Unraveling the “Special Purpose Entity” Web

The term “special purpose entity” (SPE) has become synonymous with the Enron collapse because these entities were at the center of Enron’s aggressive business and accounting practices. SPE’s are separate legal entities set up to accomplish specific company objectives. For example, SPE’s are often created to help a company sell off assets. After identifying which assets to sell to the SPE, the selling company secures an outside investment of at least three percent of the value of the assets to be sold to the SPE.⁷ The company then transfers the identified assets to the SPE. The SPE pays for the contributed assets through a new debt or equity issuance. The selling company can then recognize the sale of the assets to the SPE and thereby remove the assets and any related debts from its balance sheet. This is all contingent on the outside investors bearing the risk of their investment. In other words, the investors cannot finance their interest through a note payable or other type of guarantee that may absolve them from accepting responsibility if the SPE suffers losses or fails.⁸

While SPE’s are commonplace in corporate America, they are controversial. Some argue that SPE’s represent a “gaping loophole in accounting practice.”⁹ Tradition dictates that once a company owns 50% or more of another, the company must consolidate. However, as the following quote from Business Week demonstrates, such is not the case with SPE’s:

The controversial exception that outsiders need invest only three percent of an SPE’s capital for it to be independent and off the balance sheet came about through fumbles by the Securities & Exchange Commission and the Financial Accounting Standards Board. In 1990, accounting firms asked the SEC to endorse the three percent rule that had become a common, though unofficial, practice in the ’80s. The SEC didn’t like the idea, but it didn’t stomp on it, either. It asked the FASB to set tighter rules to force consolidation of entities that were effectively controlled by companies. FASB drafted two overhauls of the rules but never finished the job, and the SEC is still waiting. ¹⁰

While SPE’s can serve legitimate business purposes, it is now apparent that Enron used an intricate network of SPE’s, along with complicated speculations and hedges—all couched in dense legal language—to keep an enormous amount of debt off the company’s balance sheet. Enron had literally hundreds of SPE’s. Through careful structuring of these SPE’s that took into account the complex accounting rules governing the required financial statement treatment of SPE’s (e.g., FAS 140), Enron was able to avoid consolidating the SPE’s on its balance sheet. Three of the Enron SPE’s have been made prominent throughout the congressional hearings and litigation proceedings. These are widely known as “Chewco,” “LJM2,” and “Whitewing.”

Chewco was established in 1997 by Enron executives in connection with a complex investment in another Enron partnership with interests in natural gas pipelines. Enron’s CFO, Andrew Fastow, was charged with managing the partnership. However, to prevent required disclosure of a potential conflict of interest between Fastow’s roles at Enron and Chewco, Fastow employed Michael Kopper, managing director of Enron Global Finance, to “officially” manage Chewco. In connection with the Chewco partnership, Fastow and Kopper appointed Fastow relatives to the board of directors of the partnership. Then, in a set of complicated transactions, another layer of partnerships was established to disguise Kopper’s invested interest in Chewco. Kopper originally invested $125,000 in Chewco and was later paid $10.5 million when Enron bought Chewco in March 2001.¹¹ Surprisingly, Kopper remained relatively unknown throughout the subsequent investigations. In fact, Ken Lay told investigators that he did not know Kopper. Kopper was able to continue in his management roles up until January 2002.¹²

The LJM2 partnership was formed in October 1999 with the goal of acquiring assets chiefly owned by Enron. Like Chewco, LJM2 was managed by Fastow and Kopper. To assist with the technicalities of this partnership, LJM2 engaged the accounting firm, PricewaterhouseCoopers, LLP and the Chicago-based law firm, Kirkland & Ellis, where Whitewater prosecutor Kenneth Star serves as partner. Enron used the LJM2 partnership to deconsolidate its less productive assets. Eventually, these actions generated a 30 percent average annual return for the LJM2 limited-partner investors.

The Whitewing partnership, another significant SPE established by Enron, engaged in purchasing an assortment of power plants, pipelines, and water projects originally purchased by Enron in the mid-1990s that were located in India, Turkey, Spain, and Latin America. The Whitewing partnership was crucial to Enron’s move from being an energy provider to becoming a trader of energy contracts. Whitewing was the vehicle through which Enron sold its energy production assets.

In creating this partnership, Enron quietly guaranteed investors in Whitewing that if Whitewing’s assets (transferred from Enron) were sold at a loss, Enron would compensate the investors with shares of Enron common stock. This obligation—unknown to Enron’s shareholders—totaled $2 billion as of November 2001. Part of the secret guarantee to Whitewing investors surfaced in October 2001, when Enron’s credit rating was downgraded by credit agencies. The credit downgrade triggered a requirement that Enron immediately pay $690 million to Whitewing investors. When this obligation surfaced, Enron’s talks with Dynegy to sell the company failed. Enron was unable to delay the payment and was forced to disclose the problem, stunning investors and fueling the fire that led to the company’s bankruptcy filing on December 2, 2001.

