Finance
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ENRON TAKE-HOME ASSINGMENT
Introductory Readings
Compiled by Dr. Christian Rauch (Assistant Professor of Finance, American University of Sharjah), using publicly available
material comprising newspaper clips, SEC filings, proprietary research and press articles. All sources are mentioned.
Group 1: Business Model & Evolution
1) Explain Enron’s Business Model
2) How did it evolve over time? Why was Enron an “innovative” company? How did that,
eventually, cause problems?
Group 2: Bankruptcy & Aftermath
1) Give an overview of the events surrounding Enron’s filing for Chapter 11
2) What were the direct causes for the Chapter 11 filing? What happened in the days and weeks
thereafter?
Group 3: Mark-to-Market Accounting
1) Explain how and why Enron used Mark-to-Market Accounting
2) How did the company benefit from it, and how did it contribute to its demise?
Group 4: Prepayment Schemes
1) Explain how and why Enron used so called prepayment schemes
2) How did the company benefit from it, and how did it contribute to its demise?
Group 5: Special Purpose Vehicles
1) Explain how and why Enron used so called Special Purpose Vehicles. What are they, and how
do they relate to on- and off-balance sheet recording of activities?
2) How did the company benefit from it, and how did it contribute to its demise?
Group 6: Corporate Governance
1) What were the flaws in Enron’s governance? What were the conflicts of interest that caused
the company problems?
2) What was the role of Enron’s auditor in its demise?
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Reading #1: Fortune Magazine
Source: Fortune Magazine website
(http://archive.fortune.com/magazines/fortune/fortune_archive/2000/10/02/288448/index.htm)
Published: Oct 2, 2000
Last February, FORTUNE published a list of America's Most Admired Companies. This list goes a
step further, evaluating companies in 27 industries all over the world. To compile the rankings,
executives and analysts grade companies according to nine attributes: quality of management; quality
of products and services; innovativeness; long-term investment value; financial soundness; ability to
attract, develop, and retain talent; community responsibility; use of corporate assets; and global
business acumen. Companies are ranked within their industry, and the top 25--the All-Stars--are culled
from across all industry groups.
The newcomers to this year's All-Star list--Enron, Nokia, Charles Schwab, UPS, and Goldman Sachs--
all embody business strategies that bridge the old and new economic worlds. Companies that lost their
All-Star status--IBM, Hewlett-Packard, AT&T, Procter & Gamble, DaimlerChrysler--have had difficulties
integrating new business concepts or absorbing acquisitions.
No company illustrates the transformative power of innovation more dramatically than Enron. Over the
past decade Enron's commitment to the invention--and later domination--of new business categories
has taken it from a $200 million old-economy pipeline operator to a $40 billion new-economy trading
powerhouse. In 1985, Enron recognized the opportunities wrought by natural gas deregulation and
began to trade it like a commodity. Soon it was opening new markets trading electric power, pulp,
paper--even broadband. Jeff Shenkman, the COO of Enron Global Markets, credits the company's
culture for its success in building frontier markets. "Challenging conventional wisdom is something we
push here," he says. "The way we do things today is different from how we will do it six months from
now." For example, Louise Kitchen, a trader in Enron's London office, was able to attract a group of
350 people for a project to take the company's gas-trading operations online--before upper
management even knew about it. Launched in November 1999, Enron Online has racked up $129
billion in transactions, making it one of the largest e-commerce sites in the world. "We didn't start it
because the chairman said we needed an e-commerce strategy," says EVP Steve Kean. "The quality
and strength of ideas are determined by how many employees support them--not by upper
management. Good ideas are able to attract the resources they need to move forward freely.
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Reading #2: CNN Fast Facts on Enron
Source: CNN website (http://edition.cnn.com/2013/07/02/us/enron-fast-facts/index.html)
Last Updated: Apr 17, 2017
Here's a look at what you need to know about Enron.
Before its collapse, Enron marketed electricity and natural gas, delivered energy and other physical
commodities, and provided financial and risk management services to customers around the world.
Most of the top executives were tried for fraud after it was revealed in November 2001 that Enron's
earnings had been overstated by several hundred million dollars.
Enron was once ranked the sixth-largest energy company in the world.
Enron shares were worth $90.75 at their peak in August 2000 and dropped to $0.67 in
January 2002.
Top Enron executives sold their company stock prior to the company's downfall.
Lower-level employees were prevented from selling their stock due to 401k restrictions and
many subsequently lost their life savings.
Enron paid the top 140 executives $680 million in 2001. Kenneth Lay received $67.4 million
and Jeffrey Skilling received $41.8 million.
Timeline:
July 1985 - Enron is formed by the merger of Houston Natural Gas and Omaha-based
InterNorth.
2000 - Enron reaches No. 7 on the Fortune 500 list.
August 14, 2001 - Skilling resigns as CEO, and Lay becomes CEO again. (He had been CEO
from 1985-2000.)
August 15, 2001 - Sherron Watkins sends a memo to Lay about accounting issues.
October 16, 2001 - Enron announces a third-quarter loss of $618 million.
October 31, 2001 - The SEC opens a formal investigation into Enron's transactions.
November 9, 2001 - Enron and Dynegy announce a $7.8 billion merger agreement. It would
form Dynegy Corp, in which Dynegy would own 64% and Enron 36%.
November 28, 2001 - Dynegy announces it has terminated merger talks with Enron.
December 2, 2001 - Enron files for Chapter 11 protection, becoming the largest bankruptcy in
US history at that time and leaving thousands of workers with worthless stock.
January 9, 2002 - The US Department of Justice opens a criminal investigation into Enron's
collapse.
January 11, 2002 - The SEC widens its investigation to include Enron's chief auditor, Arthur
Andersen, due to reports of document shredding.
January 15, 2002 - The NYSE suspends trading of Enron shares.
January 17, 2002 - Enron ends its partnership with Arthur Andersen.
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January 23, 2002 - Lay resigns as chairman of the board and CEO.
January 25, 2002 - Former Enron vice chairman J. Clifford Baxter commits suicide in
Sugarland, Texas.
January 30, 2002 - Enron appoints Stephen Cooper as its interim CEO.
February 4, 2002 - Lay resigns from Enron's board of directors.
