enron and arthur andersen case study summary

• Contributors

Twenty Years Later: The Lasting Lessons of Enron

Michael Peregrine  is partner at McDermott Will & Emery LLP, and  Charles Elson  is professor of corporate governance at the University of Delaware Alfred Lerner College of Business and Economics.

This spring marks the 20th anniversary of the beginning of the dramatic and cataclysmic demise of Enron Corp. A scandal of exceptional scope and impact, it was (at the time) the largest bankruptcy in American history. The alleged business practices of its executives led to numerous individual criminal convictions. It was also a principal impetus for the enactment of the Sarbanes-Oxley Act and the evolution of the concept of corporate responsibility. As such, it is one of the most consequential corporate governance developments in history.

Yet a new generation of corporate leaders has assumed their positions since then; for others, their recollection of the colossal scandal may have faded with the years. And a general awareness of corporate responsibility principles is no substitute for familiarity with the governance failings that reenergized, in a lasting manner, the focus on effective and responsible governance. A basic appreciation of the Enron debacle and its governance implications is essential to director engagement.

Enron was formed as a natural gas pipeline company and ultimately transformed itself, through diversification, into a trading enterprise engaged in various forms of highly complex transactions. Among these were a series of unconventional and complicated related-party transactions (remember the strangely named Raptor, Jedi and Chewco ventures) in which members of Enron’s financial leadership held lucrative financial interests. Notably, the management team was experienced, and both its board and its audit committee were composed of a diverse group of seasoned, skilled, and prominent individuals.

The company’s rapid financial growth crested in March 2001, with media reports questioning how it could maintain its high stock value (trading at 55 times its earnings). Famous among these was the Fortune article by Bethany McLean, and its identification of potential financial reporting problems at Enron. [1] In a dizzying series of events over the next few months, the company’s stock price collapsed, its CEO resigned, a bailout merger failed, its credit was downgraded, the SEC began an investigation of its dealings with related parties, and it ultimately declared bankruptcy. Multiple regulatory investigations followed, several criminal convictions were obtained and Sarbanes-Oxley was ultimately enacted to curb the perceived abuses arising from Enron and several similar accounting scandals. [2]

There remain multiple important, stand-alone governance lessons from Enron controversy of which all directors would benefit:

1. The Smartest Guys in the Room . The type of aggressive executive conduct that contributed heavily to the fall of Enron was not unique to the company, the industry or the times. In the absence of an embedded culture of corporate ethics and compliance, there is always the potential for some executives to pursue “edge of the envelope” business practices, especially when those practices produce meaningful near term financial or other operational results. That attitude, combined with weak board oversight practices, can be a disastrous combination for a company.

Even though commerce has made great progress since then on internal controls, corporate responsibility ultimately depends upon the integrity of management, and the skill and persistence of board oversight. [3]

2. The Critical Importance of Board Oversight . As the company began to implode, Enron’s board commissioned a special committee to investigate the implicated transactions, directed by William C. Powers Jr., then dean of the University of Texas School of Law. The Powers Report, as it came to be known, outlined in staggering detail a litany of board oversight failures that contributed to the company’s collapse. [4]

These included inadequate and poorly implemented internal controls; the failure to exercise sufficient vigilance; an additional failure to respond adequately when issues arose that required a prompt and serious response; cursory review of critical matters by the audit and compliance committee; the failure to insist on a proper information flow; and an inability to fully appreciate the significance of some of the information with which the board was provided. [5]

3. Spotting Red Flags . Amongst the most damaging of the governance breakdowns was the failure to question the legitimacy of the related-party transactions for which so many internal controls were required. These deficiencies served to bring a once significant company and its officers to their collective knees and offer many lasting governance lessons. As the Powers Report concluded with brutal clarity, a major portion of the company’s business plan—related-party transactions—was flawed. [6]

These transactions were replete with risky conflicts of interest involving management. There was a significant “forest for the trees” concern—an inability to recognize that conflicts of such magnitude that required so many board-approved internal controls and procedures should never have been authorized in the first place. All this, despite the fact that the individual Enron directors were people of accomplishment and capability who had been recognized by the media as a well-functioning board. [7]

Yet, they lacked the actual necessary independence to recognize the red flags waving before them. Their varied relationships with company leadership made them all-too-comfortable with what they were being told about the company. [8] This connection made it difficult for them to recognize the dangers associated with the warning signals that the conflicted transactions projected. Indeed it was the revelation of these conflicts that attracted media attention and ultimately “brought the house down”. [9]

4. It Can Still Happen . The 2020 scandal encompassing the German financial services company Wirecard offers one of the latest high profile (international) examples of how alleged aggressive business practices, lax internal and auditor oversight, accounting irregularities and limited regulatory supervision can combine into a spectacular corporate collapse that prompted numerous government fraud investigations. It is for no small reason that the Wirecard scandal is referred to as the “German Enron”. [10]

5. A Significant Legacy . Yet the Enron controversy remains fundamentally relevant as the spark behind the corporate responsibility environment that has reshaped attitudes about corporate governance for the last 20 years. It’s where it all began—the seismic recalibration of corporate direction from the executive suite back to the boardroom, where it belongs. It birthed the fiduciary guidelines, principles, and “best practices” that serve as the corridors of modern corporate governance, developed in direct response to the types of conduct so criticized in the Powers Report. [11]

And that’s important for today’s board members to know. [12] Because over the years, the message may have lost its sizzle. The once-key oversight themes incorporated within “plain old” corporate responsibility seem to be yielding the boardroom field to the more politically popular themes of corporate social responsibility. And, while still important, corporate compliance seems to have had its “fifteen years of fame” in the minds of some executives; the organizational initiative has turned elsewhere.

But the pendulum may be swinging back. There is a renewed recognition that compliance programs can atrophy from lack of support. The new regulatory administration in Washington may return to an emphasis on organizational accountability. As Delaware decisions suggest, shareholders may be growing increasingly intolerant of costly corporate compliance and accounting lapses. And there’s a renewed emphasis on the role of the whistleblower, and the board’s role in assuring the support and protection of that role.

So it may be useful on this auspicious anniversary to engage the board on the Enron experience, in a couple of different ways. First, include an overview as part of formal director “onboarding” efforts. Second, have a board level conversation about expectations of oversight, and spotting operational and ethical warning signs. And third, reconsider the Enron board’s critical and self-admitted failures, in the context of today’s boardroom culture. [13]

Such a conversation would be a powerful demonstration of a board’s good-faith commitment to effective governance, corporate responsibility and leadership ethics.

1 Bethany McLean, “Is Enron Overpriced?” Fortune, March 5. 2001. https://archive.fortune.com/magazines/fortune/fortune_archive/2001/03/05/297833/index.htm. (go back)

2 See , Michael W. Peregrine, Corporate BoardMember , Second Quarter 2016 (henceforth “Corporate BoardMember”). (go back)

3 See , e.g., Elson and Gyves, In Re Caremark : Good Intentions, Unintended Consequences, 39 Wake Forest Law Review, 691 (2004). (go back)

4 Report of the Special Investigation Committee of the Board of Directors of Enron Corporation, February 1, 2002. http://i.cnn.net/cnn/2002/LAW/02/02/enron.report/powers.report.pdf. (go back)

5 See , Michael W. Peregrine, “The Corporate Governance Legacy of the Powers Report” Corporate Counsel , January 23, 2012 Monday. (go back)

6 See , Michael W. Peregrine, “Enron Still Matters, 15 Years After Its Collapse”, The New York Times , December 1, 2016. (go back)

7 F.N. 5, supra . (go back)

8 See , Elson and Gyves, “The Enron Failure and Corporate Governance Reform”, 38 Wake Forest Law Review 855 (2003) and Elson, “Enron and the Necessity of the Objective Proximate Monitor”, 89 Cornell Law Review 496 (2004). (go back)

9 John Emshwiller and Rebecca Smith, “Enron Posts Surprise 3rd-Quarter Loss After Investment, Asset Write-Downs”, The Wall Street Journal , October 17, 2001. https://www.wsj.com/articles/SB1003237924744857040. (go back)

10 Dylan Tokar and Paul J. Davies, “Wirecard Red Flags Should Have Prompted Earlier Response, Former Executive Says” The Wall Street Journal , February 8, 2021. https://www.wsj.com/articles/wirecard-red-flags-should-have-prompted-earlier-response-former-execu tive-says-11612780200. (go back)

11 Corporate BoardMember , supra . (go back)

12 See Peregrine, “Why Enron Remains Relevant”, Harvard Law School Forum on Corporate Governance, December 2, 2016. (go back)

13 Corporate BoardMember , supra. (go back)

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Hello I am writing to request if we can use this article ‘without making change of any description’ for internal training. This will mean we will host the article on our internal CPD (Continuous professional development) platform called LITMOS. This article perfectly suits learnings from a corporate governance perspective and hence we request permission for its unaltered use. Thanks Nikhil Ghate

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ANDERSEN GUILTY IN EFFORT TO BLOCK INQUIRY ON ENRON

By Kurt Eichenwald

• June 16, 2002

A federal jury convicted Arthur Andersen today of obstruction of justice for impeding an investigation by securities regulators into the financial debacle at Enron. Soon afterward, Andersen informed the government that it would cease auditing public companies as soon as the end of August, effectively ending the life of the 89-year-old firm.

