Accounting Scandal Updates on December 15, 2002
Bob Jensen at Trinity University

Bob Jensen's main document on the Enron scandal and other accounting frauds is at http://www.trinity.edu/rjensen/fraud.htm 

Probers claim Citi, Chase helped Enron hide debt
Reuters, December 9, 2002

WASHINGTON, Dec 9 (Reuters) 

Congressional investigators charged on Monday that Citigroup Inc. (NYSE:C - News) and J.P. Morgan Chase & Co. Inc. (NYSE:JPM - News) helped Enron Corp.(Other OTC:ENRNQ.PK - News) hide debt and pad profits through previously undisclosed deals that show financing abuses by Wall Street banks.

Three deals -- known as Sundance, Bacchus and Fishtail -- were complex accounting transactions, while a fourth known as Slapshot was a Canadian tax scam, investigators for the U.S. Senate Permanent Subcommittee on Investigations alleged.

"By concocting elaborate schemes of so-called 'structured finance' with no legitimate business purpose other than tax and accounting manipulation, Citigroup and JPMorgan Chase helped Enron deceive the investing public," claimed Michigan Sen. Carl Levin, ranking Democrat on the panel, in a statement.

Levin was expected to reveal specific proposals to address alleged abuses of structured finance at a public hearing scheduled for Wednesday at which officials from both banks were set to testify, along with government regulators.

The three accounting deals "were nothing more than sham contrivances that used secret agreements to make Enron look more financially healthy than it really was, violating accounting standards," Levin charged.

Sources close to the committee said lawmakers do not view numerous legislative and rule-making initiatives under way in response to the Enron scandal and others as adequate to stem alleged abuse of structured finance.

All the deals cited by investigators were tied to an electronic trading business in the pulp and paper industry created by Enron, which collapsed and filed for bankruptcy a year ago. The deals occurred from Dec. 2000 to June 2001.

In the Bacchus deal, Citigroup made a $7.5 million, 3 percent equity investment in a trust that helped Enron keep a $200 million asset sale related to its pulp and paper operations off its books, investigators said.

Documents show, however, that an Enron executive gave an informal pledge that Citigroup would recoup its investment, making it virtually risk-free -- a factor which would have required Enron to put the partnership on its books under accounting regulations, they said.

Investigators said the Bacchus transaction was not a true sale, but rather a loan to Enron that Houston-based Enron used to book at least $112 million in profits in 2000.

In the Sundance deal, Citigroup helped Enron continue to keep its money-losing pulp and paper operations off its balance sheet, investigators said.

Citigroup was expected to tell the committee at the hearing that the deals were legal and in line with accounting rules.

Citigroup said in a statement: "Today, Citigroup would not approve the transactions that have been under review. Under a new policy Citigroup initiated in August, no such financing will be approved without meaningful disclosure of its impact on a company's financial condition."

Regarding the Slapshot deal, JPMorgan Chase spokeswoman Kristin Lemkau said: "Each country has its own tax law. We were advised by two Canadian law firms that this was legal and appropriate under Canadian tax laws. While we don't think we did anything illegal or unethical, from the standpoint of reputation risk, we would not do this transaction today."

Regulators from the Securities and Exchange Commission, the Federal Reserve and the Office of the Comptroller of the Currency were expected to testify at the hearing.

"In Stormy Time, SEC Is Facing Deeper Trouble." by Stephen Labaton, The New York Times, December 1, 2002 ---  http://query.nytimes.com/search/abstract?res=FA0F16FA3A5C0C728CDDAB0994DA404482 

. . . Many of the problems facing the agency, experts say, are traceable to powerful corporate interests on Wall Street and in the accounting profession that continue, both directly and through the help of well-placed allies in Congress, to exert enormous influence on the rule-making process.

As a result, the commission's budget has remained relatively small, less than half a billion dollars, and inadequate to the task. A new law called for a spending increase of 77 percent. But officials now fear that any increase will fall far short of its needs because the agency has no leader to fight for its interests and faces a White House that has wavered over its commitment to raise the S.E.C.'s budget and a Republican Congress that has other priorities.

''We're in a very bad situation,'' said Charles A. Bowsher, a former comptroller general of the United States. ''It is probably one of the weakest oversight positions at one of the worst possible times.''