February 7, 2002 - Andrew Fastow, Michael Kopper, Richard Buy and Richard Causey all
invoke their Fifth Amendment rights before the House Energy and Commerce Committee.
February 12, 2002 - Lay invokes his Fifth Amendment right before the Senate Commerce
Committee.
February 14, 2002 - Whistleblower Watkins testifies before the House of Representatives.
February 26, 2002 - Skilling, Watkins and Jeffrey McMahon testify before the US Senate
Commerce Committee.
March 14, 2002 - US Justice Department indicts accounting firm Arthur Andersen for
obstruction of justice in the Enron case.
April 2002 - Enron rises to No. 5 on the Fortune 500 list despite its bankruptcy filing. Fortune
bases its rankings only on the first nine months of revenue in 2001, which totaled $138.7
billion.
June 15, 2002 - Arthur Andersen is found guilty of obstructing justice.
August 21, 2002 - Former Enron executive Kopper pleads guilty to conspiracy to commit wire
fraud and money laundering conspiracy.
October 2, 2002 - Fastow is charged with securities fraud, wire fraud, mail fraud, money
laundering and conspiracy.
May 1, 2003 - Fastow, his wife, and seven others are charged in a superseding indictment for
actions relating to the firm's financial scandals.
January 8, 2004 - Judge David Hittner says he will accept Lea Fastow's plea deal in
exchange for a guilty plea that could reduce her prison time.
January 14, 2004 - Fastow and his wife each plead guilty, as part of a plea agreement.
January 22, 2004 - Causey pleads not guilty to five counts of securities fraud and one count
of conspiracy to commit securities fraud.
February 19, 2004 - Former Enron CEO Skilling is indicted on fraud and conspiracy charges
and pleads not guilty.
May 6, 2004 - Lea Fastow pleads guilty to a single count of filing a false tax return and
receives a 12-month sentence.
May 19, 2004 - The former Enron vice president responsible for investor relations, Paula
Rieker, pleads guilty to insider trading.
July 7, 2004 - Lay is indicted on 11 counts - one count of conspiracy to commit security and
wire fraud, two counts of wire fraud for misleading statements at employee meetings, four
counts of securities fraud for false statements in presentations to securities analysts, one
count of bank fraud and three counts of making false statements to banks.
July 8, 2004 - Lay pleads not guilty to all 11 charges and is released on $500,000 unsecured
bond.
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November 3, 2004 - The first criminal trial ends with the acquittal of former accountant Sheila
Kahanek.
November 17, 2004 - Enron comes out of bankruptcy after selling its interest in three natural
gas pipelines to CCE Holdings for $2 billion.
May 31, 2005 - The US Supreme Court overturns Arthur Andersen's obstruction of justice
conviction.
December 28, 2005 - Causey pleads guilty to securities fraud for his role in the Enron
scandal. He will serve only seven years in exchange for cooperating with prosecutors seeking
convictions of his former bosses, Lay and Skilling.
March 28, 2006 - The judge dismisses three counts against Skilling (two charges of securities
fraud and one charge of lying to auditors) and one count of securities fraud against Lay.
May 25, 2006 - The jury in the Enron case finds former CEO Skilling and founder Lay guilty of
conspiracy and fraud. Lay is convicted of all six counts against him and Skilling is found guilty
on 19 counts of conspiracy, fraud, false statements and insider trading. Skilling is found not
guilty on nine counts of insider trading. Judge Simeon T. Lake announces four guilty verdicts
in the separate bench trial of Lay on separate counts of conspiracy and fraud.
July 5, 2006 - Lay dies in Aspen, Colorado, from a heart attack brought on by severe coronary
artery disease.
September 26, 2006 - Fastow is sentenced to six years in prison, four years less than his plea
agreement stipulated in January 2004.
October 17, 2006 - Judge Lake erases Lay's fraud and conspiracy convictions. This is a long-
standing legal practice of the US federal courts if the defendant dies before he/she has a
chance for an appeal to be heard.
October 23, 2006 - Skilling is sentenced to 24 years and four months in prison.
November 7, 2006 - Fastow reports to the Oakdale, Louisiana, federal detention center to
begin serving his six-year sentence.
November 15, 2006 - Former COO Causey is sentenced to five years and six months in
prison for one count of securities fraud.
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Reading #3: New York Times Commentary on Enron
Source: NY Times website (http://www.nytimes.com/2002/01/26/opinion/enron-for-
dummies.html?mcubz=3)
Published: Jan 26, 2002
Enron for Dummies
''I saw this week that President Bush is 'outraged' by the Enron scandal, and I know I should be too,
but there's a lot I still don't get. For starters, what kind of company is Enron, exactly? Enron is a new-
economy company, a thinking-outside-the-box, paradigm-shifting, market-making company. In fact, it
ranked as the most innovative company in America four years in a row, as judged by envious
corporate peers in the annual Fortune magazine poll. It is also, at this point in time, a bankrupt
company.
I meant, what does Enron do? ''Do?'' Ah, a quaint old-economy question. You're probably one of those
people who like the new no-cell-phone cars on Amtrak. Enron does a lot of things, but mainly it buys
and sells energy.
What's so innovative about that? When Enron got started, natural gas and electricity were produced,
transmitted and sold by state-regulated monopolies. They were often plodding and inefficient. Enron
used Wall Street magic to transform energy supplies into financial instruments that could be traded
online like stocks and bonds. These contracts guaranteed customers a steady supply at a predictable
price. This may be a good place to pause for an Enron Lesson. The company did stupid and venal
things, but introducing the laws of supply and demand into the energy system was smart business and
is, by and large, good for customers. One sad side effect of this scandal is that some good ideas may
be discredited by association with Enron.
So where did Enron go wrong? As often happens with buccaneering entrepreneurs, it got a case of
hubris. It figured if it could trade energy, it could trade anything, anywhere, in the new virtual
marketplace. Newsprint. Television advertising time. Insurance risk. High-speed data transmission. All
of these were converted into contracts -- called derivatives -- that were sold to investors. Enron poured
billions into these trading ventures, and some failed. It turned out Enron was good at inventing
businesses, but terrible at the tedious work of running them, judging by some appalling internal
management audits discovered by The Times's Kurt Eichenwald. For a time, Enron swept its failures
into creative hiding places, but ultimately the truth came out, confidence in the company collapsed and
you now have a feeding frenzy.
