1© 2002-2007

Robert T. Sherman, Jr.

Leadership, Ethics, and

the Texas Two-Step

The Truth Behind the Fall of

Enron and Arthur Andersen

“I’d rather be a huge part of the problem than a tiny part of the solution.”

2© 2002-2007

• On December 2, 2001, Enron Corporation sought protection under Chapter 11 of the U.S. Bankruptcy Code

• It is the second largest bankruptcy in U.S. history (after WorldCom)

• Enron’s auditors, Arthur Andersen, were convicted of obstruction of justice for destroying documents related to the Enron account in anticipation of an SEC investigation; conviction was overturned

• Ten congressional committees have investigated the collapse of Enron

• Thousands of employees were fired, two former CEOs were convicted of criminal charges and more than 30 executives have been indicted; many are serving jail terms

• Cliff Baxter, a former Enron Vice-Chairman, committed suicide in despair over the company’s demise; he tried vainly to call attention to Enron’s misdeeds

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The Good Ol’ Days

• Enron was formed in the mid-1980s by Ken Lay, from the former Northern Natural Gas Co., a large interstate pipeline

• Under Lay, Enron became the largest natural gas and electricity trader in North America

• Jeff Skilling was hired by Lay in 1990; Skilling earned his reputation at McKinsey and advised Enron and other gas pipelines on unraveling “take or pay” gas purchase agreements

• Enron became the 7th largest company in America under Lay and Skilling, with a market capitalization of nearly $70 billion

• Enron became the global market leader in trading gas, electricity, broadband and even weather-related derivatives

• The company’s earnings grew by double digits every year for many years

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Growth in Market Capitalization

• In January 1998, Enron’s market capitalization was approximately $12 billion

• The company’s market capitalization approached $30 billion in August 1999 following an initial public offering of its water subsidiary (Azurix) and launching its broadband capacity trading and EnronOnline

• Enron’s market capitalization exceeded $60 billion in September 2000 after tripling net income; in April 2000 EnronOnline handled $27 billion worth of transactions

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The Dark Side of the Moon

• Lay and Skilling only hired perceived “superstars”, but each year all employees were “force ranked” and the bottom 20% were fired; top employees were paid exceptional bonuses in stock and cash

• Enron’s feared Performance Review Committee was perceived as a means by which the company would reward and punish employees based solely on paper profits booked for the company that year

• Enron’s business required billions of dollars of capital to build pipelines and power plants, purchase gas, and develop a world-class commodities trading floor in Houston

• The company developed a reputation of being the toughest in the business while offering 10-20 year commodities contracts that competitors would/could not match

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Enron’s Vision Statement• Like many companies, Enron had a vision

statement and a detailed corporate compliance policy

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“Enron people alwaysdo what they say they will do”

• A popular paperweight had that statement on one side and the following on the reverse side:

“If Enron says it will rip your face off, it will”

• One of the tenets in Enron’s vision statement:

More Darkness• Enron expanded first to the UK, then India, China, Latin

America and the Middle East, but its energy prices were perceived as very high, especially in developing countries

• Lay and Skilling pushed hard for deregulation of electric generation and transmission markets, expending huge amounts on lobbyists globally

• Enron’s executives drove hard bargains with Wall Street, demanding the best financing terms and pressuring analysts at investment banks to rate its debt/equity offerings highly, while refusing to disclose earnings by business segments, and changing its business strategy frequently

• In the late 1990s, Enron saw its return on equity declining from huge investments in power generation and acquisitions, and Skilling shifted to an “asset light” strategy, emphasizing trading commodities over owning assets

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The Beginning of the End• Sometime in the mid to late 1990s, Lay and Skilling recognized

that earnings from gas and electricity generation and trading would decline and that the booming U.S. economy of the 1990s would end

• Enron’s acquisition of Portland General Electric did not meet expectations and it was put up for sale

• The Dabhol project in India was repeatedly challenged by the Indian government; construction stopped several times, and litigation ensued

