Arbogast resisting corporate corruption; cases in practical ethics from enron through the financial crisis, 3e (2017)

Resisting Corporate CorruptionCases in Practical Ethics from Enron Through the Financial Crisis Stephen V.. Section 1 The Enron CasesPart 1 Demolishing Financial Control, Neutering the

Resisting Corporate Corruption

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Resisting Corporate Corruption

Cases in Practical Ethics from Enron Through the Financial Crisis

Stephen V Arbogast

Kenan-Flagler Business School, University of North Carolina, Chapel Hill, U.S.A.

Third Editon

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10 9 8 7 6 5 4 3 2 1

Section 1 The Enron Cases

Part 1 Demolishing Financial Control,

Neutering the Gatekeepers

Case 1 Enron Oil Trading (A): Untimely Problems in Valhalla 3

Notes 15

Essay 1 How to Do an Ethics Case Study 17

Case 2 Enron Oil Trading (B): An Opening for Enron Audit? 25

Notes 26

Essay 2 How a Corporation Becomes Corrupt 27

Case 3 Enter Mark-to-Market: Exit Accounting Integrity? 31

Author’s Note 43Notes 44

Essay 3 Necessary Ammunition: Economic Rationales

Financial Control at the Heart of Business Success: Personal

Experience 45

Notes 59

Part 2 Business Struggles, Accounting Manipulations

Case 4 Adjusting the Forward Curve in the Backroom 65

Case 5 Enron’s SPEs: A Vehicle too Far? 75

Notes 92

Case 6 Court Date Coming in California? 93

Notes 106

Part 3 Resisting Corruption at Enron 107

Case 7 New Counsel for Andy Fastow 109

Notes 121

Case 8 Nowhere to Go with the ‘Probability of Ruin’ 123

Elsewhere in Enron 129

Notes 138

Notes 154

Case 10 Whistleblowing Before Imploding in

Notes 171

Essay 4 Resisting Corporate Corruption: The Enron Legacy 173

Essay 5 Underappreciated Origins of the Financial Crisis –

Section 2 The Financial Crisis Cases

Part 1 New Business Models Undermine

Standards and Controls

Case 1 Seeking a Sustainable Business Model at

Author’s Note 212Notes 213

Case 2 Juggling Public Policy, Politics and Profits at

New Law, Politics and the ‘Housers’ Complicate Fannie Mae’s Mission 219

Wall Street Mounts an End Run, and Fannie

Notes 233

Case 3 Should Countrywide Join the Subprime

Wall Street Develops Collateralized Mortgage

Notes 252

Case 4 Subprime Heading South at Bear

Notes 273

Part 2 Consequences for Gatekeepers and Firms

Case 5 Ratings Integrity vs Revenues at

Subprime Mortgage Debt: The Ratings Methodology Challenge 284

Notes 295

Case 6 Admission of Material Omission?

Citigroup’s SIVs and Subprime Exposure 297

Conditions Worsen in the Mortgage and RMBS/CDO Markets 302

Considering Citi’s 3Q Results and IR’s Proposed

Notes 330

Case 8 Time to Drop the Hammer on AIG’s Controls? 331

FP Faces Collateral Calls on Subprime CDS 340

Notes 350

Part 3 Financial Firms and Resisters

Case 9 Write to Rubin? – Pressure on Underwriting

Notes 372

Notes 386

Essay 6 Wall Street and the Crisis – Causes, Contributions

Section 3 The Post-Crisis Cases – Reforms,

Resistance, Continuing Realities

Part 1 The Dodd-Frank Act: A Primer

Case 1 Morgan Stanley Seeks a Sustainable Business

Model after the Financial Crisis 397

Mack Guides Morgan Stanley into and Through the

Case 2 Back to the Future on Goldman Sachs

Blankfein Considers Goldman’s Options to

Notes 442

Case 3 Take Customer Cash to Survive? Compliance

Notes 460

LIBOR, its Fix Procedures, and Growth as a Global Benchmark 462

Notes 476

Case 5 Too Big to Know What’s Going on at Banamex? 477

Corbat Confronts the Banamex Scandal in a

Notes 494

Case 6 Take CitiMortgage to the Feds? 495

Hunt Meets Her Attorney 499

Notes 510

Case 7 Chipping Away at Dodd-Frank’s Volcker Rule? 511

Notes 524

Essay 7 ‘And the Young Shall be Thrown Under the

Bus’ – Lessons in Resisting Unethical Conduct

from Enron Through the Financial Crisis 525 Essay 8 Resisting Corporate Corruption, 2017 – Improved

Foreword

I first met Stephen Arbogast in 2006, when he was doing research on the first

edition to Resisting Corporate Corruption, an in-depth study focused solely on

the Enron scandal The case studies included those of the key players, the known names of Ken Lay, Jeff Skilling and Andy Fastow, but it also delved into the lesser known executives at Enron whose actions or lack thereof became critical

well-to the success of the accounting and legal fraud that well-took place at the company Arbogast’s extensive research in these case studies revealed the subtleties of corpo-rate opposition to the truth and the difficult options middle level executives and managers faced, including me Careful study of these cases can help young profes-sionals spot ethics issues early enough to address them, and also furnish tactical

options for promoting ethical outcomes and protecting themselves.

The second edition of Resisting Corporate Corruption retained the valuable

les-sons from Enron, but was updated to include real life examples from the rate and financial scandals that continued throughout the decade of the 2000s, culminating in the financial collapse of large Wall Street institutions in 2008 This

corpo-third edition to Resisting Corporate Corruption is a must read for all students of

American capitalism and specifically anyone considering a career on Wall Street

or in public company finance and M&A The new case studies on Goldman Sachs’ conflict of interest in the El Paso transaction as well as the Corzine/MF Global and the Citi-Banamex cases offer amazing insights into just a few of the compli-cated and ethically challenging issues facing those in finance today In reading these cases, including the incredible documentation/evidence presented, my first thought was that the ethical choice is very clear, so why the hand-wringing angst? What made the decisions cloudy? My conclusion in these new cases mirrors my experiences at Enron—that the incentives in place through stock-option heavy compensation structures and bonus schemes subconsciously force a rationaliza-tion of unethical behavior in leaders and managers

