Twenty years later, could another Enron happen?

In August of 2001, I’d sent an anonymous memo to Lay to warn him that I was “incredibly nervous that we will implode in a wave of accounting scandals.” I’d discovered what I believed to be accounting fraud only weeks before. With the abrupt resignation of Enron’s CEO, Jeffrey Skilling, on Aug. 14, 2001, I felt certain Lay was unaware of the accounting issues and might just believe me since Skilling’s departure seemed to lack a valid reason. Perhaps the fraud was a contributing factor? Based upon Lay’s reassurance to all employees that Enron was truly committed to its core values, I identified myself the day after sending the anonymous letter and then met with Lay on Aug. 22, 2001, armed with seven pages of memos and other documentation that listed intricate details of the situation with several recommendations. I not only expected, perhaps naively, that he’d lead a thorough investigation, but I also assumed Enron would establish a crisis management team to address the financial peril the company would face when the accounting fraud was exposed. He didn’t do that.

In the last two years of Enron’s existence, shareholders lost nearly $60 billion in value. The company had never reported a losing quarter until the oddly worded and mysterious “$544 million non-recurring write-off” in the third quarter earnings release on Oct. 16, 2001. Then the U.S. Securities and Exchange Commission (SEC), the Department of Justice (DOJ), the Department of Labor and several congressional committees began investigating. And shareholders filed dozens of lawsuits against the company, its executives and its board of directors.

Those investigations and lawsuits were the only reason I remained employed. An in-house attorney in charge of coordinating Enron’s response to shareholder litigation offered me a month or two of employment with the bankruptcy estate.

In November 2001, I’d been asked to meet with the law firms Enron had hired to defend the company, its board of directors and its executives in the shareholder lawsuits. I now understand that these law firms only met with me so I could explain the questionable accounting and what the opposing side would be claiming. I was more or less the enemy in their midst.

Financial tricks

Those questionable accounting practices included several tricks. For one, the company overstated the value of its derivative contracts to inflate unrealized trading gains in the retail energy market and bolster earnings. But much of the financial deception revolved around the complex use of hundreds of special purpose vehicles (SPVs) that “allowed” Enron to keep troubled assets, losses from bad investments and growing debt levels out of the reported financial statements.

Furthermore, Enron would also sell “impaired” assets to these SPVs at an inflated price to report a gain on its income statement — a practice that violated Generally Accepted Accounting Principles. At the same time, some of these entities were paying millions of dollars in management and structuring fees to then-CFO Andrew Fastow, who often ran and partly owned the SPVs himself. Not only did that violate Fastow’s duties to Enron’s shareholders, but his ownership stake disqualified the SPVs as off-balance-sheet entities, according to the SEC.

Indeed, a small group of Enron employees allegedly committed a John Grisham-worthy scam complete with a secret meeting in the Cayman Islands under the shadow of these SPVs. A quick read of the DOJ’s indictment of Michael Kopper, Fastow’s second-in-command, explains much of Enron’s financial shenanigans. (See “United States of America v. Michael J. Kopper,” U.S. District Court Southern District Texas, Aug. 20, 2002.)

A grand jury in Houston later indicted Fastow on 78 counts of wire fraud, money laundering and conspiracy in connection with the Enron collapse. (See “Former Enron chief financial officer Andrew S. Fastow indicted for fraud, money laundering, conspiracy,” DOJ, Oct. 31, 2002.)

All these financial ploys created the illusion that the energy company was thriving, pushing up the stock price and facilitating access to cheap funding. But the illicit financial engineering eventually proved unsustainable. On Oct. 16, 2001, Enron announced its first quarterly loss and the closure of the so-called Raptor SPVs.

This caught the eye of the SEC, which opened an investigation into related party transactions and accusations that the company’s top executives had “made millions of dollars in the form of salary, bonuses, and the sale of Enron stock at prices they had inflated by fraudulent means.” (See United States Exchange Commission v. Kenneth L. Lay, Jeffrey K. Skilling, Richard A. Causey, U.S. District Court, Southern District of Texas, and “ The Rise and Fall of Enron,” by C. William Thomas, Journal of Accountancy, April 1, 2002.)

