A primer for Freepers on three issues of the Enron fraud and investigation

self

[ken5050]

There are two distinct aspects to the Enron mess; the political mudslinging, and the criminal fraud aspects of the case as pertains to the company and its auditors, Arthur Anderson. Oddly, in all the verbiage that has been written to date, very little has been written that begins to explain the TRUE nature of the financial fraud at Enron. More oddly, it is not that difficult to understand. For those who would like some insight, I will attempt to clarify, in lay terms, three points which, I believe, will ultimately be crucial as the investigations commence. So, if you'd like to learn, and understand a few things, read on.....

[Timesink]

would you comment from your perspective as a CPA, which I'm not, about AA's destruction of documents and data, as I alluded to in my 3rd point.

The shredding of documents in cases like these would happen a lot less often if a federal law would be passed - with some actual teeth in it - mandating massive penalties, both fines and jail time, for those that do it.

[PRND21]

Bump, thanks.

[Ken H]

Do you have the date that the 401k freeze went into effect?

Do you know if employees were given advance notice of this?

[Big Bunyip]

Thank you, Ken. It's the best summation of the Enron affair I've seen anywhere. It's a sharp, truly illuminating post. If you're not a journalist, that's a big pity for the news business.

[Wphile]

Destroying the documents is perhaps the most egrecious (sp?) part of this whole mess. The timing of the shredding of documents will also be crucial. From what I had heard it was in the last two months. This makes it look really bad. Perhaps, they knew the gig was up and were trying to protect themselves. I don't think you are required to keep all workpapers but merely have to show, via checklists et al, that the appropriate work was done. This will be another black eye if that is what they are going to try to hang their hat on.

I thought it was Enron who cooked the books...

Could be so and AA turned a blind eye. But what I keep coming back to is the dollars received in consulting fees - something like 25-50 million a year! For what?

Good accounting trade publication online

Not that I know of unless the Journal of Accountancy has an online version. Of course, the print version isn't that great either. Published by the AICPA so not sure how objective it will be. I will snoop around and see if I can find something.

[Timesink]

The auditor is hired by the corporation, usually based on two factors..the lowest bid, and if the head audit partner belong to the same CC as the company CEO....

I must be blanking ... "CC"?

[hole_n_one]

CC = Country Club

[Wphile]

the auditor is hired by the corporation

To be totally accurate, the auditor is hired by the Board of Directors of the corporation. A bid process usually only happens when there is a change of auditor and it is typically awarded to the lowest bidder. However, they are not done on an annual basis. Many corporations retain the same auditor for several years in a row. Don't know what the facts are with Enron. My guess is that AA has been their auditor for some time.

[hole_n_one]

Wouldn't a sale/transfer to a party which would benefit if the transaction had some type of fraud involved (inflated value) send up a red flag to the firm performing the audit, and more importantly, the agency who has oversight responsibility for the auditing firm?

Are these internal sales common?.....(if so, that's really scary)

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Let's assume that Co. A is going to sell something to Co. B., who has no real interest in Co. A. except for the product it is selling.

Co. A says that the something's worth is 110 million dollars.

Co A. doesn't get to cherry pick the auditor.......Co. B. gets to select, correct?

............yet, when Co. A. sells to Co. A., it gets to pick the agency (most likely, the one on their payroll) to ensure that the sale is legit?

What a farce!

[nuancey]

Could all the partners in AA be possibly liable for this? Where exactly would a failed AA partner go after the company folded given that their reputations would be poisoned?

[dread78645]

The definitive synopsis. Thanks.

BTW, I think this will end with Enron pushed to dissolution, forced into a chapter 7 filing.....the company wil NOT come out of bankruptcy. Why shoiuld it survive? There's nothig left. Several of the top people will receive lenghty prison sentences, and there will be disgorgement of hundreds of millions of profits from stock sales by these folks, in an attempt to mitigiate jail time. Anderson will dissolve in a bankruptcy filing also, after being sued by everyone. The partners will lose everything, plus, and over half of them will never work for a major accounting firm again.

Minor quibble:

The executive team of Enron will (or should) get prison time.
But there are significant assest still left to the corporation; pipe, contracts, A/R, land, etc. The creditors might agree with a 25/ dollar scheme instead of 9 cents.
A total liquidation is not called for and might not be as bloody as it's made out. IMHO.

I'll agree with you on Anderson, an accounting firm has only 3 assets, Law, Trust, Independance.
AA is toast.

[Bob J]

Very nice analysis Ken!

[Mitchell]

Bump.

[zeaal]

Thank you, ken5050

This is a read, print, read again and then re-read.

[Southack]

Nice analysys.

I'd like to add that Andersen was performing both the internal and EXTERNAL audits for Enron, so Andersen was auditing its own Enron, subsidiary, and related company books. That's way out of bounds.

