Conflicts of interest in the accounting and auditing profession

Let us now examine the different types of conflicts of interest that may and do arise in the accounting and auditing profession through an examination of the Enron case. As indicated earlier, conflicts of interest may involve a conflict between one’s self-interest and the requirements of the role one occupies, or a conflict between two different roles one occupies, or further, they may involve a role confusion which serves to mask a conflict of interest. In order to place the auditors’ conflict of interest involved in the Enron case within a practical and professional context, it is important to provide in outline the general financial climate that was prevalent within Enron prior to its collapse. It was indeed this general financial climate which contributed to and precipitated the fall of Enron and it auditors, Arthur Andersen.

The chief financial officer (CFO)

The CFO traditionally is the executive officer within an organisation entrusted with enuring that the company operates with financial discipline and propriety and not excess and impropriety. However, in a business environment where investors are expecting and demanding ever-increasing earnings every financial quarter, CFOs come under constant pressure to ‘cook the books’ and make them look better than they are (Lindorff 2002, p. 2). This places CFOs in two potentially conflicting roles; the traditional role of policing the integrity and accuracy of the accounts and financial statements of a company, and the contemporary ‘role’ of making sure that the quarterly earnings of the company look the best that they can, even at times assisting this outcome by recourse to some ‘creative’ accounting. This conflict of roles creates, in turn, a conflict of interest that has the tendency, at least potentially, of interfering with the proper exercise of the CFO’s fiduciary duty of ensuring the integrity and accuracy of the company’s financial statements – a duty entrusted to them by the board of directors and the shareholders of the company, as well as prospective investors who require true and fair financial statements on which to base their informed investment decisions.

Andrew Fastow’s dual role as both CFO of Enron and manager of the Special Purpose Entities (SPEs) involved a serious conflict of interest, one which Fastow, as the company’s financial watch-dog in his role of CFO, should have avoided. Andrew Fastow joined Enron in 1990 as a banking expert and quickly rose to power to become CFO, which, after Ken Lay and Jeffrey Skilling’s positions as Chairman and CEO respectively, was the third most influential position within Enron. At the daily financial operational level, it was perhaps the most influential, which might help explain why Fastow, who masterminded a web of very complex off balance sheet partnership arrangements (the SPEs) that had the effect of hiding debt and inflating earnings, is considered to be one of the primary architects behind Enron’s spectacular collapse.

Special Purpose Entities, which were Fastow’s specialty, were initially introduced by banks and law firms as ‘structured finance’, complex financial deals intended to enable companies to generate tax deductions and move assets off a company’s books (Behr & Witt 2002). With names such as Cactus[92], Braveheart, Whitewing, JEDI, Chewco, LJM 1 and 2 (the initials standing for Fastow’s wife Lea and his two children) and Raptors, Enron used SPEs for various purposes. The primary purpose was for financing new projects in Enron’s ever-expanding trading business – which continually needed new injections of cash funds to sustain the expansion – as well as providing insurance-hedging for those projects whilst managing, sometimes legally but mostly illegally, to keep debt related to them off its balance sheet and taking up earnings relating to those projects in its income statements. For his role in those SPEs, Andrew Fastow reportedly made more than $45 million (all amounts in US dollars). In the wake of the revelations concerning Fastow’s key role in the Enron SPEs, especially Chewco and the LJMs, and just one month prior to Enron’s final collapse and bankruptcy on 2 December 2001, the company was forced to restate its earnings from 1997 through to 2002, which required a $1.2 billion equity write-down.

Chewco alone accounted for the inflation of earnings by $405 million from 1997 through to 2000, which Enron was not entitled to have on its books, and the concealment of a $600 million-debt which, by contrast, Enron was required to show on its books. Named after Chewbacca, the character from Star Wars, Chewco was set up to buy out the share of equity of the California Public Employees’ Retirement System (Calpers) in JEDI 1 (another Enron SPE alluding to Star Wars).

The main problem with Chewco, it seems, was that Enron did not meet the 3% investment rule, which required that at least 3% of equity in the SPE be held by an independent investor not associated with the company. Because this rule was not met in the case of Chewco, Enron was not legally allowed to keep the SPE off its balance sheet.

Given the complexity of the Enron SPEs – and the complexity seems now to have been intended as a deliberate ploy to obfuscate and render opaque the real purpose to outsiders – it is difficult to explain in great detail their intricate financial mechanisms. However, by focusing on one of the SPEs, LJM, which together with Chewco proved to be the catalyst that brought down the Enron empire, this much seems clear: whilst Chewco was at the periphery of financial impropriety, LJM proved to be its very nucleus.[93]

LJM and its successor LJM 2 were set up to finance an array of deals. The original LJM was set up to finance the Rhythms deal in March 1998, a deal that saw Enron invest $10 million for a block of shares in Rhythms NetConnections, a high-speed Internet service provider. As is usual with companies, Rhythms went public (in April 1999) and its shares climbed rapidly, making Enron’s investment worth $300 million. Because Enron’s accounting rules required the company to mark the shares to market on a daily basis – ‘mark-to-market’ – it meant that Enron had already booked $290 million in profits on the transaction. Concerned, however, that the profit might be reduced or turn to a loss in the future – which would require Enron to take into account substantial losses – the company had to cover for that contingency. Not allowed to sell the shares for several months, until the end of 1999, Enron wanted to get insurance against a fall in the value of those shares. Traditionally, the way to acquire insurance is through the purchase of a ‘put option’. A put option locks in a specific sale price for the shares for the life of the option. So, for example, with Rhythms trading at $65 per share, Enron might have wanted to purchase a put option until it could sell them at the end of 1999 at a lock-in price of $60. The option would not cover the first $5 of loss, but it would cover any remaining loss that might arise dollar for dollar.

