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Lessons Learned from Enron's Collapse: Auditing the Accounting

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LESSONS LEARNED FROM ENRON’S COLLAPSE: AUDITING THE ACCOUNTING INDUSTRY HEARING BEFORE THE COMMITTEE ON ENERGY AND COMMERCE HOUSE OF REPRESENTATIVES ONE HUNDRED SEVENTH CONGRESS SECOND SESSION FEBRUARY 6, 2002 Serial No. 107–83 Printed for the use of the Committee on Energy and Commerce ( Available via the World Wide Web: http://www.access.gpo.gov/congress/house U.S. GOVERNMENT PRINTING OFFICE 77–986CC WASHINGTON : 2002 For sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800 Fax: (202) 512–2250 Mail: Stop SSOP, Washington, DC 20402–0001 VerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00001 Fmt 5011 Sfmt 5011 E:\HEARINGS\77986 pfrm09 PsN: 77986 COMMITTEE ON ENERGY AND COMMERCE W.J. ‘‘BILLY’’ TAUZIN, Louisiana, Chairman MICHAEL BILIRAKIS, Florida JOHN D. DINGELL, Michigan JOE BARTON, Texas HENRY A. WAXMAN, California FRED UPTON, Michigan EDWARD J. MARKEY, Massachusetts CLIFF STEARNS, Florida RALPH M. HALL, Texas PAUL E. GILLMOR, Ohio RICK BOUCHER, Virginia JAMES C. GREENWOOD, Pennsylvania EDOLPHUS TOWNS, New York CHRISTOPHER COX, California FRANK PALLONE, Jr., New Jersey NATHAN DEAL, Georgia SHERROD BROWN, Ohio STEVE LARGENT, Oklahoma BART GORDON, Tennessee RICHARD BURR, North Carolina PETER DEUTSCH, Florida ED WHITFIELD, Kentucky BOBBY L. RUSH, Illinois GREG GANSKE, Iowa ANNA G. ESHOO, California CHARLIE NORWOOD, Georgia BART STUPAK, Michigan BARBARA CUBIN, Wyoming ELIOT L. ENGEL, New York JOHN SHIMKUS, Illinois TOM SAWYER, Ohio HEATHER WILSON, New Mexico ALBERT R. WYNN, Maryland JOHN B. SHADEGG, Arizona GENE GREEN, Texas CHARLES ‘‘CHIP’’ PICKERING, Mississippi KAREN MCCARTHY, Missouri VITO FOSSELLA, New York TED STRICKLAND, Ohio ROY BLUNT, Missouri DIANA DEGETTE, Colorado TOM DAVIS, Virginia THOMAS M. BARRETT, Wisconsin ED BRYANT, Tennessee BILL LUTHER, Minnesota ROBERT L. EHRLICH, Jr., Maryland LOIS CAPPS, California STEVE BUYER, Indiana MICHAEL F. DOYLE, Pennsylvania GEORGE RADANOVICH, California CHRISTOPHER JOHN, Louisiana CHARLES F. BASS, New Hampshire JANE HARMAN, California JOSEPH R. PITTS, Pennsylvania MARY BONO, California GREG WALDEN, Oregon LEE TERRY, Nebraska DAVID V. MARVENTANO, Staff Director JAMES D. BARNETTE, General Counsel REID P.F. STUNTZ, Minority Staff Director and Chief Counsel (II) 2 VerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00002 Fmt 0486 Sfmt 0486 E:\HEARINGS\77986 pfrm09 PsN: 77986 C O N T E N T S Page Testimony of: Chanos, James S., Kynikos Associates, Ltd ................................................... 71 Dharan, Bala G., Rice University ................................................................... 87 Lev, Baruch, New York University ................................................................. 96 Longstreth, Bevis, Debevoise & Plimpton ...................................................... 111 Raber, Roger W., National Association of Corporate Directors .................... 79 Sokol, David L., Midamerican Energy Holdings Company ........................... 122 Weil, Roman L., University of Chicago ........................................................... 82 Material submitted for the record by: Chanos, James S., Kynikos Associates, Ltd., letter dated March 8, 2002, enclosing response for the record ................................................................ 169 Tauzin, Hon. W.J. ‘‘Billy’’: Letter dated February 19, 2002, to Baruch Lev, enclosing questions, and responses to same ........................................................................... 165 (III) 3 VerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00003 Fmt 0486 Sfmt 0486 E:\HEARINGS\77986 pfrm09 PsN: 77986 VerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00004 Fmt 0486 Sfmt 0486 E:\HEARINGS\77986 pfrm09 PsN: 77986 LESSONS LEARNED FROM ENRON’S COL- LAPSE: AUDITING THE ACCOUNTING INDUS- TRY WEDNESDAY, FEBRUARY 6, 2002 HOUSE OF REPRESENTATIVES, COMMITTEE ON ENERGY AND COMMERCE, Washington, DC. The committee met, pursuant to notice, at 12:53 p.m., in room 345 Cannon House Office Building, Hon. W.J. ‘‘Billy’ Tauzin (chair- man) presiding. Members present: Representatives Tauzin, Bilirakis, Barton, Stearns, Gillmor, Greenwood, Cox, Deal, Largent, Burr, Whitfield, Ganske, Norwood, Shimkus, Shadegg, Pickering, Blunt, Davis, Bry- ant, Ehrlich, Buyer, Radanovich, Bass, Pitts, Walden, Terry, Din- gell, Waxman, Markey, Hall, Boucher, Towns, Pallone, Brown, Gor- don, Deutsch, Rush, Eshoo, Stupak, Engel, Sawyer, Wynn, Green, McCarthy, DeGette, Barrett, Capps, Doyle, John, and Harman. Staff present: Jim Barnette, general counsel; David Cavicke, ma- jority counsel, Shannon Vildostegui, majority counsel; Brian McCullough, majority counsel, Jon Tripp, assistant