The Enron accounting scandal (Part II)

Last week, we carried an article on the issue of conflict of interest with specific reference to the Enron accounting scandal. This scandal is considered the biggest audit failure in American history because of: (a) the cozy relationship that developed between the company’s auditors, Arthur Andersen, and the senior executives of Enron during the period of the company’s existence from 1985 to 2001; and (b) the serious conflict of interest that the auditors found themselves in whereby they were getting a bigger share of their income from Enron through the offer of consulting services while at the same time auditing the books of the company.

There was a second element of conflict of interest which we will discuss in this article. This relates to executive compensation. We will also examine the requirements of the Sarbanes-Oxley Act of 2002 which was enacted following the collapse of Enron.

 Enron’s executive compensation

A public company is usually judged by the performance of its shares in the stock market. If the company does well, investor confidence will be boosted and more persons and institutions will be encouraged to acquire shares in the company. Because there is a greater demand for the shares, the price will go up. Many companies have adopted a policy of rewarding senior executives with share bonuses and stock options, once agreed performance targets are met or are exceeded.

Accountability WatchWhile on the face of it, this policy is not considered bad, it has the potential of serious abuse if appropriate safeguards are not put in place to prevent such abuses. In the case of Enron, this was indeed the case as greed took centre stage. Therein, lies another serious conflict of interest – what is best for the company versus individual interest. For example, Enron’s board suspended Enron’s own code of conduct to permit the conflicts of interest inherent in off-books corporations controlled by Fastow, the former CEO. The relentless pursuit of profits at all costs was the overriding consideration, and the incentive to do so was there. In fact, there was a strong incentive to manipulate the accounts and hence financial reporting to boost Enron’s share price since this was the key performance target set by the company.

Enron paid its executives huge one-time bonuses as a reward for meeting a series of stock-price targets in 2000 at a time when the company’s profits were inflated by as much as one billion US dollars. This is in addition to other cash distributions.  In fact, just ten months before its collapse, amounts totalling US$320 million were paid out, and during the two years before the collapse, some 2,000 corporate executives received payments totaling US$432 million. One federal prosecutor suggested that “the level of compensation that we are talking about here would certainly seem to be a powerful incentive for anyone to do anything”.

Kenneth Lay, the Chairman and CEO received US$10.6 million during the period January–February 2001 while Fastow, who was largely responsible for hiding debts to bolster profits, received over US$3 million. The Chief Operations Officer, Jeffrey Skilling also received US$7.5 million during the same period.  In addition, by January 2001 Lay and Skilling had owned US$659 million and US$174 million worth of Enron’s shares respectively. There was also extravagant spending especially among the executives who were sometimes paid twice as much as their counterparts in other companies.  In fact, the top 200 highest-paid employees received salaries, bonuses and stock totalling US$193 million, and by 2000, the figure had jumped to US$1.4 billion. According to Kirk Hanson, Executive Director of the Markkula Center for Applied Ethics, the arrogance of corporate executives, who claimed that they were the best and the brightest, the most innovative and who represented themselves as superstars, should have been considered a red flag.

A third major conflict of interest arose when Sherron Watkins, vice president for corporate development,

alerted Lay about Enron’s accounting practices and warned that the company could be caught up in a wave of accounting scandals. Instead of seeking independent advice on the matter, Lay chose to consult with the company’s law firm, Vinson & Elkins. This was despite a warning from Watkins that such an action would constitute a conflict of interest. As expected, the law firm saw nothing wrong with Enron’s accounting practices, as Arthur Andersen had approved of such practices.

Investigative journalism mainly from Wall Street and Fortune Magazine analysts started to raise serious questions about the dramatic rise over the years in Enron’s share price. That price had reached as high as US$90 before plummeting within one year to less than US$1, causing shareholders to lose US$11 billion. In addition, more than 5,000 jobs and US$1 billion in employee retirement funds were wiped out.