How did it hide its mistakes? To keep its mystique alive and its stock price growing, it set up
partnerships where it could bury its losses, or generate imaginary revenues. Here's one of the more
audacious examples, pieced together by The Wall Street Journal: Enron invested a bunch of money in
a joint venture with Blockbuster to rent out movies online. The deal flopped eight months later. But in
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the meantime Enron had secretly set up a partnership with a Canadian bank. The bank essentially lent
Enron $115 million in exchange for Enron's profits from the movie venture over its first 10 years. The
Blockbuster deal never made a penny, but Enron counted the Canadian loan as a nice, fat profit.
Um, I'm not sure I follow that . . .Neither did the Canadian bank, which now holds a lot of worthless
Enron i.o.u.'s. Enron also seems to have baffled the accountants at Arthur Andersen, the bankers at J.
P. Morgan, the Wall Street geniuses who touted Enron stock, and those C.E.O.'s who kept voting
Kenneth Lay, now abruptly retired, the mastermind of the year. Also (with some exceptions) the
business press.
Did Enron break the rules? Whether it broke the law is yet to be determined. Various prosecutors are
undoubtedly reviewing the statutes on accounting fraud, insider trading and illegal destruction of
documents, among other crimes. But rules were for sissies. These were invincible innovators, who
sneered at rules. In that respect, they were the quintessential 90's company.
What's that supposed to mean? The company embodied the get-obscenely-rich-quick cult that grew
up around the intersection of digital technology, deregulation and globalization. It rode the zeitgeist of
speed, hype, novelty and swagger. Petroleum was hopelessly uncool; derivatives were hot.
Companies were advised to unload the baggage of hard assets, like factories or oilfields, which hold
you back in the digital long jump, and concentrate on buzz and brand. Accountants who tried to
impose the traditional discipline of the balance sheet were dismissed as ''bean-counters,'' stuck in the
old metrics. Wall Street looked to new metrics, new ways of measuring the intangible genius of
innovation, and the most important metrics were the daily flickers of your stock price. Above all,
everyone was looking for the killer app.
''Killer app?'' You are clueless. The killer application was the world-beating opportunity. (Mr. Lay called
that Blockbuster deal ''the killer app for the entertainment industry.'') As often as not, the killer app was
not a new product or service, but a beautiful loophole. In the new-economy best seller ''Unleashing the
Killer App,'' the first example is a guy who realizes that gas stations in Germany are exempt from the
country's rigid early-closing laws for most stores. Voila! German gas stations become virtual shopping
malls.
And how cool was Enron? About two years ago a Fortune magazine writer likened utilities and energy
companies to ''a bunch of old fogies and their wives shuffling around halfheartedly to the not-so-stirring
sounds of Guy Lombardo. . . . Suddenly young Elvis comes crashing through the skylight.'' In this
metaphor, the guy in the skin-tight gold-lamé suit was Enron. The writer left out the part where Elvis
eats himself to death. That reminds me, is it true what they say about the name ''Enron''? Mr. Lay
wanted to call it Enteron, until they realized that was a biology term for the digestive tract. In hindsight,
Enteron seems right for a company of such ungoverned appetites. Though I prefer my wife's name for
the company: End Run.
Did Enron buy political influence? Please. That's not the way things work in Washington. Enron bought
access. Money just got it in the door to make its case. (The case it made probably went something like
this: If the government does things Enron's way a lot of people will get very rich and they will be very,
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very grateful to the wise leaders who made it all possible.) If you're asking whether the Bush
administration did favors for Enron, sure it did -- and so, by the way, did the Clinton administration, and
both parties in Congress. Attention has focused on a number of fascinating loopholes lawmakers and
regulators secretly customized for Enron. But -- and here's another Enron Lesson -- most of what
Washington contributed to the glory of Enron it did in plain sight. Politicians demonized government
regulation, and methodically dismantled the safeguards set up in previous downturns to protect little
investors. They promoted the cult of stock-market speculation, even calling for Social Security funds to
be fed to Wall Street. They cut taxes and all but stopped auditing tax returns. I'd say Enron's campaign
donations, about $6 million over the past dozen years, paid off better than most of its other
investments.
Isn't that what free markets are all about -- getting government out of the way? Yes and no. Free-
marketers believe in reducing regulation. Enron believed in reducing regulation of Enron. Enron was
perfectly capable of lobbying for the federal government to take over the electric power grid from the
states -- hardly a free-market position, but one that would have made life easier for Enron. It lobbied
for tighter regulation of air pollution, because it had figured a way to make money trading emission
credits. And at the end Enron sure seemed to be fishing for a bailout. More important, a central tenet
of capitalism is that people who run companies are subject to the discipline of the marketplace, as
meted out by the shareholders. That can't work if the shareholders are lied to about the condition of
the company. Another Enron Lesson: The louder someone yells ''free markets!'' the closer you want to
look at his files (assuming they have not been shredded).
But the administration didn't bail out Enron at the end, right? No, the administration declined to climb
aboard that sinking ship. A final Enron Lesson: When business and politics meet, Kenny Boy, it's not a
relationship, it's a transaction.
What happens now? A witch hunt, of course. In the end, with any luck, Congress will stop some of the
money sloshing around the political system, and restore a bit of law and order to the wild frontier. But
first, a few burnings at the stake. My wise friend Floyd Norris says there's a basic law of the market:
When you get rich, it's because you're smart. When you get poor, it's because somebody cheated you.
Just as Enron embodied the stock-market delirium on the way up, it will, now that the euphoria is over,
be the scapegoat for all those smooth talkers who convinced us dummies that we could be rich.
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Reading #4: Andy Fastow on Trial, Explaining Enron
Source: Houston Business Journal website
(https://www.bizjournals.com/houston/stories/2006/03/06/daily13.html)
Published: Mar 7, 2006
Fastow details Enron's LJM partnerships in first day on stand
Former Enron Corp. Chief Financial Officer Andrew Fastow took the stand Tuesday morning in the
ongoing trial of former Enron top executives Kenneth Lay and Jeffrey Skilling. Fastow, appearing
weary and resigned, described the LJM partnerships that allowed Enron (Pink Sheets: ECSPQ) to
conduct transactions off of its books and, most importantly, he testified, enabled Enron to avoid
reporting losses.
