Transcript Operating Near the Edge
Preventing the Next Enron
… Lessons Learned Presented to the Florida West Coast Chapter IIA December 2, 2003 Thomas L. Richardson
IIA Standard - Deterrence, Detection, Investigation and Reporting of Fraud
• • • •
Evaluate the indicators Know the fraud indicators
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Characteristics of fraud
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Techniques used to commit fraud
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Types of fraud associated with activity Notify the appropriate authorities and recommend investigation Take Action (Due prof’l care; follow-up)
1
Where to Look for Fraud
(Follow the Cash)
ORGANIZATION 2 1 Receipts 2 Assets 3 Disbursements 3
Situational Pressures (Motive)
Red Flags • • • • •
High personal debts Severe illness in family Inadequate income / living beyond means Stock market speculation Loan shark involvement
Situational Pressures (Motive)
Red Flags
(Cont’d.)
• • • •
Excessive gambling Involvement with other men/women Undue family, peer, company, community expectations Excessive use of alcohol or drugs
Revenge Motives
• • •
Perceived inequities
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Underpaid
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Poor job assignments Resentment of superiors Frustration, usually with job
Personally Developed Opportunities
Red Flags • • •
Very familiar with operations (including cover up opportunities) In a position of trust Close association with cohorts, suppliers, and other key people
Firm Environments Which Foster and /or Create Opportunities Red Flags • • • • •
Rule of conduct/discipline not disseminated Rapid turnover of key personnel (quit or fired) No annual vacations of key personnel/execs No rotations or turnover of key personnel Not using adequate personnel
Firm Environments Which Foster and /or Create Opportunities Red Flags (Cont’d.) • • •
Absence of explicit and uniform personnel policies No record of dishonest acts or disciplinary actions No documented Code of Ethics
History of Enron
• July 1985 - Houston Natural Gas merged with InterNorth to form Enron, a natural gas pipeline company • 1989 - Begins trading natural gas • 1994 - Begins trading electricity • 1997 - Announces first transaction using weather derivatives products • 1999 - Launches EnronOnline, global commodity trading web site
Besides energy contracts Enron traded industrial commodities...
• Steel and wool fiber • Financial derivatives such as default insurance • Broadcast time for advertising • Hedges against bad weather • Internet bandwidth capacity
History of Enron (cont’d.)
• 1990 - Jeffrey Skilling joins Enron • 1996 - He becomes President & COO • 2000 - Enron stock hit an all-time high of $90.56
• Feb 2001 - Mr. Skilling becomes CEO. Former CEO Ken Lay becomes chairman
History of Enron (cont’d.)
• Aug 14, 2001 - Mr. Skilling resigns abruptly citing personal reasons; Lay becomes CEO again • Aug 15, 2001 - Sharon Watkins, VP warns Lay that the company’s accounting practices would lead the company to “implode in a wave of accounting scandals” (Anonymously) • Oct 2001 - Reports a $618m (1st qtr’ly) loss and $1.2bn reduction of shareholder equity.
History of Enron (cont’d.)