• Enron settled charges that it and others manipulated pricing for power and gas in the California energy crisis of 2000/2001; allegations include selling gas at inflated prices to power producers and receiving electricity at inflated prices that was then sold to California consumers

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More Bad News• Skilling began to push Enron’s trading activity into broadband,

which began to falter in March 2001 when a venture called “Braveheart” with Blockbuster unraveled precipitously

• The company began to book and project rosy earnings from power and gas sales, using aggressive assumptions; Enron used “mark-to-market” calculations of earnings in illiquid markets, but assumptions were designed to inflate earnings in early years, using discounted present value analyses that understated risk

• Board meeting minutes and company documents show the CFO (Andy Fastow), Lay and Skilling, as well as the Board of Directors, approved a waiver of the company’s conflict of interest policies to allow Fastow to become a partner in some Special Purpose Entities (“SPEs”) to remove large amounts of debt from Enron’s balance sheet and to generate higher earnings

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More Bad News• In January 2001, Enron came under fire from California politicians

alleging extraordinary profits from spiking electricity prices; the company’s market capitalization began to fall from $60 billion to approximately $30 billion in August 2001

• On August 14, 2001 CEO Jeff Skilling quit “for personal reasons” and Chairman Lay resumed the role of CEO; market capitalization fell to $20 billion in October 2001

• On October 16, 2001 Enron recorded a huge third quarter loss and began reporting losses in shareholder equity due to losses from SPEs; this followed an investigation by outside counsel precipitated by allegations made by Sherron Watkins, an Enron Vice President, of improprieties related to certain partnerships that were intended to hedge risks

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The Powers Report• A report, commissioned by Enron’s Board, and prepared by

the Dean of the University of Texas Law School, found that executives, including Lay, Skilling and Fastow, intentionally manipulated profits, inflating them by almost $1 billion in the year before its collapse. The report says the transactions which led to Enron’s demise were caused by: “a flawed idea, self enrichment by employees, inadequate controls, poor implementation, inattentive oversight, simple (and not so simple) accounting mistakes, and overreaching in a culture that encouraged pushing the limits.”

• The U.S. Senate Joint Committee on Taxation found that Enron’s Board of Directors was so lax that it appears “no request for a bonus or other extra pay was ever turned down.” 12

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Enron’s World ClassBoard of Directors

• Enron’s Board was largely handpicked by Ken Lay. It included some of the most experienced and brightest directors ever assembled

• The Board included Wendy Gramm (former head of the Commodities Futures Trading Corporation), Charles Lamaistre (former Chancellor of the University of Texas System) and a former dean of the Stanford Business School

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Sherron Watkins’ Allegations

• Sherron Watkins, who worked for CFO Andy Fastow, met with Chairman Ken Lay to express concern about Enron’s accounting treatment and public disclosures for certain “deconsolidated entities” known as Condor and White Wing and certain SPEs known as the Raptors

• Enron engaged Vinson & Elkins LLP to review her allegations which included apparent conflicts of interests by Mr. Fastow in ownership of various Raptor entities, the accounting treatment for the Condor and Raptor entities and adequacy of public disclosures

• V&E concluded that “the [Raptor] concept appears to have been fully discussed with the Office of the Chairman and was presented to and approved by Enron’s Board of Directors at a special meeting on June 28, 1999

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Sherron Watkins’ Allegations

• V&E further noted the Board’s waiver of Enron’s code of ethics to permit Mr. Fastow to act as a general partner of the Raptor SPE

• A second investment partnership of similar structure was approved at an October 11, 1999 meeting of the Finance Committee of the Board of Directors

• Board approval included certain requirements for internal review of these entities by the company’s chief accounting and risk officers and an annual ethics review

• V&E noted Arthur Andersen’s review of the transactions and found that it was unnecessary for a third party auditor to review these transactions, saying “AA is comfortable with the disclosure in the footnotes to the financials describing the Condor/White Wing and Raptor structures and other relationships and transactions”

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V&E’s Conclusions

• V&E concluded: “The facts disclosed through our preliminary investigation do not . . . warrant a further widespread investigation by independent counsel and auditors. Our preliminary investigation, however, leaves us with concern that because of the bad cosmetics involving [these] transactions . . . there is a serious risk of adverse publicity and litigation.”

