earlier Wednesday, Professor Arnold repeated his belief that Mr. Lay did not mislead investors about the company's financial health in the weeks before it filed for bankruptcy protection in December 2001.

Mr. Arnold said third-quarter 2001 financial statements cited by Mr. Lay in discussions with investors complied with Securities and Exchange Commission rules.

The government contends that Mr. Lay knew that many Enron assets were overvalued and that losses were coming and that he misrepresented this to the public.

Several former high-ranking Enron executives have testified that Mr. Lay misled investors when he said the losses were one-time events.

"I disagree with their interpretation," Mr. Arnold said.

Jensen Comment
What seems to be lost in this trial is the Powers Report commissioned by the Chairman of Enron's Board

"Web of Details Did Enron In as Warnings Went Unheeded," by Kurt Eichenwald and Diana Henriques," The New York Times, February 10, 2002
The article by Eichenwald and Henriques is the best summary of the 200+ page Powers report that I have seen to date

 

The 208 Page February 2, 2002 Special Investigative Committee of the Board of Directors (Powers) Report--- http://news.findlaw.com/hdocs/docs/enron/sicreport/ 
Alternative 2:  http://nytimes.com/images/2002/02/03/business/03powers.pdf 
Alternative 3:  http://i.cnn.net/cnn/2002/LAW/02/02/enron.report/powers.report.pdf 
Alternative 4:  Part One | Part Two
| Part Three | Part Four
 

Two Papers by Benston and Hartgraves

"The Evolving Accounting Standards for Special Purpose Entities and Consolidations," by Al L. Hartgraves and George J. Benston, Accounting Horizons, September 2002, pp. 245-258.

"ENRON: what happened and what we can learn from it," by George J. Benston and Al L. Hartgraves, Journal of Accounting and Public Policy, 2002, pp. 125-137 



 




 


16.
Frank Partnoy presented the best testimony before the U.S. Senate about Enron's misuse of derivative financial instruments after Enron imploded and was being investigated.  Summarize Partnoy's major conclusions about these hedging activities and their accounting.
 


Testimony of Frank Partnoy Professor of Law, University of San Diego School of Law Hearings before the United States Senate
Committee on Governmental Affairs, January 24, 2002 --- http://www.senate.gov/~gov_affairs/012402partnoy.htm 
 

TESTIMONY   

 
   

Testimony of Frank Partnoy
Professor of Law, University of San Diego School of Law
Hearings before the United States Senate
Committee on Governmental Affairs, January 24, 2002

I am submitting testimony in response to this Committee’s request that I address potential problems associated with the unregulated status of derivatives used by Enron Corporation.

I.                Introduction and Overview

I am a law professor at the University of San Diego School of Law.  I teach and research in the areas of financial market regulation, derivatives, and structured finance.  During the mid-1990s, I worked on Wall Street structuring and selling financial instruments and investment vehicles similar to those used by Enron.  As a lawyer, I have represented clients with problems similar to Enron’s, but on a much smaller scale.  I have never received any payment from Enron or from any Enron officer or employee.

Enron has been compared to Long-Term Capital Management, the Greenwich, Connecticut, hedge fund that lost $4.6 billion on more than $1 trillion of derivatives and was rescued in September 1998 in a private bailout engineered by the New York Federal Reserve.  For the past several weeks, I have conducted my own investigation into Enron, and I believe the comparison is inapt.  Yes, there are similarities in both firms’ use and abuse of financial derivatives.  But the scope of Enron’s problems and their effects on its investors and employees are far more sweeping.

According to Enron’s most recent annual report, the firm made more money trading derivatives in the year 2000 alone than Long-Term Capital Management made in its entire history.  Long-Term Capital Management generated losses of a few billion dollars; by contrast, Enron not only wiped out $70 billion of shareholder value, but also defaulted on tens of billions of dollars of debts.  Long-Term Capital Management employed only 200 people worldwide, many of whom simply started a new hedge fund after the bailout, while Enron employed 20,000 people, more than 4,000 of whom have been fired, and many more of whom lost their life savings as Enron’s stock plummeted last fall.

In short, Enron makes Long-Term Capital Management look like a lemonade stand.
It will surprise many investors to learn that Enron was, at its core, a derivatives trading firm.  Nothing made this more clear than the layout of Enron’s extravagant new building – still not completed today, but mostly occupied – where the top executives’ offices on the seventh floor were designed to overlook the crown jewel of Enron’s empire: a cavernous derivatives trading pit on the sixth floor.

I believe there are two answers to the question of why Enron collapsed, and both involve derivatives.  One relates to the use of derivatives “outside” Enron, in transactions with some now-infamous special purpose entities.  The other – which has not been publicized at all – relates to the use of derivatives “inside” Enron.
Derivatives are complex financial instruments whose value is based on one or more underlying variables, such as the price of a stock or the cost of natural gas.  Derivatives can be traded in two ways: on regulated exchanges or in unregulated over-the-counter (OTC) markets.  My testimony – and Enron’s activities – involve the OTC derivatives markets.

Sometimes OTC derivatives can seem too esoteric to be relevant to average investors.  Even the well-publicized OTC derivatives fiascos of a few years ago – Procter & Gamble or Orange County, for example – seem ages away.
But the OTC derivatives markets are too important to ignore, and are critical to understanding Enron.  The size of derivatives markets typically is measured in terms of the notional values of contracts.  Recent estimates of the size of the exchange-traded derivatives market, which includes all contracts traded on the major options and futures exchanges, are in the range of $13 to $14 trillion in notional amount.  By contrast, the estimated notional amount of outstanding OTC derivatives as of year-end 2000 was $95.2 trillion.  And that estimate most likely is an understatement.

In other words, OTC derivatives markets, which for the most part did not exist twenty (or, in some cases, even ten) years ago, now comprise about 90 percent of the aggregate derivatives market, with trillions of dollars at risk every day.  By those measures, OTC derivatives markets are bigger than the markets for U.S. stocks. 
Enron may have been just an energy company when it was created in 1985, but by the end it had become a full-blown OTC derivatives trading firm.  Its OTC derivatives-related assets and liabilities increased more than five-fold during 2000 alone.

                And, let me repeat, the OTC derivatives markets are largely unregulated.  Enron’s trading operations were not regulated, or even recently audited, by U.S. securities regulators, and the OTC derivatives it traded are not deemed securities.  OTC derivatives trading is beyond the purview of organized, regulated exchanges.  Thus, Enron – like many firms that trade OTC derivatives – fell into a regulatory black hole.

                After 360 customers lost $11.4 billion on derivatives during the decade ending in March 1997, the Commodity Futures Trading Commission began considering whether to regulate OTC derivatives.  But its proposals were rejected, and in December 2000 Congress made the deregulated status of derivatives clear when it passed the Commodity Futures Modernization Act.  As a result, the OTC derivatives markets have become a ticking time bomb, which Congress thus far has chosen not to defuse. 

                Many parties are to blame for Enron’s collapse.  But as this Committee and others take a hard look at Enron and its officers, directors, accountants, lawyers, bankers, and analysts, Congress also should take a hard look at the current state of OTC derivatives regulation.  (In the remainder of this testimony, when I refer generally to “derivatives,” I am referring to these OTC derivatives markets.)

II.                Derivatives “Outside” Enron

The first answer to the question of why Enron collapsed relates to derivatives deals between Enron and several of its 3,000-plus off-balance sheet subsidiaries and partnerships.  The names of these byzantine financial entities – such as JEDI, Raptor, and LJM – have been widely reported. 

Such special purpose entities might seem odd to someone who has not seen them used before, but they actually are very common in modern financial markets.  Structured finance is a significant part of the U.S. economy, and special purpose entities are involved in most investors’ lives, even if they do not realize it.  For example, most credit card and mortgage payments flow through special purpose entities, and financial services firms typically use such entities as well.  Some special purpose entities generate great economic benefits; others – as I will describe below – are used to manipulate company’s financial reports to inflate assets, to understate liabilities, to create false profits, and to hide losses.  In this way, special purpose entities are a lot like fire: they can be used for good or ill.  Special purpose entities, like derivatives, are unregulated.

The key problem at Enron involved the confluence of derivatives and special purpose entities.  Enron entered into derivatives transactions with these entities to shield volatile assets from quarterly financial reporting and to inflate artificially the value of certain Enron assets.  These derivatives included price swap derivatives (described below), as well as call and put options.

                Specifically, Enron used derivatives and special purpose vehicles to manipulate its financial statements in three ways.  First, it hid speculator losses it suffered on technology stocks.  Second, it hid huge debts incurred to finance unprofitable new businesses, including retail energy services for new customers.  Third, it inflated the value of other troubled businesses, including its new ventures in fiber-optic bandwidth.  Although Enron was founded as an energy company, many of these derivatives transactions did not involve energy at all.

                A.                Using Derivatives to Hide Losses on Technology Stocks
                First, Enron hid hundreds of millions of dollars of losses on its speculative investments in various technology-oriented firms, such as Rhythms Net Connections, Inc., a start-up telecommunications company.  A subsidiary of Enron (along with other investors such as Microsoft and Stanford University) invested a relatively small amount of venture capital, on the order of $10 million, in Rhythms Net Connections.  Enron also invested in other technology companies.

                Rhythms Net Connections issued stock to the public in an initial public offering on April 6, 1999, during the heyday of the Internet boom, at a price of about $70 per share.  Enron’s stake was suddenly worth hundreds of millions of dollars.  Enron’s other venture capital investments in technology companies also rocketed at first, alongside the widespread run-up in the value of dot.com stocks.  As is typical in IPOs, Enron was prohibited from selling its stock for six months.

                Next, Enron entered into a series of transactions with a special purpose entity –apparently a limited partnership called Raptor (actually there were several Raptor entities of which the Rhythms New Connections Raptor was just one), which was owned by a another Enron special purpose entity, called LJM1 – in which Enron essentially exchanged its shares in these technology companies for a loan, ultimately, from Raptor.  Raptor then issued its own securities to investors and held the cash proceeds from those investors.

                The critical piece of this puzzle, the element that made it all work, was a derivatives transaction – called a “price swap derivative” – between Enron and Raptor.  In this price swap, Enron committed to give stock to Raptor if Raptor’s assets declined in value.  The more Raptor’s assets declined, the more of its own stock Enron was required to post.  Because Enron had committed to maintain Raptor’s value at $1.2 billion, if Enron’s stock declined in value, Enron would need to give Raptor even more stock.  This derivatives transaction carried the risk of diluting the ownership of Enron’s shareholders if either Enron’s stock or the technology stocks Raptor held declined in price.  Enron also apparently entered into options transactions with Raptor and/or LJM1.

                Because the securities Raptor issued were backed by Enron’s promise to deliver more shares, investors in Raptor essentially were buying Enron’s debt, not the stock of a start-up telecommunications company.  In fact, the performance of Rhythms Net Connections was irrelevant to these investors in Raptor.  Enron got the best of both worlds in accounting terms: it recognized its gain on the technology stocks by recognizing the value of the Raptor loan right away, and it avoided recognizing on an interim basis any future losses on the technology stocks, were such losses to occur.

                It is painfully obvious how this story ends: the dot.com bubble burst and by 2001 shares of Rhythms Net Communications were worthless.  Enron had to deliver more shares to “make whole” the investors in Raptor and other similar deals.  In all, Enron had derivative instruments on 54.8 million shares of Enron common stock at an average price of $67.92 per share, or $3.7 billion in all.  In other words, at the start of these deals, Enron’s obligation amounted to seven percent of all of its outstanding shares.  As Enron’s share price declined, that obligation increased and Enron’s shareholders were substantially diluted.  And here is the key point: even as Raptor’s assets and Enron’s shares declined in value, Enron did not reflect those declines in its quarterly financial statements.

                B.                Using Derivatives to Hide Debts Incurred by Unprofitable Businesses
                A second example involved Enron using derivatives with two special purpose entities to hide huge debts incurred to finance unprofitable new businesses.  Essentially, some very complicated and unclear accounting rules allowed Enron to avoid disclosing certain assets and liabilities.

                These two special purpose entities were Joint Energy Development Investments Limited Partnership (JEDI) and Chewco Investments, L.P. (Chewco).  Enron owned only 50 percent of JEDI, and therefore – under applicable accounting rules – could (and did) report JEDI as an unconsolidated equity affiliate.  If Enron had owned 51 percent of JEDI, accounting rules would have required Enron to include all of JEDI’s financial results in its financial statements.  But at 50 percent, Enron did not.

                JEDI, in turn, was subject to the same rules.  JEDI could issue equity and debt securities, and as long as there was an outside investor with at least 50 percent of the equity – in other words, with real economic exposure to the risks of Chewco – JEDI would not need to consolidate Chewco.

                One way to minimize the applicability of this “50 percent rule” would be for a company to create a special purpose entity with mostly debt and only a tiny sliver of equity, say $1 worth, for which the company easily could find an outside investor.  Such a transaction would be an obvious sham, and one might expect to find a pronouncement by the accounting regulators that it would not conform to Generally Acceptable Accounting Principles.  Unfortunately, there are no such accounting regulators, and there was no such pronouncement.  The Financial Accounting Standards Board, a private entity that sets most accounting rules and advises the Securities and Exchange Commission, had not – and still has not – answered the key accounting question: what constitutes sufficient capital from an independent source, so that a special purpose entity need not be consolidated?

Since 1982, Financial Accounting Standard No. 57, Related Party Disclosures, has contained a general requirement that companies disclose the nature of relationships they have with related parties, and describe transactions with them.  Accountants might debate whether Enron’s impenetrable footnote disclosure satisfies FAS No. 57, but clearly the disclosures currently made are not optimal.  Members of the SEC staff have been urging the FASB to revise No. 57, but it has not responded.  In 1998, FASB adopted FAS No. 133, which includes new accounting rules for derivatives.  Now at 800-plus pages, FAS No. 133’s instructions are an incredibly detailed – but ultimately unhelpful – attempt to rationalize other accounting rules for derivatives.

                As a result, even after two decades, there is no clear answer to the question about related parties.  Instead, some early guidance (developed in the context of leases) has been grafted onto modern special purpose entities.  This guidance is a 1991 letter from the Acting Chief Accountant of the SEC in 1991, stating: “The initial substantive residual equity investment should be comparable to that expected for a substantive business involved in similar [leasing] transactions with similar risks and rewards.  The SEC staff understands from discussions with Working Group members that those members believe that 3 percent is the minimum acceptable investment.  The SEC staff believes a greater investment may be necessary depending on the facts and circumstances, including the credit risk associated with the lessee and the market risk factors associated with the leased property.” 

Based on this letter, and on opinions from auditors and lawyers, companies have been pushing debt off their balance sheets into unconsolidated special purpose entities so long as (1) the company does not have more than 50 percent of the equity of the special purpose entity, and (2) the equity of the special purpose entity is at least 3 percent of its the total capital.  As more companies have done such deals, more debt has moved off balance-sheet, to the point that, today, it is difficult for investors to know if they have an accurate picture of a company’s debts.  Even if Enron had not tripped up and violated the letter of these rules, it still would have been able to borrow 97 percent of the capital of its special purpose entities without recognizing those debts on its balance sheet. 

Transactions designed to exploit these accounting rules have polluted the financial statements of many U.S. companies.  Enron is not alone.  For example, Kmart Corporation – which was on the verge of bankruptcy as of January 21, 2002, and clearly was affected by Enron’s collapse – held 49 percent interests in several unconsolidated equity affiliates.  I believe this Committee should take a hard look at these widespread practices.

                In short, derivatives enabled Enron to avoid consolidating these special purpose entities.  Enron entered into a derivatives transaction with Chewco similar to the one it entered into with Raptor, effectively guaranteeing repayment to Chewco’s outside investor.  (The investor’s sliver of equity ownership in Chewco was not really equity from an economic perspective, because the investor had nothing – other than Enron’s credit – at risk.)  In its financial statements, Enron takes the position that although it provides guarantees to unconsolidated subsidiaries, those guarantees do not have a readily determinable fair value, and management does not consider it likely that Enron would be required to perform or otherwise incur losses associated with guarantees.  That position enabled Enron to avoid recording its guarantees.  Even the guarantees listed in the footnotes are recorded at only 10 percent of their nominal value.  (At least this amount is closer to the truth than the amount listed as debt for unconsolidated subsidiaries: zero.)

                Apparently, Arthur Andersen either did not discover this derivatives transaction or decided that the transaction did not require a finding that Enron controlled Chewco.  In any event, the Enron derivatives transaction meant that Enron – not the 50 percent “investor” in Chewco – had the real exposure to Chewco’s assets.  The ownership daisy chain unraveled once Enron was deemed to own Chewco.  JEDI was forced to consolidate Chewco, and Enron was forced to consolidate both limited partnerships – and all of their losses – in its financial statements.

                All of this complicated analysis will seem absurd to the average investor.  If the assets and liabilities are Enron’s in economic terms, shouldn’t they be reported that way in accounting terms?  The answer, of course, is yes.  Unfortunately, current rules allow companies to employ derivatives and special purpose entities to make accounting standards diverge from economic reality.  Enron used financial engineering as a kind of plastic surgery, to make itself look better than it really was.  Many other companies do the same.

                Of course, it is possible to detect the flaws in plastic surgery, or financial engineering, if you look hard enough and in the right places.  In 2000, Enron disclosed about $2.1 billion of such derivatives transactions with related entities, and recognized gains of about $500 million related to those transactions.  The disclosure related to these staggering numbers is less than conspicuous, buried at page 48, footnote 16 of Enron’s annual report, deep in the related party disclosures for which Enron was notorious.  Still, the disclosure is there.  A few sophisticated analysts understood Enron’s finances based on that disclosure; they bet against Enron’s stock.  Other securities analysts likely understood the disclosures, but chose not to speak, for fear of losing Enron’s banking business.  An argument even can be made – although not a good one, in my view – that Enron satisfied its disclosure obligations with its opaque language.  In any event, the result of Enron’s method of disclosure was that investors did not get a clear picture of the firm’s finances. 