The purpose of the partnerships, Fastow said, was to allow Enron to report what executives wanted to
report in terms of earnings. Fastow testified that he raised $15 million for the first LJM partnership,
which enabled Enron to meet its earnings goals in the second quarter of 1999. He said Enron's board
of directors approved both the initial LJM partnership and a second one, despite the fact that Fastow
had a conflict of interest in owing fiduciary obligations to both Enron and the partnerships, a violation
of Enron's code of conduct.
LJM1 worked so well that Fastow proposed to Skilling that a second partnership be created to raise
more money that would enable Enron to do more off-the-books deals and control what it reported.
"Get me as much of that juice as you can," Skilling said, according to Fastow. "Enron was using that
equity to juice the earnings -- so we could report what we wanted to report," Fastow said. Fastow
testified that he raised almost $400 million in investments for LJM2 and was paid $8 million in fees as
its general partner plus 20 percent of the partnership's profits above a certain level. Prosecutor John
Hueston asked Fastow why Enron didn't just go to a bank or investment firm to raise equity. Fastow
said there wouldn't have been anyone who would have entered into these deals, or if they would, it
would have eaten up all the earnings Enron wanted to report.
LJM2 became "the plug" for Enron North America when the unit couldn't find buyers for all of the
financial notes it needed to sell before the end of 1999, Fastow said, through a "convoluted sharing
ratio" which enabled Enron North America to avoid booking a loss. In most cases LJM served as a
"warehouse" for assets so that Enron could record sales when it wanted to and avoid reporting losses,
such as those encountered with the Cuiaba power plant in South America, which had no gas supply
among other problems. None of the LJM partnerships' deals were publicly disclosed, Fastow testified.
Nor was due diligence performed because "we were using LJM to prop up Enron's numbers. I knew
Enron wouldn't leave LJM out in the cold."
"I thought of it as a very powerful tool to make our numbers," Fastow said. "It was a good deal for me
and for Enron, I thought." Under Hueston's questioning, Fastow repeatedly tied these deals to Skilling,
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saying Skilling had approved them. In some cases, former Enron Chief Accounting Officer Richard
Causey took the deals to Skilling and "received the bear hug" -- meaning Skilling's approval, Fastow
said. Fastow looked grim during his testimony, repeatedly compressing his lips in a grimace and
puffing his cheeks before exhaling.
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Reading #5: Background Piece on Arthur Andersen (Auditor) & Enron
Source: Chicago Tribune website (http://www.chicagotribune.com/news/chi-0209030210sep03-
story.html)
Published: Sep 3, 2002
Ties to Enron blinded Andersen
Inside the gleaming Houston headquarters of Enron Corp., it could be hard to distinguish between the
energy traders and the Andersen people checking their books. By the fall of 2000, the two business
giants were so enmeshed that dozens of the Chicago accounting firm's most ambitious auditors
reported to work each day at Enron. Their paychecks came from Andersen, but their livelihoods
depended on the fast-growing darling of Wall Street. Enron could be a volatile partner, at times even a
bully. But Andersen was hooked on a relationship that it found simply too lucrative to abandon.
Many of Andersen and Enron's top number crunchers took annual golf vacations together, making
friendly bets on each round. They went on ski outings, schussing down the slopes together. Others
would sneak away from the office for Astros games at Enron Field and take turns buying margaritas at
Mama Ninfa's, a local Mexican restaurant chain. They played fantasy football against each other over
the office computers. "It was like these very bright geeks at Andersen suddenly got invited to this really
cool, macho frat party," said Leigh Anne Dear, a former senior audit manager at Andersen who
worked in Enron tower. "They were out of control, and they didn't even know it because it was so cool
to associate yourself with the top, with the guys who run a multibillion-dollar company."
In time, insiders at both disgraced firms now say, those close ties eroded the most important role
Andersen was supposed to play as Enron's auditor: providing strong, independent verification of its
financial reports. As Enron collapsed into bankruptcy in December, further depressing a weakened
stock market, Andersen leaders portrayed it as a client run amok. But a closer examination of their
relationship reveals that, in Enron, Andersen found a monster partly of its own making.
Andersen's failures at Enron were the culmination of a decade of sliding standards and audit debacles
at the firm, which had come to reward salesmanship over technical skill and to pursue higher profits
even if it meant compromising a legacy of defiant independence. The closeness between Andersen
and Enron--the firm's $58 million client in fiscal 2000 alone--largely robbed the auditor of its good
judgment, key employees inside both firms contend. Short-circuiting their system of checks and
balances and overriding their own technical staff, Andersen's lead Enron auditors signed off on
questionable deals instead of telling their client "no"--until it was too late.
The confirmation for such signoffs was often circular: Enron would tell its employees that Andersen
had approved the deals, while Andersen would tell its people that Enron's top decision-makers had
OKd them. But in the hallways and offices at Andersen, some auditors who worked on Enron had a
word for the iffy accounting calls: shambolic. When outsiders learned the details of Enron's
dealmaking, its highflying stock plummeted. By the time the energy trader imploded last fall after
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admitting it overstated earnings by hundreds of millions of dollars, Andersen had little defense, since
its signature was all over the deals.
Other major accounting firms have had their embarrassments in this season of corporate fiascoes,
from Deloitte & Touche's audits of Adelphia Communications Corp. to KPMG's sign-off on the bad
books at Xerox Corp. But none quite match the pileup attributed to Andersen: Enron, WorldCom
Inc., Global Crossing Ltd., Qwest Communications International Inc. And Andersen's inability to
safeguard investors' interests at Enron had consequences far beyond the two firms. The episode
undermined the nation's faith in the numbers that define corporate America.
Enron Corp. declined to comment for this story, and an Andersen spokesman said the firm made its
response clear during its obstruction-of-justice trial that ended in a conviction in June. Andersen
contends that its auditors sought to correctly account for Enron's books but were thwarted by
misinformation from the now-bankrupt energy-trading giant. In court filings this summer, Andersen's
lead partner on its Enron account, David Duncan, denied ignoring "alleged red flags" in the energy
trader's accounting or that his team "abandoned its professional duty to remain independent."
