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Enron was founded in 1985 through the merger of Houston Natural Gas and Inter North, a natural gas company based in Omaha, Nebraska. Under the leadership of its chairman, Kenneth Lay, Enron sought to exploit the deregulation of the gas and electricity prices.
In the year 1987
It is discovered by Enron that oil traders in Valhalla, New York office have been diverting company funds to their personal accounts. Having so learnt that Louis Borget and Tom Mastroeni, the men in charge of the Valhalla operation, were gambling beyond their limits, destroying trading reports, keeping two sets of books and manipulating accounting in order to give the appearance that Valhalla was earning steady profits, the board including founder and CEO Kenneth Lay, did not fire the executives because the later CEO stated that they were making to let them go. Rather Lay increases the trading limits of the Valhalla traders and a telex is sent to the traders stating "Please keep making us millions".
However, in October 1987 Borget and Mastroeni end up on the wrong side of a massive trade, threatening to bankrupt the company. Enron executive Mike Muckleroy manages to bluff the market and reduce the loss from one billion dollars to 140 million dollars, thus saving the company. Ken Lay professes shock at the actions of the traders. They are fired. Three years later, Borget and Mastroeni plead guilty to a number of felonies. Borget spends one year in jail; Mastroeni receives a suspended sentence.
In 1989 Enron begins trading natural gas commodities. The company will become the largest natural gas merchant in North America and the United Kingdom.
In 1990 Jeff Skilling, who had been a consultant for McKinsey & Co., joins Enron and goes on to become the COO in 1996. While in 1992 the Security Exchange Commission (SEC) approves mark-to-market accounting for Enron in which anticipated future profits from any deal were accounted for by recording their present value rather than historical cost.
In 1993 Enron and the government of the state of Maharashtra, India sign a formal agreement to build a massive power plant leading to the formation of the Dabhol Power Company, a joint venture of Enron, General Electric and Bechtel. The cost for construction ranged to 2.8 billion dollars. In this project Enron had failed to see that India could not afford to pay for the power Enron's plant produced. Thus, Dabhol ended as a ruin.
May 24, 1999
Tim Belden, head of Enron's West Coast Trading Desk in Portland Oregon, conducts his first experiment to exploit the new rules of California's deregulated energy market. Known as the Silverpeak Incident, Belden creates congestion on power lines which causes electricity prices to rise and at a cost to California of $7 million. This was the first of many "games" that Belden and his operation play to exploit "opportunities" in the California market.
In the same year Enron's Board of Directors exempts CFO Andy Fastow from the company's code of ethics so that he can run a private equity fund-LJM1-that will raise money for and do deals with Enron. The LJM Funds become one of the key tools for Enron to manage its balance sheet and make investors think that it is performing better than it is.
July Enron announces that its Broadband unit (EBS) has joined forces with Blockbuster to supply video-on-demand, claiming that the technology worked where they were struggling with the technology and the deal collapsed. Nevertheless, Stock hits all-time high of 90 dollars. Market valuation of 70 billion dollars. FERC (the Federal Energy Regulatory Commission) orders an investigation into strategies designed to drive electricity prices up in California. At the same time Enron announces that President and COO Jeffrey Skilling was taking over as chief executive in February. Kenneth Lay would remain as chairman. Later in 2000 Enron uses "aggressive" accounting to declare 53 million dollars in earnings for broadband on a collapsing deal that hadn't earned a penny in profit.
In the first few months-Senior partners from Arthur Anderson, Enron's accounting firm, meet to discuss whether to retain Enron as a client. They call use of mark-to-market accounting "intelligent gambling."
In March Enron transfers large portions of EES business into wholesale to hide EES losses. Arthur Andersen takes auditor Carl Bass off the Enron account after Bass questions Enron's accounting practices. In June FERC finally institutes price caps across the western states. The California energy crisis ends.
August 13, Board meeting. Rick Buy outlines disaster scenario if Enron's stock starts to fall. All SPEs (special purpose entities created to isolate financial risk) crash. Skilling dismisses this. That evening, in board-only session, Skilling resigns.
September Skilling sells 15.5 million dollars of stock, bringing the total of his sold shares, since May 2000, to over 70 million dollars.
