Broken Trust: Role of Professionals in the Enron Debacle
Total Page：16
File Type：pdf, Size：1020Kb
9-903-084 REV: FEBRUARY 28, 2003 ASHISH NANDA Broken Trust: Role of Professionals in the Enron Debacle In the winter of 2001 Enron, the seventh-largest corporation in the United States, collapsed spectacularly. Investors, employees, and the public were aghast to discover that what had seemed a highly profitable, globally dominant energy trader with revenues in excess of $100 billion and a market capitalization of $62.5 billion at the beginning of 2001 had become, within a few short months, the largest bankruptcy in American corporate history.1 The bankruptcy had been triggered by the unwinding during August and September 2001 of several investment partnerships formed by Enron, ostensibly to hedge risks but employed primarily to manage the balance sheet (by moving debt off) and earnings (by creating the false impression that risks had been properly hedged). Following an “asset-light” strategy of becoming an energy trader rather than an energy producer, Enron had increasingly drawn income and profits from trading activities. Enron management had used the special partnerships to window-dress its accounting figures and thereby seek capital for its business on favorable terms. The firm’s ongoing success was predicated on servicing the off-balance sheet debts of its partnerships on the base of a rising stock price. But Enron stock, after peaking at $90 in late 2000, began to decline steadily over the summer of 2001. By late summer Enron management realized that the debt burden on the partnerships had become too onerous. Enron’s third-quarter earnings for 2001, announced on October 16 of that year, included an unexpected after-tax charge of $544 million related to investment losses and early termination of structured finance arrangements. On October 22, 2001, buffeted by reports that the Securities and Exchange Commission (SEC) had asked the company to disclose its ties to the investment partnerships, Enron stock plummeted 20% to $20.65. On October 24, the firm’s chief financial officer resigned; the stock dipped to $16.41. On November 8, under intense media and regulatory scrutiny, management restated Enron’s financial statements for 1997–2000, revealing that over that period it had overstated its net income by $586 million and understated its debt by $711 million. Enron’s stock price dropped to $8.41. The restatements and subsequent revelations about the nature of the firm’s partnerships had destroyed investor trust. On November 28, with energy rival Dynegy calling off its plan, unveiled on November 9, to buy Enron for $9 billion, Enron’s stock was trading at just over a dollar. On December 2 the firm filed for bankruptcy. Shareholders and debt holders lost their capital, and employees lost their jobs and pension plans, which were held predominantly in Enron stocks. ________________________________________________________________________________________________________________ Professor Ashish Nanda prepared this note as the basis for class discussion. This note is based on HBS Working Paper No. 03-065. Copyright © 2002 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School. This document is authorized for use only in Accountants in the Profession S2, 2014 by Dr Rahat Munir at Macquarie University from July 2014 to January 2015. 903-084 Broken Trust: Role of Professionals in the Enron Debacle Much ink has been spilled on speculating about the underlying causes of the Enron collapse. Blame for the collapse was placed squarely on Enron’s board of directors and management. Senior leaders were condemned for aggressively promoting Enron shares publicly while simultaneously unloading personal stakes in the firm. Senior leaders were held culpable at a minimum for extraordinary neglect and lack of responsible leadership. Enron executives were blamed for entering into a plethora of off-balance sheet partnerships purported to be hedging instruments but that turned out to be merely instruments for managing reported earnings and the balance sheet. Accounting rules were violated in several of these off-balance sheet partnerships. Several executives became “outside parties” with ownership stakes in the partnerships, taking the other side in contractual relationships with Enron and thereby profiting from Enron’s losses. Enron’s CFO was accused of negotiating both sides of transactions between Enron (as its CFO) and the off-balance sheet partnerships that he, or one of his trusted lieutenants, led as “outside investors.” Enron’s board of directors, one of the world’s highest compensated boards, was accused of lax oversight for allowing all the shenanigans by Enron executives to occur without aggressively questioning them. The audit and compliance committee of the board was particularly criticized for not probing deeply enough into the firm’s accounting procedures.2 Spectacular as Enron’s sudden collapse was, extraordinary