The jury verdict, reached in the 10th day of deliberations, reflected a narrow reading of the events last fall that led to Andersen's indictment. In interviews, jurors said that they reached their decision because an Andersen lawyer had ordered critical deletions to an internal memorandum, rather than because of the firm's wholesale destruction of Enron-related documents. [Page 22.]

At bottom, then, the guilty verdict against Andersen -- on a charge brought because of the shredding of thousands of records and deletion of tens of thousands of e-mail messages -- was ultimately reached because of the removal of a few words from a single memorandum.

The conviction is the first ever against a major accounting firm and was based on the first criminal indictment stemming from the government's investigation into the events that led to Enron's collapse in December. Sentencing has been scheduled for Oct. 11, and Andersen faces the possibility of fines up to $500,000.

With Andersen already failing, and the firm having given up on its effort to emerge from the scandal as a model for reforming the accounting profession, the most important result of the verdict was that it closed the books on the firm's hopes of surviving even in a reduced state. Within hours of the verdict, the Securities and Exchange Commission issued a statement that Andersen was voluntarily relinquishing its ability to audit public companies in the United States, a privilege that requires authorization to practice before the agency.

''The commission is deeply troubled by the underlying events that resulted in Andersen's conviction, especially insofar as the verdict reflects the jury's conclusion that Andersen engaged in conduct designed to obstruct S.E.C. processes,'' the agency said in its statement. ''In light of the jury verdict and the underlying events, Andersen has informed the commission that it will cease practicing before the commission by Aug. 31, 2002, unless the commission determines another date is appropriate.''

Andersen is already a shell of its former self. The firm has lost 690 of its 2,311 public company clients since Jan. 1. It has shrunk from 27,000 employees in the United States to 10,000 at most, between layoffs and the departures of whole offices and practices to competing firms.

Rusty Hardin, Andersen's lead lawyer in the case, said that the firm would appeal the conviction, which would most likely take more than a year to wind its way through the courts, meaning that the outcome would have little effect on Andersen's ability to survive.

The guilty verdict came this morning after a criminal trial of almost six weeks that had frequently been slow and complex, punctuated by sometimes fiery closing arguments from the prosecution and the defense.

Prosecutors, who have been harshly criticized by Andersen and its supporters for bringing a case that crippled the firm, said that the verdict underscored the significance of the crime and provided an important lesson to an accounting industry struggling under the weight of almost daily financial scandals.

''The verdict sends a message out loud and clear to the accounting industry to get their priorities straight,'' said Samuel W. Buell, an assistant United States attorney who was one of the prosecutors. Andersen, Mr. Buell said, was working too hard to protect itself and Enron, its client, without enough attention to the interests of the investing public.

Andrew Weissmann, another lead prosecutor on the case, said the verdict also showed that employees upset about the firm's collapse ''should look to Andersen management'' for responsibility for the debacle. The indictment of Andersen came after the firm or its representatives had already faced litigation from the S.E.C. over accounting failures involving other clients, Waste Management and the Sunbeam Corporation. ''This was a management team that already had two strikes against them,'' Mr. Weissmann said. ''And they refused to take this situation seriously.''

But Andersen and its lawyers reacted to the verdict with strong disappointment, maintaining that the firm never committed a crime in its destruction of Enron documents.

''We do not regret going to trial,'' C. E. Andrews, a senior partner at the firm who attended the proceedings, said outside the courthouse. ''The purpose of this is to fight for our honor and dignity. We do not believe we committed a crime.''

Mr. Hardin, Andersen's lead lawyer in the case, said that, in describing the rationale behind its verdict, the jury members demonstrated that they had rejected the government's primary accusations against the firm -- namely, that the large scale destruction of records last fall was undertaken for the purpose of impeding a preliminary inquiry by the S.E.C. into Enron's finances.

''They convicted on a theory that wasn't even argued by the government,'' Mr. Hardin said. ''After 10 days, they could never conclude that this evidence supported the allegation that Arthur Andersen destroyed documents to keep them away from the S.E.C.''

Mr. Hardin said that the narrow basis of the decision -- involving revisions in a document that was preserved and turned over to the government -- could have a damaging effect across corporate America.

''If in fact what they chose means we're guilty of a crime, then every corporation in America ought to just cringe with fear,'' he said.

The verdict came after days of debate over a jury question, which resulted in a precedent-setting ruling on Friday by the judge in the case, Melinda F. Harmon of Federal District Court, that supported the prosecution. In response to a question from the jurors, she decided that they could find the firm guilty even if they could not agree on which of the firm's employees had the intent to commit the crime.

But jurors said today that they had ultimately agreed on a single Andersen partner as having had the intent to impede the S.E.C. inquiry. That partner, Nancy Temple, a lawyer with the firm's legal department, was a central participant in a series of discussions last fall about Enron and Andersen's response to the company's financial troubles.

The critical piece of evidence, the jurors said, was an internal memorandum written in mid-October of last year by David B. Duncan, the lead partner on the Enron account. The draft of that memorandum portrayed a conversation Mr. Duncan had with Richard A. Causey, Enron's chief accounting officer, about a news release the energy company was planning to issue regarding its third-quarter earnings. That release characterized certain losses Enron was reporting as ''nonrecurring;'' at the time, several Andersen experts, including Mr. Duncan, had concluded that such a representation was misleading.

In his conversation, Mr. Duncan told Mr. Causey that such misleading information issued by other companies in the past had resulted in actions by the S.E.C. His draft memorandum of that conversation dutifully chronicled that portion of the discussion. But, on review, Ms. Temple suggested that Mr. Duncan remove that portion of the memorandum from the final draft, and Mr. Duncan did so.

Oscar Criner, the foreman of the jury, referred to that memorandum as the smoking gun, and said that the jury concluded Ms. Temple made her suggestions for the purpose of keeping the information from the S.E.C. As such, Mr. Criner and other jurors said, the jury agreed that Ms. Temple had ''corruptly persuaded'' Mr. Duncan to alter information for the purpose of impeding an official proceeding. For that reason, they said, they voted to convict.

Under that rationale, Mr. Duncan, who has already pleaded guilty to obstruction, did not engage in a crime in making the revisions.

Andersen was charged with obstructing an S.E.C. investigation by destroying thousands of records related to its audit of Enron.

The prosecution argued that Andersen made a deliberate effort to prevent outside parties, including the S.E.C., from learning the full story about Enron's accounting. But the defense countered that the government had failed to provide any proof that anyone at Andersen had acted with corrupt intent to impede an inquiry.

According to testimony at the trial, the roots of the Andersen case emerged last year, as the growing financial problems at Enron were beginning to come to light. In August, members of the firm's Enron audit team sent memorandums to Andersen's accounting specialists in Chicago, describing consultations that they had months before about a group of partnerships known as the Raptors.

But the accounting specialists found that the memorandums did not accurately reflect the consultations and that Enron's accounting procedures had been specifically determined by the specialists to violate generally accepted accounting principles.

As the two sides discussed what the memorandums should say, it was becoming evident that this accounting dispute could have enormous financial repercussions on Enron. At about that point, the legal department at Andersen became involved in the discussions. Eventually, by late September, the matter was assigned to Ms. Temple, a relatively new lawyer in the department.

As the discussions continued, more problems with the Enron accounting began to emerge. Rapidly, it became evident that the company was facing a potential financial debacle. By Oct. 8, Ms. Temple began to discuss Andersen's document-retention policy in a series of conference calls with other members of the firm.

This policy required that final memorandums and documents be placed in the work papers maintained by the accountants, while all other records -- including e-mail messages, notes and draft memorandums -- be destroyed.

On Oct. 12, Ms. Temple sent an e-mail message to Houston, saying that ''it would be helpful'' if members of the accounting team working on Enron made sure that they were in compliance with the document-retention policy.

On Oct. 17, soon after Enron's financial problems first became public, the S.E.C sent a letter to the company saying that an informal inquiry into some financial practices had begun. Andersen learned of the letter two days later. Days later, on Oct. 23, Mr. Duncan instructed members of his team to comply with the document policy. Those instructions were repeated in the days that followed. In response, thousands of e-mail messages were deleted, and dozens of trunks full of documents were sent to the shredders.