In addition to these partnerships, Enron created financial instruments called “Raptors,” which were designed to reduce the risks associated with Enron’s own investment portfolio and backed by Enron stock. In essence, the Raptors covered potential losses on Enron investments as long as Enron’s stock market price continued to do well. Enron also masked debt using complex financial derivative transactions. Taking advantage of accounting rules to account for large loans from Wall Street firms as financial hedges, Enron hid $3.9 billion in debt from 1992 through 2001. At least $2.5 billion of those transactions arose in the three years prior to the Chapter 11 bankruptcy filing. These loans were in addition to the $8 to $10 billion in long and short-term debt that Enron disclosed in its financial reports in the three years leading up to its bankruptcy. Because the loans were accounted for as a hedging activity, Enron was able to explain away what looked like an increase in borrowings, (which would raise red flags for creditors), as hedges for commodity trades, rather than as new debt financing.¹³

The Complicity of Accounting Standards

Limitations in generally accepted accounting principles (GAAP) are at least partly to blame for Enron executives’ ability to hide debt from the company’s financial statements. These technical accounting standards lay out specific “bright-line” rules that read much like the tax or criminal law codes. Some observers of the profession argue that by attempting to outline every accounting situation in detail, standard-setters are trying to create a specific decision model for every imaginable situation. However, very specific rules create an opportunity for clever lawyers, investment bankers, and accountants to create entities and transactions that circumvent the intent of the rules while still conforming to the “letter of the law.”

In his congressional testimony, Robert K. Herdman, SEC Chief Accountant, discussed the difference between rule and principle-based accounting standards:

Rule-based accounting standards provide extremely detailed rules that attempt to contemplate virtually every application of the standard. This encourages a check-the-box mentality to financial reporting that eliminates judgments from the application of the reporting. Examples of rule-based accounting guidance include the accounting for derivatives, employee stock options, and leasing. And, of course, questions keep coming. Rule-based standards make it more difficult for preparers and auditors to step back and evaluate whether the overall impact is consistent with the objectives of the standard.¹⁴

While the specifics are still under investigation, in some cases it appears that Enron neither abode by the spirit nor the letter of these accounting rules (for example, by securing outside SPE investors against possible losses). It also appears that the company’s lack of disclosure regarding Fastow’s involvement in the SPE’s fell short of accounting rule compliance.

These “loopholes” allowed Enron executives to hide many of the company’s liabilities from the financial statements being audited by Andersen, LLP, as highlighted by the Business Week article summarized in Exhibit 2. Given the alleged abuse of the accounting rules, many are asking, “Where was Andersen, the accounting firm that was to serve as Enron’s public ‘watchdog,’ while Enron allegedly betrayed and misled its shareholders?”

Andersen in the Beginning

Andersen was originally founded as Andersen, Delaney & Co. in 1913 by Arthur Andersen, an accounting professor at Northwestern University in Chicago. By taking tough stands against clients, Andersen quickly gained a national reputation as a reliable keeper of the public’s trust:

In 1915, Andersen took the position that the balance sheet of a steamship-company client had to reflect the costs associated with the sinking of a freighter, even though the sinking occurred after the company’s fiscal year had ended but before Andersen had signed off on its financial statements. This marked the first time an auditor had demanded such a degree of disclosure to ensure accurate reporting.¹⁵

Although Andersen’s storied reputation began with its founder, the accounting firm continued the tradition for years. A phrase often said around Andersen was, “There’s the Andersen way and the wrong way.” Andersen was the only one of the major accounting firms to back reforms in the accounting for pensions in the 1980s, a move opposed by many corporations.¹⁶ Ironically, prior to the Enron debacle, Andersen had also previously taken an unpopular public stand to toughen the very accounting standards that Enron exploited in using SPE’s to keep debt off its balance sheets.

Andersen’s Loss of Reputation

Prior to the Enron disaster, Andersen’s reputation suffered largely because of the number of high profile SEC investigations launched against the firm. The firm was investigated for its role in the financial statement audits of Waste Management, Global Crossing, Sunbeam, Qwest Communications, Baptist Foundation of Arizona, and WorldCom. In May 2001, Andersen paid $110 million to settle securities fraud charges stemming from its work at Sunbeam. In June 2001, Andersen entered a no-fault, no-admission-of-guilt plea bargain with the SEC to settle charges of Andersen’s audit work on Waste Management, Inc. for $7 million. Andersen later settled with investors of the Baptist Foundation of Arizona for $217 million without admitting fault or guilt (the firm subsequently reneged on the agreement). Due to this string of negative events and associated publicity, Andersen found its once-applauded reputation for impeccable integrity questioned by a market where integrity, independence, and reputation are the primary attributes affecting demand for a firm’s services.