Mr. Bowsher said there were ominous parallels to the problems facing the commission and the difficulties that confronted regulators during the onset of the savings and loan collapses of more than a decade ago, when he led the General Accounting Office. As was the case then, he said, the regulators are sharply underfinanced, face ferocious corporate lobbying interests with friends in Congress who want to weaken the rules, and are often unable to anticipate or prevent major infractions that can wind up costing investors huge sums of money.

Mr. Pitt, who has suggested he will remain chairman until the administration finds a replacement, declined requests to discuss his 15-month tenure at the head of the commission. In public appearances, he and senior administration officials portray an agency that has responded strongly to the corporate debacles of the last year by adopting a series of tough regulations and bringing more enforcement cases -- against executives of companies ranging from Enron to WorldCom and Sunbeam.

''I'm enormously proud of our accomplishments, our regulatory reforms and our enforcement program,'' Mr. Pitt said in a recent speech at Duke University. ''They have been aggressive, creative, well focused and effective.''

But commission officials and securities experts describe a host of problems that have grown over the last decade. They trace many of the agency's shortcomings to the tenure of Arthur Levitt, the chairman of the agency under President Clinton, who faced significant challenges in the deregulatory climate of that era.

Mr. Levitt succeeded in putting a variety of measures on behalf of investors into effect, securities experts say, but he has also concluded in a new memoir, ''Take on the Street'' (Pantheon, 2002), that he was forced to reach a variety of compromises -- such as on rules governing stock analyst conflicts of interest and auditor conflicts -- that he now regrets.

Some experts say there are parallels between the problems the agency developed during his tenure and the difficulties it faced in its early days during the Depression, when the commission created the regulatory framework to prosecute white-collar criminals, invigorate corporate oversight by directors, and help restore the faith of investors in the markets.

''The two periods of greatest political controversy in the history of the Securities and Exchange Commission were the initial years, when the statute to create the commission and its full mandate were adopted, and the last period since the 1994 elections, when Newt Gingrich's Contract With America attempted as part of broad deregulatory effort to roll back the registration and enforcement mechanisms of the commission,'' said Joel Seligman, a securities expert and historian of the commission. ''We have seen a wild roller-coaster ride since 1994.''

He and other experts say many of the problems have grown worse under Mr. Pitt, who they say only belatedly sought a budget increase that was far less ambitious than the one approved in the Sarbanes-Oxley Act, the law adopted in July to improve oversight of markets, corporate governance and the accounting profession.

Now, the agency is ''at a low point'' in its history, said Alan R. Bromberg, a professor at the Dedman School of Law at Southern Methodist University who has followed the commission for more than 45 years and written extensively on corporate law issues.

The agency's challenges today hark back to its earliest days. It was created during the nation's worst financial crisis. When Franklin D. Roosevelt was sworn in as President in March 1933, the economy was paralyzed, unemployment was rampant and the nation's banking system was on the verge of collapse. In the Senate, public hearings exposed a pattern of financial abuse by such distinguished banking institutions as J. P. Morgan, National City Bank and Chase National Bank that included insider trading, market manipulation, reckless speculation and special favors to influential friends.

Congress responded with a flurry of New Deal legislation, including the Securities Exchange Act of 1934, which created the commission to keep watch over investment banks and the stock exchanges to ensure the efficiency and fairness of public markets. As in the current climate, the agency was buffeted by a variety of powerful corporate interests. William O. Douglas, an early chairman, noted at the time of the passage of one major measure in the 1930's that it had become law only ''after a bitter struggle on the Hill against as strong a lobby as ever moved into Washington, D.C.''

But the commission grew in both size and stature and became a major force in Washington and Wall Street. Now, Professor Bromberg said, ''the commission has lost its leadership in a whole bunch of vital areas.''

''It's partly because of Harvey Pitt, who came in promising to be friendlier to the accountants,'' he said. ''It's partly because of this administration, which has been friendlier to big business. And it's partly because the agency has been starved for money and resources.''

The weaknesses of the commission, he said, have encouraged state prosecutors around the nation to pursue their own investigations of Wall Street and public companies, a shift in the balance of power that some experts criticize for leading to inconsistent results and balkanized rules.