October 16 Enron reports a 638-million-dollar third quarter loss and declares a 1.01-billion-dollar non-recurring charge against its balance sheet, partly related to "structured finance" operations run by Chief Financial Officer Andrew Fastow. In the analyst conference call that day, Lay also announces a 1.2-billion-dollar cut in shareholder equity.
October 17 Wall Street Journal article, written by John Emshwiller and Rebecca Smith, appears. The article reveals, for the first time, the details of Fastow's partnerships and shows the precarious nature of Enron's business. In the same month in a massive shredding operation, Arthur Andersen destroys one ton of Enron documents. Weeks later Enron shares plunge below one dollar and on December 2 Enron files for Chapter 11 bankruptcy protection.
January 25 Cliff Baxter commits suicide soon after he had agreed to testify to Congress in the Enron case.
March 14 Former Enron auditor Arthur Andersen LLP indicted for obstruction of justice for destroying tons of Enron-related documents as the SEC began investigating the energy company's finances in October 2001 and David Duncan, Arthur Andersen's former top Enron auditor, pleads guilty to obstruction. Followed by Arthur Andersen's conviction for obstruction of justice.
October 31 Fastow indicted on 78 charges of conspiracy, fraud, money laundering and other counts.
February 19 Named in a 35-count indictment, former CEO Jeff Skilling pleads not guilty to wire fraud, securities fraud, conspiracy, insider trading and making false statements on financial reports. He's the highest-ranking Enron executive to face criminal charges in the energy giant's downfall. Charges against former Chief Accounting Officer Richard Causey also expanded in the indictment to 31 counts.
July 8 Indicted on 11 criminal counts of fraud and making misleading statements, Enron's highest-ranking executive, Ken Lay, surrenders to the FBI. After pleading not guilty, he calls a news conference to proclaim his innocence and argue that while he takes responsibility for Enron's failure.
February 25 The fraud and conspiracy trial of Kenneth Lay, the founder of the Enron Corporation, and Jeffrey Skilling, its former chief executive, is set for January 17, 2006.
January 30 Trial begins on charges of conspiracy and fraud against Ken Lay and Jeff Skilling.
May 25 Ken Lay is found guilty of all six counts against him. Jeff Skilling is found guilty of 19 of the 28 counts against him.
July 5 Enron founder Key Lay dies of a heart attack, less than four months before his scheduled October 23 sentencing.
September 26 Former Chief Financial Officer Andrew Fastow is sentenced to six years in prison for conspiracy.
December 12 Jeff Skilling begins his 24-year sentence for fraud and conspiracy at a Minnesota Federal Correctional Institute.
Issue 1-What were the measures which Enron has missed to govern during the entire scandal?
The Enron scandal essays a story where a company with too little claimed to have too much and in doing so hoodwinked its investors, stakeholders and employees. The basic causes that can be attributed for Enron's downfall are namely:
Mark -to- market accounting.
Structured Finance / Special Purpose Entities.
Using mark to market accounting meant that no matter how much money the company made to the outsiders Enron's profit could be whatever Enron said they were. Under mark-to-market rules, whenever companies have outstanding energy-related or other derivative contracts (either assets or liabilities) on their balance sheets at the end of a particular quarter, they must adjust them to fair market value, booking unrealized gains or losses to the income statement of the period. A difficulty with application of these rules in accounting for long-term futures contracts in commodities such as gas is that there are often no quoted prices upon which to base valuations. Companies having these types of derivative instruments are free to develop and use discretionary valuation models based on their own assumptions and methods.
In order to satisfy Moody's and Standard & Poor's credit rating agencies, Enron had to make sure the company's leverage ratios were within acceptable ranges. Enron CFO Andy Fastow continually lobbied the ratings agencies to raise Enron's credit rating, apparently to no avail. That notwithstanding, there were other ways to lower the company's debt ratio. Reducing hard assets while earning increasing paper profits served to increase Enron's return on assets (ROA) and reduce its debt-to-total-assets ratio, making the company more attractive to credit rating agencies and investors.
