l. The probability of discoveryis low enough and the estimated damage too great; there- fore we find a way to quietly and quickly reverse, unwind, write down these posi- tions/transactions.

2. The probability of discovery is too great, the estimated damages to the company too great; therefore, we must quantify, de- velop damage containment plans and disclose.

I firmly believe that the probability of discovery significantly increased with Skilling's shocking departure. Too many people are looking for a smoking gun .... There is a veil of secrecy around LJM and Raptor. Employees question our accounting propriety consistently and con- stantly. This alone is cause for concern .... I have heard one manager-level employee from the principal investments group say, "I know it would be devastating to all of us, but I wish we would get caught. We're such a crooked

" 1company....

Another group of Enron insiders who were in position and had a responsibility to protect investors from fraud was Enron's Board of Directors, and particularly the Board's audit committee. In theory and in law, the board's primary responsibility is to represent the interests of shareholders. In practice, the board seemed less than vigilant in fulfilling these responsibilities. Enron's board approved of Andrew Fastow's violation ofthe corporate conflicts of interest prohibi- tion when he negotiated contracts between Enron and the SPEs in which he was heavily invested and from which he profited tremen- dously. As Benjamin Neuhausen, one of An- dersen's Enron accountants, claimed, the "idea of a venture en ti ty managed by CFO is terrible from a business point of view. Con- flicts of interest galore. Why would any direc- tor in his or her right mind ever approve such a scheme?"

The final line of defense against corporate fraud should be government officials and reg- ulators. Arthur Levitt, chairman of the SEC throughout the 1990s, strongly criticized the

Ethical Issues in Finance and Accounting 413

dual auditing and consulting activities of the big accounting firms as involving conflicts of interest. Congress ignored his advice, appar- ently convinced by the lobbying efforts of the accounting profession to allow audit firms to continue working as consultants to the firms they audited.

The federal government was also actively dismantling a wide range of financial regu- latory protections during the 1990s. During the first Bush Administration, the federal government deregulated the energy indus- try, ostensibly to spur economic growth ac- cording to free market principles. One of the leading advocates for this deregulation was Wendy Gramm, who at the time was chairwoman of the U.S. Commodity Futures Trading Commission. Gramm's husband is Phil Gramm, then U.S. Senator from Texas and a member of the Senate banking, fi- nance, and budget committees that sup- ported this deregulation. Senator Gramm had received over $100,000 in campaign con- tributions from Enron during his last two Sen- ate campaigns. When Wendy Gramm left government in 1992, she joined Enron's Board of Directors as a member of their audit committee.

Questions

1. What responsibilities did DavidDuncan owe to Arthur Andersen? To Enrori's manage- ment? To Enron's stockholders? To the ac- counting profession?

2. What are the ethical responsibilities of a cor- porate attorney, such as Nancy Temple, who works for an "aggressive" client wishing to push the envelope oflegality?

3. Under what conditions should an employee such as Sherron Watkins blow the whistle to outside authorities? To whom did she owe loyalty?

4. Towhom does me board of directorsowetheir primary responsibility?Can you mink of any lawor regulations that would help ensure mat boards meet their primary responsibilities?

414 Ethical Issues in Finance and Accounting

5. What responsibilities do government regula- tors owe to business? To the market? To the general public?

6. Are accounting and law professions or.busi- nesses? What is the difference?

NOTES

1. From a report released by the U.S. House of Representatives Energy Committee, February 2002.

.as held regarding the related party transac- ions with LJM" (one of Enron's Special Pur- pose Entities). Apparently, several Andersen auditors thought that LJM costs should not be ept off of Enrorr's books. Jones goes on to

say, "The discussion focused on Fastow's con- .cts of in terest in his capacity as CFO and the

:"JM manager, the amount of earnings that Fastow receives for his services and participa- tion in LJM, the disclosures of the transaction in the financial footnotes, and Enrori's BOD's ~oard of Directors] viewsregarding the trans- actions." Enron's activities were described as "intelligent gambling," and Andersen's audi- ors acknowledged "Enrori's reliance on its current credit rating to maintain itself," its "de- pendence" on a supporting audit to meet its fi- nancial objectives, and "the fact that Enron often is creating industries and markets and transactions for which there are no specific rules [and therefore] which requires signifi- cant judgment." Enron was also described as "aggressive" in the way it structured its finan- cial statements.

But the risks of Enron were not the only is- sues discussed at that meeting. Andersen's au- ditors realized that Andersen was also doing significant consulting business with Enron, business that could be jeopardized by an un- favorable audit. "We discussed whether there vould be a perceived independence issue solely considering our level of fees. We dis- cussed that the concerns should not be on the magnitude of the fees but in the nature of the fees. We discussed that it would not be unforeseeable that fees could reach $100 million per year. Such amounts did not trou- ble the participants as long as the- nature of me services was not an issue." In the end, Andersen decided that the risks were worth laking. "Ultimately the conclusion was reached to retain Enron as a client citing that it ap- peared that we had the appropriate people and processes in place to serve Enron and manage our risks."