Andersen also publicized that Enron was financially sound mere weeks before Enron collapsed and later declared bankruptcy.

Moreover, Andersen's sister firm Accenture was raking in multi-million dollar consulting fees for its IT work at Enron while Andersen was performing all of those internal and external audits. Now here's where it gets really dicey: Accenture cares only about billing its tech flunkies by the hour. Accenture has partners with intimate ties to Andersen, and partners in both firms share financial interests. It's unthinkable that partners at Accenture would fail to hear about various opportunities and pitfalls discovered or attended to by Andersen (and that, IMO, will turn out to be the emails that got deleted).

Andersen has been down this road before. Andersen was fined multi-millions for falsifying Waste Management's books (and at least one Waste Management executive scored a mob-related RICO conviction). Andersen got busted in a similar vein for its audit of Sunbeam, and Andersen publicized that IHI was "sound" mere days before IHI became the largest bankruptcy in Australian history.

One book from back in the 1990's touches on some of Andersen's lesser shenanigans: Dangerous Company, but I suspect many more such books will be penned in the near future.

[Nix 2]

From December 12, 2001:

Enron Corp.'s outside auditor said yesterday that "illegal acts" may have been committed at the energy-trading company before it sought bankruptcy protection last week.

The chief executive of Arthur Andersen, the big accounting firm that approved years of financial statements that overstated Enron's profits and understated its debts, also said Andersen made "an error in judgment" that accounted for $103 million in overstated profits.

While Joseph F. Berardino testified yesterday on Capitol Hill, giving Andersen's first substantive explanation of why it certified Enron's reports, top Enron officers detailed a reorganization strategy for creditors at a meeting in New York. And former Enron chief financial officer Andrew Fastow, after failing to honor a Securities and Exchange Commission subpoena, surfaced at a news conference to dispel speculation that he had fled the country.

In addition to Congress and the SEC, the Justice and Labor departments are investigating Enron's collapse. More congressional hearings are expected next month.

Enron shifted hundreds of millions of dollars in debts and losses from some business ventures off its books to partnerships run by Fastow. After the extent of the partnership's troubles became known in late October, the company quickly lost the financing and customers needed to keep its massive energy-trading operations going.

That prompted Dynegy Inc. to walk away from a $23 billion merger deal and forced Enron to make the largest bankruptcy filing in history on Dec. 2. Billions of dollars in shareholder value disappeared, and thousands of employees lost their jobs and much of their retirement savings, which were heavily invested in Enron stock.

Accounting rules say a company can keep enterprises such as the Enron partnerships off its balance sheet as long as unrelated parties provide at least 3 percent of their value. But it appears that Arthur Andersen "was not provided critical information" about one of those arrangements, Berardino said at a joint hearing of two subcommittees of the House Committee on Financial Services.

In 1997, when Andersen examined Enron's relationship with a partnership called Chewco, the auditors were informed that $11.4 million of Chewco's funding had come from a large financial institution unrelated to Enron, which satisfied the 3 percent test, Berardino said.

But Andersen recently learned that Enron had agreed to an arrangement that cut in half the amount of money the institution actually put at risk, Berardino said. That meant the partnership had so little outside money that its finances should have been disclosed in Enron's statements. Chewco accounted for about 80 percent of the profit overstatements related to the partnerships, Berardino said.

Why that information wasn't given to the auditors isn't clear, Berardino said. "We don't know if that was willful or not," he said.

Berardino said that withholding information from an auditor is illegal. On Nov. 2, he said, Andersen notified the audit committee of the Enron board of directors "of possible illegal acts within the company."

That was after the Securities and Exchange Commission began looking into Enron's finances.

In a response issued yesterday, Enron said "it was the company's management, not Andersen, that discovered the arrangement and its relevance and reported it to Andersen within 24 hours." Enron said it referred the matter to a special investigative committee of the board that is working with separate lawyers and accountants.

"It has always been Enron's policy to be open with its accountant," CEO Kenneth Lay said in a statement.

Questioned after the hearing, Berardino would not say how Andersen learned the truth about Chewco. "I don't think that's something we want to get into right now," he said.

Rep. Richard H. Baker (R-La.), who presided over the hearing as chairman of one of the subcommittees, said it appears that high-level people at Enron "did not provide the disclosures that are required perhaps by law but certainly by good moral judgment."

Lay turned down an invitation to appear before the committee, citing a conflict with the creditors meeting in New York.

At that meeting, Enron Chief Financial Officer Jeff McMahon said the firm is considering selling much of the business activity that helped define it in recent years in order to settle debts of more than $31 billion.

Sources said Citigroup and UBS Warburg, two of Enron's largest creditors, are in the final stages of preparing a bid for a controlling interest in Enron's Houston-based energy-trading business, which until recently handled one-fourth of all U.S. electricity and natural gas trading. The bid would be put before the bankruptcy court, and others could then submit competing bids. J.P. Morgan Chase & Co., another major creditor, is also considering putting a bid in, but sources say the firm doesn't want to be the first to make an offer.