Enron, like many other companies, used "special purpose entities" (SPEs) to access capital or hedge risk. By using SPEs such as limited partnerships with outside parties, a company is permitted to increase leverage and ROA without having to report debt on its balance sheet. The company contributes hard assets and related debt to an SPE in exchange for an interest. The SPE then borrows large sums of money from a financial institution to purchase assets or conduct other business without the debt or assets showing up on the company's financial statements. The company can also sell leveraged assets to the SPE and book a profit. To avoid classification of the SPE as a subsidiary (thereby forcing the entity to include the SPE's financial position and results of operations in its financial statements), FASB guidelines require that only 3% of the SPE be owned by an outside investor.
Under Fastow's leadership, Enron took the use of SPEs to new heights of complexity and sophistication, capitalizing them with not only a variety of hard assets and liabilities, but also extremely complex derivative financial instruments, its own restricted stock, rights to acquire its stock and related liabilities.
With respect to Enron's defunct in corporate governance it is integral to mention the following aspects:
Conflicts of Interest
Lack of Checks and Balances and Lack of Auditing Independence (Audit Committee Relationship With Enron and Andersen)
Director Independence/Director Selection
In Enron the Chairman of the Board was Kenneth Lay, and in 2001 Enron had 15 Board Members. Most of the members were then or had previously served as Chairman or CEO of a major corporation, and only one of the 15 was an executive of Enron, Jeffrey Skilling, the President and CEO. The board had five annual meetings, and conducted additional special meetings as necessary throughout the year. As provided in U.S. Senate Subcommittee report on The Role of Enron's Board of Directors in Enron's Collapse, the five subcommittees, consisting of between four and seven members each, had the responsibilities as follows:
(1) The Executive Committee met on an as needed basis to handle urgent business matters between scheduled Board meetings.
(2) The Finance Committee was responsible for approving major transactions which, in 2001, met or exceeded $75 million in value. It also reviewed transactions valued between $25 million and $75 million; oversaw Enron's risk management efforts; and provided guidance on the company's financial decisions and policies.
(3) The Audit and Compliance Committee reviewed Enron's accounting and compliance programs, approved Enron's financial statements and reports, and were the primary liaison with Andersen.
(4) The Compensation Committee established and monitored Enron's compensation policies and plans for directors, officers, and employees.
(5) The Nominating Committee nominated individuals to serve as Directors.
The theory behind such extensive stock option grants to the firm's management and its directors is to align the interests of shareholders and management as a solution to the principal-agent problem. However, one of the major drawbacks of alignment of manager and shareholder interest by way of stock options is that it provides huge incentives for self-dealings for the managers. High powered incentive contracts may entice managers to "manipulate accounting numbers and investment policy to increase their pay." They also argue that the opportunities to self-deal increase with weak or unmotivated boards overseeing the compensation packages. With the case of Enron, management had significant financial incentive through its stock options to manipulate their earnings to boost stock prices, which created enormous windfalls for those with equity-based compensation when such manipulations occurred.
Costly risk taking was employed at Enron with the use of the highly structured and hedged partnerships. As a result, Enron management had huge potential and realized payoffs by way of their stock options, which provided them incentive to take on unnecessary risk and manipulate earnings.
We have thus seen a breakdown in another one of the institutions of corporate governance with the ineffectiveness of equity compensation for executives. Stock-based compensation is another mechanism that helps to align manager and shareholder interests and hopefully solve the principal-agent problem. This mechanism is indeed a tool of corporate governance designed to help protect investors and shareholders in the firm. However, in the case of Enron such a technique essentially failed because of the massive incentives for management self-dealings and to manipulate financial statements.
Conflicts of Interest
One of the major governance issues that was brought to light by the Enron scandal was the blatant conflict of interest involved with having financial officers of a company both manage and be the equity holders of entities that conducted significant business transactions with Enron. Enron's Code of Ethics and Business Affairs explicitly prohibits any transactions that involve related parties unless "the Chairman and CEO determined that his participation 'does not adversely affect the best interests of the Company". With respect to the Chewco transaction, which was managed by Mr. Kopper, the Powers Report concluded that there was "no evidence that his participation was ever disclosed to, or approved by, either Kenneth Lay (who was Chairman and CEO) or the Board of Directors". Mr. Kopper's involvement in the Chewco transaction as both general manager and investor therefore was in direct violation of Enron's Code of Ethics and Business Practices, and should have never occurred. The management of Enron should have recognized the conflict and either sought approval from Mr. Lay, in which case one would hope the transaction would have been restructured with a different general manager, or it should have been abandoned completely. In either case, such a conflict should not have been allowed.