as the failings of the board and leadership of Enron were, equally extraordinary was the combined failure of the various professionals associated with the firm—accountants, financial analysts, investment bankers, lawyers, consultants, and credit raters—to anticipate the impending collapse and warn shareholders, financial markets, and the public. The very structure of modern financial markets rests on the assumption that reliable information is readily available thanks to the independent and effective operations of auditors, investment banks, and law firms. Organizations that are expected to ferret out mismanagement and corporate wrongdoing had failed to do so. And it was not one or two but across the entire range of professions that the dogs that are supposed to bark at the first sign of malfeasance all remained strangely quiet. Every profession that had come into contact with Enron seemed to have missed or ignored signs of its demise, and every profession appeared to have powerful motives for doing so. As in a detective novel, let’s review the available clues at the scene of Enron’s death and try and track from these whether the professionals that came in contact with the firm were culpable in the destruction wrought by its sudden demise. The Accountants Andersen, Enron’s auditor since 1985, had failed to report the firm’s various accounting irregularities. As auditor, Andersen was supposed to be the investors’ representative, ensuring the robustness of Enron’s accounting systems and verifying the accuracy of its accounting reports, all the while maintaining independence from Enron management. Instead, the accounting firm was accused of helping to conceal rather than report Enron’s liabilities, abetting management in reporting transactions in a way that obscured rather than revealed performance numbers and colluding with Enron management to violate the spirit, if not the law, of open disclosure of accounting performance. Investigations revealed multiple strands that linked the two firms and raised questions about how independent of Enron management’s influence Andersen might have been in conducting its audits. Besides being Enron’s independent auditor, Andersen had since 1993 been working as the firm’s internal auditor as well. In addition to auditing, Andersen also provided consulting services to Enron. In 2000 Andersen received $25 million from Enron for auditing services and $27 million for nonauditing services. Andersen auditors and consultants occupied permanent office space at Enron headquarters and blended in with Enron employees. Over the years several Andersen alumni had joined Enron’s accounting department in senior positions. 2 This document is authorized for use only in Accountants in the Profession S2, 2014 by Dr Rahat Munir at Macquarie University from July 2014 to January 2015. Broken Trust: Role of Professionals in the Enron Debacle 903-084 On January 10, 2002 Andersen announced that employees in its Houston office had destroyed a number of documents related to Enron. In the ensuing firestorm, regulators asserted that Andersen’s partners, fearing legal inquiry into their management of the Enron audits, had willfully and illegally shredded documents pertinent to the Enron case. In March news leaked that besides the civil class- action lawsuit filed against it on behalf of Enron shareholders and creditors, Andersen would also have to face a criminal suit of obstruction of justice filed by the U.S. Justice Department over the document destruction. Its reputation for probity in tatters, the firm began hemorrhaging audit clients. Foreseeing significant economic costs associated with the ongoing litigations and departure of clients, several Andersen partners, including entire national partnerships, bolted the firm for competitors. The criminal trial began on May 8. On June 15 the jury convicted Andersen of obstruction of justice. On August 31, even as it continued its attempts to settle civil lawsuits related to its role in Enron’s collapse, the venerable 88-year-old firm surrendered its licenses to practice accounting in the United States. A healthy, profitable partnership employing 85,000 professionals and earning in excess of $9 billion per annum had literally evaporated within six short months. Tragic though Andersen’s fall was, the U.S. Congress, focusing on the much broader question— what needed to be done to ensure the veracity of accounting statements—acted swiftly and in July 2002 passed into law the Sarbanes-Oxley Act, which included several strictures on audit practice.3 Although the new act would strengthen controls over audit practices, whether tighter regulation was the appropriate way to ensure independent audits by accounting firms was an open question. With the demise of Andersen, the number of major accounting firms fell from the “Big Five” to the “Final Four,” dramatically increasing concentration in the accounting profession and raising the specter of higher audit fees.