Three Felonies a Day

by Harvey Silverglate

  In The New Yorker magazine of January 8, 2007, the highly respected essayist Malcolm Gladwell published an article entitled, “Open Secrets: Enron, intelligence, and the perils of too much information.”33 Gladwell was writing about the case assembled against former Enron CEO Jeffrey Skilling, a companion case to Lay’s that Barrionuevo and Eichenwald in the Times called “the parallel case assembled against” both. Trial Judge Simeon Lake addressed Skilling on October 23, 2006, immediately before imposing a 24-year (essentially a life) sentence. “The evidence established that the defendant repeatedly lied to investors, including Enron’s own employees, about various aspects of Enron’s business,” the judge intoned. Gladwell quoted from the lead prosecutor’s closing arguments to the jury at Skilling’s trial: “This is a simple case,” the prosecutor had argued. “It’s black-and-white. Truth and lies.”

  Gladwell makes some disturbing observations about the “black-and-white” nature of the case. He notes that in July 2000, Jonathan Weil of The Wall Street Journal, having just had a conversation with an acquaintance in the investment-management business who urged Weil to examine the sources of Enron’s income, wrote a column for the Texas regional edition of the paper. Weil focused on certain accounting practices of Enron, known as “mark-to-market” accounting, that results in the reporting of income as current income even though it is not expected in hard cash for some years in the future. It is an aggressive form of financial reporting, especially for certain industries, but it is well-known and generally accepted within the accounting profession.

  Weil had bothered to obtain and examine Enron’s annual reports and quarterly SEC filings, and he compared the figures on both income statements and cash-flow statements. While it took Weil some time to figure it all out, he came to the conclusion (he checked with an accounting professor at Michigan State University) that much of Enron’s reported income was “unrealized;” it was anticipated rather than actually received. Looked at from a current cash-in-hand perspective, reported Weil, the company had a significant loss rather than a profit for the quarter studied.34

  Weil invited Enron executives to comment on his reporting. Weil told Gladwell that a half-dozen executives flew to Dallas to meet with Weil and answer his questions. The officials readily acknowledged that the earnings of the company were almost entirely what the company anticipated realizing at some point in the future. The real issue subject to debate was how confident the company was, or should have been, that these earnings would materialize. These questions, the executives told the reporter, were answered by the company’s enormously complex mathematical models.

  When a Wall Street financier and short-seller named James Chanos read Weil’s column, reported Gladwell, Chanos delved into the publicly filed and readily available Enron financial reports. Cash flow was negligible, he discovered. “They were basically liquidating themselves,” Chanos told Gladwell. As a result, he proceeded to short-sell Enron shares, a financial maneuver that reaps profits if and when the price of the stock declines. Bethany McLean, tipped off by Chanos, wrote an article in Fortune, headlined “Is Enron Overpriced?,” in March 2001.

  As analysts and investors followed suit and began to look at Enron’s financial statements, confidence plummeted. Enron, in the energytrading business where confidence had to be maintained, experienced a disastrous loss of confidence and filed for bankruptcy in December 2001. The information contained in Enron’s publicly available financial statements thus brought the company down when the financial press and the investment community finally bothered to read them.

  An additional problem, above and beyond the accounting treatment of anticipated profits, made Enron’s financial reporting extremely difficult to assess. A considerable number of the firm’s non-earning assets were off-loaded into what were called “special-purpose entities” (“SPE”). SPEs, Gladwell noted, “have become commonplace in corporate America.” The end result of the use of this particular vehicle by Enron had the effect of removing losses or dubious investments from the company’s balance sheet and avoiding having the losses affect Enron’s reported current income. Gladwell concluded that the use of this accounting strategy in Enron’s case was “not only legally questionable but extraordinarily risky” and, in the end, helped trigger the crisis in confidence when its house-of-cards came to the attention of the financial press. “Legally questionable” accounting devices, in murky areas where experts will differ, are not usually thought to be a proper basis for a criminal prosecution that has to be proven to a jury “beyond a reasonable doubt.” But the use of this device was disclosed in the footnotes to Enron’s financial statements, approved by the company’s auditor. Is it fraud when questionable accounting practices, approved by an auditor, are hidden in full view?

  Gladwell draws attention to another aspect of the Enron scandal that bears consideration when one is trying to decide whether a fraud involving covering up the truth about the company’s financial position was committed. He cites Professor Victor Fleischer of the University of Colorado Law School, who noted that Enron was not paying any taxes. The reason, Fleischer pointed out, was that the IRS recognized that Enron’s earnings were illusory. Any investor seeing this in Enron’s published financial statements should have wondered why he should believe in earnings that the IRS, always looking to maximize taxes and hence earnings, conceded were non-existent.

  Gladwell concluded his tour de force by noting that in the spring of 1998, six Cornell business school students, as a class project, did an analysis of Enron. This was long before even a whiff of scandal arose. In six weeks, these students came to the conclusion that the stock of this darling of the investment community, one of the nation’s most respected companies at the time, was significantly overpriced. The first page of their report had a boldfaced conclusion: “Sell.”