But interviews with executives and staffers at both firms and a review of thousands of pages of court
transcripts and internal documents illustrate just how intoxicating Enron became for Andersen, which
often accommodated its prized client despite the doubts of some of Andersen's own auditors. One
executive still at Enron describes the allure: "It's like Patty Hearst, you start identifying with your
kidnappers."
An inherent conflict
Andersen was present at Enron's creation. The energy trader was formed by the 1985 merger of two
well-established natural gas companies, Houston Natural Gas and InterNorth. Andersen was
InterNorth's auditor and, as is often the case, the dominant partner in the merger retained its existing
accounting firm. But the awkwardly close relationship that came to mark the engagement didn't take
hold until the early 1990s. That's when Andersen was pushing its partners to "develop practice"--that
is, convince clients to buy a whole range of services beyond traditional auditing of financial
statements.
Typical of those new services was internal auditing. Unlike the external audits that accounting firms
had done for decades, an internal audit would not report on the fairness of financial statements but, for
instance, would tell the client how efficient its operations were. Andersen took over internal auditing for
Enron in 1994. As part of a five-year, $18 million contract, dozens of Enron staffers immediately
became Andersen employees working out of Enron tower. The rapid growth of Enron meant that within
two years, the fees had already surpassed $18 million, according to Dear, a former internal auditor on
the job.
Alberto Gude watched it all play out on the 44th floor. As vice president of information systems for
Enron Corp., Gude worked for Rick Causey, a former Andersen audit manager who had become
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Enron's chief accounting officer. Gude's department shared the floor with Andersen's new team of
internal auditors. "All of a sudden your independent auditor was your internal auditor, and probably
right there you had a conflict," said Gude, 62, who retired from Enron two years ago. The potential
conflicts were only worsened, Gude said, by the close relationships Andersen employees had with the
many alumni of the firm who had taken jobs at Enron.
"It was difficult to separate that relationship from what they should have really been doing--telling
Enron, `Hey, this doesn't make any sense,"' Gude said. Andersen employees in their 20s and 30s
would give up their free time to work on Enron, betting their career would rise by serving the high-
profile client. One of those eager workers was a bright Andersen auditor named David Duncan. He
grew up in Beaumont, Texas, on the middle-class west side of town. He attended Forest Park High
School, where he was known as a "pencil pusher"--quiet, studious and not particularly popular. He
played no sports and participated in few extracurricular activities.
After high school, Duncan earned a degree in accounting from Texas A&M University, where he joined
a fraternity and distinguished himself as one of the best minds in the accounting program. Only two
years after Duncan made partner in 1995, his bosses put him in charge of the Enron account. It was a
plum assignment because Enron by then had morphed from an old-economy pipeline company into a
new-economy favorite credited with revolutionizing how American business bought its power. From
Enron's perspective, the 37-year-old Duncan was a good fit. Its chief accounting officer, Causey, an
Andersen alumnus, was friends with Duncan. Causey had been a manager on the Enron account, part
of the team of auditors working with the client, before he took a job at the energy trader.
The pair often vacationed together, leading a group of Enron and Andersen colleagues on an annual
golf outing to elite courses around the country. The two were decent golfers but better fundraisers in
the last several years as they co-chaired the Open Heart Open, a Houston golf tournament that
benefited the American Heart Association, one of the pet charities of Enron Chairman Kenneth Lay.
Although the event featured no celebrities, it consistently sold out, according to Duncan's former
executive assistant, Shannon Adlong. "Everybody wanted to pay their $2,500 to join a foursome," she
said. "We had to turn people away." The draw wasn't the margaritas and the buffet dinner. The event
was popular because people in Houston were eager to network with Enron employees and maybe get
a job there. But even as its hometown was toasting Enron, the company's finances were raising
eyebrows. Well before its most notorious deals were struck, the perils of Enron's use of off-balance-
sheet partnerships and the coziness between auditor and client were lampooned by an Andersen
partner in its Houston office.
James Hecker didn't work on the Enron account but was close friends with many people on the Enron
engagement team and heard their complaints about Enron's aggressive ways. One autumn afternoon
seven years ago, he sat at his computer and tapped out a parody of Enron to the tune of the Eagles'
"Hotel California." "Hotel Kenneth-Lay-A," Hecker called it, after Enron's chairman. The lyrics mocked
Andersen's willingness to sign off on Enron's hundreds of partnerships called special purpose entities.
Years later, investigators would allege that Enron used those partnerships to hide debt and inflate
profits.
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In the process, several Enron executives profited handsomely, including Michael Kopper, who last
month pleaded guilty to wire fraud and money-laundering charges related to one of the partnerships.
"They livin' it up at the Hotel Cram-it-Down Ya," Hecker's song went. "When the suits arrive, bring your
alibis..."
His parody continued:
`Relax,' said the client,
`We are programmed to succeed
You can audit anytime you like,
but we will never bleed.'
The song reflected the pressured atmosphere in Houston, where Enron's finance staff was on the
phone nearly every day, demanding that Andersen auditors sign off on some transaction. "They would
call you on a Friday night and say they needed an answer by Saturday," said Warren White, a former
Andersen partner in the Houston office. "We were having midnight conferences with them." If
Andersen accountants objected, they would get on the phone with their Enron counterparts and call
Andersen's Chicago headquarters, seeking the advice of senior partners. The conference calls would
stretch for hours, with the Andersen staffers flipping through financial documents and policy
statements, finding ways to appease Enron. The marathon sessions would pressure Andersen
auditors to view accounting issues Enron's way--if only to get home. White and his co-workers knew
what Enron wanted and usually sought to give it to them.
"You would try to find ways to do it," White recalled. "We all knew they were the largest single client" in
the Houston office. When Enron didn't like the advice it got from Andersen, the company would press
to get the answer it wanted.
Patricia Grutzmacher, a former senior manager at Andersen who worked on the Enron account,
testified about such "push back" at Andersen's criminal trial. The more money involved, the stronger
the push back, which would force her to work as late as one or two in the morning. Sometimes, Enron
would go over her head, insisting that Andersen senior partners overrule her. Routinely, her superiors
at Andersen would reach the conclusion Enron wanted. "I would think to myself, `Why am I even
here?' " Grutzmacher testified.
