What

1
Whats the source?

• Under the right circumstances, a producer could
  make more money with a flop than he could with a
  hit--
• Its simply a matter of creative accounting

2

• Top Ten Signs Your Olympic Event Is Fixed- Event
  judge by former Enron CEO Kenneth Lay
• Top Ten Super Bowl Moments-Drunk, desperate
  deposed Enron CEO Kenneth Lay steals
  commemorative coin used in opening toss
• Top Ten Features Of The New Elvis Theme
  Resort-The opportunity to take part in the worst
  financial scheme since Enron
• Top Ten Things Overheard at Martha Stewart's
  Thanksgiving Dinner-Let's give thanks that we
  live in a country where vast wealth still has a
  good shot at keeping you out of prison"
• -"A meal like that is worth a dozen cartons of
  cigarettes"

3
(No Transcript)
4
Companies Under Investigation

• Aldelphia
• Arthur Andersen
• AOL
• Bristol Myers Squibb
• Computer Associates International
• Deloitte Touche
• Enron
• Ernst Young
• Global Crossing

5
Investigation contd

• Halliburton
• Imclone
• Kmart
• KPMG
• Peregrine
• PricewaterhouseCoopers
• Qwest
• Tyco
• Worldcom Inc.
• Xerox

6
Why so many financial statement frauds all of a
sudden?

• Good economy was masking many problems
• Ethical ambiguity in corporate culture
• 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"
7
Good Economy Masked Problems

• With increasing stock prices, increasing profits
  and increasing wealth for everyone, no one
  worried about potential problems.
• How to value a dot.com company
• Take their loss for the year
• Multiply the result by negative 1 to make it
  positive
• Multiply that number by at least 100
• If stock price is less than the resultbuy if
  not, buy anyway
• People were making nonsensical investment
  decisions

8
Corporate Ethics

• Attendees at the April, 1998 Business Week Forum
  of Chief Financial Officers
• 67 of CFOs said they had fought off other
  executives requests to misrepresent corporate
  results
• 12 of CFOs admitted they had yielded to the
  requests while 55 said they had fought off
  requests to misrepresent corporate results
• Honesty studies
• People are becoming less honest
• Less modeling and labeling

9
Ethical ProblemsThe Transformation of Andersen

• Leonard Spacek and the DuPont
• Compare to Waste Management decision

10
Executive Incentives

• Meeting Wall Streets Expectations
• Stock prices are tied to meeting Wall Streets
  earnings forecasts
• Focus is on short-term (quarterly) performance
  only
• Companies are heavily punished for not meeting
  forecasts
• Executives have been endowed with hundreds of
  millions of dollars worth of stock optionsfar
  exceeds salary-based compensation (tied to stock
  price)
• Bernie Ebbers (WorldCom)
• 1997 Compensation--935,000 per year
• 1997 Stock options1.2 million shares at 26 per
  sharestock went to 64.50 (46.2 million in
  profit)
• Performance is based on earnings stock price

11
High Amounts of Debt Leverage

• During 2000, Enrons derivates-related
  liabilities increased from 1.8 billion to 10.5
  billion
• Enron hid billions in off-balance sheet (SPE)
  debt
• Enrons on-balance sheet debt was huge
• WorldCom had nearly 100 billion in debt
• Not only did Bernie Ebbers borrow 100 billion
  for WorldCom but he also racked up over 1.3
  billion in personal debt while CEO of WorldCom
• Every company that committed financial statement
  fraud had huge amounts of debt

186 public companies with 368 billion in debt
filed for bankruptcy in 2002includes WorldCom,
Conseco, Global Crossing, United Airlines
12
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 makes rules for every
  situation

13
Auditorsthe CPAs

• Failed to accept responsibility for fraud
  detection (SEC, Supreme Court, public expects
  them to detect fraud) If auditors arent the
  watchdogs, then who is?
• Became greedy--500,000 per year per partner
  compensation wasnt enough saw everyone else
  getting rich (Andersens partners were jealous of
  Accenture partners income)
• Audit became a loss leader
• Easier to sell lucrative consulting services from
  the inside
• Became largest consulting firms in the U.S. very
  quickly (Andersen Consulting grew to compete with
  Accenture)
• A few auditors got too close to their clients
• Entire industry, especially Arthur Andersen, was
  punished for actions of a few

14
Accounting Regulation

• Early 20th century economic growth also gave rise
  to rise in business scandals
• International Match debacle resulted in mandatory
  audits for all companies with listed securities.
• Securities Act of 1934 created SEC

15
The Securities and Exchange Commission
(www.sec.gov)

• Independent, nonpartisan regulatory agency
• Chair and four additional commissioners appointed
  by President to 5 year terms (staggered)
• Polices federal securities laws
• Does not assess the quality of the securities
  offered.