• V&E noted that it had reported its conclusions verbally to Mr. Lay and to the Chairman of the Audit Committee of Enron’s Board of Directors and at his direction, gave a verbal summary of their review and conclusions to the full Audit Committee.

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Some SPEs the Justice Department pursuedin its investigation of Enron

Raptors• The Raptors were “hedging”

vehicles set up to protect Enron against losses on certain assets. To be considered independent for accounting purposes – and kept off Enron’s balance sheet – at least 3% of their capital had to be in the form of equity from outside investors. Yet it isn’t clear whether the 3% accounting rule was met. If it wasn’t, prosecutors could consider charging executives with perpetrating a fraud.

Chewco• Chewco was another Enron effort

to keep debt off its balance sheet. In this case, the crucial 3% outside equity was supposedly put into Chewco by independent entities. But Enron itself backed much of the 3% infusion, eventually forcing the company to reverse more than $400 million in earnings.

Source: The Wall Street Journal, April 30, 2002

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Some SPEs the Justice Department pursuedin its investigation of Enron

Southhampton Place• Several Enron executives were given a chance to get in

on a limited partnership set up by Chief Financial Officer Andrew Fastow. They reaped a windfall when an entity owned by the partnership sold Enron stock back to the company – in at least two cases, a million dollars on a $5,800 investment. Enron’s Treasurer, Ben Glisan, served three years of a five year sentence, forfeited $1.3 million for his role in this scheme.

Source: The Wall Street Journal, April 30, 2002 18

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Some SPEs the Justice Department pursuedin its investigation of Enron

Braveheart• Braveheart was an entity organized and funded by

Canadian Imperial Bank of Commerce that held the company’s stake in a joint venture with Viacom’s Blockbuster unit.

• Braveheart was established to create an on-demand movie business. At its peak, the venture counted only 1,000 test customers, yet Enron claimed over $116 million in profits using mark-to-market accounting.

• Ken Rice, the head of Enron’s broadband unit, pleaded guilty to securities fraud and faces 10 years in prison and large fines.

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The Skilling Tapes

• The Associated Press reports that at a 1997 party for departing Enron President Rich Kinder, former President Bush was shown on videotape as saying “Nobody has done more than you to support George [now President] Bush

• In a skit, Kinder doubted that Skilling could pull off 600% revenue growth

• Skilling jokingly replied: “We’re going to move from mark-to-market accounting to something I call HFV, or hypothetical future value accounting”

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Enron Operated “Tax Free” for Years

• The U.S. Senate Finance Committee issued a three volume report finding that Wall Street banks, legal and accounting firms helped Enron devise shelters that let the company operate tax free for years.

• Sen. Grassley of Iowa said, “The report reads like a conspiracy novel.” Enron’s tax department was “converted into an Enron business unit, complete with annual revenue targets.”

• The front page of one tax shelter deal known as the Steele Project was titled “Show Me The Money!”

• Sen. Grassley said that the people involved displayed “unbridled greed and blatant disregard for the law of fairness.”

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Accusations in California

• On May 6, 2002 the Federal Energy Regulatory Commission released memos from Enron that indicate Enron and others may have intentionally manipulated California’s power market using at least ten strategies

• The memos refer to market-manipulation strategies known as “Death Star,” “Fat Boy” and “Ricochet”; these strategies, which may not be illegal, created artificial conditions in the state’s power grid that may have resulted in substantial profits to Enron and other power traders

• One Enron memo described the net effect of the Death Star strategy to be that “Enron gets paid for moving energy to relieve congestion without actually moving any energy or relieving any congestion”

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Accusations in California

• Under the Fat Boy strategy, Enron allegedly bought power in California under price caps and sold it into other states where it could get a better price. An Enron memo said that “This strategy appears not to present any problems other than . . . the fact that such (electricity) exports may have contributed to . . . a Stage 2 Emergency yesterday”