In the weeks that followed, the Enron debacle escalated, ending with the company's filing for bankruptcy protection in December. Congress began its investigations, and Andersen was on the hot seat. In early January, as lawyers for the firm were examining laptop computers for e-mail messages related to Enron, they discovered that the records had been wiped clean. Soon, top Andersen executives learned of the huge effort to destroy documents.

Andersen alerted the S.E.C., the Justice Department and the Congressional committees investigating Enron. Within days, it determined that Mr. Duncan had improperly engaged in a destruction effort and fired him. In testimony before Congress late in January, a senior Andersen official said all evidence pointed to the fact that Mr. Duncan was destroying records to keep them away from investigators.

By early March, the government decided how it would handle the matter.

Based largely on what had happened in the conference calls, and on the evidence of Ms. Temple's actions, prosecutors determined that the document destruction was a coordinated effort led from Chicago, and thus merited the indictment of Andersen.

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• PROFESSIONAL ISSUES

The Rise and Fall of Enron

When a company looks too good to be true, it usually is..

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• Accounting & Reporting

If you’re like most, you’ve been astonished, disillusioned and angered as you learned of the meteoric rise and fall of Enron Corp. Remember the company’s television commercial of not so long ago, ending with the reverberating phrase, “Ask why, why, why?” That question is now on everyone’s lips. The Enron case is a dream for academics who conduct research and teach. For those currently or formerly involved with the company, such as creditors, auditors, the SEC and accounting regulators, it’s a nightmare that will continue for a long time.  

Formal investigations of Enron are now under way, headed by the company’s board, the SEC, the Justice Department and Congress. The exact causes and details of the disaster may not be known for months. The purpose of this article is to summarize preliminary observations about the collapse, as well as changes in financial reporting, auditing and corporate governance that are being proposed in response by Big Five accounting firms, the AICPA and the SEC.

IN A WAY IT'S SIMPLE, IN A WAY IT'S NOT

On the surface, the motives and attitudes behind decisions and events leading to Enron’s eventual downfall appear simple enough: individual and collective greed born in an atmosphere of market euphoria and corporate arrogance. Hardly anyone—the company, its employees, analysts or individual investors—wanted to believe the company was too good to be true. So, for a while, hardly anyone did. Many kept on buying the stock, the corporate mantra and the dream. In the meantime, the company made many high-risk deals, some of which were outside the company’s typical asset risk control process. Many went sour in the early months of 2001 as Enron’s stock price and debt rating imploded because of loss of investor and creditor trust. Methods the company used to disclose (or creatively obscure) its complicated financial dealings were erroneous and, in the view of some, downright deceptive. The company’s lack of transparency in reporting its financial affairs, followed by financial restatements disclosing billions of dollars of omitted liabilities and losses, contributed to its demise. The whole affair happened under the watchful eye of Arthur Andersen LLP, which kept a whole floor of auditors assigned at Enron year-round.

THE BEGINNING PRESAGES THE END

In 1985, after federal deregulation of natural gas pipelines, Enron was born from the merger of Houston Natural Gas and InterNorth, a Nebraska pipeline company. In the process of the merger, Enron incurred massive debt and, as the result of deregulation, no longer had exclusive rights to its pipelines. In order to survive, the company had to come up with a new and innovative business strategy to generate profits and cash flow. Kenneth Lay, CEO, hired McKinsey & Co. to assist in developing Enron’s business strategy. It assigned a young consultant named Jeffrey Skilling to the engagement. Skilling, who had a background in banking and asset and liability management, proposed a revolutionary solution to Enron’s credit, cash and profit woes in the gas pipeline business: create a “gas bank” in which Enron would buy gas from a network of suppliers and sell it to a network of consumers, contractually guaranteeing both the supply and the price, charging fees for the transactions and assuming the associated risks. Thanks to the young consultant, the company created both a new product and a new paradigm for the industry—the energy derivative.

Lay was so impressed with Skilling’s genius that he created a new division in 1990 called Enron Finance Corp. and hired Skilling to run it. Under Skilling’s leadership, Enron Finance Corp. soon dominated the market for natural gas contracts, with more contacts, more access to supplies and more customers than any of its competitors. With its market power, Enron could predict future prices with great accuracy, thereby guaranteeing superior profits.

THE BEST, THE BRIGHTEST AND THE DREADED PRC

Skilling began to change the corporate culture of Enron to match the company’s transformed image as a trading business. He set out on a quest to hire the best and brightest traders, recruiting associates from the top MBA schools in the country and competing with the largest and most prestigious investment banks for talent. In exchange for grueling schedules, Enron pampered its associates with a long list of corporate perks, including concierge services and a company gym. Skilling rewarded production with merit-based bonuses that had no cap, permitting traders to “eat what they killed.”

One of Skilling’s earliest hires in 1990 was Andrew Fastow, a 29-year-old Kellogg MBA who had been working on leveraged buyouts and other complicated deals at Continental Illinois Bank in Chicago. Fastow became Skilling’s protg in the same way Skilling had become Lay’s. Fastow moved swiftly through the ranks and was promoted to chief financial officer in 1998. As Skilling oversaw the building of the company’s vast trading operation, Fastow oversaw its financing by ever more complicated means.

As Enron’s reputation with the outside world grew, the internal culture apparently began to take a darker tone. Skilling instituted the performance review committee (PRC), which became known as the harshest employee-ranking system in the country. It was known as the “360-degree review” based on the values of Enron—respect, integrity, communication and excellence (RICE). However, associates came to feel that the only real performance measure was the amount of profits they could produce. In order to achieve top ratings, everyone in the organization became instantly motivated to “do deals” and post earnings. Employees were regularly rated on a scale of 1 to 5, with 5s usually being fired within six months. The lower an employee’s PRC score, the closer he or she got to Skilling, and the higher the score, the closer he or she got to being shown the door. Skilling’s division was known for replacing up to 15% of its workforce every year. Fierce internal competition prevailed and immediate gratification was prized above long-term potential. Paranoia flourished and trading contracts began to contain highly restrictive confidentiality clauses. Secrecy became the order of the day for many of the company’s trading contracts, as well as its disclosures.

HOW HIGH THEY FLY

Coincidentally, but not inconsequentially, the U.S. economy during the 1990s was experiencing the longest bull market in its history. Enron’s corporate leadership, Lay excluded, comprised mostly young people who had never experienced an extended bear market. New investment opportunities were opening up everywhere, including markets in energy futures. Wall Street demanded double-digit growth from practically every venture, and Enron was determined to deliver.

In 1996 Skilling became Enron’s chief operating officer. He convinced Lay the gas bank model could be applied to the market for electric energy as well. Skilling and Lay traveled widely across the country, selling the concept to the heads of power companies and to energy regulators. The company became a major political player in the United States, lobbying for deregulation of electric utilities. In 1997 Enron acquired electric utility company Portland General Electric Corp. for about $2 billion. By the end of that year, Skilling had developed the division by then known as Enron Capital and Trade Resources into the nation’s largest wholesale buyer and seller of natural gas and electricity. Revenue grew to $7 billion from $2 billion, and the number of employees in the division skyrocketed to more than 2,000 from 200. Using the same concept that had been so successful with the gas bank, they were ready to create a market for anything that anyone was willing to trade: futures contracts in coal, paper, steel, water and even weather.

Perhaps Enron’s most exciting development in the eyes of the financial world was the creation of Enron Online (EOL) in October 1999. EOL, an electronic commodities trading Web site, was significant for at least two reasons. First, Enron was a counterparty to every transaction conducted on the platform. Traders received extremely valuable information regarding the “long” and “short” parties to each trade as well as the products’ prices in real-time. Second, given that Enron was either a buyer or a seller in every transaction, credit risk management was crucial and Enron’s credit was the cornerstone that gave the energy community the confidence that EOL provided a safe transaction environment. EOL became an overnight success, handling $335 billion in online commodity trades in 2000.

The world of technology opened up the Internet, and the IPO market for technology and broadband communications companies started to take off. In January 2000 Enron announced an ambitious plan to build a high-speed broadband telecommunications network and to trade network capacity, or bandwidth, in the same way it traded electricity or natural gas. In July of that year Enron and Blockbuster announced a deal to provide video on demand to customers throughout the world via high-speed Internet lines. As Enron poured hundreds of millions into broadband with very little return, Wall Street rewarded the strategy with as much as $40 on the stock price—a factor that would have to be discounted later when the broadband bubble burst. In August 2000 Enron’s stock hit an all-time high of $90.56, and the company was being touted by Fortune and other business publications as one of the most admired and innovative companies in the world.