                Enron is not the only example of such abuse; accounting subterfuge using derivatives is widespread.  I believe Congress should seriously consider legislation explicitly requiring that financial statements describe the economic reality of a company’s transactions.  Such a broad standard – backed by rigorous enforcement – would go a long way towards eradicating the schemes companies currently use to dress up their financial statements.

                Enron’s risk management manual stated the following: “Reported earnings follow the rules and principles of accounting.  The results do not always create measures consistent with underlying economics.  However, corporate management’s performance is generally measured by accounting income, not underlying economics.  Risk management strategies are therefore directed at accounting rather than economic performance.”  This alarming statement is representative of the accounting-driven focus of U.S. managers generally, who all too frequently have little interest in maintaining controls to monitor their firm’s economic realities.

                C.                Using Derivatives to Inflate the Value of Troubled Businesses
A third example is even more troubling.  It appears that Enron inflated the value of certain assets it held by selling a small portion of those assets to a special purpose entity at an inflated price, and then revaluing the lion’s share of those assets it still held at that higher price. 

Consider the following sentence disclosed from the infamous footnote 16 of Enron’s 2000 annual report, on page 49: “In 2000, Enron sold a portion of its dark fiber inventory to the Related Party in exchange for $30 million cash and a $70 million note receivable that was subsequently repaid.  Enron recognized gross margin of $67 million on the sale.”  What does this sentence mean?

It is possible to understand the sentence today, but only after reading a January 7, 2002, article about the sale by Daniel Fisher of Forbes magazine, together with an August 2001 memorandum describing the transaction (and others) from one Enron employee, Sherron Watkins, to Enron Chairman Kenneth Lay.
Here is my best understanding of what this sentence means:

First, the “Related Party” is LJM2, an Enron partnership run by Enron’s Chief Financial Officer, Andrew Fastow.  (Fastow reportedly received $30 million from the LJM1 and LJM2 partnerships pursuant to compensation arrangements Enron’s board of directors approved.)

Second, “dark fiber” refers to a type of bandwidth Enron traded as part of its broadband business.  In this business, Enron traded the right to transmit data through various fiber-optic cables, more than 40 million miles of which various Internet-related companies had installed in the United States.  Only a small percentage of these cables were “lit” – meaning they could transmit the light waves required to carry Internet data; the vast majority of cables were still awaiting upgrades and were “dark.”  The rights associated with those “dark” cables were called “dark fiber.”  As one might expect, the rights to transmit over “dark fiber” are very difficult to value.

Third, Enron sold “dark fiber” it apparently valued at only $33 million for triple that value: $100 million in all – $30 million in cash plus $70 million in a note receivable.  It appears that this sale was at an inflated price, thereby enabling Enron to record a $67 million profit on that trade.  LJM2 apparently obtained cash from investors by issuing securities and used some of these proceeds to repay the note receivable issued to Enron.

What the sentence in footnote 16 does not make plain is that the investor in LJM2 was persuaded to pay what appears to be an inflated price, because Enron entered into a “make whole” derivatives contract with LJM2 (of the same type it used with Raptor).  Essentially, the investor was buying Enron’s debt.  The investor was willing to buy securities in LJM2, because if the “dark fiber” declined in price – as it almost certainly would, from its inflated value – Enron would make the investor whole.
In these transactions, Enron retained the economic risk associated with the “dark fiber.”  Yet as the value of “dark fiber” plunged during 2000, Enron nevertheless was able to record a gain on its sale, and avoid recognizing any losses on assets held by LJM2, which was an unconsolidated affiliate of Enron, just like JEDI.

As if all of this were not complicated enough, Enron’s sale of “dark fiber” to LJM2 also magically generated an inflated price, which Enron then could use in valuing any remaining “dark fiber” it held.  The third-party investor in LJM2 had, in a sense, “validated” the value of the “dark fiber” at the higher price, and Enron then arguably could use that inflated price in valuing other “dark fiber” assets it held.  I do not have any direct knowledge of this, although public reports and Sherron Watkins’s letter indicate that this is precisely what happened.

For example, suppose Enron started with ten units of “dark fiber,” worth $100, and sold one to a special purpose entity for $20 – double its actual value – using the above scheme.  Now, Enron had an argument that each of its remaining nine units of “dark fiber” also were worth $20 each, for a total of $180. 

Enron then could revalue its remaining nine units of “dark fiber” at a total of $180.  If the assets used in the transaction were difficult to value – as “dark fiber” clearly was – Enron’s inflated valuation might not generate much suspicion, at least initially.  But ultimately the valuations would be indefensible, and Enron would need to recognize the associated losses.

It is an open question for this Committee and others whether this transaction was unique, or whether Enron engaged in other, similar deals.  It seems likely that the “dark fiber” deal was not the only one of its kind.  There are many sentences in footnote 16.

                D.                The “Gatekeepers”
These are but three examples of how Enron’s derivatives dealings with outside parties resulted in material information not being reflected in market prices.  There are others, many within JEDI alone.  I have attempted to summarize this information for the Committee.  Clearly it is important that investigators question the Enron employees who were directly involved in these transactions to get a sense of whether my summaries are complete.

Moreover, a thorough inquiry into these dealings also should include the major financial market “gatekeepers” involved with Enron: accounting firms, banks, law firms, and credit rating agencies.  Employees of these firms are likely to have knowledge of these transactions.  Moreover, these firms have a responsibility to come forward with information relevant to these transactions.  They benefit directly and indirectly from the existence of U.S. securities regulation, which in many instances both forces companies to use the services of gatekeepers and protects gatekeepers from liability. 

Recent cases against accounting firms – including Arthur Andersen – are eroding that protection, but the other gatekeepers remain well insulated.  Gatekeepers are kept honest – at least in theory – by the threat of legal liability, which is virtually non-existent for some gatekeepers.  The capital markets would be more efficient if companies were not required by law to use particular gatekeepers (which only gives those firms market power), and if gatekeepers were subject to a credible threat of liability for their involvement in fraudulent transactions.  Congress should consider expanding the scope of securities fraud liability by making it clear that these gatekeepers will be liable for assisting companies in transactions designed to distort the economic reality of financial statements.

With respect to Enron, all of these gatekeepers have questions to answer about the money they received, the quality of their work, and the extent of their conflicts of interest.  It has been reported widely that Enron paid $52 million in 2000 to its audit firm, Arthur Andersen, the majority of which was for non-audit related consulting services, yet Arthur Andersen failed to spot many of Enron’s losses.  It also seems likely that at least one of the other “Big 5” accounting firms was involved at least one of Enron’s special purpose entities. 

Enron also paid several hundred million dollars in fees to investment and commercial banks for work on various financial aspects of its business, including fees for derivatives transactions, and yet none of those firms pointed out to investors any of the derivatives problems at Enron.  Instead, as late as October 2001 sixteen of seventeen the securities analysts covering Enron rated it a “strong buy” or “buy.” 
Enron paid substantial fees to its outside law firm, which previously had employed Enron’s general counsel, yet that firm failed to correct or disclose the problems related to derivatives and special purpose entities.  Other law firms also may have been involved in these transactions; if so, they should be questioned, too.

Finally, and perhaps most importantly, the three major credit rating agencies – Moody’s, Standard & Poor’s, and Fitch/IBCA – received substantial, but as yet undisclosed, fees from Enron.  Yet just weeks prior to Enron’s bankruptcy filing – after most of the negative news was out and Enron’s stock was trading at just $3 per share – all three agencies still gave investment grade ratings to Enron’s debt.  The credit rating agencies in particular have benefited greatly from a web of legal rules that essentially require securities issuers to obtain ratings from them (and them only), and at the same time protect those agencies from outside competition and liability under the securities laws.  They are at least partially to blame for the Enron mess.

                An investment-grade credit rating was necessary to make Enron’s special purpose entities work, and Enron lived on the cusp of investment grade.  During 2001, it was rated just above the lowest investment-grade rating by all three agencies: BBB+ by Standard & Poor’s and Fitch IBCA, and Baa1 by Moody’s.  Just before Enron’s bankruptcy, all three rating agencies lowered Enron’s rating two notches, to the lowest investment grade rating.  Enron noted in its most recent annual report that its “continued investment grade status is critical to the success of its wholesale business as well as its ability to maintain adequate liquidity.”  Many of Enron’s debt obligations were triggered by a credit ratings downgrade; some of those obligations had been scheduled to mature December 2001.  The importance of credit ratings at Enron and the timing of Enron’s bankruptcy filing are not coincidences; the credit rating agencies have some explaining to do.

                Derivatives based on credit ratings – called “credit derivatives” – are a booming business and they raise serious systemic concerns.  The rating agencies seem to know this.  Even Moody’s appears worried, and recently asked several securities firms for more detail about their dealings in these instruments.  It is particularly chilling that not even Moody’s – the most sophisticated of the three credit rating agencies – knows much about these derivatives deals.

III.                Derivatives “Inside” Enron

The derivatives problems at Enron went much deeper than the use of special purpose entities with outside investors.  If Enron had been making money in what it represented as its core businesses, and had used derivatives simply to “dress up” its financial statements, this Committee would not be meeting here today.  Even after Enron restated its financial statements on November 8, 2001, it could have clarified its accounting treatment, consolidated its debts, and assured the various analysts that it was a viable entity.  But it could not.  Why not?

This question leads me to the second explanation of Enron’s collapse: most of what Enron represented as its core businesses were not making money.  Recall that Enron began as an energy firm.  Over time, Enron shifted its focus from the bricks-and-mortar energy business to the trading of derivatives.  As this shift occurred, it appears that some of its employees began lying systematically about the profits and losses of Enron’s derivatives trading operations.  Simply put, Enron’s reported earnings from derivatives seem to be more imagined than real.  Enron’s derivatives trading was profitable, but not in the way an investor might expect based on the firm’s financial statements.  Instead, some Enron employees seem to have misstated systematically their profits and losses in order to make their trading businesses appear less volatile than they were.

                First, a caveat.  During the past few weeks, I have been gathering information about Enron’s derivatives operations, and I have learned many disturbing things.  Obviously, I cannot testify first hand to any of these matters.  I have never been on Enron’s trading floor, and I have never been involved in Enron’s business.  I cannot offer fact testimony as to any of these matters.

                Nonetheless, I strongly believe the information I have gathered is credible.  It is from many sources, including written information, e-mail correspondence, and telephone interviews.  Congressional investigators should be able to confirm all of these facts.  In any event, even if only a fraction of the information in this section of my testimony proves to be correct, it will be very troubling indeed.

                In a nutshell, it appears that some Enron employees used dummy accounts and rigged valuation methodologies to create false profit and loss entries for the derivatives Enron traded.  These false entries were systematic and occurred over several years, beginning as early as 1997.  They included not only the more esoteric financial instruments Enron began trading recently – such as fiber-optic bandwidth and weather derivatives – but also Enron’s very profitable trading operations in natural gas derivatives.

                Enron derivatives traders faced intense pressure to meet quarterly earnings targets imposed directly by management and indirectly by securities analysts who covered Enron.  To ensure that Enron met these estimates, some traders apparently hid losses and understated profits.  Traders apparently manipulated the reporting of their “real” economic profits and losses in an attempt to fit the “imagined” accounting profits and losses that drove Enron management.

                A.                Using “Prudency” Reserves
                Enron’s derivatives trading operations kept records of the traders’ profits and losses.  For each trade, a trader would report either a profit or a loss, typically in spreadsheet format.  These profit and loss reports were designed to reflect economic reality.  Frequently, they did not.

                Instead of recording the entire profit for a trade in one column, some traders reportedly split the profit from a trade into two columns.  The first column reflected the portion of the actual profits the trader intended to add to Enron’s current financial statements.  The second column, ironically labeled the “prudency” reserve, included the remainder.

                To understand this concept of a “prudency” reserve, suppose a derivatives trader earned a profit of $10 million.  Of that $10 million, the trader might record $9 million as profit today, and enter $1 million into “prudency.”  An average deal would have “prudency” of up to $1 million, and all of the “prudency” entries might add up to $10 to $15 million.

                Enron’s “prudency” reserves did not depict economic reality, nor could they have been intended to do so.  Instead, “prudency” was a slush fund that could be used to smooth out profits and losses over time.  The portion of profits recorded as “prudency” could be used to offset any future losses. 

                In essence, the traders were saving for a rainy day.  “Prudency” reserves would have been especially effective for long-maturity derivatives contracts, because it was more difficult to determine a precise valuation as of a particular date for those contracts, and any “prudency” cushion would have protected the traders from future losses for several years going forward.

                As luck would have it, some of the “prudency” reserves turned out to be quite prudent.  In one quarter, some derivatives traders needed so much accounting profit to meet their targets that they wiped out all of their “prudency” accounts. 

                Saving for a rainy day is not necessarily a bad idea, and it seems possible that derivatives traders at Enron did not believe they were doing anything wrong.  But “prudency” accounts are far from an accepted business practice.  A trader who used a “prudency” account at a major Wall Street firm would be seriously disciplined, or perhaps fired.  To the extent Enron was smoothing its income using “prudency” entries, it was misstating the volatility and current valuation of its trading businesses, and misleading its investors.  Indeed, such fraudulent practices would have thwarted the very purpose of Enron’s financial statements: to give investors an accurate picture of a firm’s risks.

                B.                Mismarking Forward Curves
                Not all of the misreporting of derivatives positions at Enron was as brazen as “prudency.”  Another way derivatives frequently are used to misstate profits and losses is by mismarking “forward curves.”  It appears that Enron traders did this, too.

                A forward curve is a list of “forward rates” for a range of maturities.  In simple terms, a forward rate is the rate at which a person can buy something in the future. 

                For example, natural gas forward contracts trade on the New York Mercantile Exchange (NYMEX).  A trader can commit to buy a particular type of natural gas to be delivered in a few weeks, months, or even years.  The rate at which a trader can buy natural gas in one year is the one-year forward rate.  The rate at which a trader can buy natural gas in ten years is the ten-year forward rate.  The forward curve for a particular natural gas contract is simply the list of forward rates for all maturities.

                Forward curves are crucial to any derivatives trading operation because they determine the value of a derivatives contract today.  Like any firm involved in trading derivatives, Enron had risk management and valuation systems that used forward curves to generate profit and loss statements.

                It appears that Enron traders selectively mismarked their forward curves, typically in order to hide losses.  Traders are compensated based on their profits, so if a trader can hide losses by mismarking forward curves, he or she is likely to receive a larger bonus.

                These losses apparently ranged in the tens of millions of dollars for certain markets.  At times, a trader would manually input a forward curve that was different from the market.  For more complex deals, a trader would use a spreadsheet model of the trade for valuation purposes, and tweak the assumptions in the model to make a transaction appear more or less valuable.  Spreadsheet models are especially susceptible to mismarking.

                Certain derivatives contracts were more susceptible to mismarking than others.  A trader would be unlikely to mismark contracts that were publicly traded – such as the natural gas contracts traded on NYMEX – because quotations of the values of those contracts are publicly available.  However, the NYMEX forward curve has a maturity of only six years; accordingly, a trader would be more likely to mismark a ten-year natural gas forward rate. 

                At Enron, forward curves apparently remained mismarked for as long as three years.  In more esoteric areas, where markets were not as liquid, traders apparently were even more aggressive.  One trader who already had recorded a substantial profit for the year, and believed any additional profit would not increase his bonus much, reportedly reduced his recorded profits for one year, so he could push them forward into the next year, which he wasn’t yet certain would be as profitable.  This strategy would have resembled the “prudency” accounts described earlier.

                C.                Warning Signs
                Why didn’t any of the “gatekeepers” tell investors that Enron was so risky?  There were numerous warning signs related to Enron’s derivatives trading.  Yet the gatekeepers either failed utterly to spot those signs, or spotted those signs and decided not to warn investors about them.  Either way, the gatekeepers failed to do their job.  This was so even though there have been several recent and high-profile cases involving internal misreporting of derivatives.

                Enron disclosed that it used “value at risk” (VAR) methodologies that captured a 95 percent confidence interval for a one-day holding period, and therefore did not disclose worst-case scenarios for Enron’s trading operations.  Enron said it relied on “the professional judgment of experienced business and risk managers” to assess these worst-case scenarios (which, apparently, Enron ultimately encountered).  Enron reported only high and low month-end values for its trading, and therefore had incentives to smooth its profits and losses at month-end.  Because Enron did not report its maximum VAR during the year, investors had no way of knowing just how much risk Enron was taking.

                Even the reported VAR figures are remarkable.  Enron reported VAR for what it called its “commodity price” risk – including natural gas derivatives trading – of $66 million, more than triple the 1999 value.  Enron reported VAR for its equity trading of $59 million, more than double the 1999 value.  A VAR of $66 million meant that Enron could expect based on historical averages that on five percent of all trading days (on average, twelve business days during the year) its “commodity” derivatives trading operations alone would gain or lose $66 million, a not trivial sum.

                Moreover, because Enron’s derivatives frequently had long maturities – maximum terms ranged from 6 to 29 years – there often were not prices from liquid markets to use as benchmarks.  For those long-dated derivatives, professional judgment was especially important.  For a simple instrument, Enron might calculate the discounted present value of cash flows using Enron’s borrowing rates.  But more complex instruments required more complex methodologies.  For example, Enron completed over 5,000 weather derivatives deals, with a notional value of more than $4.5 billion, and many of those deals could not be valued without a healthy dose of professional judgment.  The same was true of Enron’s trading of fiber-optic bandwidth.

                And finally there was the following flashing red light in Enron’s most recent annual report: “In 2000, the value at risk model utilized for equity trading market risk was refined to more closely correlate with the valuation methodologies used for merchant activities.”  Enron’s financial statements do not describe these refinements, and their effects, but given the failure of the risk and valuation models even at a sophisticated hedge fund such as Long-Term Capital Management – which employed “rocket scientists” and Nobel laureates to design various sophisticated computer models – there should have been reason for concern when Enron spoke of “refining” its own models.

                It was Arthur Andersen’s responsibility not only to audit Enron’s financial statements, but also to assess Enron management’s internal controls on derivatives trading.  When Arthur Andersen signed Enron’s 2000 annual report, it expressed approval in general terms of Enron’s system of internal controls during 1998 through 2000.

