From the Post Enron Accounting Scandals to the Subprime Crisis

A Financial History of the United States 2004–2006

Jerry W. Markham

• Editore: Routledge
• Anno: 2022
• ISBN:
  9781000592993
• Edizione: 1
• Argomento: Commerce
• Categoria: Finance

Originally published in 2011, this volume examines the Enron-era scandals and several corporate governance issues that were raised as a result of these scandals. It then describes developments in the securities and derivatives markets, covering hedge funds, venture capital, private equity and sovereign wealth funds.

Part I Enron and Corporate Reforms

1. Enron and Its Aftermath

The Enron Scandal

Background

At the height of its glory, the now-legendary Enron Corporation billed itself as the “world’s leading energy company.” Enron owned pipelines and electrical generation facilities and even branched out into water production facilities around the world. The company was also noted for its innovative trading operations, which included a “gas bank” for natural gas purchases, an electronic trading platform called EnronOnline, the delivery of high-speed Internet transmissions through Enron Broadband Services, and a broad array of merchant investments.

Enron was picked by Fortune magazine as the most innovative company in America for five years running, and it was also ranked “No. 1 in quality of management.” Enron’s chief executive officer (CEO), Ken Lay, was called a “master strategist” in the press, and the Enron board of directors was ranked by CEO magazine as one of the five best in America. Enron’s chief financial officer, Andrew Fastow, was given a CFO Excellence Award by CFO magazine. Those accolades were preceded by rapid growth in Enron’s reported profits, and its stock price tripled during a two-year period. However, these glowing reports masked some serious problems encountered by the company as the new century began. Enron’s disastrous investment in a massive power plant program in Dabhol, India, had been well publicized, but it was also facing huge losses in its Azurix water business, and elsewhere abroad, which was withheld from investors.

Enron’s “mark-to-market” accounting for its trading programs and inventory made its balance sheet volatile and earnings uncertain as market conditions worsened and the value of those assets declined. In order to conceal its deteriorating financial position, Enron began moving assets off its balance sheet into various special-purpose entities called LJM1, LJM2, and Raptors. In the midst of these operations, Jeffrey Skilling replaced Ken Lay as Enron’s CEO in an orderly transition. However, Skilling unexpectedly resigned a few months later. That resignation touched off a crisis at the company, and Ken Lay was brought back to replace him.

Lay tried to restore confidence by assuring the press and investors that the company was sound and profitable. However, Enron continued its decline, and its accounting practices were being openly questioned in the press and internally. An Enron accountant, Sherron Watkins, assumed the role of a whistle-blower by objecting to Enron’s accounting practices in a letter to Ken Lay after he returned to replace Skilling. An internal investigation concluded that there was no basis for her claims that Enron was engaged in improper accounting activities, but, unrelated to Watkins’ claims, the company subsequently reported a $618 million loss in the third quarter of 2001, and it wrote down $1.01 billion in assets. Reporters for the Wall Street Journal began an investigation into Enron’s accounting practices after that announcement. Their questioning led to the revelation that Enron’s chief financial officer (CFO), Andrew Fastow, had engaged in some “related party” transactions with Enron while moving assets off its balance sheet. Related party transactions are suspect because they involve insiders at the company who are in a position to take improper advantage in the transaction. Fastow had profited handsomely from those transactions, and he was fired after the revelation of personal profits, which totaled over $75 million, touched off a firestorm in the press. Enron’s stock then plunged, and it faced difficulty in selling its commercial paper on money markets. Lay tried to save Enron through a merger with Dynegy, a smaller competing energy company. In the midst of those negotiations, however, Enron announced that it was restating its financial statements for the period from 1997 to 2001, reducing profits by $586 million and shrinking shareholder equity by over $2 billion. Debt was thereby increased by $2.5 billion.

These problems lowered Enron’s credit rating, which in turn triggered cash repayment obligations in several of Enron’s off-balance-sheet subsidiaries. The effect was similar to a run on a bank. Enron soon exhausted all its credit lines, and its declining position effectively shut it out of the capital markets. Banks refused further lending after Enron announced that it had additional, previously undisclosed liabilities totaling $25 billion. Dynegy withdrew from the planned merger, and desperate efforts to obtain a rescue from the federal government failed. Enron declared bankruptcy on December 2, 2001. It was at that point the largest bankruptcy in American history, an honor it would not hold for long, as it was pushed aside a few months later by the bankruptcy of WorldCom, following another accounting scandal.