After nearly two decades of speaking on Enron and the topic of ethical ship, I am often dismayed at two grave misunderstandings about ethics and being ethical First, that “teaching ethics at the college level is pointless, that it is too late

leader-to mold a value system at that age.” The second is the naive outlook most college students maintain regarding the ethical challenges they will face in their career, namely that the ethical dilemma will be clearly seen and the choice to do the right thing, easy to make

The accounting scandal at Enron resulted in devastating shareholder and tor financial losses but on a more personal note, it produced over two dozen felons; twelve Enron executives served prison time, eight served probation, and one, Ken Lay, died before his sentencing for securities fraud convictions Arthur Andersen, Enron’s auditing firm, collapsed under a federal indictment for obstruction of justice (shredding documents), four Merrill Lynch bankers and three NatWest bankers were found guilty of various crimes akin to aiding and abetting Enron’s shaky financial schemes, and all seven bankers served at least some time in prison Hundreds more, at Enron, Andersen and various banks and law firms were tar-geted and investigated by the Department of Justice, often spending their life savings to avoid indictments Others lost CPA licenses, paid fines and otherwise had their careers and reputations ruined Chase, Citibank and Canadian Imperial Bank of Commerce (CIBC) settled Enron shareholder litigation with payments of

unethi-This is the reason I believe so strongly that universities must require ethics as a core curriculum in all business degrees The argument that ethical values cannot

be taught at the college level is irrelevant—that is not the point We must teach ethics so that our business graduates will not freeze like a deer in the headlights when unexpectedly faced with an ethical challenge The frozen-in-fear reaction will result in the same consequence as the deer, by not taking action, the ethical challenge leaves you as road kill You have “gone along” with it, just by not doing anything

Ethics courses that utilize case studies like those in Resisting Corporate Corruption cause students to work through a wide variety of ethical challenges

They also provide a tool kit of sorts for students to utilize in the real world This kind of practical ethical training is essential Without any knowledge of how to spot and address an ethical challenge, most employees will fall victim The pres-sures are just too great to do otherwise

Arbogast’s case studies also help to dispel the second misunderstanding about ethical dilemmas, which is that the ethical choice will be easy to see and respond

to appropriately I have been shocked at the number of college students who firmly believe they’d quit; walk out the door at the moment unethical behavior is required

of them I know of no one who, when the moment of truth arrived, has taken

that stance The pathway to avoid unethical behavior is rarely clear-cut, and often fraught with unexpected turns and outcomes Studying the winding and perilous paths presented in the case studies, with some succeeding and some ending in ethical lapses, will help prepare students for the real world Just as the financial crisis of 2008 showed us that the lessons of Enron had not been fully absorbed, the new cases added to this third edition reveal that the challenges exposed by the Wall Street financial collapse remain with us today

It is also my fervent hope that students of Resisting Corporate Corruption will be

able to take action without the historical consequences of whistleblowing When

I met with Enron’s Chairman and CEO, Ken Lay, in August of 2001, to warn him

of hidden accounting problems that I believed could kill the company if not rected, I was certain he’d form a crisis management committee to address the imminent peril Lay, perhaps purposely, did not “hear” me Deserved or not, the label Enron whistleblower means I cannot work in Corporate America again I now speak around the globe of my firsthand account of Enron’s ethical and leader-

cor-ship lessons It is not my chosen career path I appreciate that new corporate

legisla-tion offers proteclegisla-tions and a bounty program for whistleblowers and having that awareness through the work required by these case studies might be invaluable to more than just a few

Sherron S WatkinsFebruary 2017

This 3rd Edition of Resisting Corporate Corruption takes us beyond the Financial

Crisis The new case studies explore whether the causes of that Crisis have been addressed They also examine whether conditions surrounding those who resist corruption have evolved such that resisters have the necessary support to do the right thing and not be punished for it

The 1st Edition, published in 2007, dealt only with Enron It asked two tions: 1) How does a firm as famous as Enron become thoroughly corrupted; and 2) How can honest executives within such a firm resist this descent? Since 2007, these cases have been repeatedly taught in courses at the University of Houston and the Kenan-Flagler Business School, University of North Carolina at Chapel Hill Enron resisters Sherron Watkins, Jordan Mintz and Vince Kaminski came to classes where their cases were discussed

ques-This process brought increasing clarity to answering these questions Enron was led by a CEO, Ken Lay, who did not value sound financial control Early in Enron’s existence, he signaled to the Board and to employees that he would sac-rifice controls to address immediate business pressures Lay also repeatedly pro-moted individuals like Jeff Skilling who shared a similar indifference to controls and sound accounting Skilling particularly played a major role in undermining the integrity of Enron’s financial reports and the position of the accounting firm Arthur Andersen

These developments signaled Enron’s employees that any rule could be bent

if the party intent on doing so was clever Agents like Andy Fastow rose to the occasion When Enron’s performance faltered, they brought forward cover-up schemes of unimaginable complexity and audacity Lay and Skilling welcomed the schemes The story from there is well known The seeds planted early on by Lay and Skilling, when they dismantled internal audit and sound accounting, are still

not appreciated The lesson worth taking away is this—firms get corrupted when the CEO is weak on financial control and allows agency behavior to corrupt the accounting, compensation and promotion systems.

Enron’s corporate resisters enjoyed no legal protection However, effective tance was still possible within the firm Mintz, Kaminsky and Watkins enjoyed a measure of success by picking their resistance issues carefully and taking them to targeted executives Mintz showed how an attorney can go to outside counsel to buttress a position opposing corrupt actions Watkins picked the right issue, the

resis-fraudulent accounting for Fastow’s partnership deals Unfortunately, she picked the wrong recipient, sending her letter to Ken Lay By leaving a paper trail, how-ever, she left investigators a clear path to follow.