                Yet it does not appear that Arthur Andersen systematically and independently verified Enron’s valuations of certain complex trades, or even of its forward curves.  Arthur Andersen apparently examined day-to-day changes in these values, as reported by traders, and checked to see if each daily change was recorded accurately.  But this Committee – and others investigating Enron – should inquire about whether Arthur Andersen did anything more than sporadically check Enron’s forward curves.

                To Arthur Andersen’s credit as an auditor, much of the relevant risk information is contained in Enron’s financial statements.  What is unclear is whether Arthur Andersen adequately considered this information in opining that Enron management’s internal controls were adequate.  To the extent Arthur Andersen alleges – as I understand many accounting firms do – that their control opinion does not cover all types of control failures and necessarily is based on management’s “assertions,” it is worth noting that the very information Arthur Andersen audited raised substantial questions about potential control problems at Enron.  In other words, Arthur Andersen has been hoisted by its own petard.

                But Arthur Andersen was not alone in failing to heed these warning signs.  Securities analysts and credit rating agencies arguably should have spotted them, too.  Why were so many of these firms giving Enron favorable ratings, when publicly available information indicated that there were reasons for worry?  Did these firms look the other way because they were subject to conflicts of interest?  Individual investors rely on these institutions to interpret the detailed footnote disclosures in Enron’s reports, and those institutions have failed utterly.  The investigation into Arthur Andersen so far has generated a great deal of detail about that firm’s approach to auditing Enron, but the same questions should be asked of the other gatekeepers, too.  Specifically, this Committee should ask for and closely examine all of the analyst reports on Enron from the relevant financial services firms and credit rating agencies.

                Finally, to clarify this point, consider how much Enron’s businesses had changed during its last years.  Consider the change in Enron’s assets.  Arthur Andersen’s most recent audit took place during 2000, when Enron’s derivatives-related assets increased from $2.2 billion to $12 billion, and Enron’s derivatives-related liabilities increased from $1.8 billion to $10.5 billion.  These numbers are staggering. 

                Most of this growth was due to increased trading through EnronOnline.  But EnronOnline’s assets and revenues were qualitatively different from Enron’s other derivatives trading.  Whereas Enron’s derivatives operations included speculative positions in various contracts, EnronOnline’s operations simply matched buyers and sellers.  The “revenues” associated with EnronOnline arguably do not belong in Enron’s financial statements.  In any event, the exponential increase in the volume of trading through EnronOnline did not generate substantial profits for Enron.

                Enron’s aggressive additions to revenues meant that it was the “seventh-largest U.S. company” in title only.  In reality, Enron was a much smaller operation, whose primary money-making business – a substantial and speculative derivatives trading operation – covered up poor performance in Enron’s other, smaller businesses, including EnronOnline.  Enron’s public disclosures show that during the past three years the firm was not making money on its non-derivatives businesses.  Gross margins from these businesses were essentially zero from 1998 through 2000.

                To see this, consider the table below, which sets forth Enron’s income statement separated into its non-derivatives and derivatives businesses.  I put together this table based on the numbers in Enron’s 2000 income statement, after learning from the footnote 1, page 36, that the meaning of the “Other revenues” entry on Enron’s income statement is – as far as I can tell – essentially “Gain (loss) from derivatives”:

Enron Corp. and Subsidiaries 2000 Consolidated Income Statement (in millions)

 

2000

1999

1998

Non-derivatives revenues

93,557

34,774

27,215

Non-derivatives expenses

94,517

34,761

26,381

Non-derivatives gross margin

(960)

13

834

 

 

 

 

Gain (loss) from derivatives

7,232

5,338

4,045

 

 

 

 

Other expenses

(4,319)

(4,549)

(3,501)

 

 

 

 

Operating income

1,953

802

1,378

                This chart demonstrates four key facts.  First, the recent and dramatic increase in Enron’s overall non-derivatives revenues – the statistic that supposedly made Enron the seventh-largest U.S. company – was offset by an increase in non-derivatives expenses.  The increase in revenues reflected in the first line of the chart was substantially from EnronOnline, and did not help Enron’s bottom line, because it included an increase in expenses reflected in the second line of the chart.  Although Enron itself apparently was the counterparty to all of the trades, EnronOnline simply matched buyers (“revenue”) with sellers (“expenses”).  Indeed, as non-derivatives revenues more than tripled, non-derivatives expenses increased even more.

                Second, a related point: Enron’s non-derivatives businesses were not performing well in 1998 and were deteriorating through 2000.  The third row, “Non-derivatives gross margin,” is the difference between non-derivatives revenues and non-derivatives expenses.  The downward trajectory of Enron’s non-derivatives gross margin shows, in a general sense, that Enron’s non-derivatives businesses made some money in 1998, broke even in 1999, and actually lost money in 2000. 

                Third, Enron’s positive reported operating income (the last row) was due primarily to gains from derivatives (the fourth row).  Enron – like many firms – shied from using the word “derivatives” and substituted the euphemism “Price Risk Management,” but as Enron makes plain in its public filings, the two are the same.  Excluding the gains from derivatives, Enron would have reported substantially negative operating income for all three years.

                Fourth, Enron’s gains from derivatives were very substantial.  Enron gained more than $16 billion from these activities in three years.  To place the numbers in perspective, these gains were roughly comparable to the annual net revenue for all trading activities (including stocks, bonds, and derivatives) at the premier investment firm, Goldman Sachs & Co., during the same periods, a time in which Goldman Sachs first issued shares to the public.
                The key difference between Enron and Goldman Sachs is that Goldman Sachs seems to have been upfront with investors about the volatility of its trading operations.  In contrast, Enron officials represented that it was not a trading firm, and that derivatives were used for hedging purposes.  As a result, Enron’s stock traded at much higher multiples of earnings than more candid trading-oriented firms.

                The size and scope of Enron’s derivatives trading operations remain unclear.  Enron reported gains from derivatives of $7.2 billion in 2000, and reported notional amounts of derivatives contracts as of December 31, 2000, of only $21.6 billion.  Either Enron was generating 33 percent annual returns from derivatives (indicating that the underlying contracts were very risky), or Enron actually had large positions and reduced the notional values of its outstanding derivatives contracts at year-end for cosmetic purposes.  Neither conclusion appears in Enron’s financial statements.

IV.                Conclusion

                How did Enron lose so much money?  That question has dumbfounded investors and experts in recent months.  But the basic answer is now apparent: Enron was a derivatives trading firm; it made billions trading derivatives, but it lost billions on virtually everything else it did, including projects in fiber-optic bandwidth, retail gas and power, water systems, and even technology stocks.  Enron used its expertise in derivatives to hide these losses.  For most people, the fact that Enron had transformed itself from an energy company into a derivatives trading firm is a surprise.

                Enron is to blame for much of this, of course.  The temptations associated with derivatives have proved too great for many companies, and Enron is no exception.  The conflicts of interest among Enron’s officers have been widely reported.  Nevertheless, it remains unclear how much top officials knew about the various misdeeds at Enron.  They should and will be asked.  At least some officers must have been aware of how deeply derivatives penetrated Enron’s businesses; Enron even distributed thick multi-volume Derivatives Training Manuals to new employees.  (The Committee should ask to see these manuals.)

                Enron’s directors likely have some regrets.  Enron’s Audit Committee in particular failed to uncover a range of external and internal financial gimmickry.  However, it remains unclear how much of the inner workings at Enron were hidden from the outside directors; some directors may very well have learned a great deal from recent media accounts, or even perhaps from this testimony.  Enron’s general counsel, on the other hand, will have some questions to answer.

                But too much focus on Enron misses the mark.  As long as ownership of companies is separated from their control – and in the U.S. securities market it almost always will be – managers of companies will have incentives to be aggressive in reporting financial data.  The securities laws recognize this fact of life, and create and subsidize “gatekeeper” institutions to monitor this conflict between managers and shareholders. 

                The collapse of Enron makes it plain that the key gatekeeper institutions that support our system of market capitalism have failed.  The institutions sharing the blame include auditors, law firms, banks, securities analysts, independent directors, and credit rating agencies.

                All of the facts I have described in my testimony were available to the gatekeepers.  I obtained this information in a matter of weeks by sitting at a computer in my office in San Diego, and by picking up a telephone.  The gatekeepers’ failure to discover this information, and to communicate it effectively to investors, is simply inexcusable.

                The difficult question is what to do about the gatekeepers.  They occupy a special place in securities regulation, and receive great benefits as a result.  Employees at gatekeeper firms are among the most highly-paid people in the world.  They have access to superior information and supposedly have greater expertise than average investors at deciphering that information.  Yet, with respect to Enron, the gatekeepers clearly did not do their job. 

                One potential answer is to eliminate the legal requirements that companies use particular gatekeepers (especially credit rating agencies), while expanding the scope of securities fraud liability and enforcement to make it clear that all gatekeepers will be liable for assisting companies in transactions designed to distort the economic reality of financial statements.  A good starting point before considering such legislation would be to call the key gatekeeper employees to testify.

                Congress also must decide whether, after ten years of steady deregulation, the post-Enron derivatives markets should remain exempt from the regulation that covers all other investment contracts.  In my view, the answer is no. 

                A headline in Enron’s 2000 annual report states, “In Volatile Markets, Everything Changes But Us.”  Sadly, Enron got it wrong.  In volatile markets, everything changes, and the laws should change, too.  It is time for Congress to act to ensure that this motto does not apply to U.S. financial market regulation.
 

 


Committee Members
| Subcommittees | Hearings | Key Legislation | Jurisdiction
 
Press Statements | Current Issues | Video of Select Hearings | Sites of Interest

 

Source:   http://www.senate.gov/~gov_affairs/012402partnoy.htm 

Frank Partnoy is best known as a whistle blower at Goldman Sachs who blew the lid on the financial
graft and sexual degeneracy of derivatives instruments traders and analysts who ripped the public off
for billions of dollars and contributed to mind-boggling worldwide frauds.  He is a Yale University Law
School graduate who shocked the world with various books include the following:

  • FIASCO: The Inside Story of a Wall Street Trader
     
  • FIASCO: Blood in the Water on Wall Street
     
  • FIASCO:  Blut an den weißen Westen der Wall Street Broker.
     
  • FIASCO: Guns, Booze and Bloodlust: the Truth About High Finance
     
  • Infectious Greed : How Deceit and Risk Corrupted the Financial Markets
     
  • Codicia Contagiosa

His other publications include the following highlight:

"The Siskel and Ebert of Financial Matters: Two Thumbs Down for the Credit Reporting Agencies" (Washington University Law Quarterly)


You can read more about Derivative Financial Instruments Frauds around the world at http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

Also see Bob Jensen's "Rotten to the Core" document at http://www.trinity.edu/rjensen/FraudRotten.htm







 



 

17.
In round numbers, what is the amount Andy Fastow ultimately admitted to skimming from over 3,000 SPEs he set up in Enron?  What is the best estimate of the actual amount he stole from his company?

In round numbers Fastow finally confessed to Enron's Board of Directors that he'd taken around $45 million in unauthorized "fees" for managing Enron's SPE partnership.  Subsequent estimates raised this number to an estimated $60 million.  He was eventually fined roughly $30 million, which should leave him a pretty sizeable white crime nest egg when he emerges a free man from Club Fed.


Why white collar crime pays for Chief Financial Officer: 
Andy Fastow's fine for filing false Enron financial statements:  $30,000,000
Andy Fastow's stock sales benefiting from the false reports:     $13,386,896
Andy Fastow's estimated looting of Enron cash:                          $60,000,000
That averages out to winnings of $ $4,386,896 per year for each of the ten years he's expected to be in prison.
You can read what others got at http://www.trinity.edu/rjensen/FraudEnron.htm#StockSales 
Nice work if you can get it:  Club Fed's not so bad if you earn $11,887 per day plus all the accrued interest over the past 15 years.

Prosecutors informed Fastow that they would shelve plans to charge Lea (Fastow's wife)  if he would plead guilty.  Fastow refused and Lea was indicted.  Suddenly, the Fastows faced the prospect that their two young sons would have to be raised by others while they served lengthy prison terms.  The time had come for Fastow to admit the truth.

"All rise."

At 2:05 on the afternoon of January 14, 2004, U.S. District Judge Kenneth Hoyt walked past a marble slab on the wall as he made his way to the bench of courtroom 2025 in Houston's Federal District Courthouse.  Scores of spectators attended, seated in rows of benches.  In front of the bar, Leslie Caldwell, the head of the Enron Task Force, sat quietly watching the proceedings as members of her team readied themselves at the prosecutors' table.

Judge Hoyt looked out into the room.  To his right sat an array of defense lawyers surrounding their client, Andy Fastow, who was there to change his pleas.  Fastow, whose hair had grown markedly grayer in the past year and a half, sat in silence as he waited for the proceedings to begin.

Minutes later, under the high, regal ceiling of the courtroom, Fastow stepped before the bench, standing alongside his lawyers.

"I understand that you will be entering a plea of guilty this afternoon," Judge Hoyt asked.

"Yes, your honor," Fastow replied.

He began answering questions from the judge, giving his age as forty-two and saying that he had a graduate degree in business.  When he said the last word, he whistled slightly on the s, as he often did when his nerves were frayed.  He was taking medication for anxiety, Fastow said; it left him better equipped to deal with the proceedings.

Matt Friedrich, the prosecutor handling the hearing, spelled out the deal.  There were two conspiracy counts, involving wire fraud and securities fraud.  Under the deal, he said, Fastow had agreed to cooperate, serve ten years in prison, and surrender $23.8 million worth of assets.  Lea would be allowed to enter a plea and would eventually be sentenced to a year in prison on a misdemeanor tax charge.

Fastow stayed silent as another prosecutor, John Hemann, described the crimes he was confessing.  In a statement to prosecutors, Fastow acknowledged his roles in the Southampton and Raptor frauds and provided details of the secret Global Galactic agreement that illegally protected his LJM funds against losses in their biggest dealings with Enron.

Hemann finished the summary, and Hoyt looked at Fastow.  "Are those facts true?"

"Yes, your honor," Fastow said, his voice even.

"Did you in fact engage in the conspiratorious conduct as alleged?"

"Yes, your honor."

Fastow was asked for his plea.  Twice he said guilty.

"Based on your pleas," Hoyt said, "the court finds you guilty."

The hearing soon ended.  Fastow returned to his seat at the defense table.  He reached for a paper cup of water and took a sip.  Sitting in silence, he stared off at nothing, suddenly looking very frail.


Why white collar crime pays for Chief Enron Accountant: 
Rick Causey's fine for filing false Enron financial statements:    $1,250,000
Rick Causey's stock sales benefiting from the false reports:     $13,386,896
That averages out to winnings of $2,427,379 per year for each of the five years he's expected to be in prison
You can read what others got at http://www.trinity.edu/rjensen/FraudEnron.htm#StockSales 
Nice work if you can get it:  Club Fed's not so bad if you earn $6,650 per day plus all the accrued interest over the past 15 years.

"Ex-Enron Accountant Pleads Guilty to Fraud," Kristen Hays, Yahoo News, December 28, 2005 --- http://news.yahoo.com/s/ap/20051228/ap_on_bi_ge/enron_causey

A former top accountant at Enron Corp. sealed his plea deal with prosecutors Wednesday, becoming a key potential witness in the upcoming fraud trial of former CEOs Kenneth Lay and Jeffrey Skilling.

Lay and Skilling were granted two extra weeks to adjust to the setback before their much anticipated trial, the last and biggest of a string of corporate scandal cases, starts at the end of January.

The accountant, Richard Causey, pleaded guilty to securities fraud Wednesday in return for a seven-year prison term — which could be shortened to five years if prosecutors are satisfied with his cooperation in the trial. He also must forfeit $1.25 million to the government, according to the plea deal.

Causey's arrangement included a five-page statement of fact in which he admitted that he and other senior Enron managers made various false public filings and statements.

"Did you intend in these false public filings and false public statements, intend to deceive the investing public?" U.S. District Judge Sim Lake asked.

"Yes, your honor," replied Causey, who said little during the short hearing, appearing calm, whispering to his attorneys and answering questions politely.

Continued in article

Bob Jensen's threads on how white collar crime pays even if you get caught --- http://www.trinity.edu/rjensen/FraudConclusion.htm#CrimePays

Bob Jensen's threads on the Enron/Andersen frauds --- http://www.trinity.edu/rjensen/FraudEnron.htm

 






 


18.
Was Andy Fastow considered a financial genius by financial experts within Enron?  Elaborate.

Conspiracy of Fools
Sometimes the key mover in Enron's shady dealings, CFO Andy Fastow, was portrayed by the media as a financial genius. This may not be the case. Somebody called in Kaminski. He was soft-spoken yet excitable, a man who quickly assessed colleagues' brainpower --- and Fastow had never made it high on his list of high-voltage intellects. Long ago, when Fastow had incorrectly boasted that his business was unaffected by interest rate, Kaminski had concluded the man was a lightweight . . . Kaminski smiled to himself. "How could a man like this be in charge of a business?" A hedge could only offset declines in an asset's value, not operating losses from a failing business. The only hedge for a money-losing business was a moneymaking business---and one of those certainly wasn't going to be coming out of this meeting.
Kurt Eichenwald, Conspiracy of Fools (Broadway Books, 2005, pp. 93-94).




 

 


19.
Enron's auditing firm was Arthur Andersen (or just Andersen).  In the early 1990s, who was the managing partner on the Enron audit from the Houston Office?  What was Enron earning in audit billings to Enron per year?  What were the consulting fees per year paid to the Andersen's Houston office?

Just prior to Enron's bankruptcy filing in 2001, the Houston office of Andersen had billings averaging $1 million per week, half of which was for auditing services and half of which was for management consulting.  In those days the line became very cloudy between what was consulting and what was auditing.

Andersen's managing partner of the Enron audit from 1990 to 1997 was a "back slapper" named Stephen Goddard. 

None are Andersen's managing partners on the Enron audit are portrayed as rocket scientists.

You can read the following in Kurt Eichenwald, Conspiracy of Fools (Broadway Books, 2005, Page 138).