press secretary; Will Carty, legislative clerk, Jill Latham, staff assistant; David R. Schooler, minority general counsel and deputy staff director; Sue Sheridan, minority counsel; Consuela Washington, minority coun- sel; Candy Butler, minority professional staff; Nicole Kenner, mi- nority legislative clerk; and Jessica McNiece, minority intern. Chairman TAUZIN. Let me announce the order of business. We will begin opening statements on the full committee hearing this morning, but we will suspend and interrupt those opening state- ments as soon as staff informs me that we have a full quorum of the committee present to do business. At that point, we will intro- duce a resolution before the full committee with the concurrence of the minority, which will authorize the Chair with again the concur- rence of the minority to issue subpoenas in this case as we further need them in our investigation. And then we will go back to open- ing statements and introduce our witnesses and finish the hearing. The Chair will first recognize himself for an opening statement. Today, we’re taking the extraordinary step of holding a full Energy and Commerce Committee hearing to consider some of the most im- portant policy issues that relate to Enron’s collapse. These issues include corporate governance, accounting and governance of the au- diting profession and very importantly, the health of our energy in- terest and markets. We take this step because of the profoundly troubling things we’ve discovered in the investigation of Enron. (1) VerDate 11-MAY-2000 14:53 May 15, 2002 Jkt 078865 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 E:\HEARINGS\77986 pfrm09 PsN: 77986 2 Most significantly we have learned that first, senior Enron man- agement engaged in self-dealing transactions, and second, Enron transacted with partnerships controlled by CFO, the Chief Finan- cial Officer, Andrew Fastow, his associate, Michael Kopper and oth- ers, and that Enron appeared to shift the risk of loss on risky in- vestments in these partnerships, but in fact, remained fully liable for their investments and those risks. And third, Enron went ahead and reported fictitious gains on these transactions with the LJM and Raptor entities when the hedged investments declined in value, and that these gains were illusory. The partnerships lacked the economic resources to make good on the transactions. The effect of these sham transactions was to inflate Enron’s publicly reported earnings in 1999, 2000 and 2001 significantly by more than $1 billion. We have found substantial evidence of illegal activity by Enron and its management. And this activity served to deceive the public about Enron’s financial condition. It artificially pumped up Enron’s stock price and allowed these same executives to enrich themselves with the sales of Enron stock. We have also found that Enron’s auditor, Andersen, knew or should have known or should have discovered the fraudulent na- ture of the Fastow transactions and we have found that Enron’s fi- nancial statements violated numerous existing accounting rules. These statements misled investors about Enron’s financial condi- tion and over-estimated that net income by over $1 billion. In the end it turns out that the Enron debacle is an old fashioned exam- ple of theft by insiders and a failure of those responsible for them to prevent that theft. We believe this is a huge aberration of cor- porate behavior in America. For example, in one transaction, Fastow and Kopper informed the investors in LJM2, a partnership at the center of this theft, that the expected rate of return on the transaction was 2,503 percent to be realized in just 8 days. In each of the so-called Raptor transactions, Fastow extracted all of his equity, along with additional fees in the tens of millions of dollars before any transactions that involved any economic risk took place. In this way, Enron was doing business with an entity with only one asset and that was Enron’s shares that Enron had contributed. This was not a hedging transaction. Enron was merely issuing shares and calling the issuance earnings. This clearly vio- lated existing law and the most basic norms of corporate behavior. Enron’s Board of Directors, its Finance Committee and its Audit Committee failed to exercise due care with respect to these trans- actions and it simply boggles the mind that the Chief Financial Of- ficer of a company was allowed to organize partnerships and simul- taneously take the other side of deals with this company. Such an arrangement should never have happened and does not ordinarily happen in any corporation that I know of in America. Additionally, we have learned that the SEC conducted no mean- ingful review of Enron disclosures from 1997 through 2001, so be- fore we rush
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