• Ricochet involved sales of energy generated in California to adjoining states which were then imported into California, to avoid price caps

• From 1999 to 2001 Enron’s energy trading revenue in California increased from $50 million to $800 million

• Enron’s chief energy trader pleaded guilty to conspiracy to commit fraud charges in manipulating energy prices in California; the head of Enron’s California trading desk also pleaded guilty to charges of wire fraud and lying to federal investigators

• A judge at the FERC ruled that Enron should repay $32.5 million for violating FERC rules during this crisis

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Executive Compensation

• In 2001, Enron paid $745 million in cash and stock awards to 144 senior executives, including at least $104 million to Ken Lay

• Enron CFO Fastow received over $30 million from his partnership interests serving while he had a conflict of interest

• 5,000 employees who were fired after the bankruptcy received a maximum of $13,500 each ($34 million total) in severance pay

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The Costliest Bankruptcyin History

• Bankruptcy costs have totaled over $500 million. More than 3,000 lawyers and other professionals have worked on the case

• Lawyers’ fees range from $300-900/hour• A reorganization plan was approved in

2004; secured creditors will receive about 20 cents on the dollar, far less than creditors in the Kmart and WorldCom bankruptcies

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Arthur Andersen’s Role

• Until its demise, Andersen employed 85,000 people globally and had been Enron’s auditor for many years

• Andersen also provided consulting services, helping set up and opine on the validity of Enron’s SPEs under accounting rules

• Andersen received $58 million in fees from Enron in 2000 (less than half of which was from auditing services) and $50-55 million in 2001

• Documents produced for congressional investigators show that partners in Andersen’s Houston office debated whether to force disclosure of billions in off-balance sheet debt, but decided against it, citing potential growth of fees from Enron to $100 million per year

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Arthur Andersen’s Role• In May 1999, Carl Bass, an Andersen partner in its standards group,

complained about Fastow’s plan to contribute his own money into partnerships to meet a 3% threshold, saying “Conflicts of interests galore. Why would any director in his or her right mind ever approve such a scheme?”

• Andersen partner David Duncan, who pleaded guilty to felony charges, replied that “the whole thing was a bad idea” but “Andy is convinced that this is such a win- win that everyone will buy in.” The Enron Board approved the deal

• The U.S. government asserted that, after investigation of Enron began, following its bankruptcy in December 2001, Andersen destroyed/shredded thousands of documents in Houston, Portland, London and possibly other locations

• Andersen was convicted of felony obstruction of justice and ceased auditing public companies in 2002; the conviction was overturned. Appeals court found that jury instructions on “intent” were overly broad.

• Duncan’s plea was withdrawn and prosecution ceased.

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The Arthur Andersen partner was on his cell phone when he said,

“Ship the Enron documents to the feds,”

but his secretary heard,

“Rip the Enron documents to shreds.”

It turns out that it was all just a case of bad cellular.

An Explanation on the Internet

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The Bankers’ Roles• Enron borrowed billions from banks and raised additional

billions in debt and equity markets worldwide• At the same time, analysts from the same banks/investment

banks followed Enron’s stock, and gave it investment grade ratings on its debt, recommending both to investors

• In fact, nearly all analysts did not understand Enron’s complex business model, and say they had no idea it was using thousands of SPEs to keep debt off the balance sheet and pump up earnings

• Ten of 15 major analysts continued to recommend Enron securities as a “Buy” or “Strong Buy,” until just days before it filed for protection under bankruptcy law

• Investigators’ records show that many of the same institutions that were touting Enron’s stock/bonds were also selling, or buying, interests in the SPEs

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The Bankers’ Roles• Analysts claim that so-called “Chinese walls” kept

them from knowing what their peers were doing and what Enron’s true financial condition was

• Two analysts who downgraded Enron securities in mid-2001 or recommended that clients sell it allege they were fired for doing so

• Citigroup, J. P. Morgan Chase, CIBC and others paid over $300 million to state and federal authorities to settle claims that these banks assisted Enron in various frauds

• Four Merrill Lynch bankers were charged with fraud for sham purchases of barges designed to meet financial targets and maximize bonuses; convictions were overturned by the Fifth Circuit Court of Appeals

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Mahonia

• In a transaction referred to as Mahonia, Chase Manhattan Corporation allegedly accepted deliveries of natural gas which Enron then sold to them in a so-called “round trip trade.”