Since 1990, Stephen Goddard at Andersen had overseen Enron--meeting the board, reviewing deals, auditing financials. Goddard wasn't Hollywood's idea of an accountant; this was no boring technocrat with green eyeshades. He was a specialist in client services, a backslapper who maintained a close relationship with the managers whose numbers his team reviewed.

Thanks in part to that familiarity, Andersen and Enron developed an unusually close relationship. The firm was both its auditor and its consultant. Veterans of Andersen's Houston office jumped to Enron as internal auditors; even Rick Causey, Enron's top accounting guru, had been an Andersen manager. The relationship couldn't have been cozier.

 







 


20.
David Duncan became Andersen's managing partner of the Enron audit in what year?  Was Duncan a great accountant?  What were his credentials when Andersen made him the managing partner on the Enron audit?  Was he a good accountant and a responsible manager of the Enron audit?

It’s entirely clear at last that literally every Enron executive considered accounting and banking games in which the only goal was to manage earnings and otherwise cook the books.  Andersen’s managing partner on the Enron audit, David Duncan, is entirely unprofessional.  He ceased being an auditor and turned into an ardent advocate of Enron book-cooking, especially when it came to making presentations to good Andersen auditors like Carl Bass.  Bass is a hero (well only sort of because he could’ve been more forceful at Andersen’s headquarters), and Duncan is what we least want in our auditors --- ever! 

Duncan didn’t want to give up the Andersen Houston Office’s $1 million per week billings from Enron no matter how burned up (from cooking) the books became.  Duncan is also portrayed as an accounting light weight who spent far more time on the golf course than in his office.  Duncan should also have a cell near Fastow, but Duncan will probably get off because after being arrested he helped nail Fastow, Skilling, and Lay. 

It must be sad for David Duncan to live with the fact that he was the lynch pin that brought down the huge worldwide Andersen auditing and consulting firm.  But Andersen probably would’ve toppled anyway.  Andersen’s top executives gave up total quality management (TQM) of audits (e.g., in Waste Management, Worldcom, etc) long before Enron’s implosion.  Looking back at the deterioration in audit quality in Andersen, Andersen deserved to die as an auditing firm.

You can read the following in Kurt Eichenwald, Conspiracy of Fools (Broadway Books, 2005, pp. 138-139).

But by February 1997, things had to change. Andersen rotated partners on accounts every seven years, and Goddard's time was up. Some partners lobbied to move up Tom Bauer, a top-notch accountant, who audited Enron's trading operations. But Goddard thought there was only one candidate--David Duncan, a thirty-six-year-old who had worked on Enron for years. With Goddard's support, Duncan got the nod.

Duncan rarely impressed anyone as a towering intellect, and his background was unremarkable. Born in Lake Charles, Louisiana, and raised in Beaumont, Texas, Duncan attended Texas A&M, where he studied accounting. In college he had been something of a party boy; he and a group of friends had formed what amounted to a co-op for illicit drugs, purchasing large quantities of marijuana that they divided among themselves. Often, Duncan and his pals could be found around campus laughing it up, stoned.

In 1981, straight out of college, Duncan joined Andersen's Houston office but didn't change his ways. For years, he and his friends kept up their mass drug buying. Several days a week he would leave the staid accounting world and head home to toke up; sometimes he branched out to cocaine. But a few years after starting on the Enron engagement, Duncan straightened up. He didn't use illegal drugs since.

Enron seemed the ideal assignment. In his early days at Andersen, Duncan struck up a friendship with Causey, then just another accountant in the Houston office. The two became close, often lunching, golfing, or going out with their wives. Now his buddy was Enron's top accountant.

Clearly, Duncan was no accounting whiz, but nobody worried about that; like most partners, he would rely on the experts in the firm's Professional Standards Group to rule on tough issues. But he struck some partners as top-flight where it mattered--his familiarity with Enron and a close relationship with its executives. His good looks and disciplined organization didn't hurt, either.

In early February, Goddard and Duncan had an appointment with Lay, to notify him of the coming change. Lay was polite, if not particularly interested; he vaguely knew Duncan and thought he seemed competent enough.

"I'm very excited about the opportunity to work more closely with Enron," Duncan said. "It's really an honor."

Lay smiled. "We'll have a lot of fun," he said.

By any measure, Duncan seemed a man on the precipice of big things. But it was not to be; the great opportunity at Enron would be his last high-profile accounting job.

 



 


21.
At one point in 1999 Duncan privately agreed with his Andersen colleague Carl Bass that Enron should take an added $______ charge to earnings, but that these were not material. How much was this charge? Why do you really think Duncan did not want to force Enron to make this charge?

Eichenwald in Conspiracy of Fools on Page 289 states the following:

"Changing the accounting on this is going to cause Enron to take a charge of thirty million to fifty million dollars," David Duncan said.  "We can't do that."

He was on the phone with Carl Bass, now a member of Andersen's Professional Standards Group.  Duncan had called with a question about the restructuring of LJM1; apparently, he had misunderstood the accounting rules that applied to the options in the transaction.  The restructuring had changed the nature of the Rhythms hedge, Bass told him, requiring Enron to recognize losses.  But Duncan wouldn't hear of it.  The amount was too big.

"I can't go back to them on this now," he said.  "This deal is already signed or it's about to be signed."

"Dave, our advice has been consistent on this and timely," Bass replied.

It didn't matter, Duncan replied.  He wasn't reversing course now.  Enron would keep its unearned windfall, generated solely because David Duncan didn't know what he was doing.

 

Fast Acting Texas State Board of Accountancy

I think it's spelled Andersen, but why quibble years later?
"Anderson Accountants Facing Disciplinary Actions," AccountingWeb, November 10, 2005 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=101466

The Texas State Board of Public Accountancy has filed a complaint against seven former Arthur Anderson accountants who were involved in audit operations for Enron and its subsidiaries. The Houston Chronicle reports that they failed to adequately examine and report financial events leading to Enron’s implosion according to the filed complaint. The complaint was filed with the State Office of Administrative Hearings. The complaint reads that the seven accountants audited a portion of Enron’s 1997 financial statements and allegedly did not follow proper accounting procedures that specified they consolidate the statements of the two subsidiaries named for Star Wars characters, Chewco and Jedi. After notification by the Securities and Exchange Commission, these statements were changed by Enron according to the Houston Chronicle.

The Houston Chronicle reports that actions leading from the complaint include suspension or revocation of their state accounting licenses. Arthur Anderson’s accounting license was revoked in 2002. The seven accountants may also receive fines of $1000 for each violation alleged in the complaint according to the Associated Press. There has been no date specified for their hearing.


November 11, 2005 message from Clikeman, Paul [pclikema@RICHMOND.EDU]

Can somebody please help me understand this news item?

 David Duncan, who pleaded guilty to a felony, is not one of the seven AA auditors named in the complaint. Has he already been disciplined by the Texas Board?

 And Carl Bass is named in the current complaint. The media portrayed Bass as a “hero” in 2002 for objecting to Enron’s SPE accounting. Joseph Berardino claimed in a television interview that Bass was removed from the Enron audit because Enron’s executives complained about Bass’s refusal to cooperate. Is Bass not as innocent as earlier news items indicated?

 Paul M. Clikeman, Ph.D.
Associate Professor of Accounting
Robins School of Business
University of Richmond
Richmond, VA 23173

pclikema@richmond.edu

November 11, 2005 reply from Bob Jensen

If you read Page 426-427 (especially the bottom of Page 427) of Conspiracy of Fools by Kurt Eichenwald, you get the idea that Carl Bass was made a fall guy, by Andersen executives, in Braveheart, Fishtail, and Raptor.

Bass seemed all along to argue with Duncan about accounting for derivatives and SPEs, which is why Duncan himself had Bass removed from the Enron audit.  Some might argue that Bass could have done more early on in reporting his side of things with John Stewart in Chicago.  In some ways I agree with this.  Carl Bass seemed to be a good auditor who just did not blow the whistle effectively until it was too late.  I think he had ample evidence that Duncan was not going to listen to reason and buck Rick Causey at Enron.

Bob Jensen

 


 

The Justice Racer Cannot Beat a Snail:  Andersen's David Duncan Finally Has Closure

"Andersen Figure Settles Charges: Former Head of Enron Team Barred From Some Professional Duties," by Kristen Hays, SmartPros, January 29, 2008 --- http://accounting.smartpros.com/x60631.xml 

The former head of one-time Big Five auditing firm Arthur Andersen's Enron accounting team has settled civil charges that he recklessly failed to recognize that the risky yet lucrative client cooked its books.

David Duncan, who testified against his former employer after Andersen cast him aside as a rogue accountant, didn't admit or deny wrongdoing in a settlement with the Securities and Exchange Commission announced Monday.

The SEC said in the settlement that he violated securities laws and barred him from ever practicing as an accountant in a role that involves signing a public company's financial statements, such as a chief accounting officer. But he could be a company director or another kind of officer and was not assessed any fines or otherwise sanctioned.

Three other former partners at the firm have been temporarily prohibited from acting as accountants before the SEC in separate settlements unveiled Monday.

Andersen crumbled amid the Enron scandal after the accounting firm was indicted, tried and found guilty -- a conviction that eventually was overturned on appeal.

The settlements came six years after Andersen came under fire for approving fudged financial statements while collecting tens of millions of dollars in fees from Enron each year.

Greg Faragasso, an assistant director of enforcement for the SEC, said Monday that the agency focused on wrongdoers at Enron first and moved on to gatekeepers accused of allowing fraud to thrive at the company.

"When auditors of public companies fail to do their jobs properly, investors can get hurt, as happened quite dramatically in the Enron matter," he said.

Barry Flynn, Duncan's longtime lawyer, said his client has made "every effort" to cooperate with authorities and take responsibility for his role as Andersen's head Enron auditor.

That included pleading guilty to obstruction of justice in April 2002, testifying against his former employer and waiting for years to be sentenced until he withdrew his plea with no opposition from prosecutors.

"After six years of government investigations and assertions, surrounding his and Andersen's activities, it was decided that it was time to get these matters behind him," Flynn said.

Duncan, 48, has worked as a consultant in recent years.

He was a chief target in the early days of the government's Enron investigation as head of a team of 100 auditors who oversaw Enron's books. In the fall of 2001, he and his staff shredded and destroyed tons of Enron-related paper and electronic audit documents as the SEC began asking questions about Enron's finances.

Andersen fired Duncan in January 2002, saying he led "an expedited effort to destroy documents" after learning that the SEC had asked Enron for information about financial accounting and reporting.

The firm also disciplined several other partners, including the three at the center of the other settlements announced Monday. They are Thomas Bauer, 54, who oversaw the books of Enron's trading franchise; Michael Odom, 65, former practice director of the Gulf region for Andersen; and Michael Lowther, 51, the former partner in charge of Andersen's energy audit division.

Their settlement agreements said that they weren't skeptical enough of risky Enron transactions that skirted accounting rules. Odom and Lowther were barred from accounting before the SEC for two years, and Bauer for three years. None was fined.

Their lawyer, Jim Farrell, declined to comment Monday.

Duncan's firing and the other disciplinary moves were part of Andersen's failed effort to avoid prosecution. But the firm was indicted on charges of obstruction of justice in March 2002, and Duncan later pleaded guilty to the same charge.

In Andersen's trial, Duncan recalled how he advised his staff to follow a little-known company policy that required retention of final audit documents and destruction of drafts and other extraneous paper.

That meeting came 11 days after Nancy Temple, a former in-house lawyer for Andersen, had sent an e-mail to Odom advising that "it would be helpful" that the staff be reminded of the policy.

Duncan testified that he didn't believe their actions were illegal at the time, but after months of meetings with investigators, he decided he had committed a crime.

Bauer and Temple invoked their 5th Amendment rights not to testify in the Andersen trial. However, Bauer testified against former Enron Chairman Ken Lay and CEO Jeff Skilling in their 2006 fraud and conspiracy trial.

Andersen insisted that the document destruction took place as required by policy and wasn't criminal, but the firm was convicted in June 2002.

Three years later the U.S. Supreme Court unanimously overturned the conviction because U.S. District Judge Melinda Harmon in Houston gave jurors an instruction that allowed them to convict without having to find that the firm had criminal intent.

That ruling paved the way for Duncan -- the only individual at Andersen charged with a crime -- to withdraw his guilty plea in December 2005.

In his plea, he said he instructed his staff to comply with Andersen's document policy, knowing the destroyed documents would be unavailable to the SEC. But he didn't say he knew he was acting wrongfully.

I draw some conclusions about David Duncan (they're not pretty) at http://www.trinity.edu/rjensen/FraudEnronQuiz.htm

My Enron timeline is at http://www.trinity.edu/rjensen/FraudEnron.htm#EnronTimeline

My thread on the Enron/Worldcom scandals are at http://www.trinity.edu/rjensen/FraudEnron.htm









 


22.
A WSJ reporter was the first to uncover Enron's secret "Related Party Transactions."  What reporter was this and what are those transactions that he/she investigated? 
 

One time I posed a question to the, then, Editor of The Wall Street Journal Editorial Page (my former fraternity brother Bob Bartley) about why the WSJ on that very day was attacking Mike Milken as a felonious thief on Page 1 and praising Milken as a creative capitalist on the Editorial Page. Bob Bartley's truthful response was that the WSJ, more than any other newspaper, is really two newspapers bundled into one copy. The Editorial Page is an unabashed advocate of free-reining capital markets (Damn the Torpedoes). The rest of the newspaper reports the facts (and I think the WSJ reporters are among the best in the world, especially when they commenced to prickle Ken Lay and Jeff Skilling about hidden related party transactions at Enron). See Question 22 at http://www.trinity.edu/rjensen/FraudEnronQuiz.htm
It's interesting that WSJ reporters discovered related party transactions when Enron's auditors pleaded ignorance about such fraudulent dealings. But then Andersen was becoming notorious at that time for bad audits.

Mr. Lay was also asked about his alleged 2001 comment to company colleagues that The Wall Street Journal had a "hate on" for Enron in connection with a series of articles looking at Mr. Fastow and his partnership operation. "I might have used that term," Mr. Lay acknowledged, adding that the Journal was "trying to paint a very negative image of Enron." (As previously reported, the Journal said it stands by the accuracy of its coverage.)
"Lay Defends Family's Role In Selling Shares:  Enron Ex-Chairman Says He Tried to Minimize Sales To Meet Margin Calls," by Gary McWilliams and John R. Emshwiller, The Wall Street Journal, May 2, 2006; Page C3 --- http://online.wsj.com/article/SB114649255583240444.html?mod=todays_us_money_and_investing

The lead Wall Street Journal reporter that Enron learned to hate was John Emshwiller along with his sometimes reporter partner Rebecca Smith.  See Page 571 in Eichenwald's Conspiracy of Fools.

My favorite quote is the "Spike, honey" segment on Page 455 of Eichenwald's Conspiracy of Fools:

In a cramped office in the back of the Los Angeles bureau of The Wall Street Journal, a fifty-one-year-old reporter named John Emshwiller was on the phone with California's attorney general, Bill Lockyer.  Emshwiller was working on an article about the state's investigations of power marketers and their lack of success in turning up evidence of wrongdoing.

Tethered to his headset, Emshwiller took notes as Lockyer made clear his frustration in the lack of progress in the inquiries.  Emshwiller asked if Lockyer believed there would be criminal prosecutions.

"I don't have any doubt that there will be civil lawsuits prosecuted by the state," Lockyer said.

A pause.  Lockyer hadn't answered.  "There is nothing I would rather do than nail a high executive," he continued.

Silence again.  "You know what I'd really like to do?"  Lockyer asked.

"What?"

"I'm not sure I should really say this."

Words that have led to breath holding by countless reporters.

"Why not?"  Lockyer finally said.  "I'd love to personally escort Lay to an eight-by-ten cell that he could share with a tattooed dude who says, 'Hi, my name is Spike, honey.' "

Emshwiller took it all down, almost in disbelief.  This was one of those too-good-to-be-true quotes that was automatically guaranteed to be printed in the paper.
 



Eichenwald states the following on pp. 490-492 in Conspiracy of Fools:

It was section eight, called "Related Party Transactions," that got John Emshwiller's juices flowing.

After being assigned to follow the Skilling resignation, Emshwiller had put in a request for an interview, then scrounged up a copy of Enron's most recent SEC filing in search of any nuggets.

What he found startled him.  Words about some partnerships run by an unidentified "senior officer."  Arcane stuff, maybe, but the numbers were huge.  Enron reported more than $240 million in revenues in the first six months of the year from its dealings with them.

One fact struck Emshwiller in particular.  This anonymous senior officer, the filing said, had just sold his financial interest in the partnerships.  Now, it said, the partnerships were no longer related to Enron.

The senior officer had just sold his interest, Skilling had just resigned.  The connection seemed obvious.

Could Enron have actually allowed Jeff Skilling to run partnerships that were doing massive business with the company?  Now that, Emshwiller thought, would be a great story.

Emshwiller was back on the phone with Mark Palmer.  With no better explanation for Skilling's resignation, he said, the Journal was going to dig through everything it could find.  Right now he was focusing on these partnerships.  Were those run by Skilling?

"No, that's not Skilling," Palmer replied, almost nonchalantly.  "That's Andy Fastow."

A pause.  "Who's Andy Fastow?" Emshwiller asked.

The message was slipped to Skilling later that day.  A Journal reporter was pushing for an explanation of his departure and now was rooting around, looking for anything he could find.  Probably best just to give the paper a call.

Emshwiller was at his desk when the phone rang.

"Hi," a soft voice said.  "It's Jeff Skilling."

It was a startling moment.  Emshwiller had been on the hunt, and suddenly the quarry just walked in and lay down on the floor, waiting for him to fire.  So he did: why was Skilling quitting his job?

"It's all pretty mundane," Skilling replied.  He'd worked hard and accomplished a lot but now had the freedom to move on.  His voice was distant, almost depressed.

He and been ruminating about it for a while, Skilling went on, but had wanted to stay on at the company until the California situation eased up.  Then, he took the conversation in a new direction.

"The stock price has been very disappointing to me," Skilling said.  "The stock is less than half of what it was six months ago.  I put a lot of pressure on myself.  I felt I must not be communicating well enough."