The 2nd Edition, published in 2013, asked how an entire industry could become corrupted Its case studies revealed the Financial Crisis to be analogous to a major traffic accident Many elements were involved, each one contributing to a chain of causation that produced a massive pile-up with carnage Each case revealed one or more elements in the chain—from Goldman Sachs’ deliberate choice to favor Big Trading over banking, to Countrywide’s decision to follow AmeriQuest into toxic mortgage products, to Moody’s sacrifice of sound ratings methodologies for mar-ket share, to AIG’s failure to reserve for the risks embedded in the subprime credit

default swaps it wrote One constant from the Enron story became apparent In the Financial Crisis cases there also were CEOs, Corzine, Mozilo, McDaniel, Greenberg and Sullivan, who subordinated sound financial control for other priorities

The 2nd Edition also asked whether the landscape for resisters had improved The answer is a qualified yes Sarbanes-Oxley (SOX) provides a foundation of legal protection The favorable publicity surrounding Sherron Watkins, WorldCom resister Cynthia Cooper, and others improved the public’s image of whistleblow-ing However, these improvements were not enough to bring forth effective whis-tleblowing in the Financial Crisis Three whistleblowers of note appeared: Richard Bowen at Citigroup, Eric Kolchinsky at Moody’s and Matthew Lee at Lehman Brothers All dealt with managements unresponsive to their disclosures and willing to punish whistleblowing All ended up leaving their companies without accomplishing much in the way of influencing business conduct Each provided lessons of what not to do as a resister Kolchinsky adamantly asserted that SOX did not provide protection for whistleblowers on Wall Street

This industry-wide failure of whistleblowing was recognized in the wake of the Financial Crisis Gaps in the SOX whistleblower protections were plugged by the Dodd-Frank law Whistleblowers were also given the incentive of a Federal bounty program run by the Securities and Exchange Commission (SEC) Subsequently,

a substantial whistleblowing legal industry developed Whistleblowers can now choose from multiple legal firms who provide assistance in return for a share of potential bounties A National Whistleblowers Center helps guide resisters try-

ing to figure out what to do The Whistleblower’s Handbook is available to educate

business people before they have to confront a crisis

These developments profoundly change the landscape for resisting corporate corruption Are they enough to help turn back the tide of corruption visible during the Financial Crisis?

This brings us to the purpose of this 3rd Edition Scandals have continued since the Crisis and the passage of Dodd-Frank Are these evidence that underlying problems haven’t been fixed? Or, are they the spasms of an industry on a glide path

to a safer and more ethical course of conduct? The new cases provide tunity to explore these questions—the major post-Crisis scandals are here: MF

the oppor-Global, LIBOR and Banamex Two cases, Morgan Stanley’s revisions to sation and Goldman’s handling of the El Paso-Kinder Morgan merger, provide opportunities to consider whether bank CEOs are sorting out the conflicts inher-ent in their Big Trading business models The MF Global and CitiMortgage cases present new junior employees, Edith O’Brien and Sherry Hunt, struggling with classic resistance issues within the new landscape Do these endangered employees enjoy fundamentally better conditions for resisting corruption than in the past?This 3rd Edition retains the classic Enron cases which chart that firm’s trajec-tory to fraudulent demise Almost all of the Financial Crisis cases return, the omis-sions being the follow-up Fannie Mae and Moody’s cases A new essay summarizes the causes of the Financial Crisis as illuminated by these case studies A primer

compen-on Dodd-Frank is provided to provide ccompen-ontext for the post-Crisis cases Finally, two closing essays have been added, one summarizing the best tactics available to motivated resisters and the second providing an assessment of whether the condi-tions promoting corporate corruption have been adequately addressed

We conclude this Preface with this point: the legal conditions for external whistleblowing have never been stronger and the support available has never been so accessible Potential whistleblowers with evidence of profound

wrongdoing now have a chance to disclose it to authorities without facing financial

ruin For those resisters still seeking to work within the firm, there is still the need to master resistance tactics and organizational smarts.

Most resisters will want to tread this internal path if at all possible These cases provide a laboratory for developing this skill set in advance of a personal, firm, or industry crisis

Chapel Hill, North Carolina,

January 23, 2017

Note to Faculty: How to Use this Book

Resisting Corporate Corruption, 3rd edition, is intended for use by Business School

faculty in a full semester MBA course Selected cases are also recommended for incorporation into Law School and continuing legal education (CLE) courses Corporations and financial firms will find many of the cases helpful for business practices and ethics training

The book is best used within a full semester framework The 1st edition

pro-vided the central text for a 13 week course, Finance and Ethics, at the University

of Houston’s C T Bauer College of Business This course was taught from 2008–2014 Students typically prepared and presented solutions to two cases per class The solutions emphasized the method discussed in the Essay: How to Work

an Ethics Case (see Essay 1) The professor supplemented the case work with short lectures introducing controls-related subjects and business practice issues, e.g., the role of internal audit, guidelines for related party transactions Finally, notable resisters were brought into class to review proposed solutions to their cases These visitors included Enron’s Sherron Watkins, Jordan Mintz, and Vince Kaminski, and Eric Kolchinsky of Moody’s

The Enron case solutions developed from this course work were compiled and

are available in the Solutions Manual to Resisting Corporate Corruption This CD

can be obtained from www.scrivenerpublishing.com Teachers considering use of the 3rd edition are encouraged to look at the Solutions Manual It will provide concrete examples of the kinds of tactical toolkits and plans which were alluded

to in the Preface Since business ethics is not physics, these solutions may not be the only or even the best possible plans The key point is to get students think-ing within this framework and motivated to find better solutions within today’s circumstances

Resisting Corporate Corruption, 3rd edition, now consists of 27 case studies,

versus 17 in the 1st edition A typical 13 week semester course can readily modate 22 case presentations This leaves time for introductory material and a midterm This approach also leaves room for including outside material and some cases that can be used as exams

accom-Individual cases can be assigned as exams “Court Date Coming in California”

served this purpose in the UH-Bauer courses, with students asked to produce PowerPoint slides framing a solution and draft letters providing instructions

to Enron executives and outside counsel Other cases used as final exams

include Subprime Heading South at Bear Stearns and Write to Rubin Instructors interested in viewing examples of these exams can contact the author at Stephen_Arbogast@kenan-flagler.unc.edu.

