Finance Lecture 9 Outline Lecture 9 Enron SarbanesOxley

Finance Lecture 9

Outline Lecture 9 • Enron • Sarbanes-Oxley Keating F&A 9 -2 Spring 2008

Enron Was An Energy Distribution Company • Started out as Northern Natural Gas Company, later Inter. North, merged with Houston Natural Gas, became Enron • Also involved with electricity transmission and distribution, water utilities, bandwidth • For many years, this was a “real” company that was legitimately innovative in creating tradable financial instruments Keating F&A 9 -3 Spring 2008

Dramatis Personae • Kenneth Lay (1942 -2006), founder, CEO of Enron - Convicted of ten counts of securities fraud - Died before sentencing • Jeffrey Skilling (1953 - ), COO, later CEO of Enron - Convicted of conspiracy, insider trading, securities fraud - Currently serving 24 -year prison sentence • Andrew Fastow (1961 - ), CFO of Enron - Pled guilty to wire and securities fraud - Currently serving 6 -year prison sentence • David Duncan (1960 - ), chief Arthur Andersen partner dealing with Enron - Pled guilty to obstruction of justice but later withdrew plea Keating F&A 9 -4 Spring 2008

Enron’s Problems Centered Around “Related-Party Transactions” • Fastow set up separate legal entities (with “Star Wars”derived names, e. g. , Jedi, Chewco) that absorbed Enron losses temporarily - Made Enron financial statements look artificially good - Fastow received large fees from these entities while simultaneously being employed by Enron • On a much smaller scale, Merrill Lynch employees were convicted of abetting Enron in a fraudulent Nigerian barge deal - For accounting purposes, Merrill Lynch bought the barges in 1999 from Enron - But Enron promised to repurchase them later at a profit to Merrill Lynch - Not a true sale Keating F&A 9 -5 Spring 2008

Enron Collapsed In Fall 2001 When Arrangements Were Revealed • Thousands of Enron employees lost their jobs, retirement savings - Don’t put retirement savings in your employer’s stock! • Lay blamed The Wall Street Journal, short sellers, September 11 attacks, … • There is no law, however, against being incompetent in business. Were crimes committed? Keating F&A 9 -6 Spring 2008

The Department Of Justice Had To Figure Out Whom To Prosecute And For What • Lay and Skilling claimed to be victims of Fastow - While the government felt Lay and Skilling were deeply involved in orchestrating Fastow’s related party transactions, Lay and Skilling were more narrowly charged with securities fraud, i. e. , making public statements they knew to be false • Fastow never went to trial but the government’s argument was that he engaged in a conspiracy to commit securities fraud, i. e. , help generate false Enron accounting statements - The government had extra leverage in that his wife Lea Fastow also worked in finance for Enron so they could threaten to send both parents to prison - There was an egregious conflict of interest in his being CFO of Enron and owner of “separate” financial entities that dealt with Enron Keating F&A 9 -7 Spring 2008

Arthur Andersen’s Role With Enron Remains Controversial To This Day • Andersen was Enron’s auditor while simultaneously making much more money providing consulting services to Enron - The Enron-Andersen case was not unique, either within Andersen or within the accounting industry, in cross-selling of accounting and consulting • The government indicted Andersen for obstruction of justice - October 19, 2001 “reminder” email about “routine document shredding” - Andersen’s clients fled en masse when legal troubles began - Andersen convicted of obstruction of justice in 2002 - In 2005, the U. S. Supreme Court overturned Andersen’s conviction on the grounds the judge’s jury instructions were overly broad • Moot in that Andersen ceased to exist by then Keating F&A 9 -8 Spring 2008

What Is The Appropriate Role Of An Accountant? • Andersen claimed it was a victim of fraud by Enron personnel and that they could only assume information provided them by Enron was valid • Many outsiders’ view is that an accountant’s role also includes unearthing fraud - If Andersen didn’t understand what was going on at Enron, who could? • Andersen’s problems with Enron gave rise to Sarbanes-Oxley, which we discuss next Keating F&A 9 -9 Spring 2008

Outline Lecture 9 • Enron • Sarbanes-Oxley Keating F&A 9 -10 Spring 2008

Sarbanes And Oxley Sponsored 2002 Accounting Reform Bill • Paul Sarbanes (1933 - ), Democratic U. S. Senator from Maryland, 1977 -2007 - Longest-serving U. S. Senator in Maryland’s history • Michael Oxley (1944 - ), Republican U. S. Congressional representative from Ohio, 19812007 Keating F&A 9 -11 Spring 2008

Sarbanes-Oxley Was Signed Into Law July 30, 2002 • “Public Company Accounting Reform and Investor Protection Act of 2002” • Approved by Senate 95 -0 and by House of Representatives 423 -3 - Nays: Collins (R, GA), Flake (R, AZ), Paul (R, TX) • “Most far-reaching reforms of American business practices since Franklin Roosevelt was president” – George W. Bush Keating F&A 9 -12 Spring 2008

Key Sections of Sarbanes-Oxley • 201 – Auditing companies cannot do other kinds of business apart from auditing with the same clients • 302 – Mandates internal procedures designed to ensure accurate financial disclosure • 404 – Requires management and an independent, external auditor to report on the adequacy of the company’s internal control over financial reporting Keating F&A 9 -13 Spring 2008

SOX Increases Criminal Penalties For Corporate Malfeasance • Title VIII – It is a felony to “knowingly” destroy or create documents to “impede, obstruct or influence” any existing or contemplated federal investigation • Title IX – Creates a crime for tampering with a record or otherwise impeding any official proceeding • Obviously, there is a big difference between a civil violation (with prospective finance penalties) and criminalizing violations Keating F&A 9 -14 Spring 2008

Subsequent To Its Enactment, Concerns Have Been Raised About SOX • Mandated procedures are overly burdensome for small businesses? - SOX compliance might be viewed as a fixed cost, so it is proportionally more expensive for smaller firms • International firms have chosen not to register securities in the US to avoid SOX? • More small firms being bought by private acquirers rather than by public ones? • Unleashing “batteries of lawyers across the country” generating a “huge preoccupation with the dangers and risks of making the slightest mistake” (William Donaldson, Chairman of Securities and Exchange Commission, 7 -30 -03)? Keating F&A 9 -15 Spring 2008

There May Be Advantages To SOX • Prevent, or at least more quickly reveal, some types of fraud? • Make corporate finances more accurate and transparent? - A “Seal of Approval” for good firms? - Discouraging some firms from listing in the US isn’t prima facie bad news • Note: Improved financial accounting from SOX does not necessarily imply better management accounting and, hence, decisionmaking Keating F&A 9 -16 Spring 2008

SOX’s Effect On Accounting Firms Has Been Ironic • Though Arthur Andersen’s alleged shortcomings with Enron (and other firms) were a catalyst, the law’s effect has been to increase demand for auditing services - SOX-induced demand offsets prohibition on other consulting by auditors - Few Andersen employees were unemployed for long! • The vast majority of auditing is now done by the “Big Four” - Deloitte Touche Tohmatsu - Ernst & Young - KPMG - Pricewaterhouse Coopers - Auditing is a reputation-centric business where entrance by new firms appears to be difficult Keating F&A 9 -17 Spring 2008

It Seems Reasonable To Suspect SOX’s Impacts, Positive And Negative, Will Diminish Over Time • Firms will “figure out” and standardize compliance procedures, reducing their cost • Malefactors will symmetrically figure out ways to behave badly despite SOX rules Keating F&A 9 -18 Spring 2008