• A J. P. Morgan executive said in an email, “[Enron] loves these deals as they are able to hide funded debt from their equity analysts because they book it as deferred rev or (better yet) bury it in their trading liabilities.”

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What’s Next for the Banks?• J. P. Morgan Chase, Citigroup and other banks have agreed to

new procedures that will require them to obtain “complete and accurate information” about how their customers will account for transactions they advise on and how they would disclose any deals in financial reports

• The settlement agreement is unusual in that it requires a bank to perform due diligence and form an opinion about a transaction from the customer’s viewpoint

• According to the SEC examiner who negotiated this settlement, the banks who are party to the agreement may lose all their claims against Enron in its bankruptcy proceeding; these claims total nearly $5 billion

• Merrill Lynch has agreed to accept responsibility for the barge deal, agreeing to oversight by the government

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Where Did the Regulators Fail?

• SPEs were “legal”; that is, with only 3% equity investment, which in many cases was not “at risk,” but was guaranteed by Enron, SPEs could be kept off balance sheet

• The same firm that was auditing Enron, and certifying its financials, provided consulting services that helped create the SPEs, and did not require disclosure

• Banks/investment banks who promoted Enron’s stock/debt securities helped create and market SPEs; they did not disclose them to analysts in their own firms

• Despite warnings from former SEC Chairman Arthur Levitt and others, the SEC did not challenge any of Enron’s public filings until after it collapsed

• Mr. Levitt testified in Senate hearings that “Sell-side analysts in the U.S. today have lost all credibility . . .”

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Government Investigations

• Enron’s activities were investigated by both the U.S. House and Senate (at least 32 bills introduced to change laws)

• Vice President Dick Cheney was sued by the General Accounting Office, which sought release of information on secret meetings held by Lay with Cheney on energy policy. The GAO lost the case which Cheney won using an “executive privilege” argument; now on appeal to the US Supreme Court

• President Bush has distanced himself from Lay and Enron. His administration has been heavily lobbied to intervene but apparently has not

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Government Investigations

• The Financial Times has reported that Enron gave over $10.2 million to Washington politicians over two election cycles, and in 1997-2000 gave $1 million to Texas political action committees and state candidates, while contributing $139,000 to Texas Supreme Court candidates and spending $4.9 million on Texas lobbyists

• In England, Enron gave over $1.13 million to a charity run by Prince Charles; “sleaze” allegations have been made against the UK party in control

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Source: The Star Tribune, Jan. 20, 2003

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39Source: The Star Tribune, Jan. 20, 2003 39© 2002-2007

Criminal Charges AgainstCompanies and Individuals

• Arthur Andersen was acquitted of obstruction of justice; one partner, David Duncan, pleaded guilty to a felony and has testified against Andersen, Lay and Skilling

• Fastow pleaded guilty to fraud and received a six year sentence; his wife Lea has completed a 1 year sentence for tax fraud; the Fastows forfeited $23.8 million

• Lay refused to testify in congressional hearings, citing the Fifth Amendment, but publicly denied any wrongdoing; Skilling says when he left as CEO in August 2001, “everything was fine,” blaming politicians for “election year politics” in pursuing an investigation of him

• Skilling says Enron’s demise was due to a “liquidity crisis,” not illegal activities

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Ken Lay

• Ken Lay was convicted of fraud, lying to Enron shareholders and other securities law violations. He appealed his conviction but died of a heart attack before the appeal was heard. His conviction was overturned since he was not able to complete his appeal. Civil suits against his estate continue.

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Jeff Skilling

• Skilling received a 24 year jail sentence which he is now serving in Minnesota. His case is on appeal. He may have to pay up to $60 million in fines.