Several cases make use of attachments labeled “Historical Recreation.” Most times these are presented as draft documents meant to capture a protagonist’s

thinking or the work of a staff member It is important to note that these are not

actual historical documents Rather, they are teaching materials designed to

pro-vide background and frame choices for the case decision maker This technique has been used because the public record frequently provides relevant information, just not in the condensed format most compatible with a case study Where this

technique is used, faculty should consult the Author’s Note at the end of the case

It will describe the reasons for providing the attachment and the source material

on which it is based

Law and financial training courses will want to select individual cases suited

to their particular focus For example, several cases contain material on securities laws, SEC rules, and the challenges of public disclosure from a difficult set of facts Others discuss the role of internal audit and its need to sustain political support for investigations into sensitive areas These cases can provide a practical dose of reality to complement a fundamental treatment of what the law says or how audits are conducted

Select cases (and central issues) recommended for use by Law Schools and CLE

Write to Rubin? Pressure on Underwriting Standards at Citigroup

(Control structures in large organizations; political pressures on underwriting practices)

Take CitiMortgage to the Feds? (Quality assurance and reporting

At the same time, the difficulties awaiting resisters should not be underplayed Students unlucky enough to face circumstances analogous to those of Watkins, Kolchinsky, Lee or Hunt will not have an easy time Knowing their stories, know-ing too the new legal protection and communication options in play, can help them confront the difficult choices they face

Instilling the broader perspectives offered by these cases may also enable future executives to spot and defuse ethics problems before they reach the critical condi-tions portrayed in this book

As a third edition, this book owes an obvious debt to all who encouraged the publication of the first two editions This especially includes all of my ExxonMobil colleagues, who were responsible for training me in the fundamentals of finance, controls and business ethics Thanks also go to my publisher, Martin Scrivener, who supported the vision of the book from its inception

Special thanks also go to the Enron resisters, Sherron Watkins, Jordan Mintz and Vince Kaminski These three gave generously of their time during the writing

of the first edition Each then came to my Ethics and Finance class at University

of Houston’s Bauer College to discuss their case studies The discussions were not always easy for them Frequently they involved searching critiques of their actions and their reasons for not taking other routes All three not only remained open to the discussion, they actively participated in the “what else could have been tried” brainstorming Sherron Watkins has also been a steady font of information about the latest developments in corporate governance, business ethics and whistleblow-ing It was Sherron who put me in contact with Richard Bowen; the Citigroup cases were made possible as a result More recently, Sherron connected me with Helen Sharkey whose Dynegy story is discussed in Essay 7 Sherron has also come

to UNC Kenan-Flagler to discuss her Enron case

Thanks also go to those who looked at the outline for the second edition or the Financial Crisis cases, offering encouragement and suggestions Gretchen Morgenson and Bethany Mclean both looked at the book’s outline and encouraged

me to proceed Loren Steffy, then business columnist for the Houston Chronicle,

did the same Loren also put me in touch with Francine McKenna, whom he described as a most valuable source on accounting and auditing issues Francine completely lived up to that reputation Several cases, notably the AIG case, were significantly improved as a result Richard Bowen patiently guided me through the labyrinth of Citigroup’s organization and controls system

Eric Kolchinsky, the former Moody’s Managing Director, deserves special ognition Despite having to rebuild his career from scratch following his forced departure from Moody’s, Eric found time to educate me on the methodologies used to rate subprime mortgage RMBS and CDOs He also candidly described the life of a whistleblower in the financial world This shed light on certain inadequa-cies in the SOX whistleblower protections, a reality recognized by the fact that such protections were enhanced by Dodd-Frank

rec-The new cases for this third edition were compiled with the help of Flagler MBA teaching assistants John Socha, Amela Dybeli and Rob Liford Sam Shaw, a UNC undergraduate, also helped research these post-Financial Crisis cases I am grateful to the Kenan-Flagler Business School for allowing me to adapt

Kenan-my UH course into a new course, “Resisting Corporate Corruption” This course now forms part of the School’s core ethics curriculum

Last but not least, more than thanks go to my wife, Deborah, and my son, Greg Their love and encouragement, plus the occasional reminder to take a needed break, were essential to sustaining me during the writing of this work

Section 1

THE ENRON CASES

Part 1

DEMOLISHING FINANCIAL CONTROL, NEUTERING THE

GATEKEEPERS

Resisting Corporate Corruption, (1–16) 2017 © Scrivener Publishing LLC

Resisting Corporate Corruption, (3–16) 2017 © Scrivener Publishing LLC

IT WAS THE END OF THE BUSINESS DAY, February 1, 1987 Ken Lay, CEO

of Enron Corporation, sat at his desk, ruminating over his agenda for the ing day Tomorrow’s schedule showed a morning meeting with Internal Audit and two top officers from Enron Oil Trading (EOT) Louis Borget, president of EOT and Tom Mastroeni, the treasurer, were coming down from their headquarters in Valhalla, New York They had been called to Houston to answer charges of open-ing undisclosed bank accounts to conduct unauthorized transactions

follow-Lay had already heard a bit about the controversy He again skimmed an Internal Audit memo (Attachment 1) that summarized the issues The essence of the matter concerned an account opened by EOT at the Eastern Savings Bank Borget and Mastroeni were the authorized signatories on the account but had failed to report its existence to Enron’s Houston headquarters Millions of dollars from EOT trades had found their way into this account More worrisome, some

$2  million had then been transferred into Mastroeni’s personal account at the same bank Internal Audit suspected that Borget and Mastroeni had EOT engag-ing in unauthorized and/or fictitious trading, skimming money for personal gain.Houston oversight of EOT was the responsibility of John Harding and Steve Sulentic Lay sought out their views upon receiving Internal Audit’s report Eventually, they got back to Lay with a story that the undisclosed account involved transactions that were legitimate and in Enron’s interests The transactions in question were “twinned trades”: equal and offsetting buy/sell transactions used to move profits from one accounting quarter to another; such trades, they observed, were not uncommon in the trading business Borget and Mastroeni would come to Houston, bring their bank records, and explain everything Lay had pressed lightly on the point of EOT’s not reporting the Eastern Savings account to Houston and had gotten an answer to the effect that per-haps some unfortunate shortcuts had been taken but the underlying motives were ok

Ken Lay hoped that this would turn out to be true As he pondered how to run tomorrow’s meeting, his mind wandered back over Enron’s recent history and cur-rent predicaments.