Again with the LJM transactions, conflicts of interest were abundant and should have been avoided. However, the LJM transactions differed from Chewco in one major respect: the conflict of interest arising from having the CFO, Mr. Fastow, manage and invest in the entities was approved by the Chairman and Board of Directors. Along with the Board's ratification of the Chairman and CEO's approval was the Board's understanding that a set of controls to monitor the partnerships and ensure fairness to Enron was being implemented by management. Concerns about such a conflict of interest were expressed amongst senior personnel at Andersen, in which it is clear that such a conflict should have never been allowed.
With the Chewco partnership, management, in particular Kopper, time and again took advantage of the residual control rights he retained. The manager used these control
rights to expropriate funds to the manager-owned and operated partnerships. This is a prime example of the agency problem associated with the separation of ownership and management, and is very similar to the other example of Fastow's expropriation of funds through transfer pricing. Kopper's expropriation of funds is again a breakdown in one of the corporate governance institutions that was in place to protect shareholders. As an employee in the finance division, Kopper had a fiduciary duty to the shareholders, yet he elected to enrich himself and other investors in the partnerships and thus another layer of the corporate governance mechanisms had failed.
Lack of Checks and Balances and Lack of Auditing Independence (Audit Committee Relationship With Enron and Andersen)
These conflicts of interest highlight more of the fundamental breakdowns in governance within Enron and the lack of Board oversight once such conflicts had been approved. After approving such related-party transactions, the Board of Directors had a general and specific fiduciary responsibility to closely monitor the partnerships and ensure that the policies and procedures in place were in fact regulating the partnerships. However, they failed to do the same. The procedures and controls included the review and approval of all LJM transactions by Richard Causey, the Chief Accounting Officer; and Richard Buy, the Chief Risk Officer; and, later during the period, Jeffrey Skilling the President and COO (and later CEO). A system of controls as those mentioned would have provided Enron with a safeguard of checks and balances to protect the interests of Enron.
More specifically, the Finance Committee should have taken a more proactive role in examining and monitoring the transactions. It can be concluded that the Finance Committee failed in its responsibility of monitoring the transactions, especially given that they were aware of the precarious nature of the related-party transactions. A forum for more extensive questioning from directors regarding the transactions was the reason that such a committee existed. Their job was to probe and take apart the transactions that they reviewed and to oversee risk, neither of which they did for these related-party transactions.
Further, the Audit and Compliance Committee also failed to closely examine the nature of the transactions, as is outlined in their duties. Such complex and risky transactions with related-parties deserved close scrutiny, not the cursory review it received.
Audit Committee Relationship with Enron and Andersen
During Board meetings Andersen auditors briefed the Enron Audit and Compliance Committee members about Enron's current accounting practices, informed them of their novel design, created risk profiles of applied accounting practices, and indicated that because of their unprecedented application, certain structured transactions and accounting judgments were of high risk. However, as provided in the charter of the Audit and Compliance Committee, it was the Committee's responsibility to determine and "provide reasonable assurance that the Company's publicly reported financial statements are presented fairly and in conformity with generally accepted accounting principles". Materials from Audit Committee meetings indicate that its members were aware of such high-risk accounting methods being employed by Enron, but did not act on them.
Certainly within Andersen it was clear that Enron was engaging in "Maximum Risk". These concerns, however, were never properly addressed and were not effectively communicated to the Audit and Compliance Committee by Andersen. Despite Andersen's wrongful approval of such transactions, the Audit and Compliance Committee had a duty to ensure that accurate financial statements were produced. The blame for such major accounting errors is not easily assigned, and includes a web of poor decisions by management, Andersen auditors, and the Audit and Compliance Committee. While it's not reasonable to expect Audit Committee members to know the intricacies of off-balance sheet accounting and non-consolidation rules for Special Purpose Entities, it is reasonable to expect them to ask the right questions which get at the heart of a potential problem as well as to create a framework within their oversight duties that allows for conversation, open, candid conversation with management and with external consultants like Andersen.
