Monster Mess
The Enron fallout has just begun. Things can't stay the same, can they?
FORTUNE
Monday, February 4, 2002
By Bethany McLean
Anytime a stock market bubble bursts, a business scandal that epitomizes the excesses of that
particular period is seldom far behind. The Roaring '20s had Teapot Dome. The end of the bull
market in the early 1970s was marked by the collapse of Equity Funding Corp. The 1980s, of
course, had Michael Milken.
Until recently it wasn't easy to choose the scandal that encapsulated the 1990s bubble. That's
not because there was a shortage of sleazy behavior but rather because there was an
abundance of it. Rampant conflicts of interest on Wall Street. Wildly creative accounting. Auditors
who didn't audit. Money managers who didn't manage. A stunning lack of oversight by
regulators. We could go on.
But now the wait is over: Enron's bankruptcy is, without doubt, the grand finale of the last
decade of the 20th century. The company's rise and fall was made possible by a willingness to
overlook--and indeed, for a time, even to reward--all of the above behavior.
Then there's the politics. The hint of impropriety at the highest levels of government has
cemented the energy giant's place in history, producing a barrage of coverage that has even
supplanted the war in Afghanistan as the lead story in newspapers. That alone, in today's weird
circular logic, would be enough to make a nonresponse by the political system nearly impossible.
But politics are almost beside the point. As a financial scandal, Enron is much bigger than anyone
imagined--and, more important, the factors that enabled it haven't gone away. "Systemic conflicts
of interest are more pervasive and corrosive than either Congress, regulators, investors, or the
press appreciate," Scott Cleland, CEO of the Precursor Group, an independent research firm,
said in congressional testimony. "The breathtakingly swift collapse of Enron is no isolated
incident that can be dismissed as unique, brushed under the rug, and ignored.'' The real question
should be not whether the Enron debacle will change anything, but how much and how soon?
The most scintillating Enron tidbits are emerging from a nondescript set of rooms on Capitol Hill,
filled with some 40 boxes of documents from the company and its auditor, Arthur Andersen.
Over the past few weeks as many as ten people, four of them working full-time, have been
combing through the boxes. On the wall of a room is a map laying out details of Enron's
controversial myriad partnerships. The investigation is being conducted by the House Energy and
Commerce Committee, chaired by Louisiana's Billy Tauzin, whose work makes it seem unlikely
that the financial story will be buried by either its sheer complexity or the unfolding political
sideshow.
What has the committee discovered? For one thing, founder and chairman Ken Lay, who often
came across as clueless as Enron unraveled, deserves a great deal of blame. If nothing else,
Lay allowed a culture of rule breaking to flourish, and he obviously misled investors. Enron's
adventures in creative accounting are not a recent development. Back in mid-1995, Jim
Alexander, then CFO of Enron Global Power & Pipelines, walked into Lay's office to report
concerns he had about Enron's numbers for overseas projects. "I told him I had heard there
were manifold serious problems with the [accounting on] international projects,'' Alexander
recalls. Lay's reaction? Nothing.
That wasn't the only warning. One of the most remarkable documents unearthed by Energy and
Commerce researchers was an unsigned seven-page letter from Enron vice president Sherron
Watkins to Lay, written on Aug. 15, 2001. The letter informed him, among other things, that Enron
executives "consistently and constantly'' questioned the company's accounting methods to
senior officials, including former CEO Jeff Skilling. "I am incredibly nervous that we will implode in
a wave of accounting scandals,'' she wrote. That was around the same time Lay was telling
Wall Street that there weren't any "accounting issues, trading issues, or reserve issues" at
Enron. Two months later, when Enron announced its quarterly financial results, Lay had this to
say: "The continued excellent prospects in these businesses and Enron's leading market position
make us very confident in our strong earnings outlook."
In reality, of course, Enron was a bigger financial scandal than even the most critical observers
believed. Watkins' letter makes it clear that the partnerships and off-balance-sheet entities that
Enron created weren't used just to "reduce risk,'' as the company claimed repeatedly last fall.