One such deal that kept Grutzmacher up late was Merlin, the code name for a 1999 transaction that
involved Enron Chief Financial Officer Andrew Fastow and a partnership he controlled. Now a crucial
part of government investigations into Enron's finances, such deals allowed Enron to pass unwanted
assets onto Fastow's partnerships, which dealt in everything from power plants to stock investments.
Merlin was one of hundreds of off-balance-sheet partnerships Enron used. They are by no means
unusual, as executives look for innovative ways to raise cash and paint the best possible picture of
their debts.
15
What was jarring at Enron was the sheer scale, frequency and complexity of the deals that it struck in
its attempts to hide the true state of its finances. Within two years, Merlin got into financial trouble,
prompting Enron to buy back the declining assets and take the hit. Fastow and his partners lost
nothing. Enron's willingness to cover the losses of a supposedly independent party, Grutzmacher
noted in her trial testimony, may have violated a cardinal rule of accounting. If a business deal of this
type does not include some element of risk, it is sham.
Grutzmacher testified that she complained to an Enron executive. "I can't believe y'all want to do this,"
she told him. She contended that Enron should have to restate its earnings to reflect Merlin's losses.
The Enron executive would hear none of it. "It is what it is," he said, telling her that "the higher-ups" at
Enron "have already decided that it's going to be done."
Critical voices silenced
Andersen was so willing to accommodate Enron's executives that it sometimes allowed them to
influence who at Andersen would audit the client. One of their least favorite people at the firm was Carl
Bass. He was a member of Andersen's Professional Standards Group, its once-influential unit of
accounting experts. For decades, the group's word was accepted as law at Andersen. Auditors
perplexed by an accounting problem would consult with the group, which was based in the Chicago
headquarters. Bass was one of the only members of the standards group who worked outside of
headquarters, a nod to his desire to live in his native Texas.
Like some other members of the standards group, Bass lacked the bedside manner that elevated the
careers of partners such as Duncan. But it wasn't just the style of Bass' advice that irritated Enron
executives. In 2000, he began to complain about questionable business practices at the energy trader.
In one memo to his Andersen colleagues describing one of Fastow's partnerships, he wrote "this
whole deal looks like there is no substance."
Tensions grew between him and Enron until Enron insisted that Bass be excluded from its account;
they considered him a roadblock to their rapid-fire dealmaking, according to testimony by several
Andersen partners. Instead of standing up to the client, Andersen senior partners went along. Early in
2001, they removed him from day-to-day troubleshooting on the account. "I was upset," Bass testified
in Andersen's criminal trial, "that we had a client that was telling the firm, basically, who they would or
would not have the engagement team consult with on their transactions."
Weeks passed after Bass asked Duncan to go back and talk to Enron about him returning to the
engagement. In court testimony, Duncan explained how he felt compelled to ask Enron's Causey
whether Bass could remain part of Andersen's team. "I told him I would make an appeal to Mr. Causey
and see if there were some movement there," Duncan testified. But he eventually told Bass that
Causey would not back down. The idea that Enron could shove aside someone from the standards
group made a tremendous impression on Andersen's Houston auditors. "I felt like that if you didn't act
a certain way sometimes or give certain answers in certain circumstances, that it could jeopardize your
existence on the Enron engagement," Grutzmacher testified in the Houston trial.
16
The Enron account had become so lucrative for Andersen that the firm was unwilling to step away,
even when it determined the engagement was one of its most risky--part of a firm-wide assessment of
clients begun years earlier in the wake of litigation. The question came up during the firm's annual
review of the Enron account in February 2001, when Houston partners briefed their Chicago
headquarters in a conference call. Andersen partners described Enron's accounting for trades as
"intelligent gambling." They also discussed whether outsiders would question Andersen's
independence given that fees on the Enron account could soar to as much as $100 million. But
Andersen's leaders decided to retain Enron as a client and determined the size of fees was not an
issue. "Such [an] amount did not trouble the participants," wrote Andersen auditor Michael Jones in an
e-mail to Duncan the following day.
Andersen auditors weren't the only ones raising concerns about Enron's books. By July of last year, a
growing number of Enron executives were starting to question their employer's finances as well. One
of them was Margaret Ceconi, who negotiated deals for Enron Energy Services, which promised
locked-in prices to big users of power and other commodities in return for long-term contracts. Many of
the people she worked with at EES didn't have the accounting background to ask tough questions
about the division's deals. When they did, Ceconi said, Enron's finance people had the same answer:
"We have our models, and Andersen has signed off on it."
"That's usually how they shut everyone up," she said. Ceconi, though, had a degree in accounting and
experience as a banker and became suspicious after Enron announced its second-quarter 2001
results. She knew that many EES deals were losing big money, partly because customers were
balking at paying high prices that had dropped since the deals had been signed. (In one such case,
Enron recently sued Tribune Co., accusing it of reneging on a contract to purchase newsprint.) But
EES' financial woes weren't reflected in Enron's second-quarter numbers. The word around Enron was
that the losses at EES had simply been shifted to Enron North America, the company's profitable
energy-trading arm. In July, Ceconi e-mailed the Securities and Exchange Commission with a
question of her own. Not wanting to identify her company, she used a hypothetical example: Say you
have a food company that makes both hot dogs and ice cream. If the hot dog stand is making money,
and the ice cream stand is losing money, can the company put the ice cream losses on the profitable
hot dog books since they both have the same owner?
Two days later, a woman from the SEC contacted her and said the answer was clear: Such
accounting would misrepresent the performance of each of the food stands. Armed with the
information, Ceconi began to try to find documentation. But before she could, Ceconi was laid off Aug.
3 along with other dealmakers at the faltering EES. Less than two weeks later, Enron Chief Executive
Jeff Skilling stepped down, citing a desire to spend more time with his family. Skilling's speedy exit--he
had only taken the job earlier that year--got Wall Street analysts talking. Until then, Enron was a star
performer. The month before his departure, all but one of 16 major analysts covering the company
were urging investors to buy it. The company's stock had soared 89 percent the year before, on top of
a 58 percent gain in 1999.