It is important to emphasize that Enron was using technologies (or complex financial techniques) that helped to obscure the firm's true financial results. Had investors been more aware of and understood the significance of such highly structured partnerships, they would not have been as deceived by the financial results and would have looked more sceptically at the firm's financial condition.
By obscuring financial results through the use of the SPEs and partnerships, there was a dramatic case of information asymmetry between those who understood Enron's financial structures, essentially management and the auditors, and the shareholders and analysts who did not. The result of the information asymmetry was a transfer of costs to shareholders who were not informed of Enron's accurate financial status. Shareholders were now shouldering the costs associated with the highly structured and risky strategies Enron was employing, a cost they paid for as Enron's stock price dropped with the public disclosure of the financial impact the transactions were having on the firm.
The lack of financial reporting transparency represents the failure of another layer of corporate governance protection that shareholders are normally provided. Shareholders rely on the financial reports and information that management produces. When such reports are inaccurate and have been manipulated shareholders are stripped of another mechanism that helps to truly monitor the performance of management, which is what happened with the case of Enron.
Director Independence/Director Selection
It is important to identify the lack of independence and its implications when looking at the directors of Enron's Board. The independence of directors can play a critical role in evaluating one's ability to provide objective judgment. From an outside vantage point it would appear that Enron indeed had an independent board, as it contained only one Enron executive. Financial ties, however, between Enron and a majority of its directors seem to have weakened their objectivity in their oversight of Enron. The following are examples of such financial ties contributing to the lack of true independence amongst Enron Board members, as cited was cited in the U.S. Senate Subcommittee report on The Role of Enron's Board of Directors in Enron's Collapse:
Lord Wakeham received $72,000 in 2000 for his consulting services to Enron, in addition to his Board compensation.
Herbert Winokur also served on the Board of the National Tank Company, a company which recorded significant revenues from asset sales and services to Enron subsidiaries from 1997 to 2000.
Donations from Enron and the Lay Foundation totaled more than $50,000 to the Mercatus Center in Virginia, where Board member Dr. Wendy Gramm is employed.
Hedging arrangements between Belco Oil and Gas and Enron have existed since 1996 worth tens of millions of dollars. Board member Mr. Belfer was Chairman and CEO of Belco.
Frank Savage was a director for both Enron and the investment firm Alliance
Capital Management, which since the late 1990's was the largest institutional investor in Enron and one of the last to sell off its holding.
Such relationships with Enron may have made it difficult for such board members to be objective or critical of Enron management. Many of these Enron Board members may have felt that their compensation (as a director or to the director's affiliated organizations) might be jeopardized by probing and questioning extensively in Board meetings, producing puppets controlled by the company as directors and thus weakening the imperative oversight role of the Board and contributing to the fall of Enron.
The lack of independence on Enron's Board suggests another breakdown of one of the most fundamental corporate governance institutions. The lack of independence gets to the core oversight function of a board of directors. It is imperative that a board be capable of looking objectively at the management and outside professional advisors of a firm, and Enron's Board was not capable in this respect. This layer of corporate governance, that is the board oversight function, should act as a final mechanism to protect investors when other governance institutions have broken down. It should serve to help avoid conflicts of interest, ensure auditing independence and accurate financial reporting, oversee compensation practices, as well as many other breakdowns that occurred within Enron. This last layer, however, failed to serve its purpose and was compromised largely because of the relationships between Enron, management, and the directors themselves.
Issue 2- Lacuna in the existing law due to which the Enron scandal took place
Enron, an energy trading company is the first scandal which shook up the auditing profession although there were many cases involving auditors since the 18 century. Enron has caused a crisis to the confidence in auditors and the reliability of financial reporting. The audit quality and the independence of the auditors were questionable. This is because the auditors, who were Arthur Andersen, were not only receiving fees for auditing but for non-audit services too i.e. for consultancy services. In 2001, Arthur Andersen earned US $55 million for non-audit services. Furthermore, there were regular exchanges of employees within Enron from Arthur Andersen. To hide their debt, Enron engaged in "aggressive accounting." They created partnerships with nominally independent companies. Those companies were headed by Enron execs, and backed, ultimately, by Enron stock. But Enron did not count their "partners"' debt as its own, using "off-balance-sheet" accounting. Enron also found ways to count loans from banks as "profit."