Testifying to Congress, Lay’s lying, execs lining pockets

In January 2002, Enron complied with congressional subpoenas of documents with a common tactic: sending roomfuls of boxes to try to drown investigators searching for evidence. However, a diligent congressional staffer discovered the memos, and copies of worksheets and board presentations that I’d delivered to Lay in our August meeting.

My name was leaked to the press, and my life changed forever. Congressional committees soon requested more information from Vinson & Elkins, Enron’s external lawyers; Arthur Andersen, the external auditors; and Enron. They also requested my personal testimony via a formal subpoena.

When I appeared before Congress in February 2002, I was shown a memo from Vinson & Elkins sent back to Enron that stated, “You requested the possible consequences of discharging employees who reported accounting irregularities.” That memo was dated Aug. 24, 2001, just two days after I’d met with Lay. I hadn’t realized how close I’d come to being sacked. I was shocked and disappointed that his first action was to consider firing me, not to determine if I was presenting credible evidence of accounting fraud. (See The Financial Collapse of Enron — Parts 3 and 4, “Hearing before the Subcommittee on Oversight and Investigations of the Committee on Energy and Commerce, House of Representatives,” GPO.gov, Feb. 14 and March 14, 2002.)

My disappointment in Lay’s flawed leadership was followed closely by more bad news of broader leadership shortcomings. Journalists were pouring over Enron’s bankruptcy filings and soon reported that those Enron executives who’d laid off nearly 5,000 employees on Dec. 3, 2001, had paid themselves exorbitant bonuses the week before Enron’s bankruptcy filing. Those bonuses often equaled two, three and five times their annual base salary — the purpose of which was to “retain” their employment at the bankrupt estate for three months. (See “Enron’s last-minute bonus orgy,” by Jake Tapper, salon, Feb. 8, 2002.)

I’m still alarmed that these executives were able to fire their staff so easily with no severance and no insurance, while lining their pockets with a multi-year cushion of cash. How had the culture and value system gone so terribly wrong at Enron? Were these executives any more ethical or moral than Andy Fastow, Enron’s CFO and primary perpetrator of the accounting fraud? If so, not by much. How could I have worked at Enron for more than eight years and not recognized that the culture was rotten? See below, "Heed these 10 risk indicators from Enron's failings."

Greed subverts principles

The drivers for fraud are well known: motive, opportunity and rationalization. The accounting fraud at Enron fit perfectly: 

Motive: Management couldn’t miss earnings and cash-flow targets.

Opportunity: Ambiguity in accounting rules allowed Enron to pressure its compliant auditor, Arthur Andersen, to accept Enron’s application of those rules. An outsourced and outmatched internal audit department proved worthless, as did Enron’s rubber-stamp board of directors.

Rationalization: Accounting rules, and Enron’s interpretation of them, trumped accounting principles that required a fair representation of the corporation’s financial condition. The ends (shareholder value and stock price) justified the means.

The irony of the demise of Arthur Andersen, which came on the heels of the indictment by the DOJ for destroying evidence in the Enron matter, is that Andersen knew better. The accounting firm had mandated a client retention analysis each year to focus on companies that were flying too close to the edge of propriety and to consider dropping them as clients. In fact, Andersen walked away from its savings and loan clients in the mid-1980s, concerned that what had become normal accounting in the industry wasn’t representative of the financial condition of the savings and loan businesses. In early 2001, Andersen did identify Enron as a risky client but decided to keep the relationship, noting in a memo introduced at Andersen’s trial that annual billings from the Enron engagement could possibly reach $100 million a year. (See “Two Memos Reveal Arthur Andersen Had Knowledge of Enron’s Difficulties,” by Tom Hamburger and Ken Brown, The Wall Street Journal, Jan. 17, 2002.)

Andersen might still be in business today if it had kept its impeccable principles in place from the 1980s and stuck by its client retention analysis policy. For investors, employees, accountants, auditors and fraud examiners, developing a macro-style risk analysis of publicly traded companies is a great policy to adopt and/or maintain.

