The Collapse

During my EMBA, we had a class on Business Law. The dean of the program taught the law class and used a fascinating technique to teach what could have otherwise been a dry subject around contract law. On the first day of class, he provided a newspaper clipping of a story about the Archer-Daniels-Midland (ADM) company. The article was from the early nineties concerning allegations of price fixing (the EMBA class was some 5 years later, circa 1997) and our assignment was to read and discuss.  Each week Harry provided us with a few more articles in the story for review. Thus we learned of the ADM scandal and ultimate outcomes, bit-by-bit, as the course evolved over 12 weeks. For the curious, ADM was found guilty of collusion and fined $100M, the largest antitrust fine in history at the time. Whiteacre, the whistle blower and FBI informant also found himself in trouble (embezzlement) along with Michael Andreas (top ADM executive) who did time in a federal prison for his efforts. Again, it was a fascinating way to learn about law and the approach really stuck with me. 

That Sunday evening in late October, is when I first noticed Enron proper and started cutting out articles about it and Arthur Andersen. It was also when it first dawned on me that this could be devastating for Arthur Andersen. Over the next 6 months I collected newspaper articles, business magazines, emails and just about anything else pertaining to the growing saga. And it only had taken about six months to see the end game because by March of 2002, it was all over except the ongoing litigation that may well exist, even today. Those newspaper stories, articles and magazines provided much of the information for this series of blogs.

“Coming Storm”

Thinking about it from a strict ‘start to finish’ timeframe, one could pick any of one of a number of points to use as the trigger for the collapse. In part II of this series, I mentioned the fortune article in March 2001 where Bethany Mclean asked, “Is Enron Overpriced?” This was an early instance of openly questioning how Enron made money. The Wall Street Journal also ran a series of articles nearer to the actual collapse timeframe (fall of 2001) along with other newspapers and magazines that were starting to write about Enron as its stock price slid. Personally, the Fortune article serves as the beginning of the collapse for me.

In an early July issue of ‘The Economist’ that same year, there was a piece questioning auditor independence. In the article, the magazine gave examples of potential conflicts including the Marriott International audit (Arthur Andersen was paid $1M for the 2000 audit) and how Andersen had also provided Marriott ‘other’ services that same year for $30.3M. Ominously, the Economist article also referred to Waste Management, a previous Arthur Andersen audit client that had run into problems. The 1992 – 1996 Waste Management pre-tax income had been overstated by $1.48B resulting in, at the time, a record fine of $7M to Arthur Andersen based on evidence culled from Andersen's own ‘work papers’ (work papers are handwritten, unofficial notes and work product used to prepare the final audit papers). Lock that company name in – Waste Management – I’ll come back to it in a later discussion around my view of root cause contributors to the collapse of Arthur Andersen. 

Note that the focus on auditor independence by ‘The Economist’ was not the exception, rather, it was more the rule at the time. For several years running, Arthur Levitt (Chairman of the SEC from 1993-2001) and now the incoming Chairman under the Bush administration, Harvey Pitt we’re both very focused on the matter of independence in public accounting. A focus that only intensified after the dot.com bubble burst in late 2000 and was working toward a crescendo.

So in the summer of 2001, we had Enron's share price coming under pressure while the regulators were increasing their focus on audit quality and the industry post the dot.com market crash. 

Collapse

In retrospect, the flame out of Enron and then Arthur Andersen was incredibly swift. At the time of Enron’s share price peak in late December 2000 (SP at $80/share) through to January 2001, the US Congress had just approved the Commodity Futures Modernisation Act. This Act further exempted energy-derivatives from regulatory scrutiny and bolstered profits. However, by June of 2001 (SP now around $55/share) with the Fortune article in the background and regulators starting to intervene in the Western electricity market, the negative impacts were engulfing both Enron’s profits and share price. 

Then came a major surprise on August 15th when Jeffrey Skilling abruptly announced he was stepping down as president and COO after 4 years (SP hits $45/share).  Although he cited ‘personal reasons’ for stepping down, Skilling must have known the jig was up because around that same time, there were a few pivotal conversations / meetings which were later exposed in the aftermath of the collapse. 

In one example, Sharon Watkins wrote a memo (anonymously) to Lay shortly after Skilling’s resignation saying “I’m incredibly nervous that we will implode under a wave of accounting scandals. The business world will consider the past successes as nothing but an elaborate account hoax”. Another example was a conversation between James Hecker, a Houston-based partner of Arthur Andersen, and Sharon Watkins (via phone) on August 20th. The fact that this conversation had occurred came out during the DOJ trial against Arthur Andersen. It's important to note that these conversations (and likely many others) were all prior to Enron notifying the SEC on August 28th of the accounting issues. 

From the beginning of September through Enron’s announcement of a third-quarter loss of $618M on Oct 16th (SP hits $32/share), details as to the magnitude of the misstatement was limited to a small group - executives at Enron, Arthur Andersen and Enron’s law firm, Vinson & Elkins (who interestingly never faced any repercussions for their role in the scandal).

From there things moved swiftly. 

On Oct 31st, Enron announced that the SEC had launched a formal investigation into the company’s financials (SP now at $15/share). Around this same time, Arthur Andersen made an internal announcement to the Partners regarding the matter and advising that any questions to be redirected to communications. 

From November and past Enron’s declaration of bankruptcy on Dec 2nd (SP hits $0.0) through to January 11th 2002 when Arthur Andersen officially acknowledged the destruction of ‘some undisclosed amount’ of documents, internal communications continued to flow through to the Partners of Arthur Andersen.  On January 16th, Arthur Andersen took the unprecedented move of firing David Duncan, the lead partner on the Enron account. Between these two events (destruction and termination), even the most casual of observers realised that this was essentially the end of Arthur Andersen. 

The firm was losing clients in an accelerating fashion throughout this time which put pressure on cash flow. With the announcement of document destruction, the market began to sense that criminal charges were coming against Arthur Andersen. It was also during this time that large groups of partners and staff were attempting to sell themselves off to competitors (secretly, of course). 

Finally, on Marth 7th the Department of Justice (DOJ) announced a sealed indictment against Arthur Andersen (although it had been hinted for some time that an indictment may be in the wings) which was essentially the final nail in the coffin. Discussions were held between the DOJ and Arthur Andersen where the DOJ was looking for an unqualified admission of guilt from Arthur Andersen. 

All Over but the Crying

Failing to negotiate a settlement with the DOJ regarding pending but unknown charge(s), the indictment was unsealed on March 14th revealing a single charge of obstruction of justice – thus sealing (no pun intended) the fate of Arthur Andersen. After that, major clients such as United Airlines announced their intention to change auditors, groups of partners expedited their exodus. “Icarus” had flown too close to the sun, one too many times.

The trial started shortly and moved swiftly. After only 5 weeks of testimony, Arthur Andersen was found guilty of a single count of obstruction of justice.  A key piece of evidence was an e-mail from Arthur Andersen’s in-house lawyer Nancy Temple (first year Partner) to Michael Odem (Houston-based Senior Partner) advising that it “might be useful to consider” reminding the Enron audit team “of our document and retention policy. It would be helpful to make sure we have complied with the policy.” Whilst Andersen asserted it was simply cleaning up superfluous and unneeded support documents, the jurors believed the e-mail was a thinly veiled message to destroy evidence that may implicate Arthur Andersen.  

And there you have it, the collapse of Arthur Andersen in about 6 months. 

Jeffery Eberwein is a senior partner at EY in the Consulting practice focused on digital transformation and its implications on business. The views expressed in this article are the views of the author and not Ernst & Young. Jeff can be contacted at jeffery.eberwein@au.ey.com