16
Insider Trading

• Trading done by a person with access to key
  non-public information.
• Imclone - Sam Waksal
• Sams friend Martha Stewart

17
SEC Open Case

• 6/6 Board member (also audit committee member)
  receives co flash report predicting 2nd qtr
  losses of 4M
• 6/11 attends meeting where AA warns of a
  potentially significant loss (gt4M)
• 6/22 sells 212,140/317,152 shares for 848,560
• 7/10 deadline for filing SEC Form 4 (filed 8
  mths later)
• 8/20 co announces loss of over 23 M
• 12/31 price continually drops to 1

18
PCAOB Public Company Accounting Oversight Board

• Created by SOX
• Private sector organization subject to SEC
  oversight
• Responsible for all auditing, attestation,
  quality control, ethics and independence
  standards applicable to registered public
  accounting firms.
• Became the authoritative body for auditing
  standards, taking that responsibility away from
  the AICPA and the profession.

19
Rise of Corporate Cops

• Pat Gnazzo
• Window Dressing?
• Do they have too much power?

20
Lets examine a few

• Tyco
• WorldCom
• Health South
• Enron

21
Tyco - Operations

• 100 countries and revenues in excess of 36
  billion.
• Four key businesses Fire and security,
  Electrical and electronic components, Healthcare,
  and Financial services.
• CEO Dennis Kozlowski and former CFO Mark H.
  Swartz were the main players in the fraud

22

• May 28, 2001

23

• December 23, 2002

24
(No Transcript)
25
What happened?

• Poster Boy of corporate excess and greed
• Chisels NYC out of 1 million in Sales tax due on
  fine art (he was worth 500 million at the time)
• Hit with 38 felony counts for pilfering 170
  million directly from the company and for
  pocketing an additional 430 million through
  tainted sales of stock

26
Bending the numbers

• Loading up on Goodwill
• Purchasing Accounting Liabilities
• Immaterial Acquisitions and Plenty of Them!

27
Tax Tricks

• Moved Offshore
• Set Up a Finance Subsidiary
• Set Up over 100 Subsidiaries

28
The Trial

• Coercive letter to juror prompts the judge to
  end the first 6-month trial
• Dennis Kozlowski and Mark Swartz were convicted
  last June on 22 of 23 counts of grand larceny,
  conspiracy, securities fraud and falsifying
  business records. Sentenced to 8-25 years in
  state prison

29
World Com

• Largest corporate fraud in US history
• Bernard Ebbers, former CEO, convicted on
  conspiracy, securities fraud and filing false
  statements to regulators in an 11 billion
  accounting fraud (the biggest in history).
• Sentenced to 25 years in prison
• Fraud led to the largest corporate bankruptcy in
  history in 2002

30
The Trial

• Prosecutors have secured guilty pleas from five
  of his underlings, including his former CFO Scott
  Sullivan
• Under pressure to meet analysts expectations
• Equity shareholders received 250 million in
  stock when Enron emerged from bankruptcy

31
The Fraud

• http//www.aicpa.org/download/antifraud/121.ppt

32
HealthSouth

• From 1996-2003 HealthSouths value was inflated
  by more than 2.7 billion through an accounting
  fraud at the company.
• Fifteen former HealthSouth executives, including
  5 of the comppanys FOs, pleaded guilty to
  criminal charges in connection with the fraud.
• Scrushy was acquitted last June by a jury in
  Birmingham of all 36 federal criminal charges
  that he took part in the fraud.

33
HealthSouth

• Judge ordered Scrushy to repay HealthSouth more
  than 47.8 in bonuses
• HealthSouth rejected demands from Scrushy for
  more than 100 million in severance pay and
  bonuses. He is suing.
• Scrushy paid a writer 10,000 to produce several
  favorable articles for an AL newspaper that he
  reviewed before publication during his fraud
  trail.

34
Public Relations

• Scrushy son-in-law acquired a cable TV station in
  Bham while on trial and broadcasted a daily
  update along with Viewpoint program with wife
• Son-in-law acquired another TV station in
  Montgomery weeks before Scrushy was to appear
  before Federal court on charges of bribing a
  former governor of AL.