Impact on Employees, Shareholders, Others

• Enron’s stock, which was once worth almost $70 billion, is now worthless

• Employees’ 401(k) and pension plans are worth only a fraction of original value; company matching portion of 401(k) benefits was required to be held in Enron stock

• The collapse of Enron had a major effect on the Houston economy

• Directors’ and officers’ liability insurance policies will not cover the losses

• Anderson and others have reached settlements of civil litigation but very little will go to injured parties after legal fees and costs

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Leadership and Ethical Failures

• Creating a “win at all costs” earnings mentality

• Conflicts of interest by officers investing privately in Enron partnerships

• Failure to disclose material information to investors

• Undue pressure on Andersen, analysts

• A “culture of fear” that prevented employees from approaching top management to stop abusive practices

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Leadership and Ethical Failures

• Not having a truly independent, active Board of Directors

• Using high levels of political contributions to push aggressive corporate regulatory agendas worldwide

• Extremely high levels of performance-based compensation provided potential rewards so great that officers were encouraged to take unreasonable risks (see February 6, 2002 report of Frederick W. Cook & Co., Inc.)

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What’s Next?

• Enron’s plan of reorganization calls for distributions of about 20 cents on the dollar to secured creditors; three businesses to be spun off

• Andersen is no longer functioning as a going concern• Key executives lost tens of millions of dollars in

personal fortunes• Congress enacted Sarbanes Oxley legislation that

requires CEOs to certify financials and put bonuses, fees at risk if misleading

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What’s Next?

• Many companies are now expensing stock options and looking at new forms of compensation

• FASB rules on SPEs changed to require higher equity investment, truly “at risk” (but will still be too low)

• FASB Interpretation Number 46 became effective July 1, 2003 and will require many “off balance sheet entities” to be reported on the balance sheet

• SEC, others mandated a divestiture of advisory practices from audit practices and whistleblower rules for lawyers

• A crisis of confidence in Wall Street ensued, leading to calls for greater Board oversight and revamping of executive compensation

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Lessons Learned

• There are “other Enrons” out there; it can happen again (HealthSouth, WorldCom, Qwest, Tyco and Xerox)

• Enron’s demise was not the result of concerted crimes; it was brought about by a series of significant personal leadership failures and creeping mistakes; passing new laws and regulations will help, but not prevent such failures

• Ethical Standards to Apply– Wall Street Journal standard: If you don’t want

to read about it in the Journal, don’t do it!– It is not enough to say it’s okay to do it if it’s

legal48

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Some Practical Advice

• Avoid building a culture that emphasizes winning at all costs; there are other legitimate goals such as providing quality products and services, having a safe, enjoyable place to work, etc. that deserve equal billing with profit maximization

• Treat investors, employees, customers and suppliers like family; don’t use or mislead them

• Create an active, independent Board of Directors; surrounding yourself with “yes men” won’t get you the clear, unbiased thinking you need to be successful

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Some Practical Advice• Emphasize personal accountability – starting with

yourself! As CEO or a senior officer, you will set the most important standards. If you cheat on your taxes or lie to customers, employees will know it and will soon follow suit.

• Err on the side of too much, not too little disclosure. If what you want to do is right, the markets will reward you, but only if they know about it. If what you want to do is wrong, and you can’t bear to tell everyone about it, don’t do it!

• Install an effective ethics compliance program and encourage/reward people who do come forward with evidence of improper practices.

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Postscript

• Even today, “It can’t happen in my company” is a prevalent attitude among CEOs and business owners; many companies have ethics compliance policies but don’t emphasize hiring ethical leaders over “superstars”

• Some complain that Sarbanes Oxley is “too expensive” and are lobbying for major changes in accounting rules

• It’s too late to begin to teach ethical values in business school or to senior executives; efforts need to begin at home, in elementary school and throughout the education process

• “If it’s too good to be true, it probably is” remains great advice when investing; the days of triple digit P/E multiples are (hopefully) gone

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