Presentation for

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Sherron Watkins and Company

• Presentation for
• 2009 Fraud Forensic Accounting Conference
• Enron and Leadership Bullet-proofing your
  organization is simple, but not easy
• ?July 20-21, 2009?Baton Rouge Marriott

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Sherron Watkins and Company
Reacting to smoke signals Managing a
smoking gun.. Fire prevention vs. fire
detection

• What happened at Enron?
• How to protect yourself
• How to safeguard an organization
• Warning signs for investors, customers,
  employees

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Sherron Watkins and Company

Enrons stock price, 1993 2002
21 split
Note By 2000, Enron was 7th largest company in
America based on Total Revenues
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Organizational path to ruin
Phase I Phase II Phase III
Phase IV (Enron)
Excellence Achieved Procedures
Emphasized Principles Neglected
Decline Loss of Excellence Procedures
Misused to Meet Goals Principles Abandoned
Strive to Excellence Principles in
place Procedures developed
Start up Vision of Excellence Principles
Identified
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Enrons Public Disclosures . Adequate or not?

• Cash Flow Problems A review of Enrons
  Quarterly SEC filings would have shown a glaring
  problem. The 2000 - 4th quarter cash flow smells
  of financial engineering.
• Off balance sheet debt
• Long term debt reported 13
  billion
• Total long term debt, Dec 2001 38 billion
• Related party footnote disclosure
• In 2000 and 1999, Enron entered into
  transactions with limited partnerships (the
  Related Party) whose general partner's managing
  member is a senior officer of Enron..
• In 2000, Enron entered into transactions with
  the Related Party to hedge certain merchant
  investments ... As part of the transactions,
  Enron (i) contributed to newly-formed entities
  (the Entities) assets valued at approximately
  1.2billion, including 150 million in Enron
  notes payable, 3.7million restricted shares of
  outstanding Enron common stock and the right to
  receive up to 18.0 million shares of outstanding
  Enron common stock in March 2003 (subject to
  certain conditions) and (ii) transferred to the
  Entities assets valued at approximately309
  million, including a 50 million note payable and
  an investment in an entity that indirectly holds
  warrants convertible into common stock of an
  Enron equity method investee. In return, Enron
  received economic interests in the Entities,309
  million in notes receivable, of which 259
  million is recorded at Enron's carryover basis of
  zero, and a special distribution from the
  Entities in the form of 1.2 billion in notes
  receivable, subject to changes in the principal
  for amounts payable by Enron in connection with
  the execution of additional derivative
  instruments. Cash in these Entities of 172.6
  million is invested in Enron demand notes. In
  addition, Enron paid 123million to purchase
  share-settled options from the Entities on21.7
  million shares of Enron common stock. The
  Entities paid Enron 10.7 million to terminate
  the share-settled options on14.6 million shares
  of Enron common stock outstanding. In late 2000,
  Enron entered into share-settled collar
  arrangements with the Entities on 15.4 million
  shares of Enron common stock. Such arrangements
  will be accounted for as equity transactions when
  settled. In 2000, Enron entered into derivative
  transactions with the Entities with a combined
  notional amount of approximately 2.1billion to
  hedge certain merchant investments and other
  assets. Enron's notes receivable balance was
  reduced by 36 million as a result of premiums
  owed on derivative transactions. Enron
  recognized revenues of approximately 500 million
  related to the subsequent change in the market
  value of these derivatives which offset market
  value changes of certain merchant investments and
  price risk management activities.

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What about Enrons Whistleblowers?
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The Fall of 2001 My Bleakest Time

• After memo of August 15th meeting with Ken Lay
  on August 22, 2001
• August 15th CAO response to Lay We do from
  time to time use contingent Enron equity in
  transactions. However, to the extent that the
  current economics of such a transaction would
  imply that we would issue that equity in the
  future, we must count that equity as issued and
  outstanding currently. To state it more clearly,
  all transactions that use Enron equity currently
  or in the future are fully accounted for today.
  All future commitments have been considered and
  reflected in calculating earnings per share and
  shares outstanding today.
• August 24th Vinson Elkins memo to Enron legal
  Per your request, the following are some bullet
  thoughts on how to manage the situation with the
  employee who made the sensitive report.You asked
  that I include a summary of the possible risks
  associated with discharging employees who report
  allegations of improper accounting practices..
• August 28th CFO response demanded I be fired,
  demoted, no real work
• October 16, 2001 to January 14, 2002 Whitewash
  investigation, nothing wrong, then blame-shifting
  to Andy Fastow, CFO and finance staff

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Sherron Watkins and Company
What happened at Enron?

• We do not err because truth is difficult to
  see. It is visible at a glance. We err because
  this is more comfortable.
  Alexander Solzhenitsyn
• Our lives begin to end the day we remain
  silent about things that really matter. Dr.
  Martin Luther King, Jr.