  New York Times business and financial columnist Joe Nocera, in his “Talking Business” column on January 6, 2007, sought to attack the accuracy of Gladwell’s New Yorker essay. Nocera attacked Gladwell’s implication that “the Enron scandal was as much the fault of investors as it was any Enron executive now in prison.” Nocera argued that the notion that the feds tried to criminalize “flawed business decisions” is not “remotely true.” Yet Nocera admits that Gladwell’s “central point is largely correct.” Nocera claimed nonetheless that “no matter how you slice it,” the Enron executives “lied to the investing public about the true condition of the company” and “that’s against the law.” Nocera mocked the disclosures “usually in some buried footnote.” He complained that the SPEs “were not always used for some legitimate purpose” but were “mostly…used to hide poorly performing assets.” Nocera opined that not enough details were disclosed in some instances, and that, in any event, “the point is not the sheer volume of disclosure; it’s whether disclosure illuminates or obfuscates. Enron usually did the latter.” As for the Cornell business students, Nocera noted that they did not predict that Enron would go bankrupt, but only that its high-flying stock was in for a price decline. All in all, Nocera conceded much of what Gladwell posited about a plethora of information being “hidden in plain sight” but decried the misleading ways in which the company’s financial results were reported. Gladwell likely would not disagree that the reporting was misleading, but would argue only that it was enormously (perhaps overly) inclusive.

  The importance of the Gladwell/Nocera debate lies not in any notion that either of them can, or should, be considered a legal expert. Indeed, such is far from the case, and neither likely would claim such a mantle, but it is revealing that two writers who report on such matters have such diametrically opposing views on the importance, quality, format, and value of disclosure. In particular, their dispute in part focuses on the problems caused by over-disclosure, and how that might function, in effect, as under-disclosure. In the midst of such a dispute come federal prosecutors, after the fact and with rather little warning as to where the line is to be drawn, to announce that a particular form of corporate
disclosure, which was sufficient to scare off some investors, constituted a felony sufficiently serious to land an executive in prison for life.

  CHAPTER FIVE

  Accounting for the Perils Facing Business Support Services: The Late Arthur Andersen & Co. and Its Repercussions

  In their zeal to appear to bring justice to the thousands of people who tragically lost their retirement money and pensions when Enron folded and who were now calling for blood, prosecutors sometimes went off in directions indicative of an out-of-control legal system. I refer, specifically, to the Department of Justice’s pursuit of Enron’s long-time auditor Arthur Andersen, LLP, then one of the five largest accounting firms in the country, now defunct.

  The DOJ’s scapegoating of Arthur Andersen is a horror story that, despite the accounting firm’s eventual Pyrrhic victory in the Supreme Court, almost certainly will be repeated again and again in other corporate and professional sectors of civil society. Indeed, it was later nearly repeated in connection with other national accounting firms—KPMG,1 for example, and Ernst & Young,2 both of which had by then learned the lesson that it is futile to resist and best to “cooperate” for the sake of expediency, not to mention financial prudence and the firm’s survival. With the Arthur Andersen experience fixed clearly in the rearview mirror, each of these firms chose to save itself by sacrificing individuals to criminal prosecution and by admitting error and even fraud where they likely had not existed.

  Andersen, an internationally respected member of the “Big Five” group of accounting firms,3 was a major obstacle to a successful conviction of Enron’s higher-ups. After all, the controversial transactions that “hid” Enron’s losses had been reviewed and approved by Andersen auditors. Enron or any of its individual corporate executives charged with fraud could invoke, as a highly effective defense, the fact that they relied on professional advice from one of the nation’s premier accounting firms.

  As we’ve seen, under traditional notions of criminal law, someone may be convicted of certain classes of felonies only if there is evidence that he knew or had reason to know that his actions were in violation of the law. The defendant must convince the jury not necessarily that he acted correctly, but merely that he relied in good faith on expert advice and therefore intended to act properly and thought he was doing so. In order for this defense to succeed, Enron would have had to provide its auditors at Arthur Andersen with all relevant information and documentation; the relationship between the auditing firm and the corporate client would have had to be honest and above-board; and the advice given would have had to be reasonable enough that the client would not have had good reason to believe it was erroneous or given in bad faith simply in order to please or accommodate the client.