Andersen at Enron

By 2001, Enron had become one of Andersen’s largest clients. Despite the recognition that Enron was a high-risk client, Andersen apparently had difficulty sticking to its guns at Enron:

[Andersen had] found $51 million of problems in the company’s books – and decided to let them go uncorrected. While auditing Enron’s 1997 financial results, Andersen proposed that the energy company make ‘adjustments’ that would have cut its annual income by almost 50 percent, to $54 million from $105 million.....Enron chose not to make those adjustments and Andersen put its stamp of approval on the company’s financial report anyway.¹⁷

Andersen chief executive, Joseph F. Berardino, testified before the U.S. Congress that, after proposing the $51 million of adjustments to Enron’s 1997 results, the accounting firm decided that those adjustments were not material.¹⁸ Congressional hearings and the business press allege that Andersen was unable to stand up to Enron because of the conflicts of interest that existed due to large fees and the mix of services Andersen provided to Enron.

In 2000, Enron reported that it paid Andersen $52 million—$25 million for the financial statement audit work and $27 million for consulting services. Andersen not only performed the external financial statement audit, but also carried out Enron’s internal audit functions, a relatively common practice in the accounting profession before the Sarbanes-Oxley Act of 2002. Ironically, Enron’s 2000 annual report disclosed that one of the major projects Andersen performed in 2000 was to examine and report on management’s assertion about the effectiveness of Enron’s system of internal controls.

Comments by investment billionaire, Warren E. Buffett, summarize the perceived conflict that often arises when auditors receive significant fees from audit clients: “Though auditors should regard the investing public as their client, they tend to kowtow instead to the managers who choose them and dole out their pay.” Buffett continued by quoting an old proverb: “Whose bread I eat, his song I sing.”¹⁹

It also appears that Andersen knew about Enron’s problems nearly a year before the downfall. According to a February 6, 2001 internal firm e-mail, Andersen considered dropping Enron as a client. The e-mail, which was written by an Andersen partner to David Duncan, partner in charge of the Enron audit, detailed the discussion at an Andersen meeting about the future of the Enron engagement. The essential text of that email is reproduced in Exhibit 3.

The Andersen Indictment

Although the massive restatements of Enron’s financial statements cast serious doubt over the professional conduct and audit opinions of Andersen, ultimately it was the destruction of Enron-related documents in October and November 2001 and the March 2002 Federal indictment of Andersen that led to the firm’s rapid downward spiral. The criminal charge against Andersen related to the obstruction of justice for destroying documents after the Federal investigation had begun into the Enron collapse. According to the indictment, Andersen allegedly eliminated potentially incriminating evidence by shredding massive amounts of Enron-related audit workpapers and documents. The government alleged that Andersen partners in Houston were directed by the firm’s national office legal counsel in Chicago to shred the documents. The U.S. Justice Department contended that Andersen continued to shred Enron documents after it knew of the SEC investigation, but before a formal subpoena was received by Andersen. The shredding stopped on November 8^th when Andersen received the SEC’s subpoena for all Enron-related documents.

Andersen denied that its corporate counsel recommended such a course of action and assigned the blame for the document destruction to a group of rogue employees in its Houston office seeking to save their own reputations. The evidence is unclear as to exactly who ordered the shredding of the Enron documents or even what documents were shredded.

However, central to the Justice Department’s indictment was an email forwarded from Nancy Temple, Andersen’s corporate counsel in Chicago, to David Duncan, the Houston-based Enron engagement partner. The body of the email states, “It might be useful to consider reminding the engagement team of our documentation and retention policy. It will be helpful to make sure that we have complied with the policy. Let me know if you have any questions.”²⁰

Andersen, like all professional service firms, has policies guiding the retention and destruction of documents. Auditors often obtain documents and other files throughout an audit that are ultimately not relevant to the audit. Unfortunately, a common problem in the audit profession is that these documents and files are often inadvertently retained by staff who fail to appropriately dispose of the files at the end of the audit. In many instances, this occurs due to the significant work pressure placed on the staff who have moved onto other engagements. As a result, the staff fail to take the time to dispose of the unused files on a timely basis. Firm document retention policies must now conform to the rigorous requirements of PCAOB’s Auditing Standard No. 3 dealing with audit documentation on audits of public companies.

