Enron Was Warned of Violations, Auditor Says
The head of the Arthur Andersen accounting firm told a congressional panel Wednesday that his firm warned Enron Corp. directors early last month that the company might be guilty of “possible illegal acts” for withholding critical financial information from Andersen auditors.
The testimony by Andersen Chief Executive Joseph F. Berardino came during the opening round of an expanding probe on Capitol Hill of the largest bankruptcy in U.S. history--one that has left tens of thousands of investors--including mutual and pension funds--with nearly worthless stock.
The allegations in the House hearing marked the first time an individual with inside knowledge of Enron’s practices has raised the prospect of illegal behavior. It also opens a serious public breach between the collapsed energy trading firm and its auditors, who are also under investigation.
Berardino disclosed that Enron officials had committed a possible violation of corporate disclosure laws by arranging a secret deal with an unnamed bank to mislead Andersen auditors.
Enron convinced the auditors that debts held by an internal partnership did not have to be included on its financial statements because the bank had made a “substantive” investment of its own in the partnership, he said.
If that were true, securities law would have allowed the partnership debts to be kept off the books. But Enron failed to tell Andersen that it had provided the bank with half the cash necessary to make the investment, Berardino said.
“It is not clear why the relevant information was not provided to us,” Berardino testified. “We are still looking into that.”
Enron officials disputed the allegation, saying the firm had always been open with its accountant. It claimed that it was company management, not Arthur Andersen, that discovered the arrangement, realized its relevance and reported it to Andersen within 24 hours.
Meanwhile, one of the key players in the Enron meltdown failed to comply Wednesday with a Securities and Exchange Commission subpoena. The SEC wanted to interview Andrew Fastow, former chief financial officer and one of the key architects of Enron’s partnership strategy. Fastow made $30 million from his management of the partnerships.
The accounting treatment of the Enron partnerships has played a key role in the firm’s collapse. When Andersen belatedly learned of the transaction, Berardino said, it issued its warning to the audit committee of Enron’s board of directors. That triggered a restatement of Enron’s earnings on Nov. 8 in which the company admitted overstating profit by $569 million over the previous four years.
That confession was one of the key events that shook the investment community’s confidence in Enron, sending its stock into a death spiral and causing its former trading partners to shun the world’s biggest energy trader.
An eleventh-hour takeover bid by Houston neighbor and rival Dynegy Inc. was announced Nov. 9, but that deal was scuttled Nov. 28 after more disclosures about Enron’s questionable finances. With the Dynegy rescue off the table and Enron’s stock price under $1, Enron last week filed for Chapter 11 bankruptcy protection.
The Enron debacle and the resulting congressional investigations could produce legislation on a number of fronts: stronger requirements for disclosure of financial information by corporations, limits on how much of an employee’s pension funds can be invested in the employer’s stock and new conflict-of-interest rules for accountants and stock analysts.
Opening Wednesday’s hearing, Rep. Richard H. Baker (R-La.), chairman of the House Financial Services subcommittee on capital markets, said the Enron case has “far-reaching implications.”
“We must make the careful determination of whether we are dealing with a case of outright fraud and violation of existing securities laws. Or whether investors failed to receive an accurate picture of Enron’s financial condition as a result of existing disclosures and accounting standards that are insufficient and require revision,” Baker said.
The session with the two House Financial Services subcommittees--the first of a string of planned congressional hearings--was held without its star witness, Enron Chairman and Chief Executive Kenneth L. Lay, a big campaign contributor and friend of President Bush.
The congressional investigation puts lawmakers in a politically awkward position. Enron contributed more than $1.6 million in the last election cycle, most of it to Republicans. GOP House leaders have pledged to grill Enron and its executives and joined Democrats on Wednesday in assailing Enron bosses for cashing out more than $1 billion in stock while employees were barred from selling stock in their retirement accounts.
The hearing was conducted in the room Republicans used to investigate President Clinton’s Whitewater real estate venture. Some Democrats are relishing the opportunity to look into Enron executives’ ties to Bush and their private meetings with Vice President Dick Cheney, which produced the administration’s energy policy.
Rep. Luis V. Gutierrez (D-Ill.) raised the prospect of new limits on the investment of employee 401(k) retirement funds in company stock.
Rep. Paul E. Kanjorski of Pennsylvania, the top Democrat on the House Financial Services subcommittee on capital markets, expressed concern that accounting firms that collect consulting fees from the companies they audit could pose a conflict.
Arthur Andersen collected $47.5 million from Enron last year.
But Berardino said, “I do not believe the fees we received compromised our independence.”
And, he said, “The accounting profession will have to reform itself. Our system of regulation and discipline will have to be improved.”
Perhaps the most bewildering Enron transactions involved “special-purpose entities,” or SPE’s, which were limited partnerships or other structures set up so that Enron could potentially reap profit and tax advantages from certain investments while keeping large amounts of debt off its balance sheet.
Enron attempted to misuse complex accounting rules to do so, Berardino said.
Accounting rules say a company does not have to include the operations of a partnership or SPE if there is a “substantive” investment in the venture by an independent third party. Generally, that minimum investment is about 3% of the equity, or ownership, although that figure also is a source of debate.
In 1997, Enron told Andersen that an unnamed, large international bank held an $11.4-million stake in a partnership named Chewco--an investment that met the 3% threshold, meaning that Enron could keep the partnership off its books.
“However, we recently learned that Enron had arranged a separate agreement with that institution under which cash collateral was provided for half of the bank’s investment,” Berardino testified.
In other words, Enron slipped the bank half of its money back while keeping its auditors in the dark. When Andersen learned of the secret deal, it warned the audit committee that withholding such information is illegal. Six days later, Enron restated its earnings.
Enron responded Wednesday that it had moved quickly after it rooted out the problem. Enron said it referred that matter to a special investigative committee of its board of directors, which uses another accounting firm.
Andersen’s description of events “falls a bit outside the scope of what actually happened,” Enron spokesman Mark Palmer said. “We uncovered the information. . . . The board and Enron acted upon that information” by restating earnings.
In papers filed with the District Court in Washington in connection with Fastow’s subpoena, the SEC said, “Enron’s spectacular collapse was related, in part to these limited partnerships. Fastow’s testimony is therefore relevant to the Commission’s investigation.”
The federal agency filed papers Wednesday seeking a court order that would compel Fastow to meet with SEC investigators. An earlier interview was canceled by the government and the parties are now disagreeing over a new date, though Fastow’s attorneys said he will meet with the SEC.
Fastow has hired David Boies, former Vice President Al Gore attorney in last year’s effort to overturn the results Florida’s presidential vote, and the lawyer who represent the government its antitrust suit against Microsoft Corp.
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Times staff writers Jerry Hirsch and Nancy Rivera Brooks in Los Angeles contributed to this report.