Justice is served

The Enron Task Force created by the DOJ to investigate criminal activity at Enron was very successful, with over two dozen executives who either pleaded guilty or were found guilty at trial. Additionally, seven bankers who did business with Enron served prison time for their roles in aiding and abetting Enron’s financial and accounting schemes.

We can have some measure of satisfaction that justice was served, and those executives and organizations responsible for either perpetrating Enron’s accounting frauds — or standing by and providing outside auditing or financial assistance for Enron’s schemes — were held to account. (See chart “Enron convictions.”) We have no such satisfaction for those business leaders and organizations who created the Great Recession of 2008. Those Wall Street firms and banks haven’t seen any repercussions for their risky and often financially misleading activities. A quick review of the bankruptcy examiner reports on Lehman Brothers shows how the use of Repo 105 transactions mirrors some of Enron’s more creative financial structures. Repurchase agreements, or repos, are a type of short-term loan. One firm sells securities such as U.S. Treasuries to another party in exchange for cash and then buys back the asset that backed the loan at a higher price. Repos form a multitrillion-dollar market and accounting rules define them as debt that stay on the balance sheet.

What made the so-called Repo 105 different from traditional repos and similar to Enron’s financial tricks was that they both involved circumventing the Financial Accounting Board’s FAS 140 guidelines on asset transfers in structured products to make their books look more pristine than they really were. Lehman found a loophole in the FAS 140 rule that allowed it to count the Repo 105 transaction as a sale, as opposed to debt on its balance sheet. (See “Lehman’s Demise and Repo 105: No Accounting for Deception,” Wharton, March 31, 2010.)

Remedies to prevent future fiascoes

Enron’s shoot-the-messenger response (and I was one of those messengers) prompted Congress to include whistleblower retaliation protections in corporate reform legislation, the Sarbanes-Oxley Act, that it passed in July 2002 in the wake of the corporate scandals of Enron, WorldCom and other entities that year.

The 2010 Dodd-Frank Act supplemented and enhanced those whistleblower protections and created a reward program for tips, complaints and referrals to the SEC. The successful SEC Office of the Whistleblower, created by Dodd-Frank, is now a decade old.

From the inception of the program through June 2021, the SEC has awarded approximately $938 million to 179 whistleblowers. (See “A History of Corporate Whistleblower Protection Laws and the Efforts to Undermine Them,” by Sherron Watkins, Whistleblower Network News, July 13, 2021.) We should vigorously protect the ability for whistleblowers to remain anonymous and hire legal support to report potential wrongdoing at their companies. See below, "Introduced U.S. Senate bill could enable more whistleblowers."

Heed these 10 risk indicators from Enron’s failings

1/ State of risk management: The internal audit department is fully outsourced. Control and risk management personnel don’t have autonomy or equal power with revenue departments. The chairs of the audit and finance committees of the board of directors rarely, if ever, meet with the head of the company’s risk management departments alone. It goes without saying that the lack of internal auditors meant no fraud examiners were employed at Enron either.

2/ Tone at the top: The CEO abuses their position in some way. (Ken Lay required all employees to book business travel through his sister’s travel agency. His use of corporate jets for personal reasons was well known among executives who found  Lay’s personal needs would circumvent their legitimate business trips.)

3/ Stock option overuse: The compensation system relies significantly on stock options. Also, the company’s full compensation to its board and employees, including salaries, bonuses, stock grants and stock options, ranks well above its peer group or similar companies in the same jurisdiction.

4/ Diffusion of responsibility: Employees can’t adequately explain complex transactions or accounting treatments without relying on highly paid outside experts (accountants, auditors, lawyers, consultants) who’ve “blessed” the transactions or accounting machinations. This is important: If a business professional truly understands a transaction, they should be able to explain it successfully to a first grader. Enron executives and board directors stopped asking questions to try to understand Enron’s complex and confusing off-balance-sheet SPVs and just accepted some version of “I’m not an accountant; Andersen has approved the vehicle, so it must be OK.”