This quote was given to all Enron employees -
was on 1 of 4 telephone notepads distributed in
the company to highlight one of Enrons core
values communication
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The Root Causes of Enrons Demise

• Diffusion of responsibility
• Board level - too large (17), relied on outside
  experts
• Executive level - PRC issue - not my job, not an
  accountant
• Lack of open dialogue
• CLM (career limiting move) for control personnel
  to say no
• Skillings standard response to ?s he/she
  doesnt get it
• Various messengers were shot, discouraging others
• Rationalizing fraudulent behavior
• The end result justifies the means by which we
  get there (S/V)
• Group think - everyone else is doing it its
  expected
• Form over substance compliance with GAAP
• Never outsource your Internal Audit Department
  

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Sherron Watkins and Company
Immediate Reaction to Enrons Bankruptcy

• Over 2 dozen shareholder lawsuits
• Litigation is against Board members, executives,
  accounting firms, banks, and law firms
• 13 Congressional committees launch investigations
• SEC, FBI and Department of Justice form Enron
  Task Force to look into criminal and civil
  violations
• California grand jury investigates trading
  operation and energy market manipulation
• Enrons board forms special committee, Chair is
  UT law dean Bill Powers
• Committee investigates and reports results in
  The Powers Report on February 1, 2002 Report
  concludes the Enron Board of Directors failed
  in its oversight duties with serious
  consequences for Enron, its employees and
  shareholders. Additional conclusions condemn
  management by name.

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Summary of U.S. Senates Investigation of
Enrons Board of Directors

• Fiduciary failure by Enrons Board
• Allowed Enron to engage in high risk accounting
• Allowed inappropriate conflicts of interest
• Allowed extensive undisclosed off-the-books
  activities
• Allowed excessive executive compensation
• Board witnessed questionable practices over
  several years and chose to ignore them
• Independence of Board was compromised by
  financial ties between Enron and certain board
  members

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Unintended Results at Enron . the Department
of Justice and SEC investigations
Erased after death, since sentencing and appeal
had not yet occurred DOJ pursuing .
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Unintended Results at Enron .
the DOJ and SEC investigations, continued
Accused of securities law violations by SEC
settled with the SEC, Neither confirming nor
denying wrongdoing
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Unintended Results at Enron ..the DOJ/SEC
and Tx CPA Board actions, continued
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• Unintended Results at Enron
• . the Civil Investigations
  Litigation

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1.1 Billion in Insider Sales of Stock from 1998
to 2001
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Retention Bonuses of 105 million paid in
November 2001
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Results of Enrons Bankruptcy on Rank and File
Employees

• Number of employees laid off on December 3,
  2001 4,500
• Number of employees laid off in January
  2002 1,000
• Severance for laid off employees, federally
  mandated 4,500
• Medical insurance None,
  paid via COBRA
• Notice to depart building 30
  minutes to a few hours

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My New Passion Ethics, Integrity and
Organizational Behavior

• Essential Components to a Healthy Culture
• Leaders must have pristine ethics
• Channels for bad news must exist and be robust
• Ethically-challenged employees must go
• Exception reporting must be outside the chain
  of command
• Compliance should be with spirit of existing
  laws and regulations
• Fight form over substance compliance
• For individuals use the 3M test and seek peer
  support if it fails
• For board develop informal channels of
  communication within the organization

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Sherron Watkins and Company
Great organizations maintain failsafe management
systems

• Leaders understand how management systems fall
  short
• Recognize the importance of control and risk
  personnel
• Maintain robust employee feedback mechanisms
• Supervise the means to an end
• Stay alert to diffusion of responsibility
• Dedicate resources to maintaining the value
  system
• Never ignore negative or bad news
• Develop plans for the unexpected

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Ten Questions Every Board Member Should Ask
Fortune Magazine, October 27, 2003
1. How does the company make money ?2. Are our
customers paying up ?3. What could really hurt,
or kill the company in the next few years ?4.
How are we doing relative to our competitors ?5.
If the CEO were hit by a bus tomorrow, who could
run this company ?6. How are we going to grow
?7. Are we living within our means ?8. How much
does the CEO get paid ?9. How does bad news get
to the top ?10. Do I understand the answers to
questions 1 through 9 ?
Even more critical than asking the questions
above is the process of questioning and
interacting with the company's management.
Concludes Fortune R Charan J Schlosser
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Sherron Watkins and Company
Practical Safeguards follow the Keep It
Simple rules

• Rule no. 1 is never waive your code of conduct
• Separate Chairman and CEO roles is critical
• Board of directors must actively
  develop/cultivate relationship with
• Internal audit
• Legal
• Risk Management
• Outside auditors
• Leaders must actively adopt governance best
  practices
• Diligence and attention to a certain protocol are
  critical to prevent a slow creep towards an
  Enron-like board situation
• Preventive maintenance is preferable to crisis
  management
• Remember that success and familiarity breed
  complaint, lax behaviors
• Anonymous employee hotlines are critical
• Recognize that control and risk personnel will
  prevent problems that will never be quantified
  Risk group needs autonomy and equal power

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Sherron Watkins and Company
What happened at Enron?

• We do not err because truth is difficult to
  see. It is visible at a glance. We err because
  this is more comfortable.
  Alexander Solzhenitsyn
• The safeguards and solutions are simple but
  theyre not easy or pain free. It takes
  conviction and discipline.

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Sherron Watkins and Company

• Conclusion All you need is love (and courage)
• When leaders love the organization, self
  interest is in last place
• Care and respect for employees breed loyalty and
  ownership
• Workplace enjoyment and pride will safeguard
  assets
• Listening skills generate revenue ideas and
  prevent problems
• Be courageous when confronted with unethical
  behavior

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• Question period

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Sherron Watkins and Company
Moral Hazard People Doing Bad ThingsThe
Economics of CorruptionYale University, 1970
Likelihood of being
Urgency of Reward Successful
Need/Greed Penalty, Likelihood of ,
Personal Being Caught Moral
Ethic Component A Component B
Component C Risk/Reward
Probability of Personal
Success
Inclination
MH f
Source Platts Energy Business and Technology,
July/August 2003, by Dunham L. Cobb, entitled
Moral Hazard The Assassin Lurking Within Energy
Trading Organizations.