Natural Gas Pipelines in Crisis

Ken Lay had only joined Enron in June 1984 It was not then known as Enron; the company that Lay took over as chairman and CEO was called Houston Natural Gas (HNG) Lay had assumed the helm at a difficult transition time for the natural gas pipeline industry Long-standing players, such as HNG, were finding that the industry business model was rapidly changing Prior to the mid-1980s, natural gas producers sold gas to pipeline owners under long-term contracts In order to induce producers to commit their gas, pipeline owners customarily provided long-term deals with floor prices and a commitment to “take or pay” for gas, i.e., take a minimum volume of gas at a stipulated price or pay the cash equivalent of having taken the specified gas amount

Two things happened in the 1980s to destabilize this model The first concerned the value of newly produced natural gas; prices had fallen to rock-bottom lev-els, below $2 per million BTUs The second was a regulatory change No longer would pipeline operators be able to lock out producers who didn’t commit to ship through their lines Instead, gas producers were now able to sell directly to end users and require pipelines to ship their volumes for a simple transport tariff.These changes rocked the gas pipeline industry Newly developed gas started finding its way directly to end users at the low spot market price Major carri-ers increasingly found themselves burdened with gas purchased earlier at higher prices under take-or-pay contracts Pipeline company financial conditions dete-riorated Debt ratings were downgraded The carriers labored to work their way out from under disadvantageous contracts HNG was no exception

Ken Lay thought he knew how things would play out His assessment was that natural gas market deregulation would continue to progress; from this, he concluded that future profitability would become a function of scale—that is, the biggest pipeline companies with the most extensive networks would become low-cost providers and would end up dominating a market of natural gas production sold largely at spot prices and moved via low-cost logistics

As if on cue, the gas pipeline industry began to consolidate Again, HNG was

no exception In April 1985, a call came from Omaha-based InterNorth suggesting

a merger InterNorth was approximately three times the size of HNG However, its senior management was aging, its board was divided and both were uncertain about how to cope with the deregulated market A corporate raider, Irwin Jacobs, was stalking the company InterNorth needed a deal

Immediately prior to the merger talks, HNG stock was trading at $45 a share

In just eleven days, Lay was able to extract both a $70 per HNG share price (a

56  percent control premium) and a commitment that he would move up to CEO after a couple of years The InterNorth/HNG merger closed within the year, and the new entity was christened Enron in 1986

Unfortunately, the merger did little to alleviate the pipeline company’s diate economic straits Profitability was miserable The natural gas glut seemed

imme-to produce ever-lower prices Enron had imme-to face this deteriorating environment with more than $1 billion in take-or-pay contract liabilities Enron reported a

$79  million loss for 1985, its first year of operation Attachment 2 details Enron’s financial performance for 1985–86 Although Enron reported net profits of

$556 million for 1986, the bulk of that reflected recoveries of past income taxes Enron’s financial condition was more accurately reflected by the following: earn-ings before interest and taxes (EBIT), $230 million; interest expense: $421 million.Enron was now heavily debt-laden, the product of InterNorth’s having used debt

to fund the premium price for HNG’s stock To some extent, this leveraging up of the company had been intentional Irwin Jacobs’ group was being paid $350 million to hand over its InterNorth stake and go away InterNorth thus reckoned that a heavy debt burden would act as shark repellant for future raiders; however, high debt levels also hamstrung the newly merged entity Ken Lay found that his firm’s bank loans contained covenants requiring quarterly interest expense to be covered 1.2 times by EBIT; failure to do so would mean an event of default Enron would be especially exposed in such case, as the firm also had more than $1 billion of commercial paper outstanding These unsecured short-term promissory notes had to be rolled over continuously A hiccup on bank loan covenants could spark a full-fledged financial crisis should it lead commercial paper buyers to flee from Enron’s paper

In January 1987, Moody’s Investors Service downgraded the company’s term rating to below investment grade, i.e., to junk status

long-This perilous financial condition meant that Ken Lay spent much of 1986 focused on maintaining liquidity and avoiding the default triggers in Enron’s bank loans Lay froze senior executive pay and sold some pipeline assets Enron stayed afloat, but the company was barely scraping by

In fact, a good portion of the company’s razor-thin margin for error was being contributed by a little-known and understood entity, EOT InterNorth had cre-ated the subsidiary back in 1984 Trading oil commodities was a relatively new business at that time InterNorth chose to enter the business by hiring an estab-lished trader, Louis Borget InterNorth lured him away from Gulf States Oil and Refining, where Borget had set up a similar unit three years earlier The package

to induce Borget to move included bonuses tied to the profits produced by the trading operation

EOT immediately began to report profits In 1985, when the merged InterNorth/HNG lost $79 million, EOT made $10 million In 1986, when Enron couldn’t cover interest expense with operating earnings, EOT reported profits of

$28 million

Ken Lay still wasn’t sure what to do to fix Enron’s financial problems He believed that long term, deregulation would reward his company For the near term, Enron seemed bogged down in a bad business environment of low prices, intense competition, and the burdens of high debt One thing he did know was that EOT’s contribution was helping the company cope in the short run while it waited for the longer run to bring improved conditions

Lay had another, more political problem closer to home The board of InterNorth had rebelled against his predecessor, Sam Segnar, concluding that he had caved in

to HNG’s demands during the merger negotiations Segnar had ended up paying with his corporate head Lay replaced him but soon faced bitter resistance from former InterNorth directors on a series of secondary but highly symbolic issues: the appointment of Enron’s public accountant and the relocation of Enron’s head-quarters to Houston The issues eventually were resolved, with Lay getting his way

on the relocation Lay had also begun to replace former InterNorth directors with selections more supportive of his leadership Still, at the outset of 1987, Ken Lay was a CEO under the microscope, facing a board that was divided and in some cases personally bitter toward him

None of this was lost on Ken Lay as he skimmed over Internal Audit’s memo yet another time

Considering the Options

Lay’s mind quickly focused on shaping an outcome for the meeting

What do I do to resolve this issue? I’d better walk into this meeting with some idea of the answer we want at the end.

What really matters here? What issues take priority over others? I have

to give preference to the financial condition of our company This means that EOT’s profit-generating capability needs to be preserved Moreover,

a financial scandal right now could be devastating Not only might EOT’s profit contributions be affected, but Enron’s past financial results might have to be restated Accounting restatements are yellow flags, signs that something major is amiss inside a company It wouldn’t be long before Enron’s equity analysts and lenders get wind of unreported bank accounts, and dubious transactions They’d assume the worst and wonder what else they didn’t know The result could be a major crisis of confidence leading to a liquidity crisis for Enron.

Borget and Mastroeni have undoubtedly broken some rules That’s not

a total surprise coming from traders and their culture We have to find some means to limit abuses while leaving EOT’s risk-taking culture intact.

