Corporate Accounting Scandals

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Corporate Accounting Scandals Insurance
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Agenda for Today

• The diminishing audit quality of the 1990s
• The bubble burst
• Enron, WorldCom, Global Crossing, Tyco, Adelphia,
  etc
• Reform!!! Sarbanes-Oxley and newfound corporate
  accountability
• Newfound litigation grounds ? New Need for
  Insurance!!!

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Why so many financial statement frauds all of a
sudden?

• Good economy was masking many problems
• Moral decay in society
• Executive incentives
• Wall Street expectationsrewards for short-term
  behavior
• Nature of accounting rules
• Behavior of CPA firms
• Greed by investment banks, commercial banks, and
  investors
• Educator failures

"The Perfect Storm"
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These Are Interesting Times

• Number and size of financial statement frauds are
  increasing
• Number and size of frauds against organizations
  are increasing
• Some recent frauds include several peopleas many
  as 20 or 30 (seems to indicate moral decay)
• Many investors have lost confidence in
  credibility of financial statements and corporate
  reports
• More interest in fraud than ever beforenow a
  course on many college campuses

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Why Was There Earnings Management?

• What is Earnings Management?
• Basically, it is manipulating the financial
  statements of a company to misrepresent the true
  financial health of the company.

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Incentives for F.S. Fraud
Incentives to commit financial statement fraud
are very strong. Investors want decreased risk
and high returns. Risk is reduced when
variability of earnings is decreased. Rewards are
increased when income continuously improves.
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Nature of Accounting Rules

• In the U.S., accounting standards are
  rules-based instead of principles based.
• Allows companies and auditors to be extremely
  creative when not specifically prohibited by
  standards.
• Examples are SPEs and other types of off-balance
  sheet financing, revenue recognition approaches,
  merger reserves, pension accounting, and other
  accounting schemes.
• When the client pushes, without specific rules in
  every situation, there is no room for the
  auditors to say, You cant do thisbecause it
  isnt GAAP
• It is impossible to make rules for every situation

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Why Was There Earnings Management?

• Reasons are probably wide and varied.
• Complex problem.
• Earnings management almost became the norm in
  corporate America.
• Corporations needed to manage their earnings to
  remain competitive with other companies.

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Why Was There Earnings Management?

• Audit quality was insufficient.
• Competition for business was driving the price of
  audits down. Not much of a premium paid for
  having accurate audits.
• Accounting firms focusing more on profitable
  services like consulting.

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Why Was There Earnings Management?

• Financial service firms offered consulting
  services in addition to audits.
• Consulting is Advisory services to help senior
  management improve the effectiveness of corporate
  strategy, process, or operations by assessing
  business needs and reviewing business functions,
  plans and directions.

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Why Was There Earnings Management?

• Possible conflict of interest with accounting
  firms providing both audit services and
  consulting services.
• Audit partners becoming more friendly with
  upper management. After all, they want to keep
  business!
• Audit partners compensated more on bringing in
  business than on their technical skills.

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The Scandals

• The culmination of the aforementioned accounting
  problems was the bubble burst of the late 1990s
  and the early 2000s.
• Some companies that weve all heard of failed as
  a result of corruption and fraud
• Enron
• WorldCom
• Global Crossing
• Adelphi

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Largest Bankruptcy Filings (1980 to
Present)from BankruptcyData.com
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Enron
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Enron

• Using Special Purpose Entities as a haven for
  debt, synthetic profit.
• Enron created several hundred of these special
  purpose entities.
• Auditors failed to stop the misstatements.
• Investors lost nearly 60 Billion in the collapse
  of the 5th largest corporation in the US.

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Enron

• 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.
• Enron incurred massive debt and no longer had
  exclusive rights to its pipelines.
• Needed new and innovative business strategy
• Kenneth Lay, CEO, hired McKinsey Company to
  assist in developing business strategy. They
  assigned a young consultant named Jeffrey
  Skilling.
• His background was in banking and asset and
  liability management.
• His recommendation that Enron create a Gas
  Bankto buy and sell gas

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Enrons History (contd)

• Created Energy derivative
• Lay created a new division in 1990 called Enron
  Finance Corp. and hired Skilling to run it
• Enron soon had more contracts than any of its
  competitors and, with market dominance, could
  predict future prices with great accuracy,
  thereby guaranteeing superior profits.
• Skilling hired the best and brightest traders
  and rewarded them handsomelythe reward system
  was eat what you kill
• Fastow was a Kellogg MBA hired by Skilling in
  1990Became CFO in 1998
• Started Enron Online Trading in late 90s
• Created Performance Review Committee (PRC) that
  became known as the harshest employee ranking
  system in the country---based on earnings
  generated, creating fierce internal competition

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Enrons Use of Special Purpose Entities (SPEs)

• To hide bad investments and poor-performing
  assets (Rhythms NetConnections). Declines in
  value of assets would not be recognized by Enron
  (Mark to Market).
• Earnings managementBlockbuster Video deal--111
  million gain (Bravehart, LJM1 and Chewco)
• Quick execution of related-party transactions at
  desired prices. (LJM1 and LJM2)
• To report over 1 billion of false income
• To hide debt (Borrowed money was not put on
  financial statements of Enron)
• To manipulate cash flows, especially in 4th
  quarters
• Many SPE transactions were timed (or illegally
  back-dated) just near end of quarters so that
  income could be booked just in time and in
  amounts needed, to meet investor expectations

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What did Arthur Andersen Do?