• Oct 2001 - Enron admits SEC investigation for COI between Enron and its partnerships. Enron shares lose a fifth of their value • Nov 2001 - Enron says that it overstated profits dating back to 1997 by $600m • Dec 2, 2001 - Enron files for bankruptcy, the largest in US history. • Jan 2002 - Justice Department announces criminal investigation of Enron
Jeffrey Keith Skilling
• Attended SMU (over Princeton) on an engineering scholarship • Graduated with a BS in Applied Science • Worked in asset and liability management at First City National Bank • Grad School Harvard; MBA, top 5% • McKinsey & Co., consulting firm, advising Houston Natural Gas and Internorth (Enron)
The Gas Bank
• Skilling realized immediate profits with his Gas Bank concept in 1989 • Industrial customers and power plants paid a premium for guaranteed gas supply • Gas fired plants became attractive; more business for pipelines and trading business • Created a futures market in natural gas
Mark-to-Market Accounting
• Mark-to-market accounting was Skilling’s brainchild. The SEC approved mark-to-market with Enron Gas Services on natural gas trading • Enron became the first non-financial company to use mark-to-market accounting • Enron implemented mark-to-market accounting a full year earlier than the SEC expected • Used mark-to-market accounting in every part of the business, not just Enron Gas Services
Enron Online
• The toast of cyberspace • Sold electricity, natural gas,coal, plastics, oil, paper, petrochemicals, and clean air credits among over 800 products • Traded over the web instead of fax and phone • Largest energy marketer in the world; made the rules
Material Adverse Change Clause
• Created protection in derivative contracts • If counterparty experienced material adverse change to its business, collateral could be demanded • It worked both ways; Enron couldn’t lose • Rich Kinder: Enron was “smoking its own dope”
The Exemption
• Board was asked to waive the Ethics Policy • Fastow reported that each transaction would be approved by CAO and CRO • Also, Board Audit Committee would review all transactions annually • Arthur Andersen had objected; relented if Board and CEO approved each transaction • Board was told that Andersen approved
Deregulation of Securities and Investments Market
• Glass-Steagall Act of 1933 kept banks, ins cos and brokerage houses from merging • In 1999 Graham-Leach-Bliley Services Modernization Act repealed Glass-Steagall • J.P. Morgan offered an array of services to Enron – Advisor (Merger talks with Dynergy - $45m) – Lender (Helped raise $1B in loans) – Investor (Invested in Fastow’s LJM2 scheme) – Source of Research (Guided investors)
Operating Near the Edge
• Off-balance-sheet entities - created to eliminate losses • Rather than face write-offs, they tried to hide them with accounting • Related-party transactions (suspended COI policy) • Off-balance-sheet loans collateralized by Enron stock • Inaccurate, incomplete or misleading disclosures • Aggressive,questionable accounting methods
Operating Near the Edge (cont’d.)
• Complex, high-risk trading activities (derivatives, special purpose entities, hedging, etc.) • Form over substance reporting • Arrogant corporate culture - took big risks
Where Was Management?
• Ken Lay - CEO and Chairman • Jeff Skilling - President and COO • Accounting staff came from Andersen • Questions raised by Enron executive was referred to and cleared by in-house counsel • Enron’s executives were dumping stock while encouraging employees to buy • Employees could not sell during “blackout” • (Michael Kopper plead guilty to conspiracy to commit money laundering and wire fraud. 8/21)
Where Were the External Auditors?
• Andersen decided to maintain Enron as a client • Andersen collected $25M for year-end auditing services and $27M for consulting • Andersen provided internal auditing services • Difficult to distinguish between Andersen’s external and internal audit services
Where Were the External Auditors?
• Local partner did not stand up to the client • Concurring partner overridden • Allegations that documents were destroyed • Andersen was ultimately convicted for obstruction of justice • (Chicago firm was on probation re Waste Mgt) – Waste Mgt inflated profits by $1.4bn
– Andersen paid $700m to settle charges; no further wrongdoing • (David Duncan, former Andersen Partner, admitted to obstruction of justice, 5/13/02)
Where Were the Internal Auditors?
• Enron outsourced internal audit to Andersen – First major organization to totally outsource its internal audit services (same people, now paid by Andersen) – About 40 auditors went to Andersen – The CAE was made an Andersen partner • Enron began to bring in internal audit – CAE was from PwC; reported to CAO at HQ – Internal auditors were housed in the business units – CAE did not control performance or compensation – Sensitive issues were left to external auditors
Where Were the Internal Auditors?
• CAE developed a risk assessment process – CAE identified some high risk areas – CAE questioned some transactions in high risk – Mgmt told CAE that these were being handled by the financial auditors. CAE chose not to audit - it would be redundant
Where Was the Audit Committee?