What exactly are the allegations of wrong doing here? It seems that Borget and Mastroeni either received or thought they’d received signals from Houston to manage the timing of EOT’s reported profits They responded by doing some of what others in their industry also do— twinned trades that give another party profits in one period to be offset

by profits returned in the subsequent period Such trades are not gal They altered quarterly results, but that’s not uncommon: Everybody

ille-“manages earnings” one way or another The worst that can be said is that

they executed these trades in a fashion that was less than aboveboard Clearly, they must have assumed that not everyone in Houston was on board with managing earnings Why else would they have not reported the new bank accounts? And what’s this about company money going into Mastroeni’s personal account? Whatever the reason, and I’m sure they’ll have one, that’s got to stop.

What to do about it all? How best to keep the big picture in mind but still send a message that excess won’t be tolerated?

With this, Ken Lay picked up a pen and began to outline a set of options He began by listing categories of possible remedial actions:

Immediate issue management

He then expanded each bullet point with possible options to consider:

Immediate issue management

Define the transgressions associated with EOT bank accounts, trades, and the mingling of corporate money with personal accounts, and the mitigating circumstances

Ensure that Enron’s financial condition is a major factor ing any resolution of the incident

shap-Determine the “materiality” of accounting issues and the need for any restatement of public financial reports

Personnel discipline: options

Terminate Borget or Mastroeni or both

Terminate Harding or Sulentic, or both

Discipline some or all of the above in terms of future sation, responsibilities, and title

compen-Possible organizational reforms

Revise Houston’s oversight of EOT, either changing out current management and/or intensifying oversight in terms of stew-ardship reviews and/or oversight of controls

Embed new management at EOT:

New trading personnel loyal to Houston management, charged to learn EOT’s business model

New financial management loyal to Houston charged to ensure that controls are sound and rules are respected

A financial controls advisor assigned to EOT for the nite future.

indefi-Transactional rules

Have Internal Audit recommend new/clarified rules for rizing and reporting bank accounts, trades, and unit financial results

autho-Have the chief accounting officer and/or Arthur Andersen opine on the acceptability of twinned trades done solely for the purpose of managing earnings; consider whether such trades might have other economic rationales

pres-Review who should be EOT’s legal counsel and whether that presence should be in Houston or Valhalla

Well, I clearly have a range of options available Possibly I can blend a couple of different actions to not upset the apple cart while still making it clear to EOT that there are boundaries

It flitted through Lay’s mind that the meeting’s outcome would go some distance toward setting the tone on financial control for the newly merged company:

There have been whispers in Houston that EOT is not respecting its oil-trading limits The division’s open position is not supposed to exceed eight million barrels;

if losses exceed $4 million, the open position is to be liquidated Some of Enron’s Houston-based traders are questioning how EOT could generate the profits it was reporting without breaching these boundaries After all, trading limits contain the magnitude of gains as well as losses Still, nothing hard has surfaced Perhaps this

is only professional jealousy at work

Whatever I decide, it will have to be smoothly executed Enron is in no tion to absorb public scandal This will have to be handled carefully

posi-It also occurred to Lay that this episode could contain an opportunity Sometimes, rule breaches are expressions of pressures that need to be resolved; under such pressures, managers sometimes choose the path of least resistance Was EOT one of these cases? If so, was there a way Lay could use EOT to deliver

a message that might reverberate positively throughout the struggling pipeline business?

Lay packed up his notes without making a firm decision on a course of action

He found himself leaning toward correcting the abuses without firing anybody

However, he would reserve judgment on the severity of corrective actions until

he heard the full story Lay also reflected that the oil-trading business was thing of a mystery It was relatively new and not a heritage HNG business; profits seemed to be closely tied to the quality of the individuals doing the trading

some-In 1986, Borget himself had told the Enron Board that oil trading “as done by professionals in the industry today, using the sophisticated tools available, can generate substantial earnings with virtually no fixed investment and relatively low risk.”1

Lay resolved to listen carefully to what emerged between the lines at the next day’s meeting—especially to the vibes regarding how EOT generated its prof-its Would there be anything more to the auditors’ allegations than what he had already seen in writing and heard from Harding and Sulentic? If so, Lay might have to adjust his plan of action right there at the meeting

The Meeting with Internal Audit

The meeting convened with Borget and Mastroeni present, along with Enron’s general counsel Rich Kinder, as well as Harding and Sulentic David Woytek and John Beard represented Internal Audit Lay opened the meeting, calling on EOT president Lou Borget to address Internal Audit’s concerns

Borget and Mastroeni laid out the following facts EOT had been highly itable in 1986 As this became known, company managers requested that they find a way to shift some profits into 1987 They were told to do this by “whatever legitimate business practice we could.” As a result, EOT resorted to matched, or twinned, trades that would net out over the period 1986–87 Borget observed that such trades were commonly used by other trading companies Mastroeni stated that EOT had identified three firms interested in boosting their 1986 profits: Isla Petroleum, Southwest Oil and Commodities, and Petropol Energy EOT then entered into trades with those three entities, selling oil at prices that delivered profits to them during December 1986; the deal was for EOT to buy back oil and recoup equal gains during the first part of 1987 Mastroeni explained that they opened the Eastern Savings Bank account as a place to hold cash proceeds from the 1986 sales However, because this account was in Enron’s name, Mastroeni stated that he had moved money to his personal account to avoid attracting atten-tion and complicating Enron’s year-end statements Their intention was to return all funds to Enron in 1987

prof-Sulentic then added that it was all a misunderstanding, that Borget and Mastroeni believed that they were acting in Enron’s best interests He added: “I say

we accept that mistakes were made, do what needs to be done to correct them, and move on to a profitable 1987.”2

Ken Lay then spoke, making it clear that he disapproved of the methods EOT had used to accomplish its goals He asked whether anyone else at the meeting had anything to add

David Woytek spoke up, pointing out that the bank statements EOT had brought to the meeting had been altered Transactions showing funds transfer into and out of the accounts had been removed Woytek had the statements pro-vided by the Eastern Savings Bank to document the point.