A major factor in the scandals of 2001 is an increased focus on share price. This began in the early 1980s, during a period of hostile takeovers when a high price was the best defence. The impetus for high executive compensation tied to performance came originally from companies taken over that needed to raise share price quickly. Institutional investors encouraged this trend because it seemed to promote good corporate governance by aligning executives' interests more closely with those of shareholders. Under the common law duties and obligations, there is no duty reposed on the auditors to avoid conflict of interests. Thus, the fact that Arthur Andersen was offering non-audit services is not a breach of law in the first place. A second important factor is the deregulation that has occurred since the 1980s. Market deregulation, especially in energy and telecommunications, started a scramble to develop business models for a future that no one could predict accurately. In addition to market deregulation, a reduction occurred in the 1990s in the legal liability of accounting firms and investment banks. It is difficult for a company to commit massive fraud without the complicity of its accountants, bankers and lawyers. Accounting firms had discovered that it was lucrative to sell consulting services to their audit clients, thus tempting them to go easy on audits lest they lose the consulting business.
It could be seen under the common law duties and obligations, that there is no duty reposed on the auditors to avoid conflict of interests. Thus, the fact that Arthur Andersen was offering non-audit services is not a breach of law in the first place. Further under 'the Companies Act', although independence of the auditors is essential as can be seen in S. 9 of 'the Companies Act' which disqualifies certain persons from being eligible as auditors, the provision does not deal with issues concerning the offering of non-audit services to the company. This is because the provision only prohibits an employee, officer, partner or employee or employer of an officer from being appointed as an auditor. The offering of the non-audit services by the auditors to a company is in the capacity of an independent contractor. The law assumes that such persons are independent. This is because independence is the cornerstone for auditing. Nevertheless, there will be conflict of interest and therefore the independence of the auditor will be affected.
Although Arthur Andersen was making a report on the company's accounts, they did not report fraud to the stakeholders. This is because the fraud was committed by the management. Kenneth Lay took home US$152 million although the company was facing a loss. If the auditors were to report they probably will not be appointed in subsequent years or be engaged for non-audit services. They made sure that they were in the management's good books. They maintained confidentiality but for the wrong reasons.
The U.S. government assured the stakeholders that Enron was just a case of one bad apple. Nonetheless, in 2002, WorldCom which is one of the biggest telecommunications company in US collapsed. The issue regarding auditors reached a high level due to Enron. It was found that the auditors, Arthur Anderson, did not take proper steps in detecting accounting irregularities. Although it is the duty of the auditors to detect accounting irregularities, they failed to do so. Since they failed to do so rightfully, they should be liable. As a result of Enron, the audit firm Arthur Andersen in Malaysia was dissolved.
On the other hand, it is difficult to determine the ambit of the auditors' duties and obligations. This is because in at least four matters, the American International Group Incorporated's auditor i.e. PricewaterhouseCoopers are aware of problematic accounting but decided that they were not material. If the view is shared by the auditing profession, it can be considered that the auditors have performed their duties and obligations accordingly. Nonetheless, the view must also be agreed by the courts before establishing whether the auditors have performed their duties and obligations accordingly.
Issue 3- What were the Amendments that were brought in post Enron Issue?
The FEI post Enron Bankruptcy formed a task force to scrutinize the issue emanating from the same. The task force identified four principal areas:
-Strengthening financial management & commitment to et hical conduct.
-Improving corporate governance & effectiveness of audit committees.
-Rebuilding confidence in the accounting industry & effectiveness of the audit process.
-Modernizing financial reporting & reform of the accounting standard-setting process.
It was stated by several individuals that it the current structure of auditing firms makes auditing independence impossible even among the most honest & well- intentioned auditors. Consultant Dean Mc Mann stated "With Enron's collapse focusing attention on ... forced rotation of auditing firms is an option lawmakers might consider ... to keeping auditing separate from other services."
After the collapse of Enron, several issues were earmarked for the attention of reformers including:
The role of business funds in political campaigning.
