Learning from Financial Fraud Series Episode 5: Uncovering the Enron Accounting Scandal

Announcer  00:04

Welcome to the Treasury Update Podcast presented by Strategic Treasurer, your source for interesting treasury news, analysis, and insights in your car, at the gym, or wherever you decide to tune in.

Jonathan Jeffery  00:18

Welcome back to the Treasury Update Podcast, you’re listening to the Learning from Financial Fraud Series. In this series, we explore multiple major financial fraud cases, we discuss how each one occurred, and was kept hidden for a period of time, and we’ll dissect how it was eventually discovered, and get insights and guidance on how to prevent this type of situation from happening to you and your organization. I’m Jonathan media production specialist here at Strategic Treasurer and your host for this podcast. And I’m here with Craig Jeffery, managing partner. Hi, Craig. How’s it going?

Craig Jeffery  00:49

It’s going well, Jon.

Jonathan Jeffery  00:51

Well, thank you for joining us. So as a recap on this series, we’ve looked at four cases so far, Parmalat, Satyam, Wirecard, and FTX. Craig, do you have any special notes from any of those you want to share with the listeners on today’s podcast?

Craig Jeffery  01:05

I’ll do a quick thumbnail sketch overview of those. Hopefully people are listening to their podcast and I hope by the time we get up to 10 I don’t have to recount all of them. But Parmalat was an Italian dairy company. They had significant fraud. They created fictitious balances, they fooled the auditors think the loss was a total of a little over 8 billion, 4 billion with one bank that was fraudulently reported in scam Satyam Indian, it firm, the loss was greater than a billion. It was carried out through both accounting collusion and setting up fictitious employees to exfiltrate funds out of the organization. And this was discovered from a confession letter which I think is extra interesting, right the the conscience bearing witness on their poor mind and needing to free it up with a with a confession letter. The Wirecard fraud was a lot more current, there was a lack of visibility, and it was counting funds moving between different institutions and countries. It was a form of kiting and presenting information that way, this was a big payment company fraud, so rock that rock that world pretty heavily. The FTX trading fraud. This was a company that blew up and grew up very quickly. From the digital currency trading world. They made many political donations they named the stadium for in the Miami Heat, as well as the university stadium. They use customer funds for personal use. They move money, move customer money, not just for personal use, but also to fund other organizations and trading activity. Today, we’re adding another one to the list our fifth topic on this series, and today we’re looking at one of the very massive bankruptcy we’re looking at the Enron accounting scandal. This was one of the top 10 bankruptcies in the US.

Jonathan Jeffery  03:00

So Craig, can you walk us through what happened with this scandal?

Craig Jeffery  03:05

Sure, I’ll give you the real quick thumbnail. So if this happened in 2001, the bankruptcy occurred in 2001. So it’s more than two decades old. But anybody who’s older than probably 20 still remembers how, what kind of impact that had. So Enron is an energy company. They were accused and proven in court to be guilty of multiple financial irregularities. People trying to report the problem. One, one lady, in particular VP, blew the whistle many, many times and it was ignored for quite a long time. And this also resulted not only bankruptcy, a lot of jail activity. And the end of the Arthur Andersen name. For all intents and purposes, this is back when I’m not sure if it was the big six or Big Eight, the large accounting firms, if that had shrunken down below eight at that time, but that took the Arthur Andersen name out of play. That was a significant significant development. Yeah, yeah, this is a pretty popular one. I was asking someone recently if they remember the name Enron, and they said, Yeah, isn’t that didn’t they have some big scandal? So it’s a it’s a pretty well known pretty well known case? Well, John, one of the things too, on this that I hadn’t mentioned is this is where special purpose entities got a particularly bad name because Special Purpose entities exist for a reason. But they were used in this case very heavily to hide the problems with Enron Move, Move liabilities off the balance sheet and transfer in sensibly assets to make the larger company appear better. So that was a that was a significant development there and how people look at special purpose entities going forward.

Jonathan Jeffery  04:46

Yeah, and we’ll get into that in a little bit. One of the interesting things about this was compared to the previous episodes in this fraud series, is there’s a lot of people involved and a lot of people were charged. I was reading an article when I was researching this and and they were talking about, it was someone who had worked there that there was this culture of if you started asking questions about how the structure work, how the accounting work, the special entities, they would tell you that, if you don’t understand it, you’re not smart enough to get it. And they would just kind of like shame you to feel like you have to just pretend you understand if you don’t. And so it made it hard for people to ask questions. And we talked about this on our last episode, where if you see something, say something, don’t be ashamed of it, you have to be able to bring it forward. And here’s an example of where people were saying that they did say something. And they were just kind of pushed out of the way said, Oh, you’re not smart enough to do this. So that was an interesting, something interesting that I found when I was researching this. So let’s go through some of the people involved, what they were accused of what they were convicted of. Can you walk us through that, Craig?