35
Whats to come?

• Civil case filed by SEC is set for trial in April
  2007.
• Bribery trial is scheduled later this year.

36
Enron

• So many players

37
Enron Fraud

• Compared to other financial statement frauds,
  Enron was a very complicated fraud.
• What we are looking at here is an example of
  superbly complex financial reports. They didnt
  have to lie. All they had to do was to obfuscate
  it with sheer complexityalthough they probably
  lied too.
• Senator John Dingell

38
Enrons History

• 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.
• Kenneth Lay, CEO, hired McKinsey Company to
  assist in developing business strategy. They
  assigned a young consultant named Jeffrey
  Skilling.
• Feb. 2001-- Fortune magazine names Enron The
  Most Innovative Company in America -- company
  was worth 60 billion
• Dec. 2001 Enron files the biggest bankruptcy in
  U.S. history (now exceeded by WorldCom)

39
Role Players

• Enron
• Kenneth Lay
• Founding and last CEO
• Jeff Skilling
• CEO from 2/2001 to 8/2001
• Andrew Fastow
• CFO
• Michael Kopper
• Assistant to Fastow

• Andersen
• David Duncan
• Audit Partner
• Michael Odom
• Risk Mgt Partner
• Nancy Temple
• Firm Attorney

40
Enrons Strategy

• Created Energy derivative
• 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.
• 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

41
Enrons Corporate Strategy

• Enrons core business was losing moneyshifted
  its focus from bricks-and-mortar energy business
  to trading of derivatives (most derivatives
  profits were more imagined than real with many
  employees lying and misstating systematically
  their profits and losses in order to make their
  trading businesses appear less volatile than they
  were)
• During 2000, Enrons derivatives-related assets
  increased from 2.2 billion to 12 billion and
  derivates-related liabilities increased from 1.8
  billion to 10.5 billion

42
Enrons Changing Business
Total Revenues Total Revenues Total Revenues Total Revenues
Transportation and Distribution Wholesale Services Retail Energy Services
1998 1,849B 27,725B 1,072B
1999 2,032B 36,287B 1,807B
2000 2,955B 94,906B 4,615B
43
Enrons Changing Business
44
The Motivation

• Enron delivered smoothly growing earnings (but
  not cash flows.)
• It was all about the price of the stock.
• In its last 5 years, Enron reported 20 straight
  quarters of increasing income.
• Enron, that had once made its money from hard
  assets like pipelines, generated more than 80 of
  its earnings from a vaguer business known as
  wholesale energy operations and services.

45
Aggressive Nature of Enron

• Because Enron believed it was leading a
  revolution, it pushed the rules.
• Employees attempted to crush not just outsiders
  but each other.

Enron took more risk than othersit swung
for the fences.
46
Enrons Arrogance

• Enrons banner in lobby Changed from The
  Worlds Leading Energy Company to THE WORLDS
  LEADING COMPANY
• Older, stodgier companies will topple over from
  their own weight Skilling
• Conference of Utility Executives in 2000 Were
  going to eat your lunch.Jeff Skilling

47
Value at Risk (VAR) Methodology

• Investors didnt know how much risk Enron was
  taking
• Enron had over 5,000 weather derivatives deals
  valued at over 4.5 billioncouldnt be valued
  without professional judgment
• In 2000 annual report In 2000, the value at risk
  model utilized for equity trading market risk was
  refined to more closely correlate with the
  valuation methodologies used for merchant
  activities.
• Enrons statement that it would refine its own
  models should have raised concerns

48
Special Purpose Entities (SPEs) (Enrons
principal method of financial statement fraud
involved the use of SPEs (Special Purpose
Entities))

• Originally had a good business purpose
• Investors wanted risk and reward exposure limited
  to the pipeline, not overall risks and rewards of
  the associated company
• SPE limited by its charter to those permitted
  activities only
• Really a joint venture between sponsoring company
  and a group of outside investors
• Cash flows from the SPE operations are used to
  pay investors

49
Enrons Use of Special Purpose Entities (SPEs)

• To hide bad investments and poor-performing
  assets
• Earnings
• Quick execution of related-party transactions at
  desired prices.
• To report over 1 billion of false income
• To hide debt
• 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

50
LJM1 SPE

• One Enron Example (the Rhythms transaction)
• Enron held Internet stock in company called
  Rhythms NetConnections
• Stock was restricted
• Enron didnt want exposure to risk of a price
  drop
• The solution was simple! A hedge
• No one to do the deal
• Another simple solution! Start a company (a
  Special Purpose Entity or SPE) to take the other
  side of the transaction (Enron called it LJM1)
• Where did the financing come from?
• 97 from bank loan ? Guaranteed with Enron stock
• 3 from entity other than Enron ?Andrew Fastow
  and others!