McMahon said Enron also wants to sell its water and foreign power assets to raise as much as $6 billion. That would leave the company with its energy development, generation and exploration divisions, refashioning it into a firm of tangible assets -- the very kind of you-can-kick-the-tire items that Enron's top brass scoffed at in recent years in favor of more esoteric, less-tangible assets such as financial contracts.

Details of the plan would have to be accepted by the 15-member creditors' committee that was named yesterday and then approved by U.S. Bankruptcy Court Judge Arthur Gonzalez.

Fastow, meanwhile, appeared in New York yesterday with one of his attorneys, David Boies. Fastow will meet with SEC investigators in the future, Boies said, but had not had time to prepare his testimony yesterday. Fastow faces a civil fraud investigation by the SEC and a federal criminal probe, according to an SEC affidavit.

Boies would not allow Fastow to speak, other than to let him tell reporters: "Hello. I wish you a happy holiday season. Thank you for coming."

REST

[freedom4ever]

Check this out! In reference to your reply #74, the Sec. of the Army, Thomas White does not ring a bell by name, but I got to thinking and doing some research. Lo and behold, Arthur Anderson does our companies internal auditing. So we have , Cinergy's CEO coming from Enron, the Sec. of the Army coming from Enron. FYI, here is another connection to my company and Federal government and all this mess:

PSI Energy President Named Assistant Energy Secretary

CINCINNATI, March 27, 2001 – Cinergy Corp. (NYSE:CIN) today congratulated Vicky A. Bailey, president of its PSI Energy, Inc. subsidiary, on her nomination by President George W. Bush as Assistant Secretary for International Affairs and Domestic Policy of the U.S. Department of Energy. “We are very pleased that the President has chosen Vicky for this important assignment,” said James E. Rogers, chairman, president and chief executive officer of Cinergy. “While we hate to lose her, we also know that this is an honor that she cannot pass up.” “Secretary Abraham is gaining a key player for his management team with Vicky’s extensive knowledge of federal and state energy issues. We are confident that she will do an excellent job in helping form a strong national energy policy at this critical point in time,” he added. A search for a replacement for Bailey as president of PSI will begin immediately. She joined Cinergy in February 2000 after serving on the Federal Energy Regulatory Commission and the Indiana Utility Regulatory Commission.

Vicky A. Bailey is president of PSI Energy, Inc., Indiana’s largest electric supplier and the Indiana operating company of Cinergy Corp. She joined PSI in February 2000 and was previously a commissioner at the Federal Energy Regulatory Commission. She was nominated to the commission by President Clinton on May 10, 1993, for a term ending June 30, 1996. She was renominated by President Clinton on June 10, 1996 and confirmed by the Senate on June 26, 1996. Ms. Bailey also was a member of the Executive and Electricity committees of the National Association of Regulatory Utility Commissioners (NARUC). She was the NARUC representative to the North America Electric Reliability Council’s (NERC) Board of Trustees. She was active with the Mid-American Regulatory Commissioners Conference and on the Executive Committee of the Great Lakes Conference. Ms. Bailey is a participant in the Keystone Center Energy Project and the Harvard Electricity Policy Group.

[AmerRepb]

Wasn't Billy Sol Estes a conentrepreneur down in Texas...about the same period of time as Bill Cullen and the $64,000 Question game show (scandal)?

I'm curious to find out if Joseph Berardino, CEO and managing partner of AA knew what was going on, or did X number of accountants just take it upon themselves (with a little help from some of the ENRON higher up muckeydemucks?)to falsify the books. I'm no accountant, and I'm not really sure if any of this makes sense (it doesn't to me), but I'm posting it anyway (I'm not sure why...). Thanks for the post Ken.

[Nix 2]

Although some details are still murky, one thing is clear: Arthur Andersen, Enron’s outside accountant, is in big trouble, and it (or its insurers) will have to fork over big bucks. Andersen’s big problem stems from a company called JEDI—as in “Star Wars”—that Enron now says should have been on its books since 1997. Andersen allowed JEDI to remain off the books for years. The other deal, involving a company called Raptor, caused the net-worth disappearance that set Enron on the road to ruin.