Skilling rambled as Emshwiller took it down.  India.  California.  Expense cuts.  The good shape of Enron.

"Had the stock price not done what it did..."  He paused.  "I don't think I would have felt the pressure to leave if the stock price had stayed up."

What?  Had Emshwiller heard that right?  Was all this stuff about "personal reasons" out the window?  Had Skilling thrown in the towel because of the stock price?

"What was that, Mr. Skilling?" Emshwiller asked.

The employees at Enron owned lots of shares, Skilling said.  They were worried, always asking him about the direction of the price.  He found it very frustrating.

"Are you saying that you don't think you would have quit if the stock price had stayed up?"

Skilling was silent for several seconds.

"I guess so," he finally mumbled.

Minutes later, Emshwiller burst into his boss's office.  "You're not gong to believe what Skilling just told me!"
 







 


23.
What is Chewco and why did it ultimately lead to a major split between Enron and Andersen?


Chewco is one of the SPEs where Andy Fastow claimed that a Bill Dodsen (Michael Kopper's secret gay lover) was a wealthy investor who put up the required 3% outside investor funding required by SEC rules.  Actually Dodsen was not wealthy and did not provide the outside funding.  There was no outside equity funding as required by the SEC and the FASB for off-books accounting.  This lie became the straw that years later led to split between Andersen and Enron as noted in testimony by the CEO, Joe Berardino, of Andersen before the House Financial Services Committee on December 12, 2001 (see Eichenwald, Conspiracy of Fools, Pages 584 and 638).  Millions were distributed from Chewco to Fastow's wife (Lea) and became a basis for her indictment.

For Chewco details see http://news.findlaw.com/hdocs/docs/enron/sicreport/chapter2.pdf
The following is a quotation from pp. 42-44 of the above document.  Note how Andy Fastow repeatedly violated Enron's Code of Conduct quoted in Footnote 8 below.

When the Chewco transaction was reviewed closely in late October and early November 2001, both Enron and Andersen concluded that Chewco was an SPE without sufficient outside equity, and that it should have been consolidated into Enron's financial statements.  As a result, Enron announced in November that it would restate its prior period financial statements from 1997 through 2001.  The retroactive consolidation of Chewco--and the investment partnership in which Chewco was a limited partner--had a huge impact.  It decreased Enron's reported new income by $28 million (out of $105 million total) in 1997, by $133 million (out of $703 million total) in 1998, by $153 million (out of $893 million total) in 1999, and by $91 million (out of $979 million total) in 2000.  It also increased Enron's reported debt by $711 million in 1997, by $561 million in 1998, by $685 million in 1999, and by $628 million in 2000.

A.    Formation of Chewco

In 1993, Enron and the California Public Employees' Retirement System ("CalPERS") entered into a joint venture investment partnership called Joint Energy Development Investment Limited Partnership ("JEDI").  Enron was the general partner and contributed $250 million in Enron stock.  CalPERS was the limited partner and contributed $250 million in cash.  Because Enron and CalPERS had joint control, Enron did not consolidate JEDI into its consolidated financial statements.

In 1997, Enron considered forming a $1 billion partnership with CalPERS called "JEDI II".  Enron believed that CalPERS would not invest simultaneously in both JEDI and JEDI II, so Enron suggested it buy out CalPERS' interest in JEDI.  Enron and CalPERS attempted to value CalPERS' interest (CalPERS retained an investment bank) and discussed an appropriate buyout price.

In order to maintain JEDI as an unconsolidated entity, Enron needed to identify a new limited partner.  Fastow initially proposed that he act as the manager of, and an investor in, a new entity called "Chewco Investments"--named after the Star Wars character "Chewbacca."  Although other Enron employees would be permitted to participate in Chewco, Fastow proposed to solicit the bulk of Chewco's equity capital from third-party investors.  He suggested that Chewco investors would want a manager who, like him, knew the underlying assets in JEDI and could help manage them effectively.  Fastow told Enron employees that Jeffrey Skilling, then Enron's President and Chief Operating Officer ("COO") had approved his participation in Chewco as long as it would not have to be disclosed in Enron's proxy.7/

Both Enron's in-house counsel and its longstanding outside counsel, Vinson & Elkins, subsequently advised Fastow that his participation in Chewco would require (1) disclosure in Enron's proxy statement, and (2) approval from the Chairman and CEO under Enron's Code of Conduct of Business Affairs ("Code of Conduct").8/  As a result, Kopper, an Enron employee who reported to Fastow, was substituted as the proposed manager of Chewco.  Unlike Fastow, Kopper was not a senior officer of Enron, so his role in Chewco would not require proxy statement disclosure (but would require approval under Enron's Code of Conduct).


7/    Skilling told us that he recalled Fastow's proposing that the Chewco outside investors be members of Fastow's wife's family, and that Skilling told Fastow he did not think that was a good idea.

8/    Enron's Code of Conduct provided that no full-time officer or employee should "[o]wn an interest in or participate, directly or indirectly, in the profits of any other entity which does business with or is a competitor of the Company, unless such ownership or participation has been previously disclosed in writing to the Chairman of the Board and Chief Executive Officer of Enron Corp. and such officer has determined that such interest or participation does not adversely affect the best interests of the Company."





 





 

24.
Virtually all of Enron's executives benefited from massive fraud just prior to the declaration of bankruptcy by Enron in December of 2001.  What was this fraud?

From "Unfair Values --- Enron's Shell Game," by James N. Burdotha, Jr. --- http://bodurtha.georgetown.edu/enron/Enron_Shell_Game_insert.htm

As Enron crumbled, executive compensation levels remained high, Wall Street Journal, June 17, 2002, "Enron Paid Managers $681 Million Even as Firm Slid Toward Collapse." With earnings of $975 million in 2000, Enron’s senior management totaled $750 million compensation bonuses. The U.S. Senate Government Affairs Subcommittee Report, “The Role of the Board of Directors in Enron's Collapse,” July 7, 2002, pg. 54. 65 This reserve is reported in the Board Special Report (pg. 125), but sees to As Enron crumbled, executive compensation levels remained high, Wall Street Journal, June 17, 2002, "Enron Paid Managers $681 Million Even as Firm Slid Toward Collapse." With earnings of $975 million in 2000, Enron’s senior management totaled $750 million compensation bonuses. The U.S. Senate Government Affairs Subcommittee Report, “The Role of the Board of Directors in Enron's Collapse,” July 7, 2002, pg. 54.

 

Eichenwald in Conspiracy of Fools on Page 629 states the following:
 

The next morning, the lobby at the International Bank of Commerce was jammed with Enron executives.  The paperwork seemed to last forever, but eventually the bankers produced a small box, filled with cashier's checks.

A portion of the bonuses was going to be paid another way.  But these checks for the remainder had to be purchased; they couldn't be used to draw down a specific client account.  The bank president came toward Bowen, carrying another blank check, the kind that any of the local customers would receive when opening a new account.

"You need to fill out this check for the cashier's checks," the president said.

Bowen looked down at the check.  Blank, nothing.  No name, no logo.  Just an account number.  He started writing.

$38 million.  Thirty-eight million and 00/100.

It was the largest check he had ever seen, much less written.  He handed it to the bank president.  The box of cashier's checks was turned over to David Oxley, an executive from Enron's human-resources division.

Oxley looked at Bowen.  "See ya," he said.

He and a colleague, Robert Jones, ran out to their car, so they could deliver the checks to Enron's top employees.

Jones and Oxley parked their car and were hustling toward the Enron building.  Before they could even get in, they stumbled across Lavorato and another division president, Louise Kitchen, who were waiting for them.  They both demanded their checks right away.  Oxley fished them out of the box and handed them over.

Kitchen and Lavorato hurried away.  They wanted to get to their banks and deposit the checks while there was still a chance they would clear before Enron went under.
 


 





 



 

25.
What Time Magazine's Woman of the Year was noted for a very foul mouth? 
Hint:  She's best known for her whistle blowing memo.  She was an undervalued accounting executive without much to do.  She finally took the trouble on her own to unravel the exceeding complexity of one of Andy Fastow's most complex SPEs that "had no skin."

Sherron (Smith) Watkins is best known for sending a memo to Ken Lay informing him that when she really unraveled LJM partnerships, there really was "no skin."  By this she meant that Enron stock was being used to hedge Enron stock value.  You cannot hedge the value of an item by owning the item itself.  Ms. Watkins in the days she was single and named Smith was a colorful character in Enron circles, and she was also a darn good accountant.
 

"She tried too hard to be one of the boys"
Time Magazine's Foul-Mouthed 2002 Person of the Year

Sherron (Smith) Watkins was the Enron executive credited with blowing the whistle about Andy Fastow's illegal SPE dealings.  She sent her now famous letter to both CEO Ken Lay and to the Andersen auditors where she'd been employed before coming to Enron.  She was eventually named one of Time Magazine's 2002 "Persons of the Year" --- http://www.time.com/time/personoftheyear/2002/

From Kurt Eichenwald's Conspiracy of Fools:  A True Study, (Broadway Books, 2005, pp. 95-96).

Sherron Smith flipped through the pages of an investment presentation, her face tightening in disgust.

A former accountant, Smith had worked at Enron since October 1993, when she was hired to manage JEDI, Enron's joint venture with Calpers. At first she had enjoyed Enron and her boss, Andy Fastow, who struck her as energetic and dynamic, with occasional touches of thoughtfulness. But over time, Fastow's shortcomings as a manager had alienated her. That year he had even failed to show up at the semiannual Performance Review Committee meeting, where managers pushed to get bonuses and promotions for their staff. As a result, Smith had come away with a disappointing fourteen-thousand-dollar bonus and a simmering anger toward Fastow. She had even considered quitting.

Then, salvation. Fastow moved to retail. Rick Causey, Skilling's favorite accountant, took over, and her world brightened. Causey was a friendly, doughy man who had already promised to get raises for Smith and her colleagues. The change rekindled her good feelings for Enron.

Her job, put simply, was to act as JEDI's gatekeeper. Executives around Enron were always looking for JEDI to invest in their deals. But too many proposals were fanciful--badly thought out, badly structured, or just plain bad.

When deal makers made a sloppy presentation to Smith, she savaged them. She delighted in shocking people with uncomfortable truths--about anything at all, including herself. The knock on Smith was that she tried too hard to be one of the boys--so long as the boys were truck drivers and longshoremen. Her foul mouth at meetings was legendary, and this day, no one expected to be any different.

Smith closed up the presentation, staring hard across the table at the executives who brought it to her.

"What the fuck is this?" she snorted. "This thing looks like a circle jerk to me."

Smirks all around. Sherron was just being Sherron.

"Sherron, I know you've got strong opinions, but there's a lot of value--," one of the executives began.

"Oh, come on, Smith interrupted. "Let's not sit around blowing each other, okay?"

One side of the table, a couple of Smith's colleagues, Shirley Hudler and Bill Brown, listened to the exchange and winced. They respected Smith but thought her salty approach to business discussions damaged her.

Oh, God, Sherron, Hudler thought. Shut up.

The deal team pushed hard for Smith to change her mind. Smith countered with responses about the problems with the transaction; her arguments were strong. The case for doing the deal crumpled.

Smith quashed another proposal--but, as always, at a price. Her colleagues whispered that her coarse language was undermining her credibility, that her penchant for one-upmanship was giving her the reputation as someone who wouldn't listen. If she didn't stop, if she didn't learn how to play nice in a corporate setting, if she didn't learn to be more of a team player, they had no doubt that Sherron Smith's future at Enron would be bleak.

None of her colleagues could have imagined that Smith would be one of Enron's few executives to emerge from the company in high stead, known worldwide under her then-married name as Sherron Watkins, the Enron whistle-blower.

 




 










 

26.
Did Rebecca Mark have a high level position in Enron? 
Was she competent? 
What famous accounting ratio could she just not comprehend?

What's clear is that Enron had way too many unethical and unbelievably incompetent executives like Rebecca Mack who kept throwing billions after badly invested billions and took most of her pleasures in life in corporate jets and luxury hotels.  She was a very high level executive in charge of all international operations, including huge electricity and water generating plant constructions and operations. 

Skilling and Lay never could teach her the simple fact that the Return on Investment (ROI) ratio has a denominator.  Up to the very end when Skilling fired her (too long after her billions in damages), she kept screaming “look at the numbers” where the numbers she presented were only based on the ROI numerator. 

From pp. 362-364 in Eichenwald's Conspiracy of Fools:

Lay steeled himself as he neared Rebecca Mark's office on the tenth floor of Allen Center.  He arrived in her doorway, looking somber.  Mark had been expecting him.

"Ken, good to see you," she said breezily.

He stepped across the limestone floor and took a chair.  Mark sat directly across from him.

It was best to get right to the point.  "Rebecca, you must know that things aren't going very well here."  A beat.  "I think that it's time for you to resign."

Mark said nothing as Lay rambled on about the contribution she had made to the company, about how she had raised the international stature of both Enron and Azurix.

"We really thank you for what you've accomplished," he said.  "But now it's time for you to leave."

Mark blinked, showing no reaction.

Eighteen years.  That was all she could think.  Mark gave eighteen years to Enron, gave Lay his international stature with her division.  Now, she thought, he was making a bad decision, based on Skilling's numbers.  Skilling had made her look incompetent, and apparently it had worked.

"Ken, if that's what you and the board want, then I accept that," she began.  "But I really think you need to take a look at the numbers we put together.  Our performance in international has been better than Jeff says.  Our performance here is very promising."

Lay's anger swelled.  He had seen too much evidence of shaky financial analysis coming out of her teams.  So much money had been wasted.  He just wanted this to be over.

"Rebecca, that is not the issue here," he said.

"Ken I really think you need to take a look at our numbers," Mark pressed.

Lay's patience vanished.  "Rebecca!" he snapped.  "I don't give a fuck about your numbers!"

Days later, just after eight on the morning of August 24, Rebecca Mark sat for the last time with the Azurix board.  The summit was being held at Enron in a room on the fiftieth-floor mezzanine; Azurix couldn't even host its own board meetings anymore.

Mark was the first to speak.  "I disagree with your decision.  I think it's the wrong thing to do."

No one responded.

"But the decision's been made," Mark said.  "Before I agree to this, though, there are three things I require."

Mark listed her demands quickly.  Her bonus for the year, prorated.  Input in the press release announcing her departure.  And, if she ever returned to buy Azurix assets, a commitment that she would be taken seriously.

Skilling leaned in.  "Tell me about this bonus."

When another senior Azurix executive was terminated, Mark said, the company had given him a prorated bonus, based on the amount he had received the prior year.

Skilling snorted.  "Yeah, but when he left, Azurix was still on budget."

"I should be paid for the time I worked."

"Okay," Skilling retorted.  "And this thing about buying assets.  Are you asking for preferential treatment?"

"Of course not," Mark said.

Pug Winokur, who was acting as chairman, glanced around the room.  No more questions.  "All right, Rebecca," he said.  "If you give us a moment, we'll discuss it."

Mark left the room.  Skilling started right in.

"Paying her a bonus is absolutely incomprehensible!" he said.  "We pay for performance.  She should get nothing."

The debate went on for several minutes.  Winokur brought it to an end.  "Look, Rebecca is not a wilting flower.  This is a small amount of money, just to get this over with and make sure that she leaves quietly and that we can get back to business."

Winokur's argument won.  The directors decided to pay Mark several hundred thousand dollars and send her on her way.
 









 

27.
Aside from Andy Fastow's suggested use of SPEs for off-book transactions, who was the main instigator of accounting irregularities for items on the books of Enron? 
What were some of the most typical types of accounting irregularities? 
Also mention some of Fastow's accounting irregularities.

Literally none of Enron's many executives had any respect for accounting integrity.  The books were cooked mainly to boost stock price and annual bonuses.

"Lesser Known Enron Executive Is Key Witness:  Imprisoned Ex-Treasurer Glisan Brings 'Boy Scout' Reputation To Testimony on Financial Deals," by John R. Emshwiller, The Wall Street Journal, March 20, 2006; Page C1 --- http://online.wsj.com/article/SB114281177496502519.html?mod=todays_us_money_and_investing 

Although he lacks the star power of some who have preceded him, Ben Glisan Jr. could become the most important witness in the government's effort to convict former Enron Corp. executives Jeffrey Skilling and Kenneth Lay of conspiracy and fraud.

Prosecutors hope the 40-year-old Mr. Glisan, Enron's former treasurer, will provide jurors with convincing support for allegations made by prior witnesses in the trial. Unlike some of those prior witnesses, Mr. Glisan was high enough up the corporate ladder to have regular contact with Messrs. Skilling and Lay, including

A trained accountant, Mr. Glisan helped design some of the financial transactions that are a major part of the alleged fraud at Enron -- and, thus, he should be able to discuss those transactions with an authority that some previous witnesses lacked. Unlike other witnesses who are cooperating with the government in hopes of reducing their sentences, Mr. Glisan simply pled guilty to an Enron-related crime to settle a 26-count indictment and is serving his five-year prison term -- potentially boosting his credibility to jurors.

Mr. Glisan was a protégé of one of the alleged fraud's central figures, former Enron Chief Financial Officer Andrew Fastow, who recently completed four days of often-contentious testimony. While privy to Mr. Fastow's thinking and actions at Enron, Mr. Glisan doesn't carry all the negatives of his former boss, who was feared and disliked by many at Enron and has admitted to stealing millions from the company.

By contrast, the affable Mr. Glisan was a generally popular figure. Even Mr. Skilling, interviewed by Enron investigators shortly after the company's December 2001 collapse into bankruptcy court, was quoted as describing Mr. Glisan as having the reputation of a "boy scout."

Defense attorneys won't be singing Mr. Glisan any campfire tunes when they cross-examine him. They are expected to portray the former treasurer as a liar who betrayed the trust of Messrs. Skilling and Lay by sharing in the booty that Mr. Fastow stole. Mr. Glisan has acknowledged reaping $1 million from a $5,000 investment with a Fastow partnership -- with the profit coming from money that Mr. Fastow admitted filching from Enron and some of his other partners. Defense attorneys hope to bring out contradictions between what Mr. Glisan and Mr. Fastow have told federal officials.