51

• Where did the financing come from?
• 97 from bank loan ? Guaranteed with Enron stock
• 3 from entity other than Enron ?Andrew Fastow
  and others!
• Enron gave 168 million in Enron shares to LJM1
  (LJM1s primary asset)
• LJM1 gave Enron a note for 64 million and a put
  option valued at 104 million
• When everything settled out, Fastow received
  15 million for his 1 million investment
• Enron got to hedge (i.e., not report) a 103
  million market loss on its stock investment

52
Fastows Explanation of Partnerships (SPEs)

• The partnerships were used for unbundling and
  reassembling the various components of a
  contract. We strip out price risk, we strip out
  interest rate risk, he said. Whats left may
  not be something that we want.
• The obvious question is Why would anyone want
  whatever was left?

53
The Unwinding of Enron--Notable Events

• Jeff Skilling left in Augustgave no reason for
  his departure.
• By mid-August 2001, the stock price began falling
• Former CEO, Kenneth Lay, came back in August
• Oct. 16announced 618 million loss but not that
  it had written down equity by 1.2 billion
• OctoberMoodys downgraded Enrons debt
• Nov. 8Told investors they were restating
  earnings for the past 4 and ¾ years
• Dec. 2Filed bankruptcy

54
Clue 1 Warnings about Enron

• In early 2001, Jim Chanos, who runs Kynikos
  Associates, a highly regarded firm specializing
  in short selling said publicly that no one could
  explain how Enron actually made money. He noted
  that Enron had completed transactions with
  related parties that were run by a senior
  officer of Enron and assumed it was a conflict
  of interest. (Enron wouldnt answer questions
  about LJM and other partnerships.)

55
Clue 2 Fortune ArticleMarch 5, 2001

• To skeptics, the lack of clarity raises a red
  flag about Enrons pricey stockthe inability to
  get behind the numbers combined with ever higher
  expectations for the company may increase the
  chance of a nasty surprise. Enron is an
  earnings-at-risk story
• At the least, these sorts of hard-to-predict
  earnings are usually assigned a lower
  multiple...In 1999 its cash flow from operations
  fell from 1.6 billion the previous year to 1.2
  billion. In the first nine months of 2000, the
  company generated just 100 million in cash. (In
  fact, cash flow would have been negative if not
  for the 410 million in tax breaks it received
  from employees exercising their options.

56
Clue 3 Executives Abandon Enron

• Rebecca Mark-Jusbasche, formerly CEO of Azurix,
  Enrons troubled water-services company left in
  August, 2000
• Joseph Sutton, Vice Chairman of Enron, left in
  November, 2000.
• Jay Clifford Baxter, Vice Chairman of Enron
  committed suicide in May, 2001
• Thomas White, Jr., Vice Chairman, left in May,
  2001.
• Lou Pai, Chairman of Enron Accelerator, departed
  in May 2001.
• Kenneth Rice, CEO of Enrons Broadband services,
  departed in August 2001.
• Jeffrey Skilling, Enron CEO, left on August 14,
  2001

57
Clue 4 Enrons Cash Flows

• Enrons cash flows bore little relationship to
  earnings (a lot due to mark to market.) On
  balance sheet debt climbed from 3.5 billion in
  1996 to 13 billion in 2001.
• Key Ratio
• Net Income (from Operations) Cash Flow (from
  Operations) Net
  Income (from Operations)
• Would expect to be about zero or slightly
  negative over time

From the Income Statement From the Statement
of Cash Flows
58
Enrons Cash Flow Ratio
Negative Cash Flows 1st three quarters in 1999,
1st three quarters in 2000, 1st two
quarters in 2001.
59
Statement of Cash Flows
1996 1995 1994
Net Income 584 520 453
Net Cash Provided by Used in) Operating Activities 1040 (15) 460
60
Enrons Earnings Picture
(in millions) 1996 1995 1994
Total Rev 13,289 9,189 8,987
Operating Rev 690 618 716
Net Income 584 520 453
61
AR relative to the ADA
(in millions) 1996 1995
Trade Receivables (net of allowance for doubtful accts of 6 and 12) 1,841 1,116
62
Role of Andersen