THE ROLE OF MARK-TO-MARKET ACCOUNTING

Enron incorporated “mark-to-market accounting” for the energy trading business in the mid-1990s and used it on an unprecedented scale for its trading transactions. Under mark-to-market rules, whenever companies have outstanding energy-related or other derivative contracts (either assets or liabilities) on their balance sheets at the end of a particular quarter, they must adjust them to fair market value, booking unrealized gains or losses to the income statement of the period. A difficulty with application of these rules in accounting for long-term futures contracts in commodities such as gas is that there are often no quoted prices upon which to base valuations. Companies having these types of derivative instruments are free to develop and use discretionary valuation models based on their own assumptions and methods.

The Financial Accounting Standards Board’s (FASB) emerging issues task force has debated the subject of how to value and disclose energy-related contracts for several years. It has been able to conclude only that a one-size-fits-all approach will not work and that to require companies to disclose all of the assumptions and estimates underlying earnings would produce disclosures that were so voluminous they would be of little value. For a company such as Enron, under continuous pressure to beat earnings estimates, it is possible that valuation estimates might have considerably overstated earnings. Furthermore, unrealized trading gains accounted for slightly more than half of the company’s $1.41 billion reported pretax profit for 2000 and about one-third of its reported pretax profit for 1999.

CAPITALISM AT WORK

In the latter part of the 1990s, companies such as Dynegy, Duke Energy, El Paso and Williams began following Enron’s lead. Enron’s competitive advantage, as well as its huge profit margins, had begun to erode by the end of 2000. Each new market entrant’s successes squeezed Enron’s profit margins further. It ran with increasing leverage, thus becoming more like a hedge fund than a trading company. Meanwhile, energy prices began to fall in the first quarter of 2001 and the world economy headed into a recession, thus dampening energy market volatility and reducing the opportunity for the large, rapid trading gains that had formerly made Enron so profitable. Deals, especially in the finance division, were done at a rapid pace without much regard to whether they aligned with the strategic goals of the company or whether they complied with the company’s risk management policies. As one knowledgeable Enron employee put it: “Good deal vs. bad deal? Didn’t matter. If it had a positive net present value (NPV) it could get done. Sometimes positive NPV didn’t even matter in the name of strategic significance.” Enron’s foundations were developing cracks and Skilling’s house of paper built on the stilts of trust had begun to crumble.

RELATED PARTIES AND COMPLEX SPECIAL PURPOSE ENTITIES

In order to satisfy Moody’s and Standard & Poor’s credit rating agencies, Enron had to make sure the company’s leverage ratios were within acceptable ranges. Fastow continually lobbied the ratings agencies to raise Enron’s credit rating, apparently to no avail. That notwithstanding, there were other ways to lower the company’s debt ratio. Reducing hard assets while earning increasing paper profits served to increase Enron’s return on assets (ROA) and reduce its debt-to-total-assets ratio, making the company more attractive to credit rating agencies and investors.

Enron, like many other companies, used “special purpose entities” (SPEs) to access capital or hedge risk. By using SPEs such as limited partnerships with outside parties, a company is permitted to increase leverage and ROA without having to report debt on its balance sheet. The company contributes hard assets and related debt to an SPE in exchange for an interest. The SPE then borrows large sums of money from a financial institution to purchase assets or conduct other business without the debt or assets showing up on the company’s financial statements. The company can also sell leveraged assets to the SPE and book a profit. To avoid classification of the SPE as a subsidiary (thereby forcing the entity to include the SPE’s financial position and results of operations in its financial statements), FASB guidelines require that only 3% of the SPE be owned by an outside investor.

Under Fastow’s leadership, Enron took the use of SPEs to new heights of complexity and sophistication, capitalizing them with not only a variety of hard assets and liabilities, but also extremely complex derivative financial instruments, its own restricted stock, rights to acquire its stock and related liabilities. As its financial dealings became more complicated, the company apparently also used SPEs to “park” troubled assets that were falling in value, such as certain overseas energy facilities, the broadband operation or stock in companies that had been spun off to the public. Transferring these assets to SPEs meant their losses would be kept off Enron’s books. To compensate partnership investors for downside risk, Enron promised issuance of additional shares of its stock. As the value of the assets in these partnerships fell, Enron began to incur larger and larger obligations to issue its own stock later down the road. Compounding the problem toward the end was the precipitous fall in the value of Enron stock. Enron conducted business through thousands of SPEs. The most controversial of them were LJM Cayman LP and LJM2 Co-Investment LP, run by Fastow himself. From 1999 through July 2001, these entities paid Fastow more than $30 million in management fees, far more than his Enron salary, supposedly with the approval of top management and Enron’s board of directors. In turn, the LJM partnerships invested in another group of SPEs, known as the Raptor vehicles, which were designed in part to hedge an Enron investment in a bankrupt broadband company, Rhythm NetConnections. As part of the capitalization of the Raptor entities, Enron issued common stock in exchange for a note receivable of $1.2 billion. Enron increased notes receivable and shareholders’ equity to reflect this transaction, which appears to violate generally accepted accounting principles. Additionally, Enron failed to consolidate the LJM and Raptor SPEs into their financial statements when subsequent information revealed they should have been consolidated.

OBSCURE DISCLOSURES REVEALED

A very confusing footnote in Enron’s 2000 financial statements described the above transactions. Douglas Carmichael, the Wollman Distinguished Professor of Accounting at Baruch College in New York City, told the Wall Street Journal in November of 2001 that most people would be hard pressed to understand the effects of these disclosures on the financial statements, casting doubt on both the quality of the company’s earnings as well as the business purpose of the transaction. By April 2001 other skeptics arrived on the scene. A number of analysts questioned the lack of transparency of Enron’s disclosures. One analyst was quoted as saying, “The notes just don’t make sense, and we read notes for a living.” Skilling was very quick to reply with arrogant comments and, in one case, even called an analyst a derogatory name. What Skilling and Fastow apparently underestimated was that, because of such actions, the market was beginning to perceive the company with greater and greater skepticism, thus eroding its trust and the company’s reputation.

IT ALL COMES TUMBLING DOWN

In February 2001 Lay announced his retirement and named Skilling president and CEO of Enron. In February Skilling held the company’s annual conference with analysts, bragging that the stock (then valued around $80) should be trading at around $126 per share.

In March Enron and Blockbuster announced the cancellation of their video-on-demand deal. By that time the stock had fallen to the mid-$60s. Throughout the spring and summer, risky deals Enron had made in underperforming investments of various kinds began to unravel, causing it to suffer a huge cash shortfall. Senior management, which had been voting with its feet since August 2000, selling Enron stock in the bull market, continued to exit, collectively hundreds of millions of dollars richer for the experience. On August 14, just six months after being named CEO, Skilling himself resigned, citing “personal reasons.” The stock price slipped below $40 that week and, except for a brief recovery in early October after the sale of Portland General, continued its slide to below $30 a share.

Also in August, in an internal memorandum to Lay, a company vice-president, Sherron Watkins, described her reservations about the lack of disclosure of the substance of the related party transactions with the SPEs run by Fastow. She concluded the memo by stating her fear that the company might “implode under a series of accounting scandals.” Lay notified the company’s attorneys, Vinson & Elkins, as well as the audit partner at Enron’s auditing firm, Arthur Andersen LLP, so the matter could be investigated further. The proverbial “ship” of Enron had struck the iceberg that would eventually sink it.

On October 16 Enron announced its first quarterly loss in more than four years after taking charges of $1 billion on poorly performing businesses. The company terminated the Raptor hedging arrangements which, if they had continued, would have resulted in its issuing 58 million Enron shares to offset the company’s private equity losses, severely diluting earnings. It also disclosed the reversal of the $1.2 billion entry to assets and equities it had made as a result of dealings with these arrangements. It was this disclosure that got the SEC’s attention.

On October 17 the company announced it had changed plan administrators for its employees’ 401(k) pension plan, thus by law locking their investments for a period of 30 days and preventing workers from selling their Enron stock. The company contends this decision had in fact been made months earlier. However true that might be, the timing of the decision certainly has raised suspicions.

On October 22 Enron announced the SEC was looking into the related party transactions between Enron and the partnerships owned by Fastow, who was fired two days later. On November 8 Enron announced a restatement of its financial statements back to 1997 to reflect consolidation of the SPEs it had omitted, as well as to book Andersen’s recommended adjustments from those years, which the company had previously “deemed immaterial.” This restatement resulted in another $591 million in losses over the four years as well as an additional $628 million in liabilities as of the end of 2000. The equity markets immediately reacted to the restatement, driving the stock price to less than $10 a share. One analyst’s report stated the company had burned through $5 billion in cash in 50 days.

A merger agreement with smaller cross-town competitor Dynegy was announced on November 9, but rescinded by Dynegy on November 28 on the basis of Enron’s lack of full disclosure of its off-balance-sheet debt, downgrading Enron’s rating to junk status. On November 30 the stock closed at an astonishing 26 cents a share. The company filed for bankruptcy protection on December 2.