Continued in article

Also see http://www.nytimes.com/2006/03/20/business/businessspecial3/20enron.html?_r=1&oref=slogin

"Former Enron Treasurer Details His View of Internal Operations," by Gary McWilliams and John R. Emswiller, The Wall Street Journal, March 22, 2006; Page C3 --- Click Here 

He testified the company's senior executives were "manufacturing" earnings and misleading investors in 2001 to cover shortfalls and prop up the energy firm's falling stock price.

As of mid-August 2001, Messrs. Lay and Skilling knew that the company was struggling financially, yet falsely told investors it was in excellent shape, he alleged. Mr. Glisan said that in the succeeding months Enron's condition became "significantly worse," yet Mr. Lay continued to assure investors to the contrary.

Among the problems he said were "billions of dollars of embedded losses" in Enron's international assets. The prosecution introduced an Enron chart that indicated Mr. Skilling estimated the company's international businesses carried a value of $4.5 billion less than the value shown on Enron's books. Mr. Glisan said the company didn't write down the assets because it would have required "a larger loss than we could have stomached" and have serious repercussions for Enron in financial markets.

Enron Top Executives Modified Enron Data, Jury Is Told
Ms. Rieker, testifying in the fourth week of the trial in Federal District Court here, said that another former chief executive, Jeffrey K. Skilling, ordered last-minute changes to at least two quarterly earnings reports so that Enron could meet or beat analysts' expectations. She also said that Mr. Skilling directed her to misrepresent in a news release the source of most of the revenue at the struggling broadband unit. Mr. Lay, 63, and Mr. Skilling, 52, are accused of conspiring to defraud Enron, the former energy-trading giant that filed for bankruptcy in December 2001. Mr. Skilling, who abruptly quit the company in August 2001, is charged with conspiracy, fraud and insider trading. Mr. Lay is accused of fraud and conspiracy.
Alexei Barrionuevo, "Executives Modified Enron Data, Jury Is Told," The Wall Street Journal, February 22, 2006 --- http://www.nytimes.com/2006/02/22/business/businessspecial3/22enron.html

Rich Kinder probably dreamed up some creative accounting ploys before he left Enron in 1997.  But the head chef of accounting book cooking, often with the blessings of and/or consultation with Andersen's David Duncan, was the Chief Accounting Officer from 1997 until meltdown from overly cooked books in December 2001.  His name was Rick Causey. 

Probably the most popular ploy to boost earnings in Enron was to apply mark-to-market accounting in an unconventional manner, breaking away from traditional oil and gas accounting traditions.  Look up the many references to mark-to-market on Page 738 of Eichenwald's Conspiracy of Fools.

Another popular scheme was to have secret reserves of various sorts or various departures from Generally Accepted Accounting Principles (GAAP) in order to lift earnings per share or hide debt.  The following is stated about reserves in Eichenwald's Conspiracy of Fools on Page 673:

"It looks like you have an embarrassment of riches in that regard," she said.

The magistrate then turned to Buell, who recited the charges that Skilling faced.  It was a grab bag of allegations, the most serious involving Fastow and his dealings.  It charged that, along with Causey, he knew that the LJM funds were being used to manipulate Enron's earnings through deals like the Raptors and Cuibá sale.  He was also charged with fraud for what the government said was his involvement with Causey and Fastow in Project Grayhawk, the transaction designed to allow Enron to profit from the increase in its own stock price following the 2000 analysts' conference.

But most of the allegations had nothing to do with Fastow and instead were spread across a wide range of Ernon's businesses.  In the wholesale division, Skilling and Causey were charged with manipulating earnings in 2000 and 2001 through the establishment of the reserves to hold the profits from California trading.  In retail, they were charged with disguising losses by shifting the divisions' trading book into the wholesale division in early 2001.  And in Broadband, Skilling was charged with lying to investors about its prospects and technology.

As Buell spoke, Skilling turned to face the prosecutor, clasping his hands in front of him.  He didn't flinch when Buell said that the charges could bring a maximum of 325 years in prison.

Magistrate Stacy asked Skilling for his plea.

He stood up straight.  "I plead not guilty to all counts," he said.
 

The most notorious way to manipulate reported earnings and hide debt off the balance sheet centered on ways used by Enron to account for derivative financial instruments.  Frank Partnoy testified as follows:

Testimony of Frank Partnoy Professor of Law, University of San Diego School of Law Hearings before the United States Senate Committee on Governmental Affairs, January 24, 2002 --- http://www.senate.gov/~gov_affairs/012402partnoy.htm 

The key problem at Enron involved the confluence of derivatives and special purpose entities.  Enron entered into derivatives transactions with these entities to shield volatile assets from quarterly financial reporting and to inflate artificially the value of certain Enron assets.  These derivatives included price swap derivatives (described below), as well as call and put options.

                Specifically, Enron used derivatives and special purpose vehicles to manipulate its financial statements in three ways.  First, it hid speculator losses it suffered on technology stocks.  Second, it hid huge debts incurred to finance unprofitable new businesses, including retail energy services for new customers.  Third, it inflated the value of other troubled businesses, including its new ventures in fiber-optic bandwidth.  Although Enron was founded as an energy company, many of these derivatives transactions did not involve energy at all.

                A.                Using Derivatives to Hide Losses on Technology Stocks
                First, Enron hid hundreds of millions of dollars of losses on its speculative investments in various technology-oriented firms, such as Rhythms Net Connections, Inc., a start-up telecommunications company.  A subsidiary of Enron (along with other investors such as Microsoft and Stanford University) invested a relatively small amount of venture capital, on the order of $10 million, in Rhythms Net Connections.  Enron also invested in other technology companies.

                Rhythms Net Connections issued stock to the public in an initial public offering on April 6, 1999, during the heyday of the Internet boom, at a price of about $70 per share.  Enron’s stake was suddenly worth hundreds of millions of dollars.  Enron’s other venture capital investments in technology companies also rocketed at first, alongside the widespread run-up in the value of dot.com stocks.  As is typical in IPOs, Enron was prohibited from selling its stock for six months.

                Next, Enron entered into a series of transactions with a special purpose entity –apparently a limited partnership called Raptor (actually there were several Raptor entities of which the Rhythms New Connections Raptor was just one), which was owned by a another Enron special purpose entity, called LJM1 – in which Enron essentially exchanged its shares in these technology companies for a loan, ultimately, from Raptor.  Raptor then issued its own securities to investors and held the cash proceeds from those investors.

                The critical piece of this puzzle, the element that made it all work, was a derivatives transaction – called a “price swap derivative” – between Enron and Raptor.  In this price swap, Enron committed to give stock to Raptor if Raptor’s assets declined in value.  The more Raptor’s assets declined, the more of its own stock Enron was required to post.  Because Enron had committed to maintain Raptor’s value at $1.2 billion, if Enron’s stock declined in value, Enron would need to give Raptor even more stock.  This derivatives transaction carried the risk of diluting the ownership of Enron’s shareholders if either Enron’s stock or the technology stocks Raptor held declined in price.  Enron also apparently entered into options transactions with Raptor and/or LJM1.

                Because the securities Raptor issued were backed by Enron’s promise to deliver more shares, investors in Raptor essentially were buying Enron’s debt, not the stock of a start-up telecommunications company.  In fact, the performance of Rhythms Net Connections was irrelevant to these investors in Raptor.  Enron got the best of both worlds in accounting terms: it recognized its gain on the technology stocks by recognizing the value of the Raptor loan right away, and it avoided recognizing on an interim basis any future losses on the technology stocks, were such losses to occur.

                It is painfully obvious how this story ends: the dot.com bubble burst and by 2001 shares of Rhythms Net Communications were worthless.  Enron had to deliver more shares to “make whole” the investors in Raptor and other similar deals.  In all, Enron had derivative instruments on 54.8 million shares of Enron common stock at an average price of $67.92 per share, or $3.7 billion in all.  In other words, at the start of these deals, Enron’s obligation amounted to seven percent of all of its outstanding shares.  As Enron’s share price declined, that obligation increased and Enron’s shareholders were substantially diluted.  And here is the key point: even as Raptor’s assets and Enron’s shares declined in value, Enron did not reflect those declines in its quarterly financial statements.

                B.                Using Derivatives to Hide Debts Incurred by Unprofitable Businesses
                A second example involved Enron using derivatives with two special purpose entities to hide huge debts incurred to finance unprofitable new businesses.  Essentially, some very complicated and unclear accounting rules allowed Enron to avoid disclosing certain assets and liabilities.

                These two special purpose entities were Joint Energy Development Investments Limited Partnership (JEDI) and Chewco Investments, L.P. (Chewco).  Enron owned only 50 percent of JEDI, and therefore – under applicable accounting rules – could (and did) report JEDI as an unconsolidated equity affiliate.  If Enron had owned 51 percent of JEDI, accounting rules would have required Enron to include all of JEDI’s financial results in its financial statements.  But at 50 percent, Enron did not.

                JEDI, in turn, was subject to the same rules.  JEDI could issue equity and debt securities, and as long as there was an outside investor with at least 50 percent of the equity – in other words, with real economic exposure to the risks of Chewco – JEDI would not need to consolidate Chewco.

                One way to minimize the applicability of this “50 percent rule” would be for a company to create a special purpose entity with mostly debt and only a tiny sliver of equity, say $1 worth, for which the company easily could find an outside investor.  Such a transaction would be an obvious sham, and one might expect to find a pronouncement by the accounting regulators that it would not conform to Generally Acceptable Accounting Principles.  Unfortunately, there are no such accounting regulators, and there was no such pronouncement.  The Financial Accounting Standards Board, a private entity that sets most accounting rules and advises the Securities and Exchange Commission, had not – and still has not – answered the key accounting question: what constitutes sufficient capital from an independent source, so that a special purpose entity need not be consolidated?

Since 1982, Financial Accounting Standard No. 57, Related Party Disclosures, has contained a general requirement that companies disclose the nature of relationships they have with related parties, and describe transactions with them.  Accountants might debate whether Enron’s impenetrable footnote disclosure satisfies FAS No. 57, but clearly the disclosures currently made are not optimal.  Members of the SEC staff have been urging the FASB to revise No. 57, but it has not responded.  In 1998, FASB adopted FAS No. 133, which includes new accounting rules for derivatives.  Now at 800-plus pages, FAS No. 133’s instructions are an incredibly detailed – but ultimately unhelpful – attempt to rationalize other accounting rules for derivatives.

                As a result, even after two decades, there is no clear answer to the question about related parties.  Instead, some early guidance (developed in the context of leases) has been grafted onto modern special purpose entities.  This guidance is a 1991 letter from the Acting Chief Accountant of the SEC in 1991, stating: “The initial substantive residual equity investment should be comparable to that expected for a substantive business involved in similar [leasing] transactions with similar risks and rewards.  The SEC staff understands from discussions with Working Group members that those members believe that 3 percent is the minimum acceptable investment.  The SEC staff believes a greater investment may be necessary depending on the facts and circumstances, including the credit risk associated with the lessee and the market risk factors associated with the leased property.” 

Based on this letter, and on opinions from auditors and lawyers, companies have been pushing debt off their balance sheets into unconsolidated special purpose entities so long as (1) the company does not have more than 50 percent of the equity of the special purpose entity, and (2) the equity of the special purpose entity is at least 3 percent of its the total capital.  As more companies have done such deals, more debt has moved off balance-sheet, to the point that, today, it is difficult for investors to know if they have an accurate picture of a company’s debts.  Even if Enron had not tripped up and violated the letter of these rules, it still would have been able to borrow 97 percent of the capital of its special purpose entities without recognizing those debts on its balance sheet. 

Transactions designed to exploit these accounting rules have polluted the financial statements of many U.S. companies.  Enron is not alone.  For example, Kmart Corporation – which was on the verge of bankruptcy as of January 21, 2002, and clearly was affected by Enron’s collapse – held 49 percent interests in several unconsolidated equity affiliates.  I believe this Committee should take a hard look at these widespread practices.

                In short, derivatives enabled Enron to avoid consolidating these special purpose entities.  Enron entered into a derivatives transaction with Chewco similar to the one it entered into with Raptor, effectively guaranteeing repayment to Chewco’s outside investor.  (The investor’s sliver of equity ownership in Chewco was not really equity from an economic perspective, because the investor had nothing – other than Enron’s credit – at risk.)  In its financial statements, Enron takes the position that although it provides guarantees to unconsolidated subsidiaries, those guarantees do not have a readily determinable fair value, and management does not consider it likely that Enron would be required to perform or otherwise incur losses associated with guarantees.  That position enabled Enron to avoid recording its guarantees.  Even the guarantees listed in the footnotes are recorded at only 10 percent of their nominal value.  (At least this amount is closer to the truth than the amount listed as debt for unconsolidated subsidiaries: zero.)

                Apparently, Arthur Andersen either did not discover this derivatives transaction or decided that the transaction did not require a finding that Enron controlled Chewco.  In any event, the Enron derivatives transaction meant that Enron – not the 50 percent “investor” in Chewco – had the real exposure to Chewco’s assets.  The ownership daisy chain unraveled once Enron was deemed to own Chewco.  JEDI was forced to consolidate Chewco, and Enron was forced to consolidate both limited partnerships – and all of their losses – in its financial statements.

                All of this complicated analysis will seem absurd to the average investor.  If the assets and liabilities are Enron’s in economic terms, shouldn’t they be reported that way in accounting terms?  The answer, of course, is yes.  Unfortunately, current rules allow companies to employ derivatives and special purpose entities to make accounting standards diverge from economic reality.  Enron used financial engineering as a kind of plastic surgery, to make itself look better than it really was.  Many other companies do the same.

                Of course, it is possible to detect the flaws in plastic surgery, or financial engineering, if you look hard enough and in the right places.  In 2000, Enron disclosed about $2.1 billion of such derivatives transactions with related entities, and recognized gains of about $500 million related to those transactions.  The disclosure related to these staggering numbers is less than conspicuous, buried at page 48, footnote 16 of Enron’s annual report, deep in the related party disclosures for which Enron was notorious.  Still, the disclosure is there.  A few sophisticated analysts understood Enron’s finances based on that disclosure; they bet against Enron’s stock.  Other securities analysts likely understood the disclosures, but chose not to speak, for fear of losing Enron’s banking business.  An argument even can be made – although not a good one, in my view – that Enron satisfied its disclosure obligations with its opaque language.  In any event, the result of Enron’s method of disclosure was that investors did not get a clear picture of the firm’s finances. 

                Enron is not the only example of such abuse; accounting subterfuge using derivatives is widespread.  I believe Congress should seriously consider legislation explicitly requiring that financial statements describe the economic reality of a company’s transactions.  Such a broad standard – backed by rigorous enforcement – would go a long way towards eradicating the schemes companies currently use to dress up their financial statements.

                Enron’s risk management manual stated the following: “Reported earnings follow the rules and principles of accounting.  The results do not always create measures consistent with underlying economics.  However, corporate management’s performance is generally measured by accounting income, not underlying economics.  Risk management strategies are therefore directed at accounting rather than economic performance.”  This alarming statement is representative of the accounting-driven focus of U.S. managers generally, who all too frequently have little interest in maintaining controls to monitor their firm’s economic realities.

                C.                Using Derivatives to Inflate the Value of Troubled Businesses
A third example is even more troubling.  It appears that Enron inflated the value of certain assets it held by selling a small portion of those assets to a special purpose entity at an inflated price, and then revaluing the lion’s share of those assets it still held at that higher price. 

Consider the following sentence disclosed from the infamous footnote 16 of Enron’s 2000 annual report, on page 49: “In 2000, Enron sold a portion of its dark fiber inventory to the Related Party in exchange for $30 million cash and a $70 million note receivable that was subsequently repaid.  Enron recognized gross margin of $67 million on the sale.”  What does this sentence mean?

It is possible to understand the sentence today, but only after reading a January 7, 2002, article about the sale by Daniel Fisher of Forbes magazine, together with an August 2001 memorandum describing the transaction (and others) from one Enron employee, Sherron Watkins, to Enron Chairman Kenneth Lay.
Here is my best understanding of what this sentence means:

First, the “Related Party” is LJM2, an Enron partnership run by Enron’s Chief Financial Officer, Andrew Fastow.  (Fastow reportedly received $30 million from the LJM1 and LJM2 partnerships pursuant to compensation arrangements Enron’s board of directors approved.)

Second, “dark fiber” refers to a type of bandwidth Enron traded as part of its broadband business.  In this business, Enron traded the right to transmit data through various fiber-optic cables, more than 40 million miles of which various Internet-related companies had installed in the United States.  Only a small percentage of these cables were “lit” – meaning they could transmit the light waves required to carry Internet data; the vast majority of cables were still awaiting upgrades and were “dark.”  The rights associated with those “dark” cables were called “dark fiber.”  As one might expect, the rights to transmit over “dark fiber” are very difficult to value.

Third, Enron sold “dark fiber” it apparently valued at only $33 million for triple that value: $100 million in all – $30 million in cash plus $70 million in a note receivable.  It appears that this sale was at an inflated price, thereby enabling Enron to record a $67 million profit on that trade.  LJM2 apparently obtained cash from investors by issuing securities and used some of these proceeds to repay the note receivable issued to Enron.

What the sentence in footnote 16 does not make plain is that the investor in LJM2 was persuaded to pay what appears to be an inflated price, because Enron entered into a “make whole” derivatives contract with LJM2 (of the same type it used with Raptor).  Essentially, the investor was buying Enron’s debt.  The investor was willing to buy securities in LJM2, because if the “dark fiber” declined in price – as it almost certainly would, from its inflated value – Enron would make the investor whole.
In these transactions, Enron retained the economic risk associated with the “dark fiber.”  Yet as the value of “dark fiber” plunged during 2000, Enron nevertheless was able to record a gain on its sale, and avoid recognizing any losses on assets held by LJM2, which was an unconsolidated affiliate of Enron, just like JEDI.

As if all of this were not complicated enough, Enron’s sale of “dark fiber” to LJM2 also magically generated an inflated price, which Enron then could use in valuing any remaining “dark fiber” it held.  The third-party investor in LJM2 had, in a sense, “validated” the value of the “dark fiber” at the higher price, and Enron then arguably could use that inflated price in valuing other “dark fiber” assets it held.  I do not have any direct knowledge of this, although public reports and Sherron Watkins’s letter indicate that this is precisely what happened.