Mastroeni then explained that the deleted transactions referred to a disputed bonus paid to a trader The individual in question had been fired near the end of

1985 He had retained a lawyer and threatened to sue the company if his pated year-end bonus was not paid After some discussion, a close-out settlement

antici-of $250,000 had been agreed upon Woytek asked Mastroeni why, if that were so, there was any need to alter the bank records Mastroeni replied that the incident had nothing to do with the transactions under discussion at this meeting, so they simply took them out of the bank statements to avoid confusing the issues.Lay listened to the conversation as it surged back and forth What he had just heard amounted to new information; Borget and Mastroeni had brought doctored bank records to the meeting

They had made a decision not “to confuse” the issues, in the process attempting

to prevent some transactions from coming under scrutiny

It was getting close to the moment when Lay would need to end the sion and focus the meeting on what actions should be taken Lay had now heard Borget/Mastroeni’s stories explaining the opening of the unreported bank account, the origins of the funds transfer into the account and the outflow of money to Mastroeni’s account How much could he take those stories at face value? And how should this new information—that EOT’s managers had altered bank records—influence the perspectives and options he had mulled over the night before?

discus-Attachment 1—Historical Recreation (HRC)

MEMORANDUM

January 25, 1987

SUBJECT: Possible Irregularities at Enron Oil Trading

This memo intends to summarize our findings so far regarding potential financial irregularities at Enron Oil Trading (EOT) and to lay out the issues requiring further investigation

On January 23, Internal Audit was contacted by an officer at the Eastern Savings Bank The bank had identified unusual activity involving an Enron bank account and wanted to verify with company officials that certain trans-actions were legitimate

The officer reported that Tom Mastroeni, treasurer of EOT, had recently opened an account at the bank Mastroeni and EOT president Louis Borget are listed as signers on the account Immediately following the account opening, transfers totaling $5 million flowed into the account from a bank located in the Channel Islands, a European tax-haven location Subsequently, funds in excess of $2 million left the account and were transferred to another account registered in Tom Mastroeni’s name Eastern Savings has cooperated

by sending us statements documenting both the account opening and the funds flows into and then out of this new account

We have checked Enron’s corporate registry of bank accounts and can find

no evidence of the Eastern Savings Bank account having been recorded on the company’s books

We have interviewed Steve Sulentic and John Harding, EOT’s tact executives in Houston They advise that since 1985, EOT has, at their request, taken actions to move accounting profits from one reporting period

con-to another Apparently, the actions involved are twinned trades, i.e., taneously negotiated sale/buy oil trades having different time periods In the typical transaction, EOT would sell oil one month forward at a price attrac-tive to the buyer and contract to purchase the oil back two months forward

simul-at an equally simul-attractive price The net effect of the two trades is zero, but if done at the end of an accounting period, the first transaction creates a loss for EOT, with an offsetting gain recorded in the subsequent period

It is unclear whether Messrs Harding and Sulentic knew of the precise mechanism used by EOT to move profits between accounting periods However, these executives indicate that such transactions are not unusual among oil traders Sulentic and Harding now believe that the transactions

that led to funds transfer into the Eastern Savings account may have resulted from EOT’s entering into year-end 1986 twinned trades They also indicate that Borget and Mastroeni are available to come to Houston to clarify this matter.

As of this moment, we do not know whether the funds transfer sent legitimate EOT business transactions, trades done solely for account-ing purposes, or irregular activity It is certainly a concern that funds flowed through the Eastern Savings account and into the personal account of a company officer; such activity involving an amount over $2 million is highly irregular It is also a “red flag” that this activity took place in a new account set up in circumvention of clear corporate guidelines requiring the report-ing of all new bank accounts to corporate headquarters To the extent that these transactions are irregular, they may represent theft of corporate funds

repre-To the extent that the transactions are found to be legitimate, their books” nature could require restatement of financial records and reported results for 1986

“off-the-The issues requiring further investigation are thus the following:

For what purpose was the new account at Eastern Savings Bank opened?

Why was this account’s opening not reported to Houston? Failure to do so is a direct violation of company control standards

Was there any substantive business purpose associated with the cash transfers that entered the Eastern Savings Bank account?

What justification can be provided for corporate funds being transferred to the personal account of an employee?

Are all corporate funds accounted for?

When will the funds be returned? If not immediately, why not?

If the underlying transactions were entered into solely for the purposes of altering EOT’s reported earnings, do Enron’s

1986 financial statements need to be restated?

In conclusion, the facts known to date are of grave concern and warrant a full investigation The potential implications include loss of corporate funds

as well as misstatement of records, deliberate manipulation of records, and the creation of fictitious losses with impacts on Enron’s financial statements and tax returns for the year ending 12/31/86

Income from Continuing Operations

Before Extraordinary Charges

Author’s Note

This case relies principally on the accounts of the Valhalla financial control issues

provided in The Smartest Guys in the Room (pp 15–19) and Conspiracy of Fools

(pp 15–19) Both books treat the episode in detail and with minor discrepancies provide accounts that are consistent as to the facts

Each book offers some details not provided by the other For example, The Smartest Guys in the Room provides details of the trading limits in existence

at EOT, the financial condition and bank covenants of Enron at that time, and the fact that David Woytek sent Ken Lay a memo describing the EOT twinned

trades as creating “fictitious losses.” Conspiracy of Fools provides a detailed

account of the meeting of EOT’s Borget and Mastroeni, Enron Internal Audit, and Enron management This work also confirms that Lay attended that meeting and gave explicit instructions as to what remedial actions were to be taken

The Smartest Guys in the Room (p 18) identifies Steve Sulentic and

John Harding as Borget’s Houston-based nominal superiors That work quotes

“internal documents, court testimony and notes detailing these events” in

describ-ing how the two executives articulated a rationale for Borget to “move some profits from 1986 into 1987 through legitimate transactions.” Sulentic’s defense

of the traders’ actions as a “misunderstanding” appears in Conspiracy of Fools

(p 18)

Parts of the case are created for purposes of surfacing the issues and options facing Ken Lay Lay’s thoughts on the night before the meeting, which appear between quotation marks and in italics, have been crafted for these purposes They do not represent material found in any published source This applies also

to the list of options he outlines while sitting in his office The portrayal is, ever, consistent with (1) the fact that he received a memo from David Woytek on the possible irregularities and (2) the actions taken by Lay at the end of and right after the meeting It is also apparent from the content of the memo forwarded by

how-David Woytek that Lay had heard at least a preliminary version of the “twinned trade to move accounting profits” story that Harding and Sulentic presented at

the meeting Lay’s options list has obviously been expanded beyond the actions

he actually endorsed in order to provide students with a full range of choices to consider

Attachment 1, Beard’s memo to Woytek, is a Historical Recreation (HRC) intended to summarize the facts known to the auditors prior to the meeting with Borget and Mastroeni However, it is factually based, being grounded in not only the general accounts provided in the sources but also in: (1) the fact that Woytek did provide a memo to Lay and other senior managers, (2) published comments

from Beard’s notes, and (3) a published quote from Woytek’s memo describing the twinned trades as creating “fictitious losses.”