The problem for Enron, however, was that its block of shares in Rhythms was so large, and the company so risky, that no one would be willing to provide insurance at a price that Enron considered reasonable. Fastow’s solution was to create a company he would manage that used Enron stock as its capital to sell the insurance on Rhythms stock to Enron. Essentially, this amounted to Enron insuring itself! If the insurance was never needed, no one would be the wiser, and Fastow and his partners in the scheme, who were chosen from among his subordinates within the company, could pocket most of the premium that Enron paid, making them quite wealthy. If the Rhythms stock fell dramatically, then the Enron stock that hedged the company would cover the losses. However, if both Rhythms and Enron stocks suffered a significant fall, the company would go broke unless someone bailed it out. However, because Enron was in effect insuring itself, there really was no insurance.

What defies understanding was that such a scheme passed Enron’s board, its auditors Arthur Andersen, and its law firm Vinson and Elkins. According to the Powers Report[94], the Enron board approved a waiver of its code of ethics to allow Fastow to set up LJM, which covered the Rhythms deal. As we shall see, it wouldn’t be the first time that the ethics of the company and its corporate governance regulations were compromised by Fastow’s SPEs. Though committed to ethics on the surface, Enron’s cut-throat corporate culture was not designed to allow ethical niceties and sensibilities to get in the way of its trading and financial activities. The cultural ethos at Enron, from the employees to the executives, had a lot more to do with profits – the more the better – and the share value of Enron stock – the higher the better – and very little to do with ethics. The profit incentives at Enron that ruled supreme, and which favoured self-interest gain above all, could not allow ethical considerations to take hold. It was only as a result of people killing the goose that laid the golden eggs, even if those eggs were made of paper, that those both within and outside Enron started taking ethics more seriously.

The sequel to LJM, LJM 2, took Fastow’s ingenuity in coming up with ever more complex and ethically and legally dubious SPEs to new heights. Whilst LJM 1 was used to provide a faulty hedge in a profitable investment in the Rhythms deal, the deals which LJM 2 helped finance, and which were named ‘Raptors’ after the cunning dinosaurs in the film Jurassic Park, were used to hide the losses of unprofitable projects. In total, LJM 2 was used to conceal $1.1 billion of Enron losses. Fastow’s secret profit from LJM 1 and the Rhythms deal alone was a staggering $22 million – from a $1 million investment in little less than a year! When such profits are to be had, with the incentives for fraud and corruption existing under such favourable conditions as secrecy, power and greed that feeds self-interest to the detriment of the interest of others, as well as a total disregard for fiduciary duty abetted by a corporate culture that encourages greed and the pursuit of self-regarding gain, it’s no wonder that corruption was allowed to thrive within Enron. Add to that an array of conflicts of interest involving Enron’s board of directors, its executive officers like Fastow and Skilling, its auditors and lawyers, the media, the investment banks, and generally the ethos of generating and claiming ever new profits for the company by Enron’s trading whiz kids always seeking to increase their yearly profit-linked bonuses, and what emerges is a case of corruption waiting to happen. That it happened is not surprising, given that all the usual conditions and causes for corruption were present within the Enron organisation. What is, however, surprising is that it took so long, and required the collapse of the seventh-largest company in the United States, to uncover it.

When Jeffrey McMahon, the company’s treasurer, complained to Skilling about the conflict of interest regarding Fastow and his management of the SPEs, he was at first confronted by Fastow (who was told of the complaint by Skilling) and a week later was transferred to another part of the company and replaced by Ben F. Glisan, a close aid and associate of Fastow. It seems that if you can’t get rid of a conflict of interest, the next best thing is to get rid of those that issue warnings and complain about it!

[92] Not a name that Fastow would have chosen if the SPE was launched in Australia, due to the adverse connotations of the term ‘cactus’ in the Australian vernacular, as used in the phrase ‘It’s cactus!’, meaning that something has flopped or gone belly-up, or it’s gone bad and is no good.

[93] My account of the LJM SPEs refers primarily to the account given of those deals in Fusaro, P. C. and Miller, R. M. 2002, What Went Wrong with Enron, John Wiley & Sons, Hoboken, NJ, pp. 132-5.

[94] The Powers Report was a 218-page report on Enron’s SPEs prepared by the Powers Committee. The committee was formed by Enron’s board of directors at the same time that Fastow was fired from Enron. Its mission was to investigate Fastow’s dealings. William Powers, the dean of the University of the Texas Law School, led the committee. Powers was recruited as a board member in October 2001 to give Enron and the committee much needed credibility.