The extent of energy companies' influence on national energy policy.
The need to reform pension laws to stop over-exposure to one stock and prevent a company from investing its pension funds in its own stock.
The need for higher standards of transparency and disclosure in the audit profession.
Potential conflicts of interest between consultancy and auditing work undertaken by financial houses.
The need for tighter regulation on financial derivatives trading.
One of the first reforms that took place after the scandal was the appointment of Stephen Cooper as Enron's Chief Executive in January 2002. The most publicized repercussion of the scandal was the debacle of Enron's auditor, Andersen. Andersen lost several prestigious clients (including Delta Air Lines, Merck, Freddie Mac, SunTrust Banks and FedEx) that provided it with combined annual fees of about $100 million.
In March 2002, Andersen announced that it was in talks to sell itself to one of its major rivals; Ernst & Young or Deloitte, Touche & Tohmatsu or KPMG. Talks about a possible merger or takeover started after it became clear to Andersen that the Department of Justice and Federal prosecutors were seeking a criminal indictment against it for shredding documents relating to the investigation.
The final blows came when Andersen was banned from US government work after being indicted by a federal grand jury on the charge of obstruction of justice. This was coupled with the case brought by the US Department of Justice against the Andersen UK office for joining in the shredding of Enron documents. This caused Andersen UK practices to reopen merger talks with other accounting firms in response to these claims made against the office. On June 15, 2000, a federal jury convicted Arthur Andersen of obstruction of justice for impeding an investigation by securities regulators into the financial debacle at Enron. The decision was based on a single altered internal memo that showed the accounting firm interfering with the government's investigation into Enron's collapse.
Thus, the guilty verdict against Arthur Andersen - on a charge brought because of the shredding of thousands of records and deletion of tens of thousands of e-mail messages - was ultimately reached because of the removal of a few words from a single memorandum. Also following the conviction, multimillion dollar lawsuits brought by Enron investors and shareholders demanding compensation are likely to follow, and could bankrupt the firm. In addition Andersen faces the possibility of fines up to $500,000. The company called the verdict "wrong" and is contemplating an appeal, but at the same time informed the government that it would cease auditing public companies as soon as the end of August, effectively ending, the life of the 89-year-old firm.
â€¢ The Reinstatement of Chinese Walls
As a result, talks about the reinstatement of the Glass-Steagall Act introduced in 1933, which placed barriers between commercial banking, investment banking and insurance, were again raised. The Act was introduced in the early thirties in response to investor's protests about conflicts of interest on Wall Street following the 1929 stock market collapse.
The reinstatement of the act was brought up in response to allegations that the two investment banks: JP Morgan and Citigroup have overlooked some lending standards to win investment business from Enron. This allowed the energy giant to become over-leveraged. It also fostered conflict of interest as the investment banks acted as both creditors and advisors for Enron. This might have caused them attempt to preserve whatever value was left for Enron and encourage it to pursue riskier strategies to maximize their chance of being repaid and keep the company alive. That could have been a reason why analysts refrained from warning the market about the foreseen crash of the firm.
â€¢ The Securities and Exchange Commission (SEC) was deeply troubled by the underlying events that resulted in Andersen's conviction, especially as the verdict reflects the jury's conclusion that Andersen engaged in conduct designed to obstruct the SEC process. Accordingly, the SEC is currently considering implementing changes to its corporate disclosure rules, including speedier and fuller explanation of significant events. Under pressure from Harvey Pitt, the SEC's Chairman, the New York Stock Exchange and Nasdaq are also reviewing their governance rules and listing standards. In addition, the Financial Accounting Standards Board (FASB), planned changes to its rules on accounting for off-balance-sheet vehicles
In Enron's case the moral wrong was simple: a failure to fulfil a fiduciary duty, generally because of serious conflicts of interest. That this kind of behaviour is immoral, and often illegal, is clear, but what challenge does it pose beyond recognising that it is wrong and attempting to prevent it? Congress mandated new rules to ensure that directors and auditors are 'independent', which is another way of saying 'free of conflicting interests'. Among the many provisions of the Sarbanes-Oxley Act, for example, are the requirements that audit committees be composed entirely of independent directors with no ties to management, and that accounting firms doing audits refrain from performing certain non-audit services that could bias an audit.