THE AFTERMATH

Unquestionably, the Enron implosion has wreaked more havoc on the accounting profession than any other case in U.S. history. Critics in the media, Congress and elsewhere are calling into question not only the adequacy of U.S. disclosure practices but also the integrity of the independent audit process. The general public still questions how CPA firms can maintain audit independence while at the same time engaging in consulting work, often for fees that dwarf those of the audit. Companies that deal in special purpose entities and complex financial instruments similar to Enron’s have suffered significant declines in their stock prices. The scandal threatens to undermine confidence in financial markets in the United States and abroad.

In a characteristic move, the SEC and the public accounting profession have been among the first to respond to the Enron crisis. Unfortunately, and sadly reminiscent of financial disasters in the 1970s and 1980s, this response will likely be viewed by investors, creditors, lawmakers and employees of Enron as “too little, too late.”

In an “op-ed” piece for the Wall Street Journal on December 11, SEC Chairman Harvey Pitt called the current outdated reporting and financial disclosure system the financial “perfect storm.” He stated that under the current quarterly and annual reporting system, information is often stale on arrival and mandated financial disclosures are often “arcane and impenetrable.” To reassure investors and restore confidence in financial reporting, Pitt called for a joint response from the public and private sectors that included, among other things,

• A system of “current” disclosures, supplementing and updating quarterly and annual information with disclosure of material information on a real-time basis.
• Public company disclosure of significant current “trend” and “evaluative” data in addition to historical information.
• Identification of “most critical accounting principles” by all public companies in their annual reports.
• More timely and responsive accounting standard setting on the part of the private sector.
• An environment of cooperation between the SEC and registrants that encourages public companies and their auditors to seek advice on disclosure issues in advance.
• An effective and transparent system of self-regulation for the accounting profession, subject to SEC’s rigorous, but nonduplicative, oversight.
• More proactive oversight by audit committees who understand financial accounting principles as well as how they are applied.

The CEOs of the Big Five accounting firms made a joint statement on December 4 committing to develop improved guidance on disclosure of related party transactions, SPEs and market risks for derivatives including energy contracts for the 2001 reporting period. In addition, the Big Five called for modernization of the financial reporting system in the United States to make it more timely and relevant, including more nonfinancial information on entity performance. They also vowed to streamline the accounting standard-setting process to make it more responsive to the rapid changes that occur in a technology-driven economy.

Since the Enron debacle, the AICPA has been engaged in significant damage control measures to restore confidence in the profession, displaying the banner “Enron: The AICPA, the Profession, and the Public Interest” on its Web site. It has announced the imminent issuance of an exposure draft on a new audit standard on fraud (the third in five years), providing more specific guidance than currently found in SAS no. 82, Consideration of Fraud in a Financial Statement Audit . The Institute has also promised a revised standard on reviews of quarterly financial statements, as well as the issuance, in the second quarter of 2002, of an exposure draft of a standard to improve the audit process. These standards had already been on the drawing board as part of the AICPA’s response to the report of the Blue Ribbon Panel on Audit Effectiveness, issued in 2000.

In late December the AICPA issued a tool kit for auditors to use in identifying and auditing related party transactions. While it breaks no new ground, the tool kit provides, in one place, an overview of the accounting and auditing literature, SEC requirements and best practice guidance concerning related party transactions. It also includes checklists and other tools for auditors to use in gathering evidence and disclosing related party transactions.

In January the AICPA board of directors announced that it would cooperate fully with the SEC’s proposal for new rules for the peer review and disciplinary process for CPA firms of SEC registrants. The new system would be managed by a board, a majority of which would be public members, enhancing the peer review process for the largest firms and requiring more rigorous and continuous monitoring. The staff of the new board would administer the reviews. In protest, the Public Oversight Board informed Pitt that it would terminate its existence in March 2002, leaving the future peer review process in a state of uncertainty. The SEC and the AICPA are now engaged in talks with the POB to reassure the board it will continue to be a vital part of the peer review process in the future.

The AICPA has also approved a resolution to support prohibitions that would prevent audit firms from performing systems design and implementation as well as internal audit outsourcing for public audit clients. While asserting that it does not believe prohibition of these services will make audits more effective or prevent financial failures, the board has stated it feels the move is necessary to restore public confidence in the profession. These prohibitions were at the center of the controversy last year between the profession and the SEC under the direction of former Chairman Arthur Levitt. Big Five CPA firms and the AICPA lobbied heavily and prevailed in that controversy, winning the right to retain these services and being required only to disclose their fees.

The impact of Enron is now being felt at the highest levels of government as legislators engage in endless debate and accusation, quarreling over the influence of money in politics. The GAO has requested that the White House disclose documents concerning appointments to President George W. Bush’s Task Force on Energy, chaired by Vice-President Dick Cheney, former CEO of Halliburton. The White House has refused, and the GAO has filed suit, the first of its kind in history. Congressional investigations are expected to continue well into 2002 and beyond. Lawmakers are expected to investigate not only disclosure practices at Enron, but for all public companies, concerning SPEs, related party transactions and use of “mark-to-market” accounting.

Kenneth Lay resigned as Enron’s CEO, under pressure from creditor groups. Lay, Skilling and Fastow still have much to explain. In addition, Enron’s board of directors, and especially the audit committee, will be in the “hot seat” and rightfully so.

The Justice Department opened a criminal investigation and formed a national task force made up of federal prosecutors in Houston, San Francisco, New York and several other cities to investigate the possibility of fraud in the company’s dealings. Interestingly, to illustrate how far-reaching Enron’s ties are to government and political sources at all levels, U.S. Attorney General John Ashcroft, as well as his entire Houston office, disqualified themselves from the investigation because of either political, economic or family ties.

It appears that 2002 is shaping up to be a year of unprecedented changes for a profession that is already coping with an identity crisis.

WHERE WERE THE AUDITORS?

Arthur Andersen LLP, after settling two other massive lawsuits earlier in 2001, is preparing for a storm of litigation as well as a possible criminal investigation in the wake of the Enron collapse. Enron was the firm’s second-largest client. Andersen, who had the job not only of Enron’s external but also its internal audits for the years in question, kept a staff on permanent assignment at Enron’s offices. Many of Enron’s internal accountants, CFOs and controllers were former Andersen executives. Because of these relationships, as well as Andersen’s extensive concurrent consulting practice, members of Congress, the press and others are calling Andersen’s audit independence into question. Indeed, they are using the case to raise doubts about the credibility of the audit process for all Big Five firms who do such work.

So far, Andersen has acknowledged its role in the fiasco, while defending its accounting and auditing practices. In a Wall Street Journal editorial on December 4, as well as in testimony before Congress the following week, Joseph Berardino, CEO, was forthright in his views. He committed the firm to full cooperation in the investigations as well as to a leadership role in potential solutions.

Enron dismissed Andersen as its auditor on January 17, 2002, citing document destruction and lack of guidance on accounting policy issues as the reasons. Andersen countered with the contention that in its mind the relationship had terminated on December 2, 2001, the day the firm filed for Chapter 11 bankruptcy protection.

The fact that Andersen is no longer officially associated with Enron will, unfortunately, have little impact on forces now in place that may, in the eyes of some, determine the firm’s very future. Andersen is now under formal investigation by the SEC as well as various committees of both the U.S. Senate and House of Representatives of the U.S. Congress. To make matters worse for it, and to the astonishment of many, Andersen admitted it destroyed perhaps thousands of documents and electronic files related to the engagement, in accordance with “firm policy,” supposedly before the SEC issued a subpoena for them. The firm’s lawyers issued an internal memorandum on October 12 reminding employees of the firm’s document retention and destruction policies. The firm fired David B. Duncan, partner in charge of the Enron engagement, placed four other partners on leave and replaced the entire management team of the Houston office. Duncan invoked his Fifth Amendment rights against self-incrimination at a congressional hearing in January. Several other Andersen partners testified that Duncan and his staff acted in violation of firm policy. However, in view of the timing of the October 12 memorandum, Congress and the press are questioning whether the decision to shred documents extended farther up the chain of command. Andersen has suspended its firm policy for retention of records and asked former U.S. Senator John Danforth to conduct a comprehensive review of the firm’s records management policy and to recommend improvements.

In a move to bolster its image, Andersen also has retained former Federal Reserve Chairman Paul Volcker to lead an outside board that will advise it in making “fundamental change” in its audit process. Other members of the board include P. Roy Vagelos, former chairman and CEO of Merck & Co., and Charles A. Bowsher, current chairman of the Public Oversight Board, which disbanded in March. Volcker also named a seven-member advisory panel made up of prominent corporate and accounting executives that will review proposed reforms to the firm’s audit process.