Both President Bush and Mr. Pitt have cited the agency's record number of enforcement cases over the last year as evidence of its continued vitality. They say the agency has performed remarkably well amid the wave of corporate failures and market turbulence, particularly in putting into effect scores of regulations required by the Sarbanes-Oxley Act. The new rules require companies to make faster and more detailed disclosures of financial information, impose more obligations on executives and lawyers and set higher standards for corporate boards.

Experts say that the 24 percent increase in enforcement actions over last year, while significant, is hardly surprising given the extent of corporate abuses that have come to light, the record number of earnings restatements by companies and the precipitous decline in the markets.

Officials and experts who closely follow the S.E.C. say that the enforcement staff lacks the resources to open important investigations and that the trial unit, which has about 75 professionals nationwide, is hard pressed to bring a significant number of cases to court. Corporate corruption cases involving accounting improprieties are particularly labor intensive. More than 20 lawyers and accountants, for instance, are working on the Enron case alone. A typical case involves just one or two professionals at the agency.

Making matters worse, many corporate defendants are becoming more reluctant to settle their cases because the Sarbanes-Oxley Act and other new regulations substantially increased penalties for violations.

The agency's corporation finance division, which for years never examined in detail the filings of thousands of companies, including Enron, remains unable to analyze the majority of the 15,000 filings by corporations each year. The division now focuses on the nation's largest companies.

But in some cases, according to officials, reviewers have just one day to examine as many as six corporate annual reports to see if they are problematic. The secretarial staff is so small that many senior analysts spend huge amounts of time simply photocopying documents. Officials also labor under an antiquated computer system that makes it difficult to perform the most rudimentary kinds of analysis of financial information.

''The headline here inside the agency is a lot of noise and little action,'' said Michael Clampitt, a lawyer and accountant who has worked in the S.E.C.'s corporation finance division for the last 12 years. ''People are basically hoping that everything blows over and nothing bad happens. It has been a travesty.''

The division of market regulation, meanwhile, is years behind schedule in getting approval from the commission on a set of rules of enormous importance to how prices are set on the stock exchanges. For the last three years, the division has been working on a proposal by the Nasdaq to transform it to a stock exchange from a market, but in the regulatory triage of the last year, the issue has been shunted aside.

The new accounting oversight board, which is supposed to set auditor standards and conduct regular investigations of accounting firms, has faced difficulties recruiting senior staff members. With the resignation of William H. Webster, it has no permanent chairman.

The accounting board faces enormous political pressure from lobbyists and their allies in Congress to delegate the board's new standard-setting authority to the profession itself, which had set the rules until the Sarbanes-Oxley legislation took it away.

At the top of the S.E.C. are five commissioners -- nominated by the president and confirmed by the Senate -- who are given staggered five year terms. No more than three can be from the same political party. President Bush has appointed all of the current commissioners.

Earlier this year, Congress gave the commission a modest $30 million budget increase, to about $468 million, so that the agency could begin to hire an additional 100 professionals and enlarge its staff of about 3,100. In recent years, it has taken in fees of more than $2 billion a year, but Congress has rejected attempts to let the S.E.C. support itself directly because lawmakers are reluctant to give up their influence over the agency's agenda through its budget.

The commission has faced turmoil in the past. During Watergate, its chairman was forced to resign during a political scandal. But many say those problems pale in comparison to today's challenges.

''It's been a very disappointing year,'' Mr. Bromberg, the Southern Methodist law professor said, ''for people who admire the commission and think it has an important role to play for investors.''

GovernanceMetrics International, a new rating agency, released its first report of corporate governance rankings covering the S&P 500. Several established rating agencies are expected to follow suit in 2003. http://www.accountingweb.com/item/96815 

The GovernanceMetrics International home page is at http://www.governancemetrics.com/(5myoihfpk1zq3c55y5r50d25)/Products.aspx#updates 

Academic studies and investors’ own experiences have taught us there is a link between governance practices and investment risk. The problem for investors is how to measure governance practices across a large universe of companies, irrespective of domicile, in a cost-efficient way.

GMI was formed in April 2000 by a small group of people who recognized the need for a new, easy-to-use tool to monitor corporate governance.

Our ratings system has been developed following extensive research in multiple markets and consultations with institutional investors, corporate officers and directors and governance specialists. We conducted an in-depth test of our research methodology in nine countries. Our scoring algorithm has also been tested and validated by outside statistical experts and is patent pending.