• Was paid 52 million in 2000, the majority of
  which was for non-audit related consulting
  services.
• Enron was Andersens second largest client
• Did both external and internal audits
• CFOs and controllers were former Andersen
  executives

63
Andersen Shredding
Email message about Document Policy To Michael
C. Odom Date 10/12/2001 1053 a.m. From Nancy
A. Temple Subject Document retention
policy Mike- It might be useful to consider
reminding the engagement team of our
documentation and retention policy. It will be
helpful to make sure that we have complied with
the policy. Let me know if you have any
questions. Nancy
64
The Cost of Bad Press
65
Role of Investment Commercial Banks

• Companies like JP Morgan Chase made millions in
  loan interest and fees but hundreds of millions
  in investment banking business
• Enron paid several hundred million in fees,
  including fees for derivatives transactions.
• None of these firms alerted investors about
  derivatives problems at Enron.
• In October, 2001, 16 of 17 security analysts
  covering Enron still rated it a strong buy or
  buy.
• Example .One investment advisor purchased
  7,583,900 shares of Enron for the a state
  retirement fund, much of it in September and
  October, 2001

66
Where was Wall Street?

• 1. Few analysts did their homework.
• 2. Some Wall Street companies cashed in
  (million!) on LJM2 (names like Goldman Sachs,
  Merrill Lynch, etc.

67
Role of Law Firms

• Enrons outside law firm was paid substantial
  fees and had previously employed Enrons general
  counsel
• Failed to correct or disclose problems related to
  derivatives and special purpose entities
• Helped draft the legal documentation for the SPEs

68
Role of Credit Rating Agencies

• The three major credit rating agenciesMoodys,
  Standard Poors and Fitch/IBCAreceived
  substantial fees from Enron
• Just weeks prior to Enrons bankruptcy
  filingafter most of the negative news was out
  and Enrons stock was trading for 3 per
  shareall three agencies still gave investment
  grade ratings to Enrons debt.
• These firms enjoy protection from outside
  competition and liability under U.S. securities
  laws.
• Being rated as investment grade was necessary
  to make SPEs work

69
So Why Did Enron Happen?

• Individual and collective greedcompany, its
  employees, analysts, auditors, bankers, rating
  agencies and investorsdidnt want to believe the
  company looked too good to be true
• Atmosphere of market euphoria and corporate
  arrogance
• High risk deals that went sour
• Deceptive reporting practiceslack of
  transparency in reporting financial affairs
• Unduly aggressive earnings targets and management
  bonuses based on meeting targets
• Excessive interest in maintaining stock prices
• See NYTimes 2/5/06 Enrons Many Strands

70
Current Status

• Fraud and conspiracy trial of Lay and Skilling is
  reaching its halfway mark.
• Richard Causey pleaded guilty and will serve 7
  years
• Andrew Fastow pleaded guilty and will serve 10
  years.
• Lea Fastow completed a yearlong sentence on tax
  charge.

71
Sarbanes Oxley

• The Most Significant Financial Legislation in 70
  years
• Good policy or a politically-driven overreaction
  to the scandals that gave rise to it?
• 1974 The Foreign Corrupt Practices Act in
  response to revelations about bribery of foreign
  government officials

72
Four Themes

• Gatekeepers
• Protecting the Integrity of the Investigative
  Process
• Personal Accountability and Greater Deterrence at
  the Top
• Enhanced Financial Disclosures

73
The Gatekeepers

• Auditors established PCOAB
• Lawyers reporting duties
• Analysts conflict of interest rules
• Independent Directors particularly Audit
  Committee

74
Protecting the Integrity of the Investigative
Process

• Requires auditors maintain their workpapers for 5
  years
• Expressly probihits the destruction, alteration
  or concealment of documents
• Penalty of up to 20 years in prison
• PCAOB wants auditors to be whistle blowers

75
Personal Accountability and Greater Deterrence at
the Top

• Requires public company CEOs and CFOs to certify
  that the financial statements their companies
  issue are accurate.
• Impose greater sanctions on corporate officials
  who break the law
• Lowered the standard the SEC must meet in seeking
  officer and director bars

76
Enhanced Financial Disclosures

• Section 404 requires managements assessment of
  internal control over financial reporting, along
  with the related report of the independent
  auditor.
• PWC saw an increase in audit fees averaging 134
  thanks to Section 404
• Average cost of 5.8 billion

77
Will there be another Enron?

• No, nothing has really changed!
• Yes, Sarbanes Oxley will be an effective
  deterrent