They were used to cook the books, plain and simple. "That's just too bad, too fraudulent, surely
AA&Co. wouldn't let them get away with that,'' wrote Watkins, anticipating the reaction should
outsiders begin to dig into the accounting.
If Arthur Andersen hadn't "let them get away with it," what would Enron's earnings have looked
like? How much of the $101 billion in revenues that Enron reported in 2000 were created via
multiple transactions with entities that weren't independent third parties? And the partnerships
are only part of the story. The other issue is Enron's overly aggressive use of mark-to-market
accounting. There's nothing wrong with this method of accounting, which entails pricing
securities at their fair value and running gains or losses through the income statement. But in
illiquid markets, like those for long-term energy contracts, there's no benchmark of fair value. So
Enron often relied on internal models--which creates serious potential for abuse. And because
Skilling and Lay had established a culture in which earnings growth was paramount, managers
had plenty of incentive to push the limits.
Enron's much-hyped North American trading operation, which at one point accounted for the
majority of its reported earnings and $70 billion valuation, is now nearly worthless. After the
company declared bankruptcy, it set out to find a well-capitalized third party and create a joint
venture to restart the trading operation. Only two firms--UBS Warburg and Citigroup--were
interested (although BP Amoco did offer $25 million for some pieces of Enron's technology). UBS
Warburg, the winning bidder, will pay Enron a third of any pretax profits for ten years and has
the option to buy the business outright for a multiple of the previous years' profits--but UBS is not
assuming any of the business' liabilities. In other words, UBS basically got a free option on the
business.
All this makes Enron a political issue, but not for the obvious reasons. Much has been made of
the multiple phone calls that Enron executives placed during the company's dying days to
Administration officials--including Treasury Secretary Paul O'Neill, Fed Chairman Alan
Greenspan, Commerce Secretary Don Evans, and Treasury's Under Secretary for Domestic
Finance Peter Fisher. But despite the money that Enron lavished on all sorts of people, no one
came to its rescue. And whatever influence Enron had on energy policy (according to one
former employee, Vice President Dick Cheney had only one sit-down meeting with Lay in early
2001, and he opposed Enron on such key issues as the Kyoto Accord and nuclear power), the
company isn't around to enjoy the benefits.
The bigger political issue is not Enron's input on energy matters but rather its earlier influence on
financial policies. Most notably, Enron lobbied for legislation, passed in 2000, that exempted much
of its energy-trading business from oversight. That legislation passed through the Senate
Banking Committee, which was chaired by Phil Gramm, a big recipient of Enron funds; his wife,
Wendy, sat on Enron's board. Enron also lobbied for mark-to-market accounting; in 1998 the
Emerging Issues Task Force, which is backed by the Financial Accounting Standards Board, said
that energy-trading contracts should be booked on that basis--but the agency included few
guidelines for valuing illiquid contracts.
Clearly, the fallout from Enron has only just begun. One obvious candidate for change is the
accounting business. Enron is just the latest in a long string of disasters for the
industry--remember Waste Management, Sunbeam, and Cendant?--but it's by far the biggest.
And Arthur Andersen is facing not just a slap on the wrist but a battle for survival. That won't be
easy, given that Andersen is the only one with deep pockets left standing--and Enron's legal
strategy will be to say that complicated transactions were left to the judgment of its accounting
firm. Mark L. Cheffers, a former accounting litigation consultant who is now CEO of
Accountingmalpractice.com, estimates that Andersen may be exposed to $10 billion to $20 billion
in liabilities. The previous largest settlement of an accounting case was the $335 million Ernst &
Young paid to settle claims related to Cendant. Putting legal liabilities aside, Andersen may not
have much of a business left. "The tremendous damage done to their credibility will make it
extremely difficult to attract business to their firm,'' says Lynn Turner, the SEC's former chief
accountant. One portfolio manager says that if a company is audited by Andersen, he simply
won't invest in it.