17
Although the company continued to report rising profits, its stock had fallen nearly 50 percent by mid-
2001, along with the market's other boom-time favorites such as high-tech stocks. Its gambles on
high-speed Internet ventures were tanking, and California politicians were blaming the company for
the state's power crisis. Enron, after all, had been a top cheerleader for the power deregulation that
many contended was the root of the problem. Skilling insisted all was well, but on the day he left,
skeptical investors sent its stock down 7 percent in after-hours trading, to $39.80 a share.
Within Enron, festering grievances rose to the surface, including at least two memos to Lay, who had
reclaimed his CEO title after Skilling's departure. The first memo was sent Aug. 15 by Enron executive
Sherron Watkins, another Andersen alum. Warning Lay that a "wave" of scandals linked to Fastow's
partnerships could bring down Enron, Watkins added, "The business world will consider the past
successes as nothing but an elaborate accounting hoax." Ceconi sent a similar message on Aug. 29,
asking Lay and Enron's corporate secretary to forward it to Enron's board of directors. "I'm sure," she
wrote, "the board has only scratched the surface of the impending problems that plague Enron at the
moment."
Free fall in Texas
By late September, Enron's financial underpinnings were coming undone. The energy trader was
using its own stock to fund part of its complex web of partnerships. As the stock price soared in 1999
and 2000, its rising value helped offset any losses in the investments those partnerships held. But
when the stock started falling in 2001, the partnerships fell with it. Watkins had called her former
Andersen colleague, Hecker, to sound out her misgivings about Enron's partnerships. Hecker later
testified that he told his Houston colleagues of Watkins' concerns and that none appeared "upset" at
the news. He then wrote a memo to Duncan, referring to her claims as " `smoking guns' that you can't
extinguish." The questions only mounted. In a series of September conference calls between its
Chicago and Houston offices, Andersen auditors were struggling with how to properly restate and
account for losses that had been ignored.
John Stewart, an Andersen partner in Chicago who was perhaps the firm's most respected voice on
the Professional Standards Group, asked Bass to sit in on one of the calls. Bass listened to the update
and was stunned, not only by the amount of losses that needed to be restated but by the realization
that Enron had ignored his warnings months before. He also discovered that the lines between Enron
and Andersen had become so blurred that even senior Andersen management not involved in the
day-to-day auditing of Enron were sucked in by it. "Who signed off on this?" Michael Lowther, the
partner in charge of Andersen's energy and oil practice in the Houston office, asked his regional boss,
Mike Odom, during the conference call, according to court testimony. "You and I did," Odom replied.
Though the Enron account was on the verge of implosion, few partners knew it as several thousand
Andersen employees and their spouses gathered in New Orleans in the first week of October for the
firm's first worldwide meeting in years.
18
CEO Joe Berardino had considered postponing the two-day event because of the Sept. 11 terrorist
attacks. But he was determined to bring the partners together, mainly to show that the firm had
recovered from the nasty infighting with its consultants; after years of battling, the consultants had
finally split off from Andersen in 2000 to form Accenture. Andersen spent well over a million dollars on
the glitzy, high-tech affair. Inside the convention center, partners sat in comfy theater-style chairs
listening on earphones to translations in several languages. At one point, the faces of some of
Andersen's star partners flashed onto giant video monitors. One was Duncan, who was too busy with
the mess in Houston to attend the first day of the meeting. As Duncan's image appeared, a few
partners from Chicago seethed. To them, Duncan was a symbol of the new breed of auditor at
Andersen, those who compromised sound accounting for the sake of profit. In his keynote speech to
the larger gathering, Berardino gave no hint of any trouble at Enron and focused on "integrated
globalization," a vision of the firm doing cutting-edge audit, tax and financial advising from Berlin to
Beijing.
After Berardino finished, the stage backdrop turned into an elongated mirror, and the audience saw its
reflection. "The future is you," a voice thundered through the hall. Back in Houston, where the future of
the firm would be dashed, papers were strewn around the office. Files were piled high on desks and
cabinets, even in the hallways. Staffers walked gingerly to avoid knocking over the teetering stacks.
Tensions were escalating between Andersen and its once-prized client--this time over how they would
explain its financial woes to investors. By mid-October, they were arguing over how to tell the public
about the massive losses hidden in Enron's off-balance-sheet partnerships. Enron insisted that it
should be reported as a one-time hit, which would diminish its impact on Wall Street, but the auditors
disagreed, according to court testimony.
Late the night before Enron was scheduled to make its explanation public, Andersen auditors thought
they had convinced Enron of their position for fuller disclosure. But on Oct. 16, Enron said it would
take a $1.01 billion charge, producing its first quarterly loss in four years--a whopping $618 million.
The almost-absurd nature of the accounting was captured in testimony by Benjamin Neuhausen, a
member of Andersen's Professional Standards Group. "It was a balance sheet error that Arthur
Andersen didn't correct," Neuhausen said. "A billion-dollar debit needed to find a home. It was
classified as an asset incorrectly." Andersen auditors believed Enron had failed to divulge the true
nature of its partnership losses. They worried Enron was misleading the public and that the SEC would
come asking a lot of questions.
Andersen's Chicago headquarters was demanding answers as well. Amelia Ripepi, head of the
standards group, excused herself from a Saturday-morning church choir practice for a dire call to
Houston. She had stern words for Duncan, telling him he could be disciplined for the shoddy
accounting practices on the Enron account. Two days later, Enron shares fell another 20 percent, to
barely $20, when the company told investors that the SEC had launched an informal inquiry.
Andersen's Enron auditors faced a crisis on several fronts. Their Chicago bosses were headed their
way. So were federal investigators.
19
All-night shredding
On the morning of Oct. 23, Duncan and others from the Enron team listened in on a call between stock
analysts and Enron executives, who were trying to explain the company's financial free fall. It "did not
particularly go well," Duncan later testified. "There were many pointed questions asked." After lunch,
he called the firm's entire Enron team together in the midst of the clutter in Conference Room 37C1. In
his understated drawl, the lanky Texan told them that Andersen would have to aid in an SEC
investigation of the collapsing energy trader.