Ethical Issues in Finance and Accounting 411

Less than a year later, Enrori's third-quarter financial report would reflect Andersen's new and different judgment concerning the SPEs. On October 16,Enron reported a quarterly loss of$618 million and announced mat as a result of Andersen's auditing decisions, they would take a $1.2 billion reduction in shareholder eq- uity.Within one week, the SEC announced that it had opened an investigation into Enron's ac- counting practices. By the end of October, Enron's stock was trading atjust $10 per share, an almost a 90% drop in 18 months.

It is fair to say that Andersen overestimated their ability to manage the risks of Enron. Several decisions made by Andersen's profes- sional staff during October proved to be dis- astrous for the company. On October 12, as Andersen prepared for the public release of the new financial statements, Andersen attor- ney Nancy Temple advised head auditor David Duncan to get "in compliance" with Andersen's document retention policy. Be- cause Andersen's document retention policy included directions to destroy documents that were no longer needed, Duncan inter- preted that advice to mean that he should have Enron-related documents destroyed. Duncan then instructed Andersen employ- ees to shred Enron documents. Duncan has acknowledged that he and others at Andersen were aware of a possible SEC investigation at me time.

Four days later, on October 16, Duncan shared a draft of a press release on Enron with Temple. In her role as Andersen attor- ney, Temple advised changing the press re- lease to delete some language that might suggest that Andersen's audit was not in com- pliance with Generally Accepted Accounting Principles (GAAP), as well as certain refer- ences to discussions within Andersen's legal group concerning Enron. Temple concluded her e-mail by promising to "consult further within the legal group as to whether we should do anything more to protect ourselves

412 Ethical Issues in Finance and Accounting

from potential Section 10 issues" (Section 10 refers to SEC rules that require auditors to report illicit client activity). In early Novem- ber, two weeks after they began shredding documents, Andersen received a federal sub- poena for documents related to Enron. Only at this point did Temple advise Andersen to write a memo advising auditors at Andersen to "keep everything, do not destroy anything." By the end of November, the SEC investiga- tion was officially expanded to include Arthur Andersen.

At one time, Sherron Watkins was an Arthur Andersen auditor who worked on the Enron account. In 1993, she left Andersen to join Enron, working for Andrew Fastow in Enron's finance, international, broadband, and finally, its corporate development divi- sion. Thus, for 18 years she participated in a wide range of Enron's business activities. In August 2001, shortly after Jeffrey Skilling re- signed as Enron's CEO, she wrote a memo to Kenneth Lay.Watkins became widely known as the Enron whistle-blower as a result ofthis memo, despite the fact that she had not ex- pressed concerns earlier and she did not share her concerns with anyone outside of the company. In part, her memo to Lay reads as follows:

Has Enron become a risky place to work? For those of us who didn't get rich over the last few years, can we afford to stay?

Skilling's abrupt departure will raise suspi- cions of accounting improprieties and valuation issues. Enron has been very aggressive in its accounting-most notably the Raptor transac- tions and the Condor vehicle. We do have valu- ation issues with our international assets and possibly some of our EES MTM positions.

The spotlight will be on us, the market just can't accept that Skilling is leaving his dream job. I think that the valuation issues can be fixed and reported with other good willwrite-downs to occur in 2002. How do we fix the Raptor and Condor deals? They unwind in 2002 and 2003, we will have to pony up Enron stock and that won't go unnoticed ....

It sure looks to the layman on the street that we are hiding losses in a related company and will compensate that company with Enron stock in the future. I am incredibly nervous that we will implode in a wave of accounting scandals. My 8 years of Enron work history will be worth nothing on my resume, the business world will consider the past successes as nothing but an elaborate ac- counting hoax. Skilling is resigning now for "per- sonal reasons" but I would think he wasn't having fun, looked down the road and knew this stuff was unfixable and would rather abandon ship now than resign in shame in 2 years ....

Is there a way our accounting gurus can un- wind these deals now? I have thought and thought about a way to do this, but I keep bump- ing into one big problem-we booked the Con- dor and Raptor deals in 1999 and 2000, we enjoyed wonderfully high stock price, many ex- ecutives sold stock, we then try and reverse or fIx the deals in 2001, and it's a bit like robbing the bank in one year and trying to pay it back two years later. Nice try, but investors were hurt, they bought at $70 and $80 a share looking for $120 a share and now they're at $38 or worse. We are under too much scrutiny and there are proba- bly one or two disgruntled "redeployed" em- ployees who know enough about the "funny" accounting to get us in trouble. What do we do? I know this question cannot be addressed in the all-employee meeting, but can you give some assurances that you and Causey will sit down and take a good hard objective look at what is going to happen to Condor and Raptor in 2002 and 2003? ..