5/ Active spin machine: The public relations department is very active compared to peer or local competitors.

6/ Exceptions to the rules: Despite a strong written code of conduct and established internal control systems, the organization may reprimand but not terminate ethically challenged but successful employees.

7/ High executive turnover.

8/ Impeded communication: Methods for delivering bad news to the top are sketchy. Whistleblower hotlines aren’t robust. Intimidation shuts down dissent. The employee watercooler talk, the internal project names, the departmental skits all hint at wrongdoing. (Andy Fastow, Enron’s CFO, coined the dubious accounting structures “Raptors” and “Condor.” Enron’s traders manipulated the California energy markets with schemes called “Get Shorty,” “Ricochet” and “The Death Star.” Jeff Skilling performed a skit joking about adopting mark-to-model accounting, saying this “hypothetical future value accounting will add a kazillion dollars to the bottom line.”)

9/ Charismatic leadership masking malignant narcissism: Top leaders’ descriptors — charismatic, quick, slick — hint at narcissism. Top leaders have an air of arrogance and domineering personalities. Employees sense that rules don’t apply to those at the top. (See the “Career Connection” column in the November/December 2021 issue of Fraud Magazine.)

10/ The board of directors allows the CFO to enter a conflict of interest: At Enron, the board waived the code of conduct to allow Fastow to become the general partner of an investment partnership that helped the company close out transactions that were taking too long in the marketplace. Fastow named his investment partnership, LJM, after his wife, Lea, and two sons, Jeffrey and Matthew. Many of the Enron executives listed in the convictions table below weren’t perpetrators of fraudulent structures. They just benefited from LJM, a fraudulent structure, by boosting their earnings when they did business with it. (Hopefully, other organizations won’t imitate this infamous and preposterous action.)

Introduced U.S. Senate bill could enable more whistleblowers

A bill introduced into the U.S. Senate on July 22, 2021, could help prevent the Department of Justice (DOJ) from dissuading more would-be whistleblowers. The bill, S. 2428 by Sen. Chuck Grassley (R-Iowa), would amend the False Claims Act (FCA) to make it more difficult for the DOJ to end whistleblowers’ FCA cases when federal prosecutors contend the cases have no merit.

The FCA stipulates that the DOJ is allowed to end a whistleblower’s action at any time by giving notice of a motion to dismiss and scheduling a hearing. Grassley’s False Claims Amendments Act of 2021 would add that the DOJ would have to demonstrate “reasons for dismissal, and the qui tam plaintiff shall have the opportunity to show that the reasons are fraudulent, arbitrary, and capricious or contrary to law.”

This bill’s introduction follows the January 2018, Granston memorandum from the DOJ, which sought to halt meritless cases. (See “Grassley Bill Aims to Slow DOJ’s Pushback on Whistleblower Suits,” by Daniel Seiden, Bloomberg Law, Aug. 2, 2021.)

The SEC’s Office of the Whistleblower is a good check and balance, but we need more. The American Institute of Certified Public Accountants is undergoing an evaluation of the certification process and is developing a new licensure model for CPAs, which is expected to debut in 2024. The new process will overhaul the four-part, 16-hour exam to become a CPA and introduce new educational qualifications. My personal desire is to see fraud detection become a primary educational requirement for CPAs. (See “AICPA, NASBA launch CPA Evolution Model Curriculum,” by Courtney L. Vien, Journal of Accountancy, June 15, 2021, and “Updating Accounting Education for the ‘CPA Evolution,’” by Pamela Neely and Keith Donnelly, The CPA Journal, October 2020.)

Detecting fraud and the conditions that might lead to fraud should be a requirement for CPAs. Requiring anti-fraud expertise more broadly throughout the accounting profession could go a long way to preventing another Enron and another Great Recession.

Sherron Watkins, the former vice president, corporate development at Enron, now lectures on leadership and ethics as the executive-in-residence at the McCoy College of Business at Texas State University and as professor of the practice at Kenan-Flagler business school at the University of North Carolina at Chapel Hill. Contact her at sherronwatkins@txstate.edu.