GMI Rating Reports for 500 US companies are now available on a subscription basis. Subscribers also receive regular updates on corporate governance developments at each company rated by GMI. GMI's research universe will be expanded to cover 2000 companies, including both US and non-US coverage, by the end of 2003.

WorldCom, in the midst of the largest fraud case in U.S. history, has reached a partial settlement with the SEC that will allow it to sidestep any fines or penalties for the time being. http://www.accountingweb.com/item/96795 

Ethics Discussion Engages Business School Classes On the first day of Business School classes last fall, Elena Perron’s study group is called to the front of the lecture hall to explain how the Enron Corp. violated principles of corporate social responsibility. The discussion of Enron and other corporate misdeeds is addressed in a variety of course settings. Stanford Magazine, November 2002 http://www.stanfordalumni.org/news/magazine/2002/novdec/farmreport/news.html 

Ethics in the Wake of Enron ON THE FIRST DAY of business school, Elena Perron’s study group is called to the front of the lecture hall to explain how the Enron Corp. violated principles of corporate social responsibility. Marker in hand, Perron draws a boxed “gray area” in the middle of a horizontal line on the white board. At one end, the line reads “legal”; at the other, “illegal.” In the boxed area, Perron argues, Enron violated its fiduciary duties to its shareholders. Managers set up bogus partnerships to hide millions of dollars in losses and did not report millions of dollars in loans. “Their entire objective was to hide information from investors,” she says. Weeks before, Perron was talking over those same issues with her colleagues at Goldman Sachs in New York, where she worked in the investor marketing group. “People there were very concerned about how we can improve the financial reporting and the transparency of companies,” she says. They were also very curious about how her professors at the Graduate School of Business would teach ethics. Here’s how: David Brady, professor of political science and ethics, cuts to the chase in the first 10 minutes of class. “Should I steal if I can get away with it?” he asks Perron and her 61 classmates. “No!” Welcome to P235: Ethics, a course about managerial decision-making that Brady, David Baron and other Stanford faculty have been teaching for 30 years. They examine ethics as a basis for self-regulation and look at theories that provide moral guidelines, including utilitarianism and justice. Also on the syllabus: what is a company’s responsibility beyond maximizing profits? What is the role of financial institutions? For the past five years, students have taken the intensive, weeklong course as part of the required preterm curriculum. “We look at how to conduct business in a corrupt society, at genetic testing in the workplace, environmental justice, and Nike and the sweatshops,” Baron says. Last February, as details about Enron’s corporate greed and collapse became public, Baron was finishing the fourth edition of his textbook, Business and Its Environment (Prentice Hall, 2003). He quickly inserted material about Enron before sending the manuscript to the printer. Baron also spent a lot of time on the phone responding to reporters. “They want to know, ‘Is everybody doing what Enron did?’ And the answer is no, of course not. And [they ask] ‘Are we changing the curriculum?’ And the answer is no, we have always done ethics, and we’ve always had it integrated into other courses.” David Kreps, MA ’75, PhD ’75, senior associate dean for academic affairs at the Business School, concurs. “If you looked at our catalog, you’d see E200: Managerial Economics and think, ‘No ethics here,’” he notes in an online forum for alumni. “But you’d be wrong, and the fact that ethics is there and, I suspect, woven into many of our courses makes for much more effective teaching and discussion.” Take the course Ed Lazear teaches about incentives and productivity. “It’s a numbers-oriented course, and people tend to think that’s inhuman—to think about people as numbers,” says the professor of business and Hoover Institution senior fellow. “But there are ways to structure buyouts, for example, so that both the firm and the workers benefit. The basic theme is that if you do the right thing, workers benefit more.” Back in P235: Ethics, Brady displays a cartoon of a CFO, feet on desk. It says, “I swear that, to the best of my knowledge (which is pretty poor and may be revised in future), my company’s accounts are (more or less) accurate. I have checked this with my auditors and directors who (I pay to) agree with me.” But Brady’s parting shot is perfectly serious: “What caused the Enron collapse? Greed gone awry.”