I realize that we have had a lot of smart peo- ple looking at this and a lot of accountants in- cluding AA & Co. have blessed the accounting treatment. None of that will protect Enron if these transactions are ever disclosed in the bright light of day. (Please review the late 90s problems of Waste Management where AA paid $130 mil- lion plus in litigation re questionable accounting practices.) ...

I firmly believe that executive management of the company must have a clear and precise knowledge of these transactions and they must have the transactions reviewed by objective ex- perts in the fields of securities law and account- ing. I believe Ken Lay deserves the right to judge for himself what he believes the probabilities of discovery to be and the estimated damages to the company from those discoveries and decide one of two courses of action:

From Joseph R. Desjardins andJohnJ. McCall, Contemporary Issues in Business Ethics, 5th ed. (Belmont, CA: Thompson Wadsworth, 2005).

CASE 2. Accounting for Enron

Enron Corporation has come to symbolize the worst of recent corporate corruption scan- dals. Billions of dollars were lost by investors, and thousands of people lost their jobs and

their retirement savings when the one-time seventh-largest United States corporation went bankrupt, the largest bankruptcy in history at the time, as a result·of the fraud

410 Ethical Issues in Finance and Accounting

created by its highest-ranking executives. But the story of Enron is also the story of a failed watchdog system designed to prevent such fraud. Auditors, attorneys, and government officials who had responsibilities to protect investors and ensure the integrity of finan- cial markets systematically failed to live up to their responsibilities.

Enron's collapse began in 2001 when some independent stock analysts and journalists publicly raised questions about the value of Enron's stock. At that time, Enron's stock was trading at more than $80 a share, and Enron's CEOJeffrey Skilling was publicly claiming that it ought to be valued at well over $100 a share. During the summer of2001, several Enron in- siders, including Vice Chair Clifford Baxter, Treasurer Jeff McMahon, and Vice President Sherron Watkins, all expressed doubts inter- nally about Enron's financial practices. Dur- ing this same period, other Enron insiders, including CEO Skilling and Board Chair and former CEO Kenneth Lay, Enron's corporate counsel, and several board, members were sell- ing millions of shares of Enron stock.

In October 2001 when Arthur Andersen au- ditors finally reversed their previous decisions and restated Enron's financial situations, the collapse of Enronbegan in earnest. ByDecem- ber, when its stock was worth just pennies a share, Enron declared bankruptcy and dis- missed over 4,000 employees.

Enron's collapse was mirrored by the col- lapse of its auditing firm, Arthur Andersen. Once one of the "Big Five" accounting firms, Arthur Andersen was driven out of business by its role in the Enron scandal. On January 9, 2002, the United States Justice Department announced that it had begun a criminal inves- tigation into Arthur Andersen's activities re- lated to Enron. At the time, Arthur Andersen was already on probation by the SEC for its questionable accounting practices in previous scandals at Sunbeam Corporation and Waste Management. The next day,Andersen admit-

ted that it had shredded thousands of docu- ments related to its Enron audits. Five days later, Andersen fired David Duncan, an Andersen partner and head auditor for Enron. Soon after, the Justice Department indicted Arthur Andersen on charges of obstruction of justice. Finally, on June 15, 2002, Arthur Andersen was found guilty in a criminal trial of obstructing justice by shredding evidence relating to the Enron scandal and, as a result, the firm agreed to cease auditing public com- panies by August 3l.

Records show that as early as May 1998, Andersen's auditors were expressing grave con- cerns about Enron's financial practices. On that date, in an e-mail to David Duncan, Benjamin Neuhausen, a member ofAndersen's Professional Standards Group, expressed his thoughts on the Special Purpose Entities (SPEs) that were at the heart of the Enron scandal. "Setting aside the accounting, [sic] idea of a venture entity managed by CFO is terrible from a business point of view. Con- flicts of interest galore. Why would any direc- tor in his or her right mind ever approve such a scheme?" Neuhausen then went on to high- light the many accounting problems with the SPEs being managed by Enron CFO Andrew Fastow. Duncan replied, "But first, on your point 1 (i.e. the whole thing is a bad idea), I really couldn't agree more." Nevertheless, the Andersen auditors continued to cooperate with Enron by attesting to the soundness of Enron's financial statements.

In February 2001, more than a dozen Andersen auditors once again met to discuss the financial status of Enron's SPEs. Evidence shows that Andersen's auditors had serious concerns about the validity of Enron's finan- cial self-portrait. In light of these concerns, they considered dropping Enron as an audit client. Michael Jones, one of Andersen's Houston employees, summarized the meeting in an e-mail to David Duncan, who also partie- ipated.Jones' notes reveal "significantdiscussion