• Andersen employees ordered tons of Enron
  paperwork to be shredded before the investigation
  of the fraud began.
• Rumor U of I Arthur Andersen interns during 2001
  claim to have shredded a ton of documents!

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Enron
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WorldCom

• Capitalized their line costs.
• Line costs should have been expenses, however,
  the false capitalization overstated WorldCom's
  assets by billions of dollars.

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Global Crossing

• Management had unrealistic revenue targets.
• Tried everything they could to meet the targets.
• Swapped fiber optic capacity to boost revenue.
• Revenue restatement of 19 million, overstated
  assets by 1.2 billion

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Adelphi

• Several Vacation Homes and luxury apartments in
  Manhattan
• Several private jets
• Construction of a world-class 18-hole golf course
• Majority ownership of the Buffalo Sabres
• 700,000 membership in an exclusive golf club

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Reaction

• Investor backlash
• Billions lost in the frauds of 2001, 2002.
• US government determined to deter frauds of this
  magnitude in the future.

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Sarbanes-Oxley

• Created in 2002 in the wake of the previously
  mentioned accounting scandals.
• Created accountability among corporate executives.

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SOX 2002

• Section 302 pertains to liability.
• CEO/CFO must sign off on financial statements-
  can be held criminally liable if financials are
  false.
• Material Accuracy- The amount listed in the
  financials has to be an accurate reflection of
  where the company is at.
• Fair presentation of financial information
• Disclose controls- so material information about
  a company gets presented to top management.
• Internal Accounting controls- provide assurance
  that the financials conform to GAAP.

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SOX 2002 Section 302 Contin

• Based on the officers knowledge, the financial
  statements do not contain any material
  misstatements or omissions.
• The financial statements fairly state the
  companys financial position and results from
  past operation.

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Accountability!!!!
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New Grounds for Litigation

• In 2002, the U.S. Congress passed the Sarbanes
  Oxley Act, which has had a major impact on the
  liability of directors and officers. Although
  this legislation protects shareholders and is
  expected to improve corporate governance, it also
  bears the risk of increasing the number of
  litigations. This act establishes new fines and
  penalties for the corporate board for securities
  fraud violation involving accounting
  irregularities and financial fraud.
• http//www.aon.com/risk_management/d_and_o.jsp

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Directors Officers Insurance
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New Demand for Directors and Officers insurance

• Think of the lawsuits facing some of Enrons
  officers

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Others Paying Out From Enron

• DIRECTORSRobert Belfer- a director of
  EnronNorman Blake- a director of EnronRonnie
  Chan- a director of EnronJohn Duncan- a
  director of EnronPaulo Ferraz-Pereira- a
  director of EnronJoe Foy- a director of
  EnronWendy Gramm- a director of EnronRobert
  Jaedicke- a director of EnronCharles LeMaistre-
  a director of EnronRebecca Mark-Jusbasche-
  Chairman and CEO of Enron International and later
  Vice Chairman, and CEO of AzurixJohn Mendelsohn-
  a director of EnronJerome Meyer- a director of
  EnronFrank Savage- a director of Enron and a
  member of its Finance CommitteeJohn Urquhart- a
  director of Enron and was senior advisor to the
  Chairman in 1998John Wakeham- a director of
  EnronCharls Walker- a director of EnronHerbert
  Winokur- a director of Enron
• Class action suits in the Hundreds of millions of
  dollars range. Part of which was paid out of
  pocket due to directors not carrying adequate
  Directors and Officers Insurance.

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New Demand for Directors and Officers insurance

• Think of the liability for Arthur Andersens
  partners on the Enron account!!

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Implications of Liability

• As a company officer, you are responsible for not
  only your actions, but those of your subordinates
  as well.
• Most technical information within a company gets
  passed up through the hierarchal layers for the
  company from bottom to top.

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Professional Liability

• Most CGL policies exclude professional liability
  loss exposures.
• Legal fees for defending professional liabilities
  cases can be very costly.

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Other Effects of Enron on DOL

• Approximately 50 of all Directors and Officers
  Liability claims are tied to Employment Practices
  Liability claims. Employees that were once silent
  about workplace harassment and discrimination are
  now speaking out and taking action against their
  employers.
• Plant closings, layoffs, and mergers and
  acquisitions are commonplace events that are
  providing fertile ground for multi-million dollar
  class action claims.
• The case of Enron in late 2001, coupled with an
  already large downturn in the economy, has
  further affected the pricing for Directors and
  Officers liability.

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DO Insurance

• The cost for Director's and Officer's Insurance
  has gone up dramatically, and the exclusions for
  coverage have increased.

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A Twist to Enrons DO Policies

• Some of Enrons DL claims were not paid because
  since the claims resulted from misrepresentation,
  the insurance companies refused to pay the claim!
• Self insurance retention

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The Future?

• These scandals might be reduced by new laws, but
  they wont totally disappear.
• Watch for new developments in regulations.
• SOX adjustments
• More large DO claims.

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• Some material taken from the AICPA Website