• Some members of the audit committee were also members of the Finance team • BOD waived the COI policy, thus allowing insider trading • Audit committee had 5 main meetings lasting only one hour each, regardless of the topic • Compensation - > $400K
Where Was the Audit Committee?
• Meetings with the Internal Auditors were joint with Andersen Consultants • Only executive summaries or reports were read by the audit committee
Wendy Graham
• Wife of Senator Phil Graham (Chr Banking Cmte) • Exempted energy derivatives contracts from federal oversight • Shortly thereafter, joined Enron’s Board • Enron contributed to think tank at Geo. Mason Univ, where Graham was Dir.of regulatory studies • Attorney advise Graham that she could have a material conflict of interest • Discontinued stock options; accepted cash • Other directors were consultants and vendors
Oh, By the Way
• Wendy Lee Graham, former chair of the Commodity Futures Trading Commission – Exempted energy derivative contracts from federal regulation – Lame duck chairman with 2 vacancies of 5 person commission – Enron did not have to get a securities license, register with the SEC or report to anyone (cash supporting derivatives)
Board Members
• Joe Foy was a retired partner in law firm which did legal work for Enron • Lord John Wakeham received $6,000 per month for consulting in addition to salary – Chartered accountant, had served as Britain’s secretary of state for energy – Member of Audit Committee • Robert Belfer gained a seat after selling the family’s oil and gas exploration business to Enron
Board Members (cont’d.)
• John Mendelsohn and Charles LeMaistre, two medical doctors’ M.D.Anderson Cancer Center received millions in donations from Enron • Three other members were employees of the company (Ken Lay, Jeff Skilling, Rebecca Mark)
Items of Interest for Boards?
• Off balance sheet transactions • Treatment of related-party transactions • Related partnership issues, derivatives and other complex issues • Risk management policies (ERM) • Adequacy of internal and external auditing • Independence issues for external auditors (amount of consulting fees)
Others Have Joined the Mix
• Tyco – Spent $8bn on over 700 acquisitions in 3 years – May have spent $135m to enrich former CEO • WorldCom – Reported $4bn in improper accounting – Internal Auditors found another $3.8bn
• Adelphia – Inflated number of subscribers – Owners used company as their personal piggybank and were charged with fraud (Dad/Son led off in handcuffs)
Common Themes
• Sacrifice of long-term strategy to buttress short term strategy • Conflicts of Interest - personal enrichment • “Specific deniability” by top management • Attempt to inflate stock prices • Some are now charged with tax evasion • Common denominator - GREED!
Stock Sales (Gross Proceeds)
• Ken Lay (Chairman) • Joe Sutton (Vice Chairman) $184,494,426 $ 42,231,283 • J. Clifford Baxter (Vice Chairman) $ 34,734,854 • Robert Belfer (Board Member) $111,941,200 • Jeff Skilling (CEO) • Andy Fastow (CFO) $ 70,687,199 $ 33,675,004 • Rick Causey (CAO) • Rebecca Mark CEO, Azurix) $ 13,386,896 $ 82,536,737 • Lou Pai (CEO, Enron Energy Svcs) $270,276,065
Stock Sales (Gross Proceeds)
• Ken Rice (CEO, Broadband Svcs) $ 76,825,145 • Mark Frevert (CEO, Enron Europe)$ 54,831,220 • Ken Harrison (Board Member) $ 75,416,636 • Joe Hirco, (CEO, Enron Comm’ns $ 35,168,721 • Stan Horton (CEO, Enron Transp’n)$ 47,371,361 • Rich Buy (CRO) $ 13,386,896 • James Derrick (General Counsel) $ 12,563,928 • Wendy Graham (Board Member) $ 278,892 » Bryce, Robert, Pipe Dreams, PublicAffairs, 2002
Greed Excessive desire for getting or having, esp. wealth; desire for more than one needs or deserves; avarice; cupidity
Epilog