Case file: Enron Corp. and Arthur Andersen LLP. Sources are linked at the end and in-line as [n]. Where something is described as proven, a court, regulator or official inquiry found it. Allegations are labelled and attributed. General information only, not financial advice.

In October 2001, according to the government’s case, people on Arthur Andersen’s Enron engagement in Houston were destroying documents. Not one folder. Box after box, and emails too [9].

Less than five years later, a jury in the same city convicted Enron’s former chief executive, Jeff Skilling, on nineteen counts. Five of them were for one specific thing: making false statements to auditors [1].

Two questions drive this case. How do you mislead an audit firm for years? And what happened to the firm that was supposed to catch it?

The story Enron told

Enron began as a pipeline company. Gas went in one end and came out the other: dull, steady, easy to audit. By the late 1990s it was telling Wall Street a different story, as a trader and market-maker for energy and later for things like broadband capacity.

Wall Street loved it. According to the Justice Department, Enron’s share price climbed from about $30 in early 1998 to more than $80 in January 2001 [1]. In the case against Ken Lay and Jeff Skilling, the DOJ described what sat behind that: a scheme to make Enron look as if it was growing at a healthy, predictable rate that matched analysts’ expectations, with no significant write-offs or debt, deserving an investment-grade credit rating [1].

Red flag 1: earnings smoother than the business. Real businesses are lumpy, and trading businesses especially so. When earnings land on target quarter after quarter in a volatile industry, that isn’t comforting. It’s a question.

Part of how those numbers were produced was mark-to-market accounting. Sign a fifteen-year energy contract and, instead of recording profit as you earn it year by year, you estimate what the whole contract is worth today and book much of that up front. That’s legitimate when a real market price exists. On long, unusual contracts with nothing comparable trading, the “market value” is a model, built by people whose bonuses depend on it.

Red flag 2: profit today, cash someday. You’re no longer checking a receipt. You’re testing a forecast fifteen years out. Nudge the assumption and the profit changes, while the cash may never arrive.

The hidden debt machine

If mark-to-market flattered the income statement, the balance sheet was the other problem. Enron needed a lot of money, and a lot of borrowing worries credit rating agencies.

Enter special purpose entities (SPEs): separate legal vehicles set up for one narrow job. They’re common and often legal. Under the rules of that era, if conditions were met, including a minimum slice of genuinely independent outside equity at risk, a company didn’t have to put the entity on its own balance sheet. Everything hangs on the word independent.

Some of Enron’s most important vehicles, the LJM partnerships, were run by its own chief financial officer, Andrew Fastow. In January 2004 Fastow pleaded guilty to two counts of conspiracy to commit securities and wire fraud and agreed to cooperate and forfeit millions [2]. In 2006 a federal judge in Houston sentenced him to six years in prison [3].

The SEC’s civil case against him went further. These are allegations. The SEC alleged Fastow used these entities to help Enron manipulate its reported results while enriching himself. It alleged he secretly profited from windfarm-related entities known as RADR, with about $2.7 million in alleged unlawful gains, and that in an LJM1-related deal nicknamed “Southampton”, Enron was told a bank needed $20 million when, according to the SEC, the bank was paid $1 million [4].

Red flag 3: the CFO sits on both sides of the deal. That’s a related party, near the top of every auditor’s risk list. Who really owns this entity? Whose money is at risk? If it goes bad, who absorbs the loss? If the honest answer is “Enron, one way or another”, it’s Enron’s debt, whatever the structure chart says.

The barges

One deal sounds less like a spreadsheet and more like a heist film. In late 1999 Enron owned an interest in power barges moored off Nigeria, and the quarter was ending.

The SEC alleged that Enron arranged to “sell” an interest in the barges to an investment bank so it could book about $12 million of 1999 earnings, while the bank was assured it would be taken out within months at a profit [4]. A sale moves the risks and rewards of ownership to the buyer. If the seller has promised a guaranteed exit, the risk never moved, and what you have is a loan dressed as a sale.

A careful distinction: prosecutors took the barge deal to a criminal trial and a jury convicted four Merrill Lynch bankers of conspiracy and wire fraud. In 2006 the Fifth Circuit threw out those convictions, finding the government’s fraud theory flawed, while keeping one banker’s separate perjury and obstruction convictions [12]. So the barges remain an SEC allegation here, used to explain a pattern auditors are trained to spot.

Red flag 4: a “sale” with a promise to buy it back.

Where an auditor looks

Step out of the story. On that audit, your instincts should have sent you to four places:

  1. Related parties. Management’s list is a starting point. Check board minutes, ownership filings, who signed what.
  2. Round trips. Money goes out, comes back, and leaves profit behind. Follow the cash. If no economic risk changed hands, the profit isn’t real.
  3. Year-end deals. Large, complex transactions signed in the last days of a quarter, with paperwork finished later. Timing tells you what the deal was for.
  4. Independence. Andersen didn’t only audit Enron. The Fifth Circuit described Enron as obtaining accounting, auditing and consulting services from Andersen, and as Andersen’s largest single account [9].

Red flag 5: a client too big to say no to.

And remember those five counts against Skilling for lying to auditors [1]. Auditors depend on what management tells them. Scepticism exists because that trust gets abused, and scepticism is hard to sustain when “no” could cost your firm its biggest client.

Collapse, and the shredding

On 16 October 2001, Enron reported a third-quarter loss after about $1 billion in after-tax charges [11]. On a call with analysts that day, not in the press release, Ken Lay said shareholders’ equity was being cut by $1.2 billion. Enron’s own board committee later tied that cut to dealings with LJM2 [13].