Then, he added, they should comply with the document retention policy. Andersen had created the
policy a year and a half earlier to avoid having plaintiff lawyers use the firm's paperwork as
ammunition against it in court. No one asked Duncan what he meant, and he testified at Andersen's
trial that he never thought that his order could lead to obstruction of justice. Although his order may
have sounded vague, it launched a massive effort to clean up the office's chaotic Enron files. Within
hours, Andersen's auditors on the 37th floor of a building near Enron tower were culling their files. The
housecleaning would go on virtually around the clock. Within three days, in Houston and other
Andersen offices with Enron-related work, more than a ton of documents would be discarded--more
than is usually shredded in a year--and roughly 30,000 e-mails and computer files would be deleted.
Andersen staffers were seen huddled around file cabinets, rifling through desks and picking through
piles of paperwork in the Houston office's common workspaces, their hands stinging from paper cuts.
With the document purge at full throttle, Andersen sent a special team to Houston to make sure the
firm's office there fixed its own mistakes. When Andersen's fraud investigator, David Stulb, dropped by
Duncan's office, Duncan pulled out the e-mail from Hecker that recounted Hecker's chat with Enron
whistleblower Watkins in August. "We need to get rid of this," Duncan said, according to Stulb's court
testimony. Stulb looked him in the eye. "Dave, you really need to keep this information," he told
Duncan. "There is a strong likelihood we will need this information." Duncan nodded.
Later, Stulb phoned his boss in New York and told him, "Dave Duncan needs some guidance on
document retention." The meaning of the document retention policy had been debated repeatedly
within the firm. Its interpretation in the Enron case fell to NancyTemple, a workaholic trial lawyer who
had taken a pay cut to join Andersen from a prestigious Chicago law firm just two years earlier.
More than a week before Duncan issued his vague command, Temple had sent an e-mail urging
Andersen partners to comply with the policy. John Stewart of the Professional Standards Group didn't
understand. Was he supposed to delete the e-mails about Enron in his possession, even though the
case was attracting outside scrutiny? Stewart went upstairs to Temple's cubicle in the legal
department at 33 W. Monroe St., where she advised him that the policy called for keeping final
versions of the memos while discarding drafts. "I was bothered about doing that," Stewart later
testified, adding that he deleted the drafts only after receiving Temple's assurance that she would
retain copies of the drafts for safekeeping, which she did.
Even more important were issues raised in the memos and conference calls being held about Enron.
Given the problems with a Fastow partnership called LJM2, Stewart was concerned that Enron
20
probably had an LJM1 lurking out there with similar troubles, and he asked about it in a conference
call with at least a dozen Andersen people listening in. Duncan assured everyone that the investments
in LJM1 really were legitimate. Debra Cash, a Houston-based partner who worked for Duncan on the
Enron account, remained quiet.
But the next day, Stewart's phone rang in Chicago. Cash, he recalled, just wanted him to know that he
shouldn't interpret her silence on the conference call as agreement with Duncan's blithe assurances.
That implied to Stewart that she had reservations, and he exploded. "How was I supposed to know
that?" he demanded. "You're an Andersen partner. You have to speak up." The question of whether to
shred was eventually resolved when, on Nov. 9, Temple alerted the Andersen audit team in Houston
that the firm had received a federal subpoena. As Adlong, Duncan's assistant, later testified, she
stepped into Duncan's office with documents marked for shredding, and he snapped at her: "No, you
are not to shred anymore. Who's asking you to shred?" Taken aback by the flash of temper from her
levelheaded boss, Adlong sent an emergency e-mail to Duncan's staff. "Per Dave: no more
shredding," it read. Then Adlong went to the office shredder, grabbed a piece of paper out of a box
and scrawled a sign: "No more shredding."
Coming apart
The once-happy marriage between Enron and Andersen was nearing a final split. It came to a head in
meetings and calls at the end of October between golf buddies Duncan and Causey high in the Enron
tower. According to Duncan's testimony, another Andersen partner assigned to Enron, Causey told
them disturbing details about an off-the-books partnership loosely named after Chewbacca, a Star
Wars character. Andersen learned that Chewco had not been properly accounted for and was not an
independent entity, as Enron had told Andersen in 1997. The upshot: Its millions in debt and losses
had to be reflected on Enron's books. Duncan and another partner on the Enron engagement, Tom
Bauer, frantically tried their own form of push back, demanding answers from Enron about Chewco.
Long accustomed to getting its way, Enron sent Duncan a message: Back off. "If we continue
revisiting prior conclusions, where is that process going to end?" Duncan testified Causey told him. It
was becoming increasingly clear that federal investigators would be the ones answering that question.
On Oct. 31, Enron acknowledged that SEC officials were conducting a full-scale investigation. More
investors fled the stock, which was racing toward zero. A week later, under pressure from federal
investigators and investors, Enron made yet another stunning announcement. It revealed that it had
overstated its earnings by more than a half-billion dollars between 1997 and 2000. Die-hard investors
held out some hope. Houston rival Dynegy Inc., owner of Illinois Power, emerged as a potential savior,
and the pair signed a $24 billion merger pact. But a week after Thanksgiving, Dynegy pulled out.
Enron stock, which had traded at more than $90 per share in August 2000, closed at just 61 cents. On
Dec. 2, Enron filed the largest corporate bankruptcy in U.S. history. The relationship between the
energy trader and its auditor had imploded, taken down by lies and broken trust. Andersen would
never finish its last audit of Enron.
21
In January, in announcing its plans to fire Duncan, Andersen said its one-time star partner had
"directed the purposeful destruction of a very substantial volume of documents--and in doing so, he
gave every appearance of destroying these materials in anticipation of a government request for
documents." Later, Duncan would come to agree with that assessment. Facing a possible lengthy jail
term, he somberly told the Houston courtroom that he had done a lot of "soul-searching" before
concluding that he had indeed obstructed justice. Duncan would not go down alone, however.
Prosecutors, mindful of the firm's past regulatory run-ins, uncovered details of the shredding and
concluded that Andersen had to suffer the consequences of a criminal prosecution. Lesser penalties
weren't getting the message across. Remarkably, Andersen's leaders failed to fully recognize the
firm's dire position as they headed into fateful meetings with federal prosecutors.