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JEDI stands for Joint Energy Development Investments. It was a partnership between Enron and the California state-employees’ pension fund, known as Cal-pers. The Force was with Enron, which invested the money—$250 million each from itself and Calpers—in power plants, energy stocks and such, making more than 20 percent a year. Pretty neat. In late 1997, Calpers was willing to invest $500 million in a new partnership, JEDI 2. But it wanted to first cash in its JEDI 1 chips, worth $383 million. Instead of just liquidating JEDI, Enron got cute. (I’m not sure why. Enron declined to comment.) It went looking for an outsider to fork over $383 million and take Calpers’s place. Enter something called Chewco Investments—as in Chewbacca of “Star Wars” fame. Chewco was a partnership of Enron employees and some undisclosed outsiders. (Who they are and how much they made is a mystery, because Chewco is a private entity.) Chewco’s investors didn’t have a spare $383 million. So Enron lent Chewco $132 million and guaranteed a $240 million loan that Chewco took out elsewhere. Enron was thus at risk for its own JEDI stake and essentially all of Chewco’s. That being the case, it’s a mystery why Andersen let Enron keep JEDI off its books. Accounting experts who have looked at this transaction, which Enron disclosed last month, just shake their heads. Andersen has refused to comment, saying it’s too early to reach conclusions. Enron has restated its earnings dating back to 1997 because it says JEDI should have been on its books since then. Guess what? The restated profits are far lower than the original ones.

Oct. 16, 2001
Enron reports its first quarterly loss in over four years after taking charges of $1 billion on poorly performing businesses. Enron also discloses a $1.2 billion charge against shareholders’ equity relating to dealings with partnerships run by chief financial officer Andrew Fastow. Oct. 22, 2001 Enron says U.S. Securities and Exchange Commission is looking into transactions between Enron and the Fastow partnerships. Oct. 24, 2001 Fastow is replaced as chief financial officer by Jeff McMahon, head of Enron’s industrial markets unit.
Nov. 1, 2001
J.P. Morgan and Salomon Smith Barney agree to provide an additional $1 billion in secured credit.
Nov. 8, 2001
Enron says it overstated earnings dating back to 1997 by almost $600 million.

Nov. 9, 2001
Enron agrees to a deal in which smaller rival Dynegy Inc. will buy Enron for some $9 billion in stock. As part of the deal Chevron Texaco agrees to inject $1.5 billion in fresh capital immediately.
Nov.20, 2001
Enron discloses that a deterioration in its credit ratings could accelerate repayment of a $690 million loan. The company subsequently negotiates an extension of the loan.
Nov. 28, 2001
Major credit rating agencies downgrade Enron’s bonds to “junk” status. Dynegy terminates its agreement to buy Enron. Enron temporarily suspends all payments, other than those necessary to maintain core operations.
Dec. 2, 2001
Enron files for Chapter 11 bankruptcy and hits Dynegy with a $10 billion breach of contract lawsuit.
Dec. 3, 2001
Enron fires 4,000 employees the day after filing for bankruptcy. Dynegy countersues for control of Enron’s Northern Natural Gas Pipeline.

Dec. 4, 2001
Enron secures $1.5 billion in emergency financing, provided by major creditors J.P. Morgan Chase and Citigroup, so it can run a skeleton operation.
Dec. 12, 2001
Congressional hearings begin on Enron’s collapse, while the company announces plans to raise up to $6 billion by selling assets.
Dec. 13, 2001
Executives from accounting firm Andersen tell Congress they warned Enron about “possible illegal acts” after the energy trading giant failed to provide crucial data about it finances to Andersen.

Jan. 9, 2002
The Justice Department opens a criminal investigation of Enron.

Now, to the deals that sank Enron. As in JEDI, Enron won’t comment. These transactions involve four companies called Raptor. It looks like the Raptors were set up to let Enron use financial gymnastics to get gains from stocks it owned without actually selling them. The major holdings were Rhythms Net Connections, a now bankrupt start-up telecom company, and NewPower Holdings, which competes with established power companies for customers. At their height, Enron’s stake in these companies totaled about $2 billion. Friday’s value: about $40 million. Enron won’t say why it didn’t just sell the stock and take its profits. The most logical explanation is tax avoidance.

Now, the key to Enron’s undoing. The company committed to put $1.2 billion of Enron stock into the Raptors to make them more creditworthy. It didn’t promise a fixed number of shares—it promised $1.2 billion worth, regardless of the share price. A seriously dumb move for a company that talks about hedging risks. In return for that commitment, the Raptors gave Enron $1.2 billion of promissory notes. Enron put them on its balance sheet as an asset. When a company adds to its assets and nothing else changes, its net worth rises. Hence, Enron marked up its net worth by $1.2 billion.

But as the stock prices of Rhythms, NewPower and Enron all sank, Enron faced having to fork over a ruinous number of new shares. So Enron paid $35 million to the Raptors’ outside investors—yet another mysterious partnership—and liquidated the Raptors. That eliminated the notes, which eliminated the aforementioned $1.2 billion from Enron’s net worth. That set off the now famous October run on Enron’s credit, which ultimately led to bankruptcy. Now, far too late, Enron says it shouldn’t have counted the notes as assets.

Allan Sloan

*Pretty fancy accounting, there.