For example, suppose Enron started with ten units of “dark fiber,” worth $100, and sold one to a special purpose entity for $20 – double its actual value – using the above scheme.  Now, Enron had an argument that each of its remaining nine units of “dark fiber” also were worth $20 each, for a total of $180. 

Enron then could revalue its remaining nine units of “dark fiber” at a total of $180.  If the assets used in the transaction were difficult to value – as “dark fiber” clearly was – Enron’s inflated valuation might not generate much suspicion, at least initially.  But ultimately the valuations would be indefensible, and Enron would need to recognize the associated losses.

It is an open question for this Committee and others whether this transaction was unique, or whether Enron engaged in other, similar deals.  It seems likely that the “dark fiber” deal was not the only one of its kind.  There are many sentences in footnote 16.
 

 

Some ploys that Andersen's top brass, notably Carl Bass, did not buy into were simply approved by Andersen's David Duncan without permission.  For example, Carl bass strongly objected to deferring the expensing of some international taxes. 

Eichenwald in Conspiracy of Fools states the following on pp. 225-226:

"Isn't there another way to look at this?"  David Duncan implored.  "It's really important to Causey."

Duncan was on the phone with Carl Bass, haggling over some international deal designed to defer taxes Enron owned.  But Bass had come back and said no, it couldn't be done.  Now Duncan was pleading with him to try again, to find a way to let the tax expense go unrecognized that year.

Bass stood uncomfortably in the anteroom outside Causey's office.  It was April 10, and in recent days Causey and Duncan had been down in Augusta, Georgia, watching the Masters Tournament.  But they flew back early to meet Bass and hash through the tax issue one more time.

Causey called Bass into his office, where Duncan was already waiting.  The three men wandered to the formal sitting area.

"All right, we all know why we're here," Causey said.  "I'm going to lay out Enron's position.

Causey spoke for several minutes.  He said nothing about the rules; instead, he talked about the financial outcome Enron wanted.  Bass was unmoved.

"Sorry, Rick," Bass said.  "I've looked at this, Chicago's looked at this.  It is what it is."

"Wait," Duncan said.  "Rick, I hear your point.  So, Carl, what if you moved your position a little bit?"

Duncan explained how he thought Bass could compromise.  Bass gaped at him.  Duncan was supposed to represent the firm's opinion, not try to broker a compromise.

This isn't a negotiation, Dave.  There's an answer.  I gave it.  We're done.

"So what if you did that?  Do you think we could find a middle ground?" Duncan asked.

Did they not understand what accountants did?  "No, Dave, there's no middle ground.  There's an answer.  The firm has put in its best people.  And we have given the answer."

Causey sighed, looking furious.  "Okay, fine."

The meeting broke up.  As Bass left, anxiety welled in his mind.

God knows what these two are going to do now.
 


Carl Bass also did not agree with Enron's accounting treatment for its many derivative financial instruments.

"Andersen auditor questioned Enron:  Carl Bass raised accounting issues with Enron in 1999, documents show." CNNMoney,  April 2, 2002 --- http://money.cnn.com/2002/04/02/news/companies/andersen_bass/ 

Arthur Andersen auditor Carl Bass questioned Enron Corp.'s accounting practices as far back as December 1999, documents released Tuesday by congressional investigators show.

Bass expressed his discomfort in December 18, 1999, with Enron's aggressive hedging strategy for derivatives. In a message to John Stewart, an Andersen partner in Chicago, Bass said he told colleague David Duncan that he objected to using one derivative to hedge another derivative. Duncan was the lead audit partner on the Enron account.

Derivatives cannot hedge derivatives for accounting purposes -- now or under FASB 133," Bass said. "Does Dave [Duncan] think his accounting works even under FASB 133? No way."

Both Bass and Duncan reportedly are in talks with federal prosecutors and their testimony could be used in the obstruction case against Andersen.

Andersen in January fired Duncan for instigating the destruction of Enron Corp. documents. Houston-based Enron allegedly used off-the-book transactions to hide $1 billion in debt and to inflate profits. Enron, once the nation's seventh-largest company, filed the largest bankruptcy in U.S. history last December.

Arthur Andersen, Enron's auditor for 16 years, was hit with a federal indictment March 14 for allegedly obstructing justice when it destroyed Enron documents. Andersen is now near collapse and called off merger negotiations Tuesday with KPMG International. The proposed Andersen-KPMG transaction would have combined the two firm's non-US partnerships.

In a February 1, 2000 e-mail to Stewart, Bass laid out issues he had with a "complicated series of Enron derivatives." Three days later, Bass sent another message stating he was "still bothered" with a partnership, SPE, and believed it to be non-substantive.

Because of such complaints, a senior Enron executive asked Duncan to remove Bass from any review responsibility for the Enron account, the Wall Street Journal reported Tuesday. Bass was removed in 2000, the WSJ said.

 

And there was revenue round tripping of the kind described at  http://www.trinity.edu/rjensen/ecommerce/eitf01.htm#RoundTripping

Round tripping became wild in Enron's competitors as well as Enron itself:

"The Revenue Games People (Like Enron) Play," Carol J Loomis, Fortune, April 15, 2002 --- http://www.fortune.com/indexw.jhtml?channel=artcol.jhtml&doc_id=207024 

Of all the accounting weirdness around--could anyone ever have dreamed that accounting would vie with pedophilia as front-page news?--the aspect that has most fundamentally affected the FORTUNE 500 is the handling of what are called "energy trading contracts."

These things, almost single-handedly, made Enron one of the largest companies on our list--No. 7 in 2000 and No. 5 this year. These contracts have also caused many other energy and utility companies to show big to enormous increases in revenues from what they originally reported for 2000. A company many of our readers have most likely never heard of, Idacorp (formerly known as Idaho Power), leaped onto the list thanks to a 454% revenue increase; at American Electric Power revenues rose 347%; Calpine's jumped 233%. Another company, Mirant, which was spun out of Southern Co., is popping up on the list for the first time with an astonishing $31.5 billion in revenues--more, for example, than Dell or Motorola. All these figures were blessed by the authorities that FORTUNE has always relied on: companies' outside auditors and their watchdog, the Securities and Exchange Commission

We will explain these wacky revenue leaps. But first, an explanation as to why the Greatest Leaper of them all, Enron, is fifth on our 2001 list. To begin with, Enron, going by the restated financials it issued for the first nine months of last year, inarguably was a huge company. In fact, its $139 billion in revenues for nine months exceeded General Electric's full-year revenues of $125 billion.

Then, on Dec. 2, Enron went into bankruptcy (a fact that doesn't disqualify it from the 500 list), and it has yet to report fourth-quarter results. The missing quarter, in which we knew revenues had fallen dramatically, gave us a problem. So we took a stab at estimating full-year revenues and concluded they might reach a maximum of $160 billion. But rather than create a precedent of using revenue estimates on the FORTUNE 500 list, we decided to rank Enron based on its nine-months revenues of $139 billion--and that figure is what makes it fifth on our list, behind Wal-Mart, Exxon Mobil, GM, and Ford. (Had we used the $160 billion estimate, Enron would still have trailed Ford.) Given the questions that hang over Enron's profits, assets, and stockholders' equity, we didn't think we could report plausible figures for those categories.

So how valid are Enron's mountainous revenues? To answer that you need to understand a bit about energy trading contracts. These are commodity contracts, mainly for natural gas, oil, and electricity, and they are entered into by traders hoping to earn a profit on future shifts in market prices. The traders are not only energy companies but also--and this is a fact that's important to our revenue tale--Wall Street firms such as UBS Warburg, Salomon Smith Barney, J.P. Morgan Chase, and Morgan Stanley.

So let's imagine a contract for $1 million of natural gas (we'll skip the btu details), to be delivered six months from now. If a Wall Street firm sold this contract, nothing called "revenues" would ever be created. Instead, the firm would periodically mark the contract to market--that is, measure the profit or loss earned on the contract--and, when time came to report, put that dollar result into an income statement item called "trading gains and losses" (which is considered revenue on the FORTUNE 500). In accounting parlance, this is known as reporting "net."

But in the 1990s many energy and utility companies, with Enron apparently acting as Pied Piper, began to report a lot of contracts "gross," meaning that in our example they put the $1 million value of that contract directly into revenues. They concurrently offset those revenues with a roughly equal cost for the gas, and thereafter measure profit and loss just like the Wall Street firms. All other things being equal, they end up with an identical profit to what the Wall Street firm makes. But there's obviously a monster difference in reported revenues--zero dollars in the Wall Street case, $1 million in the energy case.

 

Stoking the Furnaces  
 
 

Big volume in energy trading contracts, and a hot method of accounting for their revenues, have put the four biggest energy companies--Enron, American Electric Power, Duke, and El Paso--into the upper reaches of the FORTUNE 500.  
 
 

 

Company   %   FORTUNE 500 rank  
 
 

American Electric Power
(AEP)
  347%   13  
 
  El Paso   162%   17  
 
  Enron   38%   5  
 
  Duke   21%   14  
 
  FORTUNE 500 Median   1.9%  
 
 
 

 


Bob Jensen's threads on revenue accounting fraud are at http://www.trinity.edu/rjensen/ecommerce/eitf01.htm










28. 
Who is Jay Cooke and what does he have, if anything, to do with the Enron scandal?


From Jim Mahar's blog on November 4, 2005 --- http://financeprofessorblog.blogspot.com/

Looking for an unsung hero of the US Civil War? You could do much worse than picking Jay Cooke.

Jay Cooke was what we would now call an investment banker.. He had made quite the name for himself selling all types of securities but especially state bonds---his Pennsylvania and Texas bond sales are particularly interesting and could be the focus of a future entry just by themselves

Cooke did things differently than most bankers at the time. Whether by necessity or plan, he marketed his securities directly to the people. Additionally he played on not only their desire for a good deal, but their patriotism.

For instance, a typical advertisement that he ran in newspapers:

“…independent of any motives of patriotism, there is considerations of self-interest which may be considers in reference to this Loan. It is a six percent loan free of any taxation”

While his pre-war career had been successful, he should be most remembered for his work during the Civil War. Starting in 1862 (after the Union lost the Battle of Bull Run), he helped sell several large Federal bond offers that literally helped to win the war by allowing the North to outspend the South. This ability to spend seemingly endless amounts of money, was a major determining factor in the North's eventual victory.

The details of his sales are fascinating. His place in history is guaranteed for his paving the way for future generations of “war bonds” and helping to open the world of finance to a much broader audience—a fact that during the later 1800s the railroads would use to their advantage). To help make these bonds available to the general public, he made bonds available in with par values as low as $50 and instructed his network of offices to remain open well into the evening so that the “working man” could invest after work.

It should be noted that these were not just “plain vanilla” bonds. He was selling debt that was callable and had a longer maturity (up to 20 years) than most debt of the day.

But that is not all; he also ran what some consider to be the first “wire house” whereby his firm used telegraphs to sell securities throughout the North from their office in Washington.

And even after the actual fighting ended (a time when the Union needed millions of dollars to help rebuild) he kept at his original ways (which angered the more traditional bankers) and now gets credit for initiating price stabilization (a practice whereby the investment banking syndicate enters the secondary market and helps to stabilize the price of the security they just helped to sell to the public).

There is today a middle school named after Cooke in Philadelphia.

Source: Wall Street: a History From Its Beginnings to the Fall of Enron, by Charles R. Geisst, pp. 49-58.

Additional sources: http://en.wikipedia.org/wiki/Jay _Cooke http://www.buyandhold.com 








29. What are Ken Lay's secret recipes for looting $184,494.426 from the corporation you manage?
What is Ken Lay's defense?

Answers to these questions can be found at http://www.trinity.edu/rjensen/FraudEnron.htm#SecretRecipes
This includes Ken Lay's speech on December 13, 2005 ---
http://www.trinity.edu/rjensen/FraudEnron.htm#KenLayDefense








 

30.
Will  Phil and Wendy Gramm forever go unpunished in the Enron scandal?

As the Enron trial unfolds, it's depressing that Phil and Wendy Gramm, the company's political enablers, are going unpunished and uncriticized.
Robert Scheer, "Enron's Enablers " The Nation, February 1, 2006 ---
http://www.thenation.com/doc/20060213/scheer0201

Back in 1993, when Enron was an upstart energy trader and Wendy Gramm occupied the position of chair of the CFTC, she granted the company, the biggest contributor to her husband's political campaigns, a very valuable ruling exempting its trading in futures contracts from federal government regulation.

She resigned her position six days later, not surprising given that she was a political appointee and Bill Clinton had just defeated her boss, the first President Bush. Five weeks after her resignation, she was appointed to Enron's board of directors, where she served on the delinquent audit committee until the collapse of the company.

There was perfect quid pro quo symmetry to Wendy Gramm's lucrative career: Bush appoints her to a government position where she secures Enron's profit margin; Lay, a close friend and political contributor to Bush, then takes care of her nicely once she leaves her government post.

Although she holds a doctorate in economics and often is cited as an expert on the deregulation policies she so ardently champions, Gramm insists that while serving on the audit committee she was ignorant of the corporation's accounting machinations. Despite her myopia, or because of it, she was rewarded with more than $1 million in compensation.

A similar claim of ignorance of Enron's shenanigans is the defense of her husband, who received $260,000 in campaign contributions from Enron before he pushed through legislation exempting companies like Enron from energy trading regulation.

"This act," Public Citizen noted, "allowed Enron to operate an unregulated power auction--EnronOnline--that quickly gained control over a significant share of California's electricity and natural gas market."

The gaming of the California market, documented in grotesque detail in the e-mails of Enron traders, led to stalled elevators, hospitals without power and an enormous debt inflicted on the state's taxpayers. It was only after the uproar over California's rolling blackouts, which Enron helped engineer, that the Federal Energy Regulatory Commission finally re-imposed regulatory control--and thereby began the ultimate unraveling of Enron's massive pyramid of fraud.

Jensen Comment
I've always been a bit harsh on Wendy Gramm because of the way she significantly helped Enron deregulate energy markets while she worked for the Government and later joined Enron's Board of Directors. In fairness, however, I must point out that while serving on the Board of Directors of Enron, Wendy Gramm's stock sales were exceedingly modest compared with the big winners --- http://www.trinity.edu/rjensen/FraudEnron.htm#StockSales

Bob Jensen over the years has written quite a lot about Wendy Gramm --- http://www.trinity.edu/rjensen/FraudEnron.htm#EnronLinks

Bob Jensen's updates on frauds are at http://www.trinity.edu/rjensen/FraudUpdates.htm

 




 

31.
Was Enron really a loser or did outside forces bring it down?

A person can be a professional thief only if he is recognized and received as such by other professional thieves. Professional theft is a group way of life.
Edwin Sutherland

There will always be white collar crime as long as it pays big even when you get caught.
Bob Jensen --- http://www.trinity.edu/rjensen/FraudConclusion.htm#CrimePays

Enron's Timeline From Beginning to End --- http://www.trinity.edu/rjensen/FraudEnron.htm#EnronTimeline

Memorable quotations about Enron, Worldcom, and Andersen --- http://www.trinity.edu/rjensen/FraudEnron.htm#Quotations

Special Report on the Fall of Enron  --- http://www.chron.com/news/specials/enron/

Frontline (from PBS) videos on accounting and finance regulation and scandals in the U.S. --- http://www.pbs.org/wgbh/pages/frontline/shows/regulation/view/ Note that one of the Frontline videos in about the Enron scandal --- http://www.pbs.org/wgbh/pages/frontline/shows/regulation/view/

Enron Declared Bankruptcy in 2001
History of the Rise and Fall of Enron --- http://www.trinity.edu/rjensen/FraudEnron.htm
Bob Jensen's Enron Quiz --- http://www.trinity.edu/rjensen/FraudEnronQuiz.htm
And don't forget about the Enron home video starring some of the real players (including Jeff Skilling) before they got caught --- http://www.trinity.edu/rjensen/FraudEnron.htm#HFV

From Wikipedia --- http://en.wikipedia.org/wiki/Enron

Enron Creditors Recovery Corporation (formerly Enron Corporation) (former NYSE ticker symbol: ENE) was an American energy company based in Houston, Texas. Before its bankruptcy in late 2001, Enron employed around 22,000 people (McLean & Elkind, 2003) and was one of the world's leading electricity, natural gas, pulp and paper, and communications companies, with claimed revenues of $111 billion in 2000. Fortune named Enron "America's Most Innovative Company" for six consecutive years. At the end of 2001 it was revealed that its reported financial condition was sustained mostly by institutionalized, systematic, and creatively planned accounting fraud (see: Enron scandal). Enron has since become a popular symbol of willful corporate fraud and corruption.

Enron filed for bankruptcy protection in the Southern District of New York in late 2001 and selected Weil, Gotshal & Manges as their bankruptcy counsel. Enron still exists as an asset-less shell corporation, emerging from bankruptcy in November of 2004 after one of the biggest and most complex bankruptcy cases in U.S. history. On September 7, 2006, Enron sold Prisma Energy International Inc., its last remaining business, to Ashmore Energy International Ltd. Following the scandal, lawsuits against Enron's directors were notable because the directors settled the suits by paying very significant sums of money personally. The scandal also caused the dissolution of the Arthur Andersen accounting firm, affecting the wider business world.

Infectious Greed:  How Deceit and Risk Corrupted the Financial Markets  (Henry Holt and Company, 2003, Page 297, ISBN 0-8050-7510-0)

A close analysis of the dealings at Enron leads to three key conclusions, each counter to the prevailing wisdom about the company. First, Enron was, in reality, a derivatives-trading firm, not an energy firm, and it took much more risk than anyone realized. By the end, Enron was even more volatile than a highly leveraged Wall Street investment bank, although few investors realized it.

Second, Enron's core business of derivatives trading was actually highly profitable, so profitable, in fact, that Enron almost certainly would have survived if key parties had understood the details of its business. Instead, in late 2001, Enron was hoist with its own petard, collapsing --- not because it wasn't making money --- but because institutional investors and credit-rating agencies abandoned the company when they learned that Enron's executives had been using derivatives to hide the risky nature of their business.

