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