  Two seemingly opposite paths emerged for the DOJ prosecution team: one, to ally with the Andersen firm and convince leading accountants to testify against their clients; or, two, to sweepingly discredit the firm and disable it from testifying for the Enron defendants. Either way, as one experienced white collar criminal defense lawyer succinctly put it, “for the prosecution, the road to Enron went through Arthur Andersen.”4

  Recognizing this, the DOJ at first resorted to its traditional playbook and sought to make a deal with Andersen to defer prosecution if the firm would agree to cooperate in the government’s assault on Enron. Under such a deferred prosecution agreement, Andersen would have had to open all of its records and make all of its employees available to the prosecutors, including an agreement to give court testimony if requested. Only after Andersen proved its willingness to comply with the government’s terms and assist fully in the prosecution of the firm’s former client would Andersen be allowed to go on its way. Such a deal would have saved the accounting firm from the destruction that was ultimately visited upon it, but it would not necessarily have reflected the truth of Andersen’s position at the time it actually performed Enron audits, or even later. One white collar criminal defense lawyer concluded that Andersen’s refusal to buy the DOJ’s offer of deferred prosecution amounted to an “inability of Andersen management to come together to save the firm.”5

  Whether Andersen was motivated by principle or by insufficient skill in cutting a cynical deal to save itself, an agreement with the DOJ was not to be. And so the prosecutors’ path became clear. Arthur Andersen had to be dealt with—indeed, had to be eliminated—as a credible source of testimonial support for the defense of Enron or any of its indicted officers.

  Since the firm’s auditing practices were not readily cast as criminal, the feds creatively indicted Andersen on a completely different charge: obstruction of justice. As was the case with investment banker Frank Quattrone, described in Chapter Four, they alleged that Andersen’s partners and employees intentionally and knowingly advised personnel to destroy relevant documents with the goal of obstructing the government’s investigation. With the help of a pliable obstruction statute and with the cooperation of a federal trial judge in Texas, the DOJ succeeded in disabling Andersen from playing any useful role in the defense of the Enron defendants.

  The indictment itself effectively destroyed the firm. No auditing firm can successfully operate once indicted, and Arthur Andersen rapidly, and predictably, disintegrated. Companies simply will not, and in nearly all jurisdictions may not, employ auditors under such a cloud. To the extent there was anything left of the firm after indictment, a 2005 jury conviction in the federal district court in southern Texas administered the coup de grace. By that time, this one-time auditing powerhouse had gone from 28,000 employees in the United States to a staff of some 200. The skeleton crew’s sole task was to clean up loose ends, dealing mostly with remaining litigation and other fallout facing the firm and its former partners.

  It came as a shock to court-watchers when the high court announced on January 7, 2005, that it would review the obstruction of justice conviction won by the Department of Justice against Andersen. Deeply embedded in Supreme Court law and lore is the notion that the high court will not review a case unless the question presented is of direct and practical importance to the party seeking review. Further, the Court normally will review a case only if it presents a question of some importance to the development of legal doctrine. Under the circumstances, the likelihood that the court would agree to review Andersen’s conviction was seen as so remote that the office of the Solicitor General—the branch of the DOJ that specializes in arguing the government’s cases before the Supreme Court—did not even bother to file an opposition to Andersen’s petition seeking review.6 While the firm and its scattered former partners doubtless had an emotional investment in getting the conviction reversed, as a practical matter the case hardly registered on anybody’s radar screen. Nor was the Supreme Court faced with an issue of seemingly practical importance to the smooth future operation of the law, since the obstruction of justice statute under which Andersen had been convicted was superseded by the Sarbanes-Oxley Act of 2002, which sought to plug what were suddenly seen as “loopholes” in the federal regulatory scheme after the Enron debacle.

  The obstruction of justice accusation arose out of a 2001 address by Michael Odom, an Andersen partner, to a general training meeting of 89 Andersen employees shortly before the Enron collapse. He urged all those present, including some members of the Enron audit team, to follow Andersen’s document-retention policy. That policy, replicated in some form in virtually every large or middling business enterprise in the country, was meant to regularize the accounting firm’s practices concerning not only retaining certain documents for specified periods of time, but also destroying documents when the retention period ended. Documents were destroyed, of course, not only for space conservation purposes, but also to assure the confidentiality of matters contained in those documents.

  Odom’s admonition at the Andersen staff meeting about the firm’s document-retention policy focused on both aspects—its purpose to retain documents that might be called for in governmental or other investigations, and its purpose to rou
tinely destroy documents after a specified period of time as long as no investigation was known to be in progress. According to the Supreme Court, he urged those assembled at the meeting that “[I]f it’s destroyed in the course of [the] normal policy and litigation is filed the next day, that’s great…. [W]e’ve followed our own policy, and whatever there was that might have been of interest to somebody is gone and irretrievable.”

  Six days after Odom met with the Andersen staff to discuss the firm’s document-retention policy, Enron released its third-quarter financial results, including a $1.01 billion charge against earnings, which could be interpreted to reflect an earlier overstatement of the company’s financial health.7 Sure enough, the following day the SEC notified Enron by letter that it had opened an investigation back in August; it now requested information and documents. On October 19, 2001, Enron sent a copy of the SEC’s letter to Andersen. The following day Andersen in-house lawyer Nancy Temple, on a conference call of Andersen’s Enron crisis-response team, reiterated the earlier advice given by her colleague Odom. She instructed everyone to “[m]ake sure to follow the [document] policy.”