Hindsight is so clear that it sometimes belies the complexity of the problem. Although fraud has not yet been proven to be a factor in Enron’s misstatements, some of the classic risk factors associated with management fraud outlined in SAS no. 82 are evident in the Enron case. Those include management characteristics, industry conditions and operating characteristics of the company. Although written five years ago, the list almost looks as if it was excerpted from Enron’s case:

• Unduly aggressive earnings targets and management bonus compensation based on those targets.
• Excessive interest by management in maintaining stock price or earnings trend through the use of unusually aggressive accounting practices.
• Management setting unduly aggressive financial targets and expectations for operating personnel.
• Inability to generate sufficient cash flow from operations while reporting earnings and earnings growth.
• Assets, liabilities, revenues or expenses based on significant estimates that involve unusually subjective judgments such as…reliability of financial instruments.
• Significant related party transactions.

These factors are common threads in the tapestry that is described of the environment leading to fraud. They were incorporated into SAS no. 82 on the basis of research into fraud cases of the 1970s and 1980s in the hope that auditors would learn from the past. Andersen will have to explain when and how it identified these factors, as well as how it responded and how it communicated with Enron’s board about them.

More important, Andersen will have to explain why it delayed notifying the SEC after learning of the internal Enron memo warning of problems. In addition, it will have to explain why the Houston office destroyed the thousands of documents related to the Enron audits for 1997 through 2000. Only time will tell, but it appears the firm is in serious trouble. In the end, and also characteristic of cases like this, the chief parties likely to benefit from this process are the attorneys.

THE HUMAN FACTOR

The Enron story has produced many victims, the most tragic of which is a former vice-chairman of the company who committed suicide, apparently in connection with his role in the scandal. Another 4,500 individuals have seen their careers ended abruptly by the reckless acts of a few. Enron’s core values of respect, integrity, communication and excellence stand in satirical contrast to allegations now being made public. Personally, I had referred several of our best and brightest accounting, finance and MBA graduates to Enron, hoping they could gain valuable experience from seeing things done right. These included a very bright training consultant who had lost her job in 2000 with a Houston consulting firm as a result of a reduction in force. She has lost her second job in 18 months through no fault of her own. Other former students still hanging on at Enron face an uncertain future as the company fights for survival.

The old saying goes, “Lessons learned hard are learned best.” Some former Enron employees are embittered by the way they have been treated by the company that was once “the best in the business.” Others disagree. In the words of one of my former students who is still hanging on: “Just for the record, my time and experience at Enron have been nothing short of fantastic. I could not have asked for a better place to be or better people to work with. Please, though, remember this: Never take customer and employee confidence for granted. That confidence is easy to lose and tough—to impossible—to regain.”  

C. WILLIAM THOMAS, CPA, Ph.D. , is the J.E. Bush Professor of Accounting in the Hankamer School of Business at Baylor University in Waco. Mr. Thomas can be reached at [email protected] . This article originally appeared in the March/April 2002 issue of Today’s CPA , published by the Texas Society of CPAs.

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Arthur Andersen LLP v. United States, 544 U.S. 696 (2005)

A conviction must be overturned if jury instructions are so vague that they allow a finding of guilt based on much less culpability than the criminal statute actually requires.

Energy conglomerate Enron Corporation enlisted Arthur Anderson LLP to audit the statements that it publicly filed and review its internal accounting practices. In response to the serious crisis in which Enron later found itself, Arthur Anderson compiled a team of investigators who worked with in-house counsel at Enron, Nancy Temple. Temple was aware of the likelihood that the SEC would investigate Enron's practices. She asked that Arthur Anderson be reminded of the document retention policy at Enron, of which employees were informed during a general training course. Temple notified the Arthur Andersen team when the SEC sent it a notice of investigation, and she attached the document retention policy to the email. She also reminded them about the policy during a conference call on the following day. In two later meetings, her supervisor stressed the importance of complying with the policy. Despite these repeated reminders, many paper and electronic documents were destroyed, including for a week after the SEC opened its formal investigation. When the SEC finally subpoenaed the documents, Arthur Andersen was indicted for violating laws against the obstruction of justice under 18 U.S.C. Section 1512. These prohibit knowingly corrupt persuasion of persons that is intended to cause them to withhold documents from a government investigation. Arthur Andersen was convicted in the trial court.

• William Hubbs Rehnquist (Author)
• Anthony M. Kennedy
• Stephen G. Breyer
• David H. Souter
• John Paul Stevens
• Ruth Bader Ginsburg
• Clarence Thomas
• Sandra Day O'Connor
• Antonin Scalia

The appropriate mental state for this offense is consciousness or knowledge. Determining the scope of liability under a criminal statute requires restraint and lenity toward defendants. Advising a client to withhold documents is not always a criminal action, since attorney-client privilege may apply to the documents. There is nothing illegal per se about having a document retention policy that is designed to shield documents from production to the government. Since the jury instructions did not emphasize conscious awareness of wrongdoing, they did not appropriately cover the mens rea element. The jury had been allowed to convict Arthur Andersen even it found that the accounting firm believed that it was acting legally, which is clearly an inaccurate interpretation of the text of the law. The prosecution also must show that there is a nexus linking the document destruction to the defendant's knowledge that the documents being destroyed might be material to a proceeding. Arthur Andersen had advised its employees on the crisis response team to follow Enron's document retention policy, so there was no liability here.

Arthur Andersen's ability to avoid liability because of the vague jury instructions likely spurred Congress to enact the Sarbanes-Oxley laws that criminalized this type of conduct more specifically. The accounting firm was destroyed by the negative publicity, notwithstanding the reversal of the conviction.

SYLLABUS OCTOBER TERM, 2004 ARTHUR ANDERSEN LLP V. UNITED STATES SUPREME COURT OF THE UNITED STATES

ARTHUR ANDERSEN LLP v . UNITED STATES

certiorari to the united states court of appeals for the fifth circuit

No. 04–368.Argued April 27, 2005—Decided May 31, 2005

As Enron Corporation’s financial difficulties became public, petitioner, Enron’s auditor, instructed its employees to destroy documents pursuant to its document retention policy. Petitioner was indicted under 18 U. S. C. §§1512(b)(2)(A) and (B), which make it a crime to “knowingly … corruptly persuad[e] another person … with intent to … cause” that person to “withhold” documents from, or “alter” documents for use in, an “official proceeding.” The jury returned a guilty verdict, and the Fifth Circuit affirmed, holding that the District Court’s jury instructions properly conveyed the meaning of “corruptly persuades” and “official proceeding” in §1512(b); that the jury need not find any consciousness of wrongdoing in order to convict; and that there was no reversible error.

Held:  The jury instructions failed to convey properly the elements of a “corrup[t] persuas[ion]” conviction under §1512(b). Pp. 6–12.

   (a) This Court’s traditional restraint in assessing federal criminal statutes’ reach, see, e.g., United States v. Aguilar, 515 U. S. 593 , 600, is particularly appropriate here, where the act underlying the conviction—“persua[sion]”—is by itself innocuous. Even “persuad[ing]” a person “with intent to … cause” that person to “withhold” testimony or documents from the Government is not inherently malign. Under ordinary circumstances, it is not wrongful for a manager to instruct his employees to comply with a valid document retention policy, even though the policy, in part, is created to keep certain information from others, including the Government. Thus, §1512(b)’s “knowingly … corruptly persuades” phrase is key to what may or may not lawfully be done in the situation presented here. The Government suggests that “knowingly” does not modify “corruptly persuades,” but that is not how the statute most naturally reads. “[K]nowledge” and “knowingly” are normally associated with awareness, understanding, or consciousness, and “corrupt” and “corruptly” with wrongful, immoral, depraved, or evil. Joining these meanings together makes sense both linguistically and in the statutory scheme. Only persons conscious of wrongdoing can be said to “knowingly … corruptly persuad[e].” And limiting criminality to persuaders conscious of their wrongdoing sensibly allows §1512(b) to reach only those with the level of culpability usually required to impose criminal liability. See Aguilar, supra , at 602. Pp. 6–9.