Attachment 2 is drawn from Enron’s restated public financial filings

Notes

1 McLean, B and Elkind, P., The Smartest Guys in the Room: The Amazing Rise and

Scandalous Fall of Enron , p 17.

2 Eichenwald, K., Conspiracy of Fools: A True Story, p 18.

Resisting Corporate Corruption, (17–24) 2017 © Scrivener Publishing LLC

Most individuals in corporate life come to ethics issues largely unprepared And then, when unlucky enough to encounter something unethical, people can find the deck stacked against them They are unprepared because they have had little train-ing and even less practice in handling the complexities ethics issues bring They may have their personal sense of morality as a guide but not much more If they had liberal arts training, they may have discussed philosophy or morality but not

in a concrete setting in which the personal consequence may be demotion or mination of employment Their business or law school training my have provided

ter-a low-emphter-asis course on corporter-ate governter-ance but not much on whter-at to do when your boss orders you to work around a law

They will find the deck stacked against them because when they first ter an ethics problem, they usually will be dealing with someone above them in management This person or persons will have the advantage not only of senior position, but also more experience managing decisions through the organization and past its gatekeepers

encoun-New employees are quickly socialized by their everyday business experiences into the real world of “gray zones.” Firms don’t violate accounting principles per se but use them adroitly to present their results in the best light People often spin or withhold information internally or from customers or partners when they perceive an advan-tage in doing so Tax departments work up almost-substanceless transactions to reduce taxes Almost everyone comes around to a belief that pressing against—even bending—the rules is part of competing and succeeding in the real world of business

So, most everyone is partially conditioned to unethical practices when denly something more substantial cuts across their radar screen The first reaction may be a flash of recognition and an impulse to push back And then the complex-ity of the situation and the personal risks come to mind If there isn’t a reliable financial control structure to look to for support, the challenge involved in resist-ing can seem overwhelming For many caught in this unhappy situation, decisions

sud-to go along or avert one’s eyes can come quick and easy

How to Do an Ethics

Case Study

The alternative answer is to practice in advance the spotting of ethics issues and the formulation of effective resistance plans These practice situations have to

be representative, realistic, and difficult Suggested solutions have to draw upon lessons of what has worked in real situations that involved difficult ethics issues.Practice will instill several valuable capacities For one, it will sharpen the ability to distinguish a serious ethics issue from the more mundane boundary pushing that con-stitutes an accepted part of normal business Real career-jeopardizing resistance should

be expended only on serious ethics issues For another, it will enhance understanding

of the tactical options available for resisting, the personal risks involved in resisting, and ways to manage the two This understanding can bring several advantages:

It can improve one’s thinking on how to win a more ethical come and thus bolster one’s sense that resistance is both feasible and worth the risk

out-It can also sharpen one’s sense of the varying personal risks posed

by different courses of action Not every act of resistance runs a termination risk Much resistance can also be mounted in ways that minimize career hazards for the resister

Finally, practice in formulating tactical plans can help one vise as necessary in a “live fire” situation The more situations one has considered and the more tactical responses one has devised, the more creative will be one’s responses to real ethics dilemmas if and when they arise

impro-With practice on these cases, students should be able to react to a real situation with a sense that they’ve seen something like this before Beginning resistance from that posture rather than one of shock or confusion is half the battle

The Solution Framework: Defining the Ethics Issue

As outlined in this Essay, individuals have to formulate resistance plans that address each of five elements:

1 A clear statement of the ethics issue, including why it deserves to

be considered exceptional

2 Statement of a boundary condition—an achievable, ethically

acceptable outcome to the concrete business situation

3 Identification of the potential personal consequences for resisting

successfully or unsuccessfully An initial assessment should be made

as to whether these consequences can be accepted if worse comes

to worst Practical consideration of how to mitigate personal risk should be deferred to after one’s tactical plans have been developed

4 Conceive an alternative business approach to the questionable

pro-posed practices The standard here is to identify the best alternative business option that is consistent with your boundary condition

5 Develop a tactical plan of resistance Most times, this plan will be

aimed at securing a decision in favor of the ethical business plan Other times, however, the tactical plan will be aimed at containing damage and/or positioning for a later time

We will now look at this five-stage process in more detail, beginning with the ethics issue When trying to define the Ethics Issue, it can be helpful to assign the problem to one of the following general categories:

Potential violations of law or regulations with force of law

Potential violations of company policies

Actions that violate sound financial control practices

Actions that weaken the fabric of internal controls, potentially paving the way for specific subsequent abuses or legal violations

Conflicts between professional roles and a responsibility to resist illegal activities (e.g., an in-house attorney’s predicament when serving a client with potentially illegal ideas)

The cases in this book pose ethics issues that fall into all of these categories Students can better determine which category best applies to each case by focus-ing on the possible consequences of allowing the questionable activity to proceed.The next step is to conceive of an acceptable ethical outcome Boundary cond-tions are difficult, and so temper one’s target outcome with realism One may wish that a firm didn’t use any aggressive tax shelters, but a realistic solution may

be stopping those likely to result in IRS penalties

One aid to finding the right balance between realism and doing the right thing

is to ask: what is the minimum outcome that could be considered ethically able in this case? By defining this minimum acceptable outcome, ethics and real-ism will have to be reconciled Defining this boundary doesn’t prevent one from striving for a solution well inside it However, knowing this boundary does help clarify where no more compromises should be made

accept-Sometimes an acceptable ethical outcome is not politically achievable In such cases, resisters can target one of the following next best outcomes:

1 Containing the damage by surrounding the unethical practices with compensating controls and review procedures

2 Making arguments and issuing warnings that set the stage for reversing the unethical decision later

3 Relocating the issue from inside the firm’s management structure out into the firm’s relationship with regulators and/or markets

When making this choice, resisters will need to consider the gravity of the unethical practice and the state of the firm’s controls For example, a decision that weakens controls but doesn’t violate the law might well be treated as a fight-another-day situation