Jensen Comment
Be that as it may, Enron's derivatives traders were performing illegal and unethical market manipulations while Enron dominated the newly unregulated energy trading market.

"The Case Against Ken Lay Enron's former chief claims he was out of the loop. How prosecutors aim to show otherwise" by Julie Rawe, Time Magazine, July 19, 2004 --- http://www.time.com/time/magazine/article/0,9171,1101040719-662791,00.html 

Oct. 23, 2001, stands out as a particularly bad day for Ken Lay. As word circulated that the energy giant he founded was under investigation for balance-sheet shenanigans, the CEO tried to pull Enron's stock out of a tailspin by arranging a special conference call with analysts. "We're not trying to conceal anything," he told them. "I'm disclosing everything we've found." After Lay got off the phone, he gathered Enron's thousands of employees via a live webcast and video teleconference, and tried to reassure them too. "Our liquidity is fine," he said of the company that was about to flame out in one of the biggest accounting scandals in history. "As a matter of fact, it's better than fine. It's strong."

Those comments came back to haunt Lay last week in an 11-count indictment accusing him of conspiring to cook Enron's books even as he touted its tainted stock. For starters, prosecutors claim that Lay failed to mention to analysts several massive problems he knew about, including some $7 billion in hidden debts. And he neglected to tell employees that the company's liquidity hinged on an emergency billion-dollar loan Enron had just obtained by offering its precious pipelines as collateral. But one egregious comment Lay made that fateful October day could end up as his salvation. During the conference call with analysts, he professed the "highest faith and confidence" in the company's chief financial officer, Andrew Fastow, who the next day suddenly took what became a permanent leave of absence. Nearly three years later, Lay claims he was unaware of Fastow's misdeeds, a defense strategy casting Lay as the world's most clueless CEO, sincerely waving his pom-poms as his team got crushed.

Government prosecutors are patting one another on the back for finally hooking the biggest fish in an investigation into what U.S. Deputy Attorney General James Comey described last week as Enron's "spectacular fall from grace." Lay, 62, was the public face of the once stodgy pipeline firm that morphed into the seventh biggest U.S. company by trading natural gas and megawatts of power. A minister's son with a Ph.D. in economics, Lay was spared being charged with approving Enron's now famous off-the-books partnerships that hid so much debt for so long. And unlike the two former colleagues he will be tried with — Enron's onetime CEO Jeffrey Skilling and chief accounting officer Richard Causey — Lay wasn't charged with insider trading by the Justice Department (although last week the Securities and Exchange Commission did so in a separate, $90 million suit in civil court, where the standard of proof is less stringent). Instead, the bulk of the charges against Lay allege that he helped keep the deceit alive after he resumed his role as CEO in August 2001, when Skilling abruptly resigned. The remaining charges deal with an obscure bank-fraud rule involving Lay's personal-loan applications. "I have to go home and look up something called a Reg U," Lay's attorney griped. "That's a stretch."

The case won't be easy to win. Lay's claim that he believed the company stock was a good buy is bolstered by the fact that he kept purchasing more and sold shares only when forced to by margin calls. Jurors' heads will be spinning from all the byzantine financial data. And, says Houston securities litigator Thomas Ajamie, "the complexity of this case will work in the defense's favor."

Even before the Enron accounting scandal started to unravel, many people were calling for Lay's head. His company was suspected of wrongdoing in early 2001, during the California energy crisis. Last month, following the release of tapes in which Enron traders gleefully spoke of ripping off Golden State grandmothers, California's attorney general sued the firm for violating the state's unfair-competition and commodities-fraud laws. After Enron collapsed, smashing the nest eggs of rank-and-file employees, political pressure to build the case against Lay intensified. One of George W. Bush's top contributors during the 2000 campaign, Lay was nicknamed "Kenny Boy" by the President. As the months went by with no indictment, Democrats in Washington grumbled that he was being insulated by the White House.

 

"Lay Says 'Classic Run on Bank' Ruined Enron:   Ex-Chairman Uses Debut on Stand To Depict Charges as 'Ludicrous,' Blames Fastow, Media, Traders," by John R. Emswhiller and Gary McWilliams, The Wall Street Journal,  April 25, 2006; Page C1 --- http://online.wsj.com/article/SB114588472143834040.html?mod=todays_us_money_and_investing

Making the most important public appearance of a long public life, former Enron Corp. Chairman Kenneth Lay took the witness stand at his criminal trial, where he admitted to mistakes but firmly denied any wrongdoing in running the energy giant.

He blamed Enron's December 2001 collapse on deceitful underlings, hostile stock traders and damaging news coverage by The Wall Street Journal. Those forces collided to provoke what he called a "classic run on the bank" that set the stage for the company's bankruptcy filing. He also portrayed himself as a man still somewhat stunned by his fall from a pinnacle where he used to rub shoulders with world leaders and other corporate titans. Of all the things he had speculated about in his life, being a criminal defendant "was nowhere in any of them," he said.

Whether the jury accepts Mr. Lay's version of events could go a long way toward determining whether he and former Enron President Jeffrey Skilling are convicted in their federal conspiracy and fraud trial here. A string of government witnesses, including several former Enron executives, have testified that the defendants knew about manipulations of the company's finances and lied to the public about its condition.

Mr. Skilling completed eight days of testimony last week, in the first phase of what is viewed as the crucial period of the two men's joint defense strategy. If anything, Mr. Lay's performance is even more important, though it is expected to be only about half as long. He is Enron's best-known figure and is widely considered a more affable, and potentially more likable, figure to jurors than the more-intense Mr. Skilling. A major part of Mr. Lay's responsibilities in Enron's last years was to serve as the company's public face.

Shortly after court began yesterday morning, the 64-year-old Mr. Lay strode to the witness box, stopping to raise his right hand well above his head as Judge Sim Lake administered the witness oath. When asked if he promised to tell the truth, he answered with a clear, almost resounding "I do."

Continued in article

"Skilling Defends Enron, Himself: In First Testimony, Ex-President Denies Plot to Defraud Investors; 'I Will Fight' Until 'Day I Die'," by John r. Emshwiller and Gary McWilliams, The Wall Street Journal, April 11, 2006; Page C1 --- http://online.wsj.com/article/SB114467495953621753.html?mod=todays_us_money_and_investing

Mr. Skilling Monday dived straight into an aggressive defense of both himself and Enron that contrasted with its public image as a symbol of corporate scandal. Mr. Skilling talked of his pride in Enron's growth and the quality of its employees, even the excitement he felt walking each day into Enron's gleaming headquarters tower here. "We were making the world better," Mr. Skilling said.

Challenging claims made by several government witnesses, Mr. Skilling said he never told any of his subordinates at Enron to lie or in any way manipulate the company's financial statements. However, he also described several of the key witnesses as honest men. The defense argues that these witnesses succumbed to government pressure and pleaded guilty to crimes that they didn't commit.

He insisted that Enron was a successful and vibrant company that was undermined by a market panic partly sparked by several Wall Street Journal articles in October 2001. Monday, Paul E. Steiger, the Journal's managing editor, said the paper's reporters "were leaders in uncovering the accounting scandal at Enron. We are proud of our work."

Continued in article

"Enron Prosecutor Attacks Theory of 2001 Collapse," by Alexei Barrionuevo and Simon Romero, The New York Times, April 27, 2006 --- Click Here




32.

Question
Should companies be allowed to outsource internal auditing to their external auditors?
An Enron Message

Shari Thompson in the early 1990s was an African American internal auditor in Enron trying her best to be a good auditor.

She gave me permission to forward two of her messages that I received out of the blue from her. For those of you that still hold deep abiding sympathies for Andersen's top management, I suggest that you read both of these messages, especially Message 2.

Message 1 appears below. Note that this message contains a lot more messaging than just her message to me. That messaging is very critical of some BYU professors and arguments that internal auditing might be outsourced to external auditors.

My main Enron and WorldCom fraud document (especially note Enron's Timeline) ---
http://www.trinity.edu/rjensen/FraudEnron.htm
This Timeline will soon be updated for Shari's assertion that Enron outsourced internal auditing to Andersen in 1994.

My Enron Quiz will soon be updated for Shari's messages --- http://www.trinity.edu/rjensen/FraudEnronQuiz.htm  

Bob Jensen's threads on professionalism and auditor independence are at (scroll down) ---  http://www.trinity.edu/rjensen/Fraud001.htm

 

Message 1 from Shari Thompson to Bob Jensen

-----Original Message-----
From: Thompson, Shari [
mailto:shari.thompson@pvpl.com
Sent: Friday, February 27, 2009 2:33 PM
To:
'dboje@nmsu.edu' ; rjensen@trinity.edu
Subject: Please update your Enron blog (from former Enron Internal Auditor)

Why is it that everyone who chronologizes Enron's fall misses a hugely significant, contributing factor to Enron's demise?  That is, that Enron's entire internal audit department was systematically eliminated by Andersen, when the internal audit function was outsourced to Andersen.  This outsourcing was instrumental in allowing Lay/Skilling/Fastow to commit accounting fraud undetected for a long period of time.

 The outsourcing of Enron's internal audit function is one of the most festering flaws in the debacle, yet no one has sufficiently reported it.  As a former Enron senior internal auditor, I have brought this flaw to the attention of reporters and bloggers over the years since 2001.  To no avail, however.  Some of them respond "interesting, I never knew that."  But that's it.  No one follows up and reports on the incestuous relationship Enron had with Andersen as the "internal" audit department.

Now we have three professors concluding that companies should outsource internal audit to external auditors.  Please be cognizant enough to add the rest of the story, so that the Finance world can clearly connect the dots between outsourcing internal audit and accounting fraud.  http://www.cfo.com/article.cfm/13111528

Shari Thompson CIA
Direct 402.829.5248 Mobile 402.740.4012

 _____________________________________________

From: Thompson, Shari

Sent: Friday, February 27, 2009 1:28 PM
To: 'richard.chambers@theiia.org' ; 'edward.nusbaum@gt.com '; 'douglas_prawitt@byu.edu '; 'nsharp@mays.tamu.edu '; 'davidwood@byu.edu'
Subject: Thank you to IIA President Richard Chambers

 Good afternoon Mr. Chambers,

I just read an article about professors at Brigham Young and Texas A&M claiming that companies gain from having external auditors perform their internal audits.  I was a senior internal auditor for Enron and subsidiaries (before outsourcing to Andersen) for 24 years (1981 to 2004).  I can attest that having companies use their external auditor as internal auditor is a toxic and deceptive practice.

Thank you so much for voicing your disagreement with this conclusion.  Please keep up the fight to not have this practice become acceptable again.

____________________________________________________________

 Mr. Nusbaum:

You've changed your tune much from your 2006 letter to the SEC when you advocated " Equally without question is that these early experiences with implementation have been costly, but we cannot and should not go back."  http://www.sec.gov/news/press/4-511/enusbaum051006.pdf

____________________________________________________________

 Messieurs Prawitt, Wood, and Sharp:

I am shocked and appalled at your "findings."  Has someone at KPMG, PWC, E&Y or D&T paid you enormous sums of money in return for your publishing such a ludicrous recommendation to outsource internal audit to external auditors?  How could you even preliminarily come to such an incestuous conclusion?

I invite you to talk to me about real world consequences of the unintelligence of outsourcing internal audit to externals.  Blending the two functions is purely a management's self-serving act.  The very phrase "outsourcing internal audit" is an oxymoron, and the terms "outsource" and "internal audit" should be forever mutually exclusive.

I'm 50 years old, an expert internal auditor that worked for Enron and its subsidiaries for 24 of my 28 years in the auditing industry.  And yet I-as well as hundreds of my former Enron colleagues, and untold others around the world-have no 401k nor ESOP savings to show for all my years of hard work.  Why?  Because of the very thing you recommend-outsourcing internal audit.

 When I was a college student years ago, I enjoyed engaging in theoretical debates with my professors.  However, they were wise enough to caveat their opinions with warnings that they'd never worked-or hadn't worked for some time-in corporate America.  Unfortunately, you lack the sageness to recognize the limitations of your insulated confines of collegiate life.

 You state: "Our results indicate that, prior to SOX, outsourcing the work of the IAF to the external auditor is associated with lower accounting risk as compared to keeping the IAF in-house or outsourcing the work of the IAF to a third party other than the external auditor."

*       Must I remind you that the lack of accounting controls is precisely what tanked Enron?

*       Must I remind you of why were there were no controls?  Because Lay, Fastow and Skilling hired Andersen to perform both internal and external audits.  Lay, Fastow, and Skilling knew that Andersen's heads would willingly participate in accounting fraud cover-up as long as Enron paid them well.  And they also knew that any Andersen soul brave enough to dissent would be summarily removed from the Enron account, or from Andersen altogether.

*       Do you know that a few months before the outsourcing to Andersen, one of my former internal audit colleagues discovered irregularities in Enron's accounting transactions related to a bank in New York?  A few months later, after the internal auditors discussed the matter with Lay, Lay outsourced the entire audit function.  This outsourcing came after several yearly sales pitches by Andersen, where Andersen requested the internal auditing job.  It's clear that Lay felt the internal auditors were getting too close to uncovering fraud.  So he outsourced the function to a bunch of yes-men.

 I can only conclude that you obviously have been recently cut in on Lay's, Skilling's or Fastow's Enron bounty.

 

Shari Thompson CIA
Direct 402.829.5248
Mobile 402.740.4012

 

Message 2 from Shari Thompson to Bob Jensen

Hi Bob,

Thanks for your reply. I should mention that I really like your website, and have referred to it many times over the years. It was very helpful when studying for the CIA exam—some of the exam study guides don’t do near a good job as your site in explaining accounting theory, especially the complexities introduced changed since I was in college…

But, to your question, the internal auditors came from a number of the (back then anyway) big 8, and also many of us were from industry. Like for instance, I’ve never worked for a public accounting firm. (Could have something to do with when I graduated in 1980 many of publics wouldn’t hear of hiring a female, let alone a African American female. But that’s another story.) So anyway, the internal audit department in Enron Houston was initially formed in 1986 as a combining of all the audit departments of Enron subsidiaries around the nation. So we came from all over. I came in from Omaha, others from Enron subsidiaries on the East Coast, Texas and Oklahoma. The goal after the “merger” of HNG & InterNorth was to centralize the audit function. So, there weren’t an inordinate amount of internal auditors from Andersen as from any other public accounting firm. I’ve not read Eichenwald’s book. I’ll check it out.

Actually the department was eliminated as far as being an effective, functional department. That is, it was eliminated by Enron’s replacing us “real” internal auditors with fake Andersen “internal” auditors. So technically the department still existed in name only, but was functionally ineffective since it was outsourced to Andersen. This outsourcing happened in 1994. I had, at that time, worked for an Enron subsidiary in Omaha for about a year, so I wasn’t at risk of losing my job. Everyone else in the Houston office, however, was told by Andersen that they had 12 months to get their CPA’s or they were out. Many of them that had CPA’s quit anyway, because they didn’t like the environment of the Andersen-run department. We didn’t know what was going on, we just knew something wasn’t right, and didn’t like it. So most of the real auditors quit, or were run out by Andersen leaning on them to get their CPA. The CPA requirement was just a ploy to get the real auditors out as fast as possible.

An interesting development: While writing this email, one of the author’s (Doug Prawitt) of the article that prompted my email called. He explained to me that the CFO.com reporter omitted key pieces of his interview. Namely, that he did not recommend outsourcing to externals, and that this finding is one of thousands of points of information in their study. I apologized for the email-trigger finger, but he said he enjoyed the opportunity to meet me. And hopes to talk to me again about my experience at Enron, which I welcome. I am definitely enjoying the opportunity to communicate with you as well.

Regards,
Shari

 

Note from Bob Jensen

My main Enron and WorldCom fraud document (especially note Enron's Timeline) ---
http://www.trinity.edu/rjensen/FraudEnron.htm
This Timeline will soon be updated for Shari's assertion that Enron outsourced internal auditing to Andersen in 1994.

My Enron Quiz will soon be updated for Shari's messages --- http://www.trinity.edu/rjensen/FraudEnronQuiz.htm  

Bob Jensen's threads on professionalism and auditor independence are at (scroll down) ---  http://www.trinity.edu/rjensen/Fraud001.htm

 

 

 

 

 

 




Bob Jensen's Enron Quiz Answer Sources
Many but certainly not all the answers come from the following major sources:





 Bob Jensen's main fraud document and links to other documents are at http://www.trinity.edu/rjensen/fraud.htm

Bob Jensen's threads on professionalism and independence are at http://www.trinity.edu/rjensen/fraud001.htm#Professionalism

Bob Jensen's threads on pro forma frauds are at http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#ProForma 

Bob Jensen's threads on ethics and accounting education are at 
http://www.trinity.edu/rjensen/FraudProposedReforms.htm#AccountingEducation

The Saga of Auditor Professionalism and Independence ---
http://www.trinity.edu/rjensen/fraud001.htm#Professionalism
 

Incompetent and Corrupt Audits are Routine ---
http://www.trinity.edu/rjensen/FraudConclusion.htm#IncompetentAudits

Bob Jensen's threads on accounting theory are at http://www.trinity.edu/rjensen/theory.htm 

Future of Auditing --- http://www.trinity.edu/rjensen/FraudConclusion.htm#FutureOfAuditing

Bob Jensen's threads on accounting theory are at http://www.trinity.edu/rjensen/theory.htm 

Future of Auditing --- Click Here

 


 

 


 




Bob Jensen's home page is at http://www.trinity.edu/rjensen/

Bob Jensen's Newsletters
Current and past editions of my newsletter called New Bookmarks --- http://www.trinity.edu/rjensen/bookurl.htm
Current and past editions of my newsletter called Tidbits --- http://www.trinity.edu/rjensen/TidbitsDirectory.htm
Current and past editions of my newsletter called Fraud Updates --- http://www.trinity.edu/rjensen/FraudUpdates.htm
Bob Jensen's past presentations and lectures --- http://www.trinity.edu/rjensen/resume.htm#Presentations