   (b) The jury instructions failed to convey the requisite consciousness of wrongdoing. Indeed, it is striking how little culpability the instructions required. For example, the jury was told that, even if petitioner honestly and sincerely believed its conduct was lawful, the jury could convict. The instructions also diluted the meaning of “corruptly” such that it covered innocent conduct. The District Court based its instruction on the Fifth Circuit Pattern Jury Instruction for §1503, which defined “corruptly” as “knowingly and dishonestly, with the specific intent to subvert or undermine the integrity” of a proceeding. However, the court agreed with the Government’s insistence on excluding “dishonestly” and adding the term “impede” to the phrase “subvert or undermine,” so the jury was told to convict if it found petitioner intended to “subvert, undermine, or impede” governmental factfinding by suggesting to its employees that they enforce the document retention policy. These changes were significant. “[D]ishonest[y]” was no longer necessary to a finding of guilt, and it was enough for petitioner to have simply “impede[d]” the Government’s factfinding ability. “Impede” has broader connotations than “subvert” or even “undermine,” and many of these connotations do not incorporate any “corrupt[ness]” at all. Under the dictionary definition of “impede,” anyone who innocently persuades another to withhold information from the Government “get[s] in the way of the progress of” the Government. With regard to such innocent conduct, the “corruptly” instructions did no limiting work whatsoever. The instructions also led the jury to believe that it did not have to find any nexus between the “persua[sion]” to destroy documents and any particular proceeding. In resisting any nexus element, the Government relies on §1512(e)(1), which states that an official proceeding “need not be pending or about to be instituted at the time of the offense.” It is, however, quite another thing to say a proceeding need not even be foreseen. A “knowingly … corrup[t] persaude[r]” cannot be someone who persuades others to shred documents under a document retention policy when he does not have in contemplation any particular official proceeding in which those documents might be material. Cf. Aguilar, supra, at 599–600. Pp. 9–12.

374 F. 3d 281, reversed and remanded.

   Rehnquist, C. J., delivered the opinion for a unanimous Court.

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Understanding enron, the enron scandal.

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What Was Enron? What Happened and Who Was Responsible

Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master's in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

Investopedia / Daniel Fishel

Enron was an energy-trading and utility company based in Houston, Texas, that perpetrated one of the biggest accounting frauds in history. Enron's executives employed accounting practices that falsely inflated the company's revenues and, for a time, made it the seventh-largest corporation in the United States. Once the fraud came to light, the company quickly unraveled, filing for Chapter 11 bankruptcy in December 2001.

Key Takeaways

• Enron was an energy company that began to trade extensively in energy derivatives markets.
• The company hid massive trading losses, ultimately leading to one of the largest accounting scandals and bankruptcy in recent history.
• Enron executives used fraudulent accounting practices to inflate the company's revenues and hide debt in its subsidiaries.
• The SEC, credit rating agencies, and investment banks were also accused of negligence—and, in some cases, outright deception—that enabled the fraud.
• As a result of Enron, Congress passed the Sarbanes-Oxley Act to hold corporate executives more accountable for their company's financial statements.

Enron was an energy company formed in 1986 following a merger between Houston Natural Gas Company and Omaha-based InterNorth Incorporated. After the merger, Kenneth Lay, who had been the  chief executive officer  (CEO) of Houston Natural Gas, became Enron's CEO and chair.

Lay quickly rebranded Enron into an energy trader and supplier. Deregulation of the energy markets allowed companies to place bets on future prices. In 1990, Lay created the Enron Finance Corporation and appointed Jeffrey Skilling, whose work as a McKinsey & Company consultant had impressed Lay, to head the new corporation. Skilling was then one of the youngest partners at McKinsey.

Enron provided a variety of energy and utility services around the world. Its company divided operations in several major departments, including:

• Enron Online : In late 1999, Enron built its web-based system to enhance customer functionality and market reach.
• Wholesale Services : Enron offered various energy delivery solutions, with its most robust industry being natural gas. In North America, Enron claimed to deliver almost double the amount of electricity compared to its second tier of competition.
• Energy Services : Enron's retail unit provided energy around the world, including in Europe, where it expanded retail operations in 2001.
• Broadband Services : Enron provided logistical service solutions between content providers and last-mile energy distributors.
• Transportation Services : Enron developed an innovative, efficient pipeline operation to network capabilities and operate pooling points to connect to third parties.

However, by leveraging special purpose vehicles, special purpose entities, mark-to-market accounting, and financial reporting loopholes, Enron became one of the most successful companies in the world. Upon discovery of the fraud, the company subsequently collapsed. Enron shares traded as high as $90.75 before the fraud was discovered but plummeted to around $0.26 in the sell-off after it was revealed.

The former Wall Street darling quickly became a symbol of modern corporate crime. Enron was one of the first big-name accounting scandals, but uncovered frauds at other companies such as WorldCom and Tyco International soon followed.

Before coming to light, Enron was internally fabricating financial records and falsifying the success of its company. Though the entity did achieve operational success during the 1990s, the company's misdeeds were finally exposed in 2001.

Pre-Scandal

Leading up to the turn of the millennium, Enron's business appeared to be thriving. The company became the largest natural gas provider in North America in 1992, and the company launched EnronOnline, its trading website allowing for better contract management just months before 2000. The company also rapidly expanded into international markets, led by the 1998 merger with Wessex Water.

Enron's stock price mostly followed the S&P 500 for most of the 1990's. However, expectations for the company began to soar. In 1999, the company's stock increased 56%. In 2000, it increased an additional 87%. Both returns widely beat broad market returns, and the company soon traded at a 70x price-earnings ratio.

Early Signs of Trouble

In February 2001, Kenneth Lay stepped down as Chief Executive Officer and was replaced by Jeffrey Skilling. A little more than six months later, Skilling stepped down as CEO in August 2001, with Lay taking over the role again.

Around this time, Enron Broadband reported massive losses. Lay revealed in the company's Q2 2001 earnings report that "...in contrast to our extremely strong energy results, this was a difficult quarter in our broadband businesses." In this quarter, the Broadband Services department reported a financial loss of $102 million.

Also, around this time, Lay sold 93,000 shares of Enron stock for roughly $2 million while telling employees via e-mail to continue buying the stock and predicting significantly higher stock prices. In total, Lay was eventually found to have sold over 350,000 Enron shares for total proceeds greater than $20 million.

During this time, Sherron Watkins had expressed concerns regarding Enron's accounting practices. A Vice President for Enron, she wrote an anonymous letter to Lay expressing her concerns. Watkins and Lay eventually met to discuss the matters, in which Watkins delivered a six-page report detailing her concerns. The concerns were presented to an outside law firm in addition to Enron's accounting firm; both agreed there were no issues to be found.

By October 2001, Enron had reported a third quarter loss of $618 million. Enron announced it would need to restate its financial statements from 1997 to 2000 to correct accounting violations.

Enron's $63.4 billion bankruptcy was the biggest on record at the time.

On Nov. 28, 2001, credit rating agencies reduced Enron's credit rating to junk status, effectively solidifying the company's path to bankruptcy. On the same day, Dynegy, a fellow energy company Enron was attempting to merge with, decided to nix all future conversations and opted against any merger agreement. By the end of the day, Enron's stock price had dropped to $0.61.

Enron Europe was the first domino, filing for bankruptcy after close of business on Nov. 30. The rest of Enron followed suit on Dec. 2. Early the following year, Enron dismissed Arthur Andersen as its auditor , citing that the auditor had yielded advice to shred evidence and destroy documents.

In 2006, the company sold its last business, Prisma Energy. The next year, the company changed its name to Enron Creditors Recovery Corporation with the intention of repaying any remaining creditors and open liabilities as part of the bankruptcy process.

Post Bankruptcy/Criminal Charges

After emerging from bankruptcy in 2004, the new board of directors sued 11 financial institutions involved in helping conceal the fraudulent business practices of Enron executives. Enron collected nearly $7.2 billion from these financial institutions as part of legal settlements. The banks included the Royal Bank of Scotland, Deutsche Bank, and Citigroup.

Kenneth Lay pleaded not guilty to eleven criminal charges. He was convicted of six counts of securities and wire fraud and was subject to a maximum of 45 years in prison. However, Lay died on July 5, 2006, before sentencing was to occur.

Jeff Skilling was convicted on 19 of the 28 counts of securities fraud he was charged with, in addition to other charges of insider trading. He was sentenced to 24 years and four months in prison, though the U.S. Department of Justice reached a deal with Skilling in 2013. The deal resulted in 10 years being cut off of his sentence.

Andy Fastow and his wife, Lea, pleaded guilty to charges against them, including money laundering, insider trading, fraud, and conspiracy. Fastow was sentenced to 10 years without parole to testify against other Enron executives. Fastow has since been released from prison.

Causes of the Enron Scandal

Enron went to great lengths to enhance its financial statements, hide its fraudulent activity, and report complex organizational structures to both confuse investors and conceal facts. The causes of the Enron scandal include but are not limited to the factors below.

Special Purpose Vehicles

Enron devised a complex organizational structure leveraging special purpose vehicles (or special purpose entities). These entities would "transact" with Enron, allowing Enron to borrow money without disclosing the funds as debt on their balance sheet.

SPVs provide a legitimate strategy that allows companies to temporarily shield a primary company by having a sponsoring company possess assets. Then, the sponsor company can theoretically secure cheaper debt than the primary company (assuming the primary company may have credit issues). There are also legal protection and taxation benefits to this structure.