 

Like the unseen menace that stalked Elm Street, the pension monster has been hidden in the shadows. Now it's stepping out into the light. And is it ever one mammoth ugly creature: Big corporate pension plans in America owe some $1.2 trillion to their current and future retirees, and for the first time in years companies don't have enough money stashed away to pay for those benefits. The size of the current shortfall? $240 billion. To put that in perspective, that's more than half of what they're expected to earn this year.

It's the day of reckoning in corporate America. You've probably read that companies are restating their pension assumptions and will take a hit to earnings as a result. You've no doubt seen how the stocks of some huge, widely held companies like General Motors, Ford, and American Airlines' parent, AMR, have been pummeled, in no small part because of concerns about their underfunded pension plans. But what you may not realize is the extent of the havoc this monster can wreak. The debit is not just an accounting mirage; companies will have to start pumping cash--some $29 billion next year alone--into pension funds. That's real money. Money that won't be going to dividends or research or new plants. In other words, the monster is going to suck the blood out of those corporations.

That loss of blood could be enough to push ailing companies over the edge into bankruptcy. Exhibits A and B: Bethlehem Steel and TWA. It's quite possible that more companies will follow. Even the most optimistic scenario assumes dozens will be forced to redirect billions in cash from shareholders to retirees. And as in any edge-of-the-seat horror flick, you can expect more hair-raising scenes before the final credits.

How did we get to this point? At the root of today's problem was a historic advance for American workers: the widespread adoption of so-called defined-benefit pension plans. First flourishing in the industrial boom of the 1950s, when corporations were flush with cash but short on workers, defined-benefit plans give employees a guaranteed annual payment upon retirement--$2,000 a month, say, for an employee with 25 years of service. The company put up all the money, and workers gained real retirement security.

Today, with many companies opting for much cheaper pension alternatives, such as 401(k) plans, in which employees themselves put up cash, many people think of defined-benefit plans as a quaint relic of a more paternalistic era. But in fact the plans are still a huge presence in publicly traded companies. According to a recent study conducted by Credit Suisse First Boston, 360 of the companies that make up the S&P 500--more than 70%--offer defined-benefit pension plans or are obligated to pay retirees the proceeds of legacy plans. While that's great for employees, it's becoming an increasingly risky financial proposition for corporations.

Here's why: Companies are required by law to set aside money for pensioners. If a pension plan's assets don't generate enough income on an annual basis to pay for those retirement benefits, the company must make up the shortfall. Thanks to the double whammy brought about by the unrelenting bear market and falling interest rates, much of corporate America is now faced with the prospect of doing just that--in a big way. An estimated 90% of those pension-paying corporations in the CSFB study now have underfunded plans (that is, the value of the assets has sunk below the estimated cost of the pension obligations). That's 325 big American companies, four times the number in 1999.

Why are the funds in such distress? The same reason, no doubt, that your own 401(k) is: the punishing stock market. Most plans hold about two-thirds of their assets in stocks, and they have been no more successful than individual investors in avoiding the carnage of the past three years. Even factoring in the plans' bond holdings, most analysts estimate that pension-plan assets have lost, on average, about 10% of their value in 2002 alone. In total, some $300 billion of pension assets have been wiped away since the bull market ended in 2000, according to David Zion, a research analyst who co-wrote the CSFB report. Those companies with the largest plans, including GM, IBM, and Verizon, have been hit the hardest--each has lost an estimated $15 billion or more since the end of 2000.

As if the hit to assets weren't bad enough, falling interest rates have also hammered companies on the liability side of the pension equation--that is, the money they owe to current and future retirees. To figure out how much money needs to be in the pension plan, a company's financial officers must calculate the present value of its obligations, or what it would cost in today's dollars to make good on its promises to workers when they retire. To determine this minimum funding level, companies factor backward using a so-called discount rate. In other words, if you know you'll owe $1,000 in 20 years and you assume you'll get interest of x% on the money you salt away each year, x is the discount rate. For pensions, companies generally use a rate that tracks the yield on high-quality corporate bonds.

Simply put, the lower the discount rate, the more a company must set aside today. Trouble is, as interest rates have plunged, so too has the discount rate. The current yield on investment-grade corporate bonds, for example, has dropped to 6.5%, down roughly half a percentage point since the end of 2001. If you're drifting off right about now, lulled to sleep by all the math, this number may wake you up: $80 billion. That's the extra "balance due" that S&P 500 companies inherited merely from that half-point decline in the discount rate, says Ron Ryan, president of New York-based asset management firm Ryan Labs.