Consequences of the scandal

Given the concerns expressed about the strong possibility that Enron was inflating its performance to boost its share price, the Securities and Exchange Commission (SEC) mounted an investigation into the operations of the company. Later, Lay and Skilling were charged with for fraud and conspiracy and were convicted in 2006.  The latter is currently in jail while the former died from a heart attack while awaiting sentencing. The government claimed that Lay derived more than US$95 million in criminal proceeds from trading Enron’s stock, manipulated the company’s line of credit and received an incentive bonus as the company was spiraling into insolvency. In addition, he paid off his Houston mortgage with multi-million dollar payments from criminal proceeds less than a week after Enron’s bankruptcy, and in early 2001 Lay had owned marketable securities of US$339 million.

As regards Arthur Andersen, after it was announced that the SEC would mount an investigation, the auditors began to shred tons of documents relating to the audit and deleted some 30,000 e-mails from its computer files. In October 2001, the Powers Company appointed by Enron’s board found that the auditors had not fulfilled their professional responsibilities in relation to the company’s audit and in bringing to the attention of Enron’s board and/or its audit committee concerns about internal contracts over related-party transactions. In January 2002, Enron dismissed Andersen, citing its accounting advice and destruction of documents as the main reasons for doing so. In June 2002, the auditors were convicted of obstruction of justice for shredding documents relating to the audit of Enron. In August 2002, the firm surrendered its licences to practice as Certified Public Accountants in the United States, as most of its clients had already abandoned it. In May 2005, the Supreme Court overturned the court ruling of June 2002.

 Sarbanes-Oxley Act of 2002

Around the same time that the Enron scandal broke out, a number of other companies found themselves in a situation similar to that of Enron, including Tyco International, Adelphia, Peregrine Systems and WorldCom. These scandals prompted the United States Government to enact the Sarbanes-Oxley (SOX) Act of 2002. The key requirements of SOX are as follows:

Creation of the Public Company Accounting Oversight Board (PCAOB): The SEC created the PCAOB with responsibility for: (a) providing independent oversight of public accounting firms providing auditing services; (b) registering auditors; (c) defining the specific processes and procedures for compliance audits; (d) inspecting and policing conduct and quality control; and (e) enforcing compliance with the specific mandates of SOX. Additional resources were provided to the SEC to enable it to discharge its enhanced mandate.

Enhanced standards for auditor independence: The Act establishes standards for external auditor independence to limit conflicts of interest.  In addition, it addresses new auditor approval requirements, audit partner rotation and auditor reporting requirements. The Act also restricts auditing firms from providing non-audit services for the same clients.

Corporate social responsibility: Senior executives are required to take individual responsibility for the accuracy and completeness of corporate financial reports. The Act defines the interactions of external auditors and audit committees, limits the behaviour of corporate officers and provides for specific forfeitures of benefits and civil penalties for non-compliance. In particular, principal officers are required to certify and approve the integrity of quarterly financial reports.

Financial disclosure requirements: The Act provides for enhanced reporting requirements for financial transactions, including off-balance sheet transactions, and detailed information on stock transactions of corporate officers. In addition, adequate internal controls are to be in place for ensuring the accuracy of financial reporting and disclosures, and these are subject to certification by the responsible officers, audit by the external auditors and reporting on their adequacy. The Act also requires the timely reporting of material changes of the financial position of the company and enhanced reviews by the SEC or its agents.

Securities analysts’ conflicts of interest: Securities analysts make, buy and sell recommendations on company stocks and bonds and therefore these activities provide opportunities for conflicts. The Act provides for measures to restore investor confidence in the reporting of securities analysts, including codes of conduct and disclosure of knowable conflicts of interest.

At the time of signing the bill into law, Former US President George Bush stated that: (a) SOX is the most far-reaching reforms of American business practices since the time of Franklin D Roosevelt; (b) the era of low standards and false profits is over; and (c) no boardroom in America is above the law. SOX-type laws have since been enacted in Japan, Germany, France, Italy, Australia, Israel, India, South Africa and Turkey.

Next week, we will look at the WorldCom accounting scandal which was larger than that of Enron.