On 8 November, Enron told the SEC it would restate its financial statements back to 1997, saying three entities kept off the balance sheet, including one tied to LJM1, should have been consolidated [11]. On 2 December 2001, Enron and a group of subsidiaries filed for Chapter 11 in New York [7]. By the measure bankruptcy researchers use, about $63 billion in assets on its books, it was the largest US corporate bankruptcy at the time; WorldCom overtook it within a year [8].

In March 2002 prosecutors charged Arthur Andersen with a single count of obstruction of justice. The government said Andersen, to protect itself and its largest single account, ordered a mass destruction of documents to keep them from the SEC [9]. On 15 June 2002 a Houston jury convicted the firm [9]. By 31 August 2002 Andersen had stopped practising before the SEC and had given up or consented to revocation of its licences in every state [14].

The verdicts, and the reversals

On 25 May 2006 the jury in the Lay and Skilling trial returned its verdicts. Lay was convicted on all six counts he faced at that trial, and separately, at a bench trial, of bank fraud and false statements to banks. Skilling was convicted on 19 of 28 counts, including conspiracy, twelve counts of securities fraud, one of insider trading and five of false statements to auditors, and acquitted on nine insider-trading counts [1].

Lay died on 5 July 2006, before sentencing or appeal. Under the abatement doctrine, the judge vacated his conviction and dismissed the indictment in October 2006 [6]. That is not a finding of innocence; the law stopped the case because he could no longer appeal.

Skilling was sentenced to 292 months. After an appeals court found a sentencing error, he was resentenced in 2013 to 168 months, under an agreement that ended his appeals and released about $42 million for victims [5].

And Andersen? In May 2005 the US Supreme Court unanimously reversed its conviction because the jury instructions failed to properly convey what the government had to prove, in particular the required consciousness of wrongdoing [10]. The Court did not find Andersen innocent. But by then there was little left to save. Andersen won the case three years after it had lost its business.

What changed

Congress passed the Sarbanes-Oxley Act in 2002. Among other things it created an independent regulator for audit firms, limited the non-audit services auditors can sell to the companies they audit, and made chief executives and finance chiefs personally certify their financial statements [15].

But rules don’t do scepticism for you. Someone still has to look at a beautifully smooth earnings line and ask why it’s so smooth, and someone still has to say “no” to the biggest client in the building.

If you’d been on that audit team in 2001, what would you have done? Reply and tell us.

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Further reading

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Sources

  1. US DOJ, Lay & Skilling verdict (25 May 2006): https://www.justice.gov/archive/opa/pr/2006/May/06_crm_328.html
  2. US DOJ, Fastow guilty plea (14 Jan 2004): https://www.justice.gov/archive/opa/pr/2004/January/04_crm_019.htm
  3. US DOJ, Fastow sentenced (26 Sep 2006): https://www.justice.gov/archive/opa/pr/2006/September/06_crm_647.html
  4. SEC v. Andrew S. Fastow, complaint (allegations): https://www.sec.gov/litigation/complaints/comp17762.htm
  5. US DOJ, Skilling resentenced (21 Jun 2013), archived: https://web.archive.org/web/20250204060322/https://www.justice.gov/opa/pr/former-enron-ceo-jeffrey-skilling-resentenced-168-months-fraud-conspiracy-charges
  6. US v. Lay, order (S.D. Tex. 2006): https://www.justice.gov/sites/default/files/criminal-vns/legacy/2014/11/07/05-25-06lay.pdf
  7. Enron bankruptcy press release, 8-K ex. 99.1 (2 Dec 2001): https://www.sec.gov/Archives/edgar/data/1024401/000102440101500046/ex-99_1.txt
  8. BankruptcyData via CNBC, “Biggest Chapter 11 Cases” (secondary): https://www.cnbc.com/2009/11/02/Biggest-Chapter-11-Cases.html
  9. US v. Arthur Andersen LLP (5th Cir. 2004): https://www.ca5.uscourts.gov/opinions/pub/02/02-21200-CR0.wpd.pdf ; indictment (Mar 2002, allegations): https://www.justice.gov/archive/dag/cftf/chargingdocs/andersenllpindictment.pdf
  10. Arthur Andersen LLP v. United States, 544 U.S. 696 (2005): https://www.law.cornell.edu/supct/html/04-368.ZO.html
  11. Enron Q3 2001 earnings release: https://picker.uchicago.edu/Enron/EarningsRelease%2810-16-01%29.pdf ; Form 8-K (8 Nov 2001): https://www.sec.gov/Archives/edgar/data/1024401/000095012901503835/0000950129-01-503835.txt
  12. US v. Brown, 459 F.3d 509 (5th Cir. 2006): https://www.ca5.uscourts.gov/opinions/pub/05/05-20319-CR0.wpd.pdf
  13. Powers Report (1 Feb 2002): http://picker.uchicago.edu/Enron/PowersReport(2-2-02).pdf
  14. CRS Report RS21120 (3 Sep 2002): https://www2.law.umaryland.edu/marshall/crsreports/crsdocuments/RS21120_09032002.pdf
  15. Sarbanes-Oxley Act of 2002, Pub. L. 107-204: https://www.govinfo.gov/content/pkg/PLAW-107publ204/pdf/PLAW-107publ204.pdf

Opening scene is a reconstruction based on the government’s case. General information only, not financial advice.