Craig Jeffery  05:50

You know, listeners may be familiar with words like Ken Lay, who is the chairman and some of the parties that he through Jeff Skilling, the CEO. So the CEO was indicted on 35 different counts of fraud, and insider trading, and trading and he he was guilty of approving and promoting deceptive accounting practices to hide the financial value right. The purpose of accounting is to accurately reflect the financial performance of the firm and this was was being hidden. He was guilty of conspiracy insider trading, five counts making false statements to auditors 12 counts of securities fraud, he also came away not guilty on nine counts of insider fraud by the jury he spent a little over 24 years in prison. So free housing and food for you know, third of a person’s life typically had a forfeit $45 million in fraudulently received gains, financial benefit that he had received prior to being convicted. And there was also civil lawsuits that came against Him. That was the first one. So that’s Jeff Skilling, the chairman Ken Lay, he was found guilty of a securities fraud and conspiracy, but he died in 2006. Before sentencing happened, so he didn’t, he didn’t actually spend time in jail. The CFO, I’ll just go through a couple other CFOs spent six years in prison, had a return about 23.8 or had a restitution amount of 23 point 8 million. The chief accounting officer and this goes to your point about there’s a lot of people involved in this, five and a half years in prison. That’s quite a bit of room and board as a managing director who pled guilty to charges of conspiracy to commit wire fraud and money laundering. He spent 37 months in prison. And I think you you already heard me say something about Arthur Andersen, they essentially that name disappeared after this, this level of fraud. So pretty significant impact to people, as well as to the name Arthur Andersen.

Jonathan Jeffery  07:49

It was interesting Arthur Andersen, I was reading something about how when they started their company, they started on the principles of they don’t work directly for their client, they work for their clients investors. And that’s completely different from where they ended up where they were involved with this case, they’re not keeping their investors in mind. They’re not looking out for them. So I thought that was an interesting flip in values. So let’s get into how was the Enron scandal initially discovered.

Craig Jeffery  08:19

There is at least one movie about this, and there’s some documentaries on it. But I’m Sharon Watkins, who was a VP there. She she wrote anonymous letters to the chairman and other top executives. That was the first blowing the whistle the second lowering of the whistle, she sent a six page report detailing those concerns. The third whistle was she presented this information to an outside law firm, beyond Enron’s accounting firm, but they all agreed there was there’s nothing here move along. So three whistle blows, never never made, never got the traction that it needed. A couple investigative journalist in particular wrote about the scandal that help break it free. So that was that’s an E. McLean from Fortune Magazine. And from the Wall Street Journal, John M. Schiller wrote on that as well. So like you said, if you see something, say something, if you smell something, tell someone or whatever the those phrases are. That idea of someone’s blowing the whistle. Certainly there’s a lot of times a whistleblower says something that’s not accurate. But you still have to look at it and see if it makes sense. And especially when more and more detail is provided. It shouldn’t just be whisked away. And this This also led to quite a bit of a having a whistleblower hotline or a ability to disclose in an anonymous or an attributed manner issues with with company so that’s that’s one of the I think positive things that come come out of this a feedback loop that has to be addressed and, and manage more diligently rather than just saying there’s nothing here. Move along.

Jonathan Jeffery  09:54

Yeah, yeah. It wasn’t resolved the first time that was. So if you see something, say something, again, again. So you mentioned already this special purpose entities. Can you walk us through what that looks like as far as what is a special purpose entity? And then what were some of the ones that they used to hide these accounting practices?

Craig Jeffery  10:15

Yeah, so so a broader discussion of special purpose entities is probably not prepared to do it in a very short period of time. But I’ll just give the Why do people set up entities, there’s reasons for different entities to be set up, there’s a, there’s a lot of valid reasons to do that. And that the challenge here for setting up entities was they set up entities to conceal not entities to handle certain activities. So I mean, you can think of organizations where it’s a shipping company, and they have lots of ships and move things to reduce liability, each ship becomes its own entity, there might be some cross ownership. But if there’s a problem or some liability, it’s contained within that one entity, which maybe houses a single ship, as opposed to there’s one lawsuit or one issue and everything goes away. Because of that. So you can see why, for risk purposes, management purposes, those, there’s good reasons for having different entities, it could be to sell things off. But a lot of these and there’s a number of entities set up and use to, to conceal activity. So I think they had hundreds of special purpose entities. And they, they use it to manage risks and to track things. But these companies, there was a number of them that were meant to create different types of schemes to move liabilities out of the main company, to move assets extensively into the main company, and to create a very difficult to see situation, just like you said, Hey, this is too confusing. You don’t get it, you’re not smart enough. You sure you want to be on the team? So if people stop asking questions, it’s like this, this magic hidden black box of what occurs. And so these these entities were set up and use there were I think it’s what’s called a Dabashi scheme, this is where you hide the assets, you movement to other portfolios, you take bad assets out of one firm, right, that have lost value movement to another and replace them with something else. And so you put your junk into one box, and you move your good stuff into another. And so it’s a, it’s a form of, of hiding that and you can use that to shift it to maybe client accounts or, or different SPS that maybe are private and not publicly, publicly traded or watched as well. If you remember, they had some pretty interesting names like Jedi, Chuco, white wing, well, I mean Jedi and Chuco, were used to move move some losses over to these special purpose entities and take them off of the the income statement and the resulting implications onto the balance sheet of, of Enron. So that kind of unraveled when the accounting method they used was disqualified. And so those losses had to come back on to Enron, resulting in this bankruptcy filing, there are other entities rafters and ljm. One and two were partnerships, funded these entities. And they used it to, you know, buy or move. So these derivative contracts off of Enron’s balance sheet. So when that when the derivatives contracts went under water, the tide went out, you could see who was swimming without their swimsuit on, that brought the the issue home, and then that led to the bankruptcy proceedings could no longer be hidden. While things were in the money it was, it was fine and acceptable, or it appeared acceptable, because no one’s was calling in. Nobody was calling them to account at that point.