Government Response

The accounting scandal at Enron touched off a media and political storm that President George W. Bush responded to with a speech on Wall Street promising tough action. That action came in the form of aggressive Justice Department prosecutions of executives at Enron and other corporations involved in accounting scandals that were blossoming as the economy slowed and the stock market crashed. This prosecutorial assignment was carried out through a Corporate Fraud Task Force—a “financial crimes SWAT team” that was headed by Michael Chertoff, assistant U.S. attorney general and later secretary of homeland security. Chertoff acted with zeal, indicting hundreds of executives caught up in these scandals. A centerpiece of Chertoff’s prosecutorial effort was the creation of an “Enron Task Force” in the Justice Department.

Justice Department prosecutors employed a number of techniques in the Enron-era scandals that were designed to break the will of the executives targeted for prosecution and to coerce them into guilty pleas. Such coerced pleas allowed prosecutors to avoid having to try a case that, given the complexity of the accounting manipulations employed at Enron and elsewhere, might be difficult to win. Hundreds of executives were arrested, and many were subjected to what became a ritual in the Enron-era scandals—the “perp walk”—in which executives were paraded in handcuffs in front of the waiting press. Ken Lay’s staged, but memorable, perp walk featured his being shackled and led into the courthouse by an attractive female FBI agent.

This practice reached its nadir with the apprehension of an executive at another company caught up in an accounting scandal. John Rigas, the eighty-year-old head of Adelphia Communications, who was suffering from cancer, was arrested in a dawn raid on his apartment in New York and shackled for his perp walk. Rigas would have voluntarily surrendered at the location of the government’s choice, but there was no drama in that. The cynicism of these theatrics was made clear when the domestic diva Martha Stewart, who was indicted on charges of obstruction of justice in an insider-trading scandal, was allowed to surrender at her leisure by the same U.S. attorney’s office that had its minions seize Rigas in his home. Stewart was allowed to surrender and enter a plea of “not guilty” without handcuffs or any other restraints.

After the arrest of an executive, the work for prosecutors really began. They immediately started coercing lower-level employees to “flip” by offering lenient sentences in exchange for testimony against senior executives. If that tactic did not work, more charges were added so that the employee faced the possibility of a long prison term unless he or she “cooperated.” If that coercion failed, the government approached family members in an effort to pressure the targeted employee. For example, as discussed below, Andrew Fastow, the Enron CFO, pleaded guilty and turned on Lay and Skilling after his wife was indicted, and prosecutors threatened to imprison them both so they could not care for their small children.

The next phase of the government’s prosecution plan was stacking the deck against any executive demanding a trial. This included sending target letters to potential defense witnesses advising them that they might be subjects of a possible criminal prosecution in order to intimidate them so that they would be afraid to testify, lest they too be indicted. That tactic was employed against Skilling, Lay, and Bernie Ebbers, the convicted former head of WorldCom. Then came the now-infamous “Thompson Memorandum,” named after its author, Deputy Attorney General Larry D. Thompson. It stated that the policy of the Justice Department was that, in order to avoid indictment for the accounting misdeeds of their employees, public companies would have to “cooperate” with the Justice Department in its investigations. Because an indictment would generally destroy or cripple a public company, cooperation was virtually mandatory. According to the Justice Department, cooperation meant waiving attorney-client privilege, firing any executive targeted by prosecutors before trial or even indictment, and then cutting off their attorney fees, even if those fees were required to be paid by contract or state law.

The Justice Department seemed to have sought convictions at any cost. Where there was no crime, the Justice Department prosecutors simply made one up and forged onward to trial. Skilling and Lay were among those so targeted. It took prosecutors two years to invent a crime for which they could be charged. Enron’s auditor, Arthur Andersen, was indicted on one theory but convicted on another, after the first theory imploded at trial. Although the Supreme Court eventually set aside that conviction, Arthur Andersen’s business was destroyed, and some 28,000 of its employees lost their jobs. Some Merrill Lynch executives caught up in the Enron scandal were tried under a nebulous theory and jailed for a year before their convictions were thrown out. That did not deter the prosecutors, who merely made up another theory and continued their relentless pursuit of those defendants, demonstrating a zeal that would have made Inspector Javert proud. As the basis for many of these charges, prosecutor used the federal “honest services” fraud statute, a twenty-eight-word law that critics called vague and unfair because of its nebulous prohibition against corporate executives engaging in a scheme or artifice that would deprive shareholders of “the intangible right of honest services.” In 2010, the Supreme Court ruled that the Justice Department had improperly applied that honest services charge to prosecute Skilling.

