1. Finance Lecture 9

2. Keating F&A 9-2 Spring 2008 Outline Lecture 9 Enron Sarbanes-Oxley

3. Keating F&A 9-3 Spring 2008 Enron Was An Energy Distribution Company Started out as Northern Natural Gas Company, later InterNorth, merged with Houston Natural Gas, became Enron Also involved with electricity transmission and distribution, water utilities, bandwidth For many years, this was a “real” company that was legitimately innovative in creating tradable financial instruments

4. Keating F&A 9-4 Spring 2008 Dramatis Personae Kenneth Lay (1942-2006), founder, CEO of Enron  Convicted of ten counts of securities fraud  Died before sentencing Jeffrey Skilling (1953- ), COO, later CEO of Enron  Convicted of conspiracy, insider trading, securities fraud  Currently serving 24-year prison sentence Andrew Fastow (1961- ), CFO of Enron  Pled guilty to wire and securities fraud  Currently serving 6-year prison sentence David Duncan (1960- ), chief Arthur Andersen partner dealing with Enron  Pled guilty to obstruction of justice but later withdrew plea

5. Keating F&A 9-5 Spring 2008 Enron’s Problems Centered Around “Related-Party Transactions” Fastow set up separate legal entities (with “Star Wars”- derived names, e.g., Jedi, Chewco) that absorbed Enron losses temporarily  Made Enron financial statements look artificially good  Fastow received large fees from these entities while simultaneously being employed by Enron On a much smaller scale, Merrill Lynch employees were convicted of abetting Enron in a fraudulent Nigerian barge deal  For accounting purposes, Merrill Lynch bought the barges in 1999 from Enron  But Enron promised to repurchase them later at a profit to Merrill Lynch  Not a true sale

6. Keating F&A 9-6 Spring 2008 Enron Collapsed In Fall 2001 When Arrangements Were Revealed Thousands of Enron employees lost their jobs, retirement savings  Don’t put retirement savings in your employer’s stock! Lay blamed The Wall Street Journal, short sellers, September 11 attacks,… There is no law, however, against being incompetent in business. Were crimes committed?

7. Keating F&A 9-7 Spring 2008 The Department Of Justice Had To Figure Out Whom To Prosecute And For What Lay and Skilling claimed to be victims of Fastow  While the government felt Lay and Skilling were deeply involved in orchestrating Fastow’s related party transactions, Lay and Skilling were more narrowly charged with securities fraud, i.e., making public statements they knew to be false Fastow never went to trial but the government’s argument was that he engaged in a conspiracy to commit securities fraud, i.e., help generate false Enron accounting statements  The government had extra leverage in that his wife Lea Fastow also worked in finance for Enron so they could threaten to send both parents to prison  There was an egregious conflict of interest in his being CFO of Enron and owner of “separate” financial entities that dealt with Enron

8. Keating F&A 9-8 Spring 2008 Arthur Andersen’s Role With Enron Remains Controversial To This Day Andersen was Enron’s auditor while simultaneously making much more money providing consulting services to Enron  The Enron-Andersen case was not unique, either within Andersen or within the accounting industry, in cross-selling of accounting and consulting The government indicted Andersen for obstruction of justice  October 19, 2001 “reminder” email about “routine document shredding”  Andersen’s clients fled en masse when legal troubles began  Andersen convicted of obstruction of justice in 2002  In 2005, the U.S. Supreme Court overturned Andersen’s conviction on the grounds the judge’s jury instructions were overly broad Moot in that Andersen ceased to exist by then

9. Keating F&A 9-9 Spring 2008 What Is The Appropriate Role Of An Accountant? Andersen claimed it was a victim of fraud by Enron personnel and that they could only assume information provided them by Enron was valid Many outsiders’ view is that an accountant’s role also includes unearthing fraud  If Andersen didn’t understand what was going on at Enron, who could? Andersen’s problems with Enron gave rise to Sarbanes-Oxley, which we discuss next

10. Keating F&A 9-10 Spring 2008 Outline Lecture 9 Enron Sarbanes-Oxley

11. Keating F&A 9-11 Spring 2008 Sarbanes And Oxley Sponsored 2002 Accounting Reform Bill Paul Sarbanes (1933- ), Democratic U.S. Senator from Maryland, 1977-2007  Longest-serving U.S. Senator in Maryland’s history Michael Oxley (1944- ), Republican U.S. Congressional representative from Ohio, 1981- 2007

12. Keating F&A 9-12 Spring 2008 Sarbanes-Oxley Was Signed Into Law July 30, 2002 “Public Company Accounting Reform and Investor Protection Act of 2002” Approved by Senate 95-0 and by House of Representatives 423-3  Nays: Collins (R, GA), Flake (R, AZ), Paul (R, TX) “Most far-reaching reforms of American business practices since Franklin Roosevelt was president” – George W. Bush

13. Keating F&A 9-13 Spring 2008 Key Sections of Sarbanes-Oxley 201 – Auditing companies cannot do other kinds of business apart from auditing with the same clients 302 – Mandates internal procedures designed to ensure accurate financial disclosure 404 – Requires management and an independent, external auditor to report on the adequacy of the company’s internal control over financial reporting

14. Keating F&A 9-14 Spring 2008 SOX Increases Criminal Penalties For Corporate Malfeasance Title VIII – It is a felony to “knowingly” destroy or create documents to “impede, obstruct or influence” any existing or contemplated federal investigation Title IX – Creates a crime for tampering with a record or otherwise impeding any official proceeding Obviously, there is a big difference between a civil violation (with prospective finance penalties) and criminalizing violations

15. Keating F&A 9-15 Spring 2008 Subsequent To Its Enactment, Concerns Have Been Raised About SOX Mandated procedures are overly burdensome for small businesses?  SOX compliance might be viewed as a fixed cost, so it is proportionally more expensive for smaller firms International firms have chosen not to register securities in the US to avoid SOX? More small firms being bought by private acquirers rather than by public ones? Unleashing “batteries of lawyers across the country” generating a “huge preoccupation with the dangers and risks of making the slightest mistake” (William Donaldson, Chairman of Securities and Exchange Commission, 7-30-03)?

16. Keating F&A 9-16 Spring 2008 There May Be Advantages To SOX Prevent, or at least more quickly reveal, some types of fraud? Make corporate finances more accurate and transparent?  A “Seal of Approval” for good firms?  Discouraging some firms from listing in the US isn’t prima facie bad news Note: Improved financial accounting from SOX does not necessarily imply better management accounting and, hence, decisionmaking

17. Keating F&A 9-17 Spring 2008 SOX’s Effect On Accounting Firms Has Been Ironic Though Arthur Andersen’s alleged shortcomings with Enron (and other firms) were a catalyst, the law’s effect has been to increase demand for auditing services  SOX-induced demand offsets prohibition on other consulting by auditors  Few Andersen employees were unemployed for long! The vast majority of auditing is now done by the “Big Four”  Deloitte Touche Tohmatsu  Ernst & Young  KPMG  Pricewaterhouse Coopers  Auditing is a reputation-centric business where entrance by new firms appears to be difficult

18. Keating F&A 9-18 Spring 2008 It Seems Reasonable To Suspect SOX’s Impacts, Positive And Negative, Will Diminish Over Time Firms will “figure out” and standardize compliance procedures, reducing their cost Malefactors will symmetrically figure out ways to behave badly despite SOX rules