All that may finally be enough to give accountants backbone. The fact that even lay people now
realize that the profession is a mess may give regulators the clout they didn't have when Arthur
Levitt, the former head of the SEC, tried to enact reforms a few years ago. At that time the
cognoscenti were well aware of the conflicts that accounting firms faced--but no one cared
enough to make the situation change. SEC Chairman Harvey Pitt has now called for an
organization that would discipline accountants for ethical violations.
But while Arthur Andersen has much to answer for, current accounting rules allowed Enron a
great deal of latitude. In the view of some, there are actually too many rules, because rules
inevitably leave loopholes that can be exploited and create a mindset where form is more
important than substance. Contrast that with Britain, where accountants have a "true and fair"
override, which they use if the accounting treatment follows the letter of the law but doesn't fully
reflect the economics of a transaction.
Another good candidate for reform is retirement plans. The talk is that Congress will finally put
limits on what percent of a plan's total assets can be in company stock--perhaps 20%--and make
it easier for ordinary employees to sell their shares. Oddly enough, there's less discussion about
options, although the fact that Enron executives were able to sell $1 billion in stock over the past
decade is precisely because they were given such generous option grants. If accounting laws
had mandated that the cost of those options be reflected in reported earnings, would
Enron--which cared deeply about reported earnings--have enriched its executives to such an
extent?
But the area most in need of reform is the one that is least likely to change. That's Wall Street.
Although Enron's inadequate financial disclosure made it impossible to ascertain the company's
true condition, those who bothered to read its documents saw enough--including curious
mentions of the partnerships as early as 2000--to be suspicious. Despite the professions of
shock about Enron's liberal use of off-balance-sheet entities, when CFO magazine bestowed the
"Excellence Award for Capital Structure Management" on former CFO Andy Fastow in 1999,
analysts and rating agencies raved about his creative use of such "unique" financing
techniques. And the fact that executives were selling stock at a frightening pace was publicly
available information. Skeptics eventually made fortunes shorting the stock. Why didn't anyone
else care? Perhaps because when everyone--money managers, analysts, banks,
management--benefits from a soaring stock, no one has any incentive to ask disturbing
questions. "A lot of knowledgeable people on Wall Street were duped, didn't care, or
purposefully went along for the ride at the expense of thousands of others,'' said Senator Carl
Levin, a Michigan Democrat.
You only have to look at Citigroup to see the multiple roles that Wall Street firms can play today.
Analyst Ray Niles of Salomon Smith Barney (which is owned by Citigroup) was one of Enron's
biggest bulls. Citigroup (along with J.P. Morgan) led most of Enron's financings in the '90s, and
was owed around $1 billion by Enron. Why did the banks, which have access to information that
equity investors don't, keep handing Enron money? And Citigroup is an investor in LJM2, one of
the Enron partnerships that was run by Andy Fastow. Of all the phone calls that were placed
during Enron's final days, the one that seems most inappropriate was made by Robert Rubin,
former Treasury Secretary and current Citigroup chairman of the executive committee, to Under
Secretary Fisher, raising the possibility that he intervene with the rating agencies on behalf of
Enron.
So far all the major players in this drama are doing whatever they can to dodge responsibility.
"Lay, Skilling, Fastow et al. have demonstrated a remarkable ability to ignore their personal
responsibility for this,'' says University of Houston management professor J. Timothy McMahon. If
it weren't so tragic, it would be comical: In Skilling's one public appearance since he abruptly
resigned from the company last August for undisclosed "personal reasons,'' he said, "I had no
idea the company was in anything but excellent shape.'' Watkins' letter suggests otherwise:
Skilling "knew this stuff was unfixable and would rather abandon ship now than resign in shame
in two years,'' she wrote. All the stories can't conflict forever, and at some point, we'll know the
answer to the biggest question of all: Who's going to jail? |