Sentencing abuses were next on the agenda. Prosecutors asked for a 215-year sentence for Rigas at Adelphia, but the judge only gave him a term of fifteen years, later reduced to twelve after an appeal. Ebbers, the WorldCom CEO, who was sixty-three and suffering from heart problems, was sentenced to twenty-five years in prison by Judge Barbara Jones. That sentence was upheld on appeal, even though it exceeded by many years sentences commonly meted out to those convicted of second-degree murder and child abuse. Indeed, life sentences are now the standard for senior corporate executives convicted in financial scandals. California, which for years banned the execution of murderers, sentenced the mastermind of a Ponzi scheme to 127 years in prison. Judge Denny Chin, of the Manhattan federal court, found such a sentence too short for seventy-one-year-old Bernard Madoff, who perpetrated the world’s largest Ponzi scheme. Madoff was sentenced to 150 years in prison.

In the end, the Justice Department’s harsh tactics gained guilty pleas from more than 300 executives and employees caught up in the Enron-era scandals. However, prosecutors suffered some embarrassing setbacks in the Enron cases that actually went to trial. Several of those convictions were set aside on appeal because of the flawed legal theories employed by the Enron Task Force. The Justice Department was also forced to revise the “cooperation” standards in the Thompson Memorandum, after being rebuked by a federal judge for using it to deny defendants their constitutional rights, but by then the damage had been done. The Justice Department had already run roughshod over anyone it targeted in the Enron-era scandals, and the effects of that misconduct could not be reversed, as evidenced in the Arthur Andersen case.

The Trials

The Arthur Andersen Fiasco

Enron’s auditor, Arthur Andersen, was widely attacked in the press for not discovering Enron’s accounting manipulations. That criticism turned into rage after the accounting firm reported that its Enron audit partner had ordered the wholesale shredding of Enron work papers. Because of that action Arthur Andersen became the first target of Chertoff’s Enron Task Force. Instead of indicting only the audit partner that had ordered the shredding, Chertoff decided that Arthur Andersen itself had to be dismantled because he did not believe the firm was cooperative enough. Chertoff was unmoved by Arthur Andersen’s offer of a massive settlement and the proposal of a restructuring of its operations, which would focus on preventing accounting manipulations in the future.

Chertoff’s task of destroying Arthur Andersen was made easier by the fact that it was already staggering from a split with its consulting partners. The consulting partners had spun off their business into Accenture, which became a very successful consulting firm. Arthur Andersen was also embroiled in litigation over other large audit failures and was paying huge sums to settle suits related to Sunbeam and the Baptist Foundation of Arizona.

One of the worst of Arthur Andersen’s problems involved the audit of Waste Management, a large trash removal company that had been forced to restate $3.5 billion in earnings in 1998. Arthur Andersen had failed to detect those manipulations and certified the accuracy of the financial statements containing those bogus earnings. Four Arthur Andersen partners were sanctioned by the Securities and Exchange Commission (SEC) for that audit failure. The firm agreed to pay the SEC a $7 million penalty, which was then the largest such sanction ever imposed on an accounting firm. Arthur Andersen also paid $220 million to settle class-action shareholder lawsuits stemming from the failed Waste Management audit engagement.¹

Arthur Andersen was regrouping and dealing with those problems before the Enron scandal broke. That effort fell apart after Arthur Andersen reported to the Justice Department that its Houston office had shredded large amounts of Enron documents and had deleted computer files and e-mails concerning Enron. David Duncan, the Arthur Andersen partner in charge of the Enron account, supervised that destruction. Duncan was indicted and agreed to plead guilty to charges of obstruction of justice. As a part of that plea bargain, Duncan also agreed to testify against his employer, Arthur Andersen.

Arthur Andersen’s negotiations with the Justice Department to avoid indictment as a result of Duncan’s actions were to no avail. Department officials were concerned with failed audits by Arthur Andersen, including WorldCom, which imploded after the Enron scandal. Chertoff was also angered by a protest rally of Arthur Andersen employees urging the Justice Department not to indict Arthur Andersen. That rally made the news and even attracted...

Indice dei contenuti

• Cover
• Title Page
• Copyright Page
• Original Title Page
• Original Copyright Page
• Dedication
• Dedication
• Table of Contents
• List of Abbreviations
• Preface
• Acknowledgments
• Introduction
• Part I. Enron and Corporate Reforms
• Part II. Financial Market Developments
• Conclusion
• Notes
• Selected Bibliography
• Name Index
• Subject Index