"Pension/OPEB Accounting: Key Year-End Issues," from PwC --- http://www.fei.org/download/HRInsight.pdf 

This year, employers are facing unprecedented challenges – reduced earnings, cash flow constraints, downsizing – coupled with enhanced scrutiny from the media, regulators and shareholders. There is a call for greater integrity and financial statement transparency, with CEOs, CFOs and the audit committee highly accountable. With respect to benefits, stock market declines and lower interest rates will result in higher expense under FAS 87, as well as year-end minimum liabilities and potentially significant charges to stockholders’ equity, possibly causing debt covenant violations. Rising health care costs and lower interest rates will result in higher expense under FAS 106. Layoffs and downsizings will create complex accounting issues under FAS 88 and FAS 112. This HR Insight highlights key benefits accounting issues that employers need to address this year-end and presents a management action plan to deal with them

From SmartPros at http://www.smartpros.com/x36216.xml 

Dec. 4, 2002 (Charleston Gazette) — A disgruntled shareholders group is suing Kmart Corp.'s auditor, accusing it of looking the other way as the century-old retailer careened toward financial collapse.

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In its claim, filed Nov. 1 in federal court in Detroit, the group says PricewaterhouseCoopers received millions of dollars in consulting fees from Kmart and had a longstanding relationship with the Troy, Mich.-based discount retailer.

As a result, the suit says, PricewaterhouseCoopers either should have known Kmart was sliding into insolvency or chose to "recklessly disregard" the facts about Kmart's finances.

PricewaterhouseCoopers says the suit is groundless and has asked U.S. District Judge Gerald Rosen to toss it out of court. The firm says it can be held responsible only for its opinions on Kmart's 2000 and 2001 financial statements and that the suit fails to allege that those opinions were false or misleading.

A spokesman for Kmart said it would be inappropriate to comment.

The suit seeks to be declared a class action. It identifies the shareholder as D.E.&J Limited Partnership and also names several former Kmart executives.

Troy lawyer Powell Miller, who filed the case, says PricewaterhouseCoopers did not do its job as a watchdog. "Investors rely on auditors to make sure the financial statements are reliable so people can have confidence in those statements when they make an investment," Miller said Wednesday. "It was crucial for them to raise the red flag, so the problems would have come to light so much sooner."

Miller's suit is believed to be the first to try to pin some of the blame for the Kmart debacle, which wiped out more than $3 billion in equity and cost 22,000 employees their jobs, on its auditor.

Joe Whall, a forensic accountant in Auburn Hills, Mich., says he expects many similar lawsuits to be filed by shareholders against the accounting industry in the wake of this year's corporate scandals. Questionable and fraudulent accounting practices are blamed for hiding problems at many of the troubled companies.

The case against PricewaterhouseCoopers raises the same questions about Kmart's auditor that members of Congress are asking about its board: What did its members know about its failing financial health and when did they know it?

The suit alleges that the signs of a collapse should have been clear to those who were paid to watch out for Kmart's investors:

The company couldn't account for its inventory and had trailers behind its stores stuffed with merchandise it couldn't sell.

Kmart set aggressive, unrealistic sales forecasts and overstated by $554 million the payments it expected to receive from vendors for stocking their goods in the first three quarters of 2001.

Kmart's relationship with vendors deteriorated as the company charged them for things like damaged pallets or late shipments, even when Kmart caused the late deliveries.

James Adamson has been a member of Kmart's board since 1996 and was chairman of the board's audit committee, which supervised PricewaterhouseCooper's work. Yet Adamson says he didn't realize Kmart faced bankruptcy until he read about the possibility in an analyst's report in early January.

Kmart filed for Chapter 11 bankruptcy protection Jan. 22. Adamson is now the company's chairman and chief executive.

Rep. Billy Tauzin, R-La., chairman of the House Energy and Commerce Committee, is looking into the role of Kmart's board as the company's finances unraveled. The FBI, Securities and Exchange Commission and Kmart's board also are investigating.

The board's investigation into what happened, what Kmart is calling a Stewardship Review, is expected to be completed by year's end.

Powell's suit says Kmart was one of PricewaterhouseCoopers' oldest and most significant clients, a