The Justice Department argued that the Andersen general counsel’s email was a thinly veiled directive from Andersen’s headquarters to ensure that all Enron-related documents that should have previously been destroyed according to the firm’s policy were destroyed. Andersen contended that the infamous Nancy Temple memo simply encouraged adherence to normal engagement documentation policy, including the explicit need to retain documents in certain situations and was never intended to obstruct the government’s investigation. However, it is important to understand that once an individual or a firm has reason to believe that a federal investigation is forthcoming, it is considered “obstruction of justice” to destroy documents that might serve as evidence.

In January 2002, Andersen fired the Enron engagement partner, David Duncan, for his role in the document shredding activities. He later testified that he did not initially think that what he did was wrong and initially maintained his innocence in interviews with government prosecutors. He even signed a joint defense agreement with Andersen on March 20, 2002. Shortly thereafter, Duncan decided to plead guilty to obstruction of justice charges after “a lot of soul searching about my intent and what was in my head at the time.”²¹

In the obstruction of justice trial against Andersen, Duncan testified for the Federal prosecution, admitting that he ordered the destruction of documents because of the email he received from Andersen’s counsel reminding him of the company’s document retention policy. He also testified that he wanted to get rid of documents that could be used by prosecuting attorneys and SEC investigators.²²

Although convicted of obstruction of justice, Andersen continued to pursue legal recourse by appealing the verdict to the Fifth U.S. Circuit Court of Appeals in New Orleans. The Fifth Court failed to overturn the verdict and so Andersen appealed to the Supreme Court. Andersen claimed that the trial judge “gave jurors poor guidelines for determining the company’s wrongdoing in shredding documents related to Enron Corp.”²³ The Supreme Court agreed with Andersen and on May 31, 2005, the Court overturned the lower court’s decision.

The Supreme Court’s decision will have little effect on the future of Arthur Andersen. By 2005, Andersen employed only 200 people, most of whom were involved in fighting the remaining lawsuits against the firm. The ruling however, may help individual Arthur Andersen partners in civil suits named against them. The ruling may also make it more difficult for the government to pursue future cases alleging obstruction of justice against individuals and companies.

The End of Andersen

In the early months of 2002, Andersen pursued the possibility of being acquired by one of the other four Big-5 accounting firms: PricewaterhouseCoopers, Ernst & Young, KPMG, and Deloitte & Touche. The most seriously considered possibility was an acquisition of the entire collection of Andersen partnerships by Deloitte & Touche, but the talks fell through only hours before an official announcement of the acquisition was scheduled to take place. The biggest barrier to an acquisition of Andersen apparently centered around fears that an acquirer would assume Andersen’s liabilities and responsibility for settling future Enron-related lawsuits.

In the aftermath of Enron’s collapse, Andersen began to unravel quickly, losing over 400 publicly traded clients by June 2002—including many high-profile clients with which Andersen enjoyed long relationships.²⁴ The list of former clients includes Delta Air Lines, FedEx, Merck, SunTrust Banks, Abbott Laboratories, Freddie Mac, and Valero Energy Corp. In addition to losing clients, Andersen lost many of its global practice units to rival accounting and consulting firms, and agreed to sell a major portion of its consulting business to KPMG consulting for $284 million as well as most of its tax advisory practice to Deloitte & Touche.

On March 26, 2002, Joseph Berardino, CEO of Andersen Worldwide, resigned as CEO, but remained with the firm. In an attempt to salvage the firm, Andersen hired former Federal Reserve chairman, Paul Volcker, to head an oversight board to make recommendations to rebuild Andersen. Mr. Volcker and the board recommended that Andersen split its consulting and auditing businesses and that he and the seven-member board take over Andersen in order to realign firm management and implement reforms. The success of the oversight board depended on Andersen’s ability to stave off criminal charges and settle lawsuits related to its work on Enron. Because Andersen failed in this regard, Mr. Volcker suspended the board’s efforts to rebuild Andersen in April 2002.

Andersen faced an uphill battle in its fight against the federal prosecutors’ charges of a felony count for the obstruction of justice, regardless of the trial’s outcome. Never in the 212-year history of the U.S. financial system has a major financial-services firm survived a criminal indictment, and Andersen would not likely have been the first, even had the firm not been convicted of a single count of obstruction of justice on June 15, 2002. Andersen, along with many others, accused the justice department of a gross abuse of governmental power, and announced that it would appeal the conviction. However, the firm also announced that it would cease to audit publicly held clients by August 31, 2002.

The details surrounding Enron’s bankruptcy and Andersen’s fall from grace will continue to be uncovered for years. Only time will tell the fate of those involved. But one thing is certain—the Enron debacle will have a profound and lasting impact on the accounting profession and on the entire business community for years to come.