The primary issue with Enron was the lack of transparency surrounding the use of SPVs. The company would transfer its own stock to the SPV in exchange for cash or a note receivable. The SPV would then use the stock to hedge an asset against Enron's balance sheet. Once the company's stock started losing its value, it no longer provided sufficient collateral that could be exploited by being carried by an SPV.

Inaccurate Financial Reporting Practices

Enron inaccurately depicted many contracts or relationships with customers. By collaborating with external parties such as its auditing firm, it was able to record transactions incorrectly, not only in accordance with GAAP but also not in accord with agreed-upon contracts.

For example, Enron recorded one-time sales as recurring revenue. In addition, the company would intentionally maintain an expired deal or contract through a specific period to avoid recording a write-off during a given period.

Poorly Constructed Compensation Agreements

Many of Enron's financial incentive agreements with employees were driven by short-term sales and quantities of deals closed (without consideration for the long-term validity of the deal). In addition, many incentives did not factor in the actual cash flow from the sale. Employees also received compensation tied to the success of the company's stock price, while upper management often received large bonuses tied to success in financial markets.

Part of this issue was the rapid rise of Enron's equity success. On Dec. 31, 1999, the stock closed at $44.38. Just three months later, it closed on March 31, 2000 at $74.88. With the stock hitting $90 by the end of 2000, the massive profits some employees received only fueled further interest in obtaining equity positions in the company.

Lack of Independent Oversight

Many external parties learned about Enron's fraudulent practices, but their financial involvement with the company likely caused them not to intervene. Enron's accounting firm, Arthur Andersen, received many jobs and financial compensation in return for their services.

Investment bankers collected fees from Enron's financial deals. Buy-side analysts were often compensated to promote specific ratings in exchange for stronger relationships between Enron and those institutions.

Unrealistic Market Expectations

Both Enron Energy Services and Enron Broadband were poised to be successful due to the emergence of the internet and heightened retail demand. However, Enron's over-optimism resulted in the company over-promising online services and timelines that were simply unrealistic.

Poor Corporate Governance

The ultimate downfall of Enron was the result of overall poor corporate leadership and corporate governance . Former Vice President of Corporate Development Sherron Watkins is noted for speaking out about various financial treatments as they were occurring. However, top management and executives intentionally disregarded and ignored concerns. This tone from the top set the precedent across accounting, finance, sales, and operations.

In the early 1990s, Enron was the largest seller of natural gas in North America. Ten years later, the company no longer existed due to its accounting scandal.

The Role of Mark-to-Market Accounting

One additional cause of the Enron collapse was mark-to-market accounting. Mark-to-market accounting is a method of evaluating a long-term contract using fair market value. At any point, the long-term contract or asset could fluctuate in value; in this case, the reporting company would simply "mark" its financial records up or down to reflect the prevailing market value .

There are two conceptual issues with mark-to-market accounting, both of which Enron took advantage of. First, mark-to-market accounting relies very heavily on management estimation. Consider long-term, complex contracts requiring the international distribution of several forms of energy. Because these contracts were not standardized, it was easy for Enron to artificially inflate the value of the contract because it was difficult to determine the market value appropriately.

Second, mark-to-market accounting requires companies to periodically evaluate the value and likelihood that revenue will be collected. Should companies fail to continually evaluate the value of the contract, it may easily overstate the expected revenue to be collected.

For Enron, mark-to-market accounting allowed the firm to recognize its multi-year contracts upfront and report 100% of income in the year the agreement was signed, not when the service would be provided or cash collected. This form of accounting allowed Enron to report unrealized gains that inflated its income statement, allowing the company to appear much more profitable than it was.

The Enron bankruptcy, at $63.4 billion in assets, was the largest on record at the time. The company's collapse shook the financial markets and nearly crippled the energy industry. While high-level executives at the company concocted the fraudulent accounting schemes, financial and legal experts maintained that they would never have gotten away with it without outside assistance. The Securities and Exchange Commission (SEC), credit rating agencies, and investment banks were all accused of having a role in enabling Enron's fraud.

Initially, much of the finger-pointing was directed at the SEC, which the U.S. Senate found complicit for its systemic and catastrophic failure of oversight. The Senate's investigation determined that had the SEC reviewed any of Enron's post-1997 annual reports, it would have seen the red flags and possibly prevented the enormous losses suffered by employees and investors.

The credit rating agencies were found to be equally complicit in their failure to conduct proper due diligence before issuing an investment-grade rating on Enron's bonds just before its bankruptcy filing. Meanwhile, the investment banks—through manipulation or outright deception—had helped Enron receive positive reports from stock analysts, which promoted its shares and brought billions of dollars of investment into the company. It was a quid pro quo in which Enron paid the investment banks millions of dollars for their services in return for their backing.

Enron reported total company revenue of:

• $13.2 billion in 1996
• $20.3 billion in 1997
• $31.2 billion in 1998
• $40.1 billion in 1999
• $100.8 billion in 2000

The Role of Enron's CEO

By the time Enron started to collapse, Jeffrey Skilling was the firm's CEO. One of Skilling's key contributions to the scandal was to transition Enron's accounting from a traditional historical cost accounting method to mark-to-market accounting, for which the company received official SEC approval in 1992.

Skilling advised the firm's accountants to transfer debt off Enron's balance sheet to create an artificial distance between the debt and the company that incurred it. Enron continued to use these accounting tricks to keep its debt hidden by transferring it to its  subsidiaries  on paper. Despite this, the company continued to recognize  revenue  earned by these subsidiaries. As such, the general public and, most importantly, shareholders were led to believe that Enron was doing better than it actually was despite the severe violation of GAAP rules.

Skilling abruptly quit in August 2001 after less than a year as chief executive—four months before the Enron scandal unraveled. According to reports, his resignation stunned Wall Street analysts and raised suspicions despite his assurances that his departure had "nothing to do with Enron."

Skilling and Kenneth Lay were tried and found guilty of fraud and conspiracy in 2006. Other executives plead guilty. Lay died shortly after his conviction, and Skilling served twelve years, by far the longest sentence of any of the Enron defendants.

In the wake of the Enron scandal, the term " Enronomics " came to describe creative and often fraudulent accounting techniques that involve a parent company making artificial, paper-only transactions with its subsidiaries to hide losses the parent company has suffered through other business activities.

Parent company Enron had hidden its debt by transferring it (on paper) to wholly-owned subsidiaries —many of which were named after Star Wars characters—but it still recognized revenue from the subsidiaries, giving the impression that Enron was performing much better than it was.

Another term inspired by Enron's demise was "Enroned," slang for having been negatively affected by senior management's inappropriate actions or decisions. Being "Enroned" can happen to any stakeholder, such as employees, shareholders, or suppliers. For example, if someone lost their job because their employer was shut down due to illegal activities they had nothing to do with, they have been "Enroned."

As a result of Enron, lawmakers put several new protective measures in place. One was the Sarbanes-Oxley Act of 2002, which enhances corporate transparency and criminalizes financial manipulation. The Financial Accounting Standards Board (FASB) rules were also strengthened to curtail the use of questionable accounting practices, and corporate boards were required to take on more responsibility as management watchdogs.

What Did Enron Do That Was So Unethical?

Enron used special purpose entities to hide debt and mark-to-market accounting to overstate revenue. In addition, it ignored internal advisement against these practices, knowing that its publicly disclosed financial position was incorrect.

How Big was Enron?

With shares trading for around $90/each, Enron was once worth about $70 billion. Leading up to its bankruptcy, the company employed over 20,000 employees. The company also reported over $100 billion of company-wide net revenue (though this figure has since been determined to be incorrect).

Who Was Responsible for the Collapse of Enron?

Several key executive team members are often noted as being responsible for the fall of Enron. The executives include Kenneth Lay (founder and former Chief Executive Officer), Jeffrey Skilling (former Chief Executive officer replacing Lay), and Andrew Fastow (former Chief Financial Officer).

Does Enron Exist Today?

As a result of its financial scandal, Enron ended its bankruptcy in 2004. The name of the entity officially changed to Enron Creditors Recovery Corp., and the company's assets were liquidated and reorganized as part of the bankruptcy plan. Its last business, Prisma Energy, was sold in 2006.

At the time, Enron's collapse was the biggest  corporate bankruptcy  ever to hit the financial world (since then, the failures of WorldCom, Lehman Brothers, and Washington Mutual have surpassed it). The Enron scandal drew attention to accounting and corporate fraud. Its shareholders lost tens of billions of dollars in the years leading up to its bankruptcy, and its employees lost billions more in pension benefits. Increased regulation and oversight have been enacted to help prevent corporate scandals of Enron's magnitude.

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