The Sarbanes Oxley Act of 2002 was enacted to restore public trust in corporate accounting practices as a direct response to corporate financial abuses and restricts non-audit services that CPAs can provide. The Act requires that the CFOs and CEOs must pledge that the company's finances are correct and face severe penalties in cases of non- compliance. Also the whistleblowers must be protected.
Congress's intent in passing Sarbanes-Oxley was to restore confidence in financial markets by increasing corporate accountability, enhancing public disclosures of financial information, and strengthening corporate governance. More severe criminal penalties for securities fraud were also enacted. The Securities and Exchange Commission (SEC) has adopted more than a dozen final rules to implement the Act's provisions. These rules raise standards of accountability for corporate executives, boards of directors, independent auditors, and corporate attorneys.
The Sarbanes- Oxley Act:
Creates a national Accounting Oversight Board that, among other activities, must establish the ethics standards used by CPA firms in preparing audits.
Requires that the auditors retain audit working papers for specified periods of time.
Requires that auditor rotation prohibiting the same person from being the lead auditorfor more than five years.
Requires that the CEO and CFO certify that the company's financial statements are true, fair and accurate.
Prohibits corporations from extending personal loans to executives and directors.
Requires that the audited company discloses whether it has adopted the code of ethics for its senior financial officers.
Requires that the SEC regularly review each corporation's financial statements.
Prevents employers from retaining against research analysts that write negative reports.
Imposes criminal penalties on auditors and clients for falsifying, destroying, altering or concealing records.
Imposes fine or punishment on any person that defrauds shareholders.
Increases penalties for mail and wire defraud from 5 to 20 years in prison.
Establishes criminal liability for failure of corporate officers to certify financial reports.
What needs to be done?
Some people argue that there are already too many rules in accounting, and that their number merely encourages the search for creative ways of getting round them. An alternative is the European approach, of employing accounting principles instead of rules. A principle-based accounting system which prescribes general goals instead of specific means allows accountants to choose, and auditors to approve, the accounting methods that provide the truest picture of a firm's financial situation. However, the European system requires a greater reliance on the integrity of the people doing accounting and auditing. American accountants already have the authority to depart from GAAP if doing so provides a truer picture, but few take advantage of this opportunity because it imposes a burden of proof that can be avoided by merely following the rules. In addition, the pursuit of principles should lead to the best methods of accounting, which can then be codified in rules. In return, these rules prevent unnecessary disagreements over the best methods. It is probably better to have precise rules where they are possible and leave principles for difficult cases that are less amenable to rules. Both fiduciary duties and market-based regulation aim at a common goal -namely to reduce risk. In particular, investors run the risk that executives will enrich themselves at the shareholders' expense, that a company's financial statements will not be accurate and that a broker's advice will not be sound. In each case, the solution has been to impose fiduciary duties that reduce the risk with a promise, in effect, not to take advantage of investors.
However, the goal of reducing risk can be achieved in a number of ways. A market-based system of regulation would shift the risk away from investors and back to the parties that now have fiduciary duties. For example, if accounting firms cannot be held liable for 'aiding and abetting' clients in fraud, then they bear little risk in facilitating 'aggressive accounting'. Removing this protection would require accounting firms to engage in more extensive risk management so that they would, in effect, be regulating themselves more closely. There are drawbacks to such a regulatory approach. An increased risk burden would lead to less risky behaviour, which might not be in the investors' interest, given that greater risk leads to higher returns. This burden involves a cost that would most probably be passed along to investors, as accounting firms, for example, might spend more money on audits or buy more insurance. However, fiduciary duties also have a cost, and so in the end.
The choice of regulatory approaches may depend on a trade-off between effective protection and the cost of that protection. However, this issue is ultimately decided, it is clear that in this post-Enron era the fiduciary duties of the various players in the American business system have become less effective protections for investors and the public. This erosion of a traditional means of regulation is a result of many changes that have taken place in recent years, some of them highly beneficial. The challenge we face, then, is whether to strengthen these fiduciary duties, in part by reducing effectively conflicts of interest, or to find other means of protection against the kinds of scandals that Enron represents.