Jonathan Jeffery  13:40

That’s interesting. You got some creative people out here, you start to see structures that are set up and they find ways to use them to their advantage, but they’re over leveraged, as soon as they get called, everything goes away.

Craig Jeffery  13:54

Well, if you have, let’s say you have a, you have a derivative on a particular exposure you have and typically accompanies by those to move in the opposite direction, you know, your exposure moves negative, your derivative should move positive. If your exposure move moves positive, your derivative derivative should move negatively, so they offset each other. You know, if you sell let’s say your derivative moves very positively, you haven’t realized that gain until you sell it? Well, if you sell it, then you realize the gain well, they were also taking into account those movements but not realizing the game. Then when they move negative, it had a very significant impact.

Jonathan Jeffery  14:35

Keep an eye on your risk, especially when everyone at the top end of your company or most at the top in your company are in the scheme. So what lessons can investors and businesses and auditors learn from this scandal?

Craig Jeffery  14:49

I think a lot of people learn from that. I mean, remember the Europeans in particular criticize us corporate governance as a result of this we also we also had you know Sarbanes Oxley Sleep became a big deal at that time to provide governments security frameworks, risk management frameworks that were put in standardized, standardized and organizations more readily. So I think there was, there was a regulatory backlash to help address the size and magnitude of what went on. The idea of these reporting hotlines or a separate back channel, I think is an excellent one that’s become much more consistent. The other part is the clear visibility. Now, when I say clear visibility, clear visibility, I’m thinking two things. One is the Treasury view, where’s our cash and our liquid assets in every bank, in every currency, derivatives are all our exposures, where are they and I need to be able to see them at all times, not just in the main company, but in any of the related entities that we’re working with. But clear visibility is also vital. And none of these fraud cases had accounting scandals, where, you know, the financial statements are meant to reflect accurately what’s going on with the business, the flow of cash, the balance of assets, and the generation of income over time to follow certain standards. Both of those are essential. And if you have, you know, opacity, or or you have a cloud over either those areas, it becomes harder to find. Both of those are different views into the financial performance and financial situation of the company. So if I can’t see all my cash, I have a problem on the Treasury side. If I don’t have accurate financial statements, I have a problem on the investor side. And on the accounting side, both of those are vital. And I think the other the other piece, you know, besides a fraud, hotline, clear visibility, you know, have the right tone at the top, so that people are like, I’m not afraid to ask questions. If you can’t get something, that’s one thing, but you should at least be able to understand it at a macro level, maybe you don’t know all the detailed nuances of how these things work at a really detailed level. But you should be able to understand it at at least a macro level. And that should be whoever’s running, it should be able to explain it in a way that reasonably intelligent people can get at least the major elements and pillars of whatever the structure is, if it’s a whole, I have to embarrass you, like, don’t you get this, that smells bad, that should always smell bad, either the person can’t explain it, or they’re hiding something, the last thing has to do, I would say that that people need to think about is understanding control frameworks, payment security, and security principles, that’s vital, whatever area of finance you’re in, and if you’re a senior person in the organization, you should make sure that the human element that people are being well managed and well trained in these in these areas. And that can be everything from the four types of reconciliation that occur to understanding the different principles of principle of least privilege to dual controls, to out of band validation, you know, all of these types of principles help companies protect themselves and are vital for each of us as individual professionals to make sure we understand that our peer group understands that the company’s acting in that type of manner or controlled manner.

Jonathan Jeffery  18:15

Now you mentioned maintaining visibility of your cash How does an upright company do that when they have 20, 30, 50, 100 special purpose entities?

Craig Jeffery  18:28

So upright meaning like ethical or transparent or when you say upright,

Jonathan Jeffery  18:32

upright, meaning someone that’s not their C suites not involved in a massive scandal.

Craig Jeffery  18:39

Okay, okay, like living living an upright life, I get it.

Jonathan Jeffery  18:43

Okay, what’s what are some ways that people can maintain visibility when they have so many different special purpose entities involved with their company?

Craig Jeffery  18:51

Well, I think there’s a couple of things. One is, you have a legal entity, a list of legal entities, you know, the ownership of those, whether they’re standalone or they’re related, all those, there should be a view to everyone who has a need to see that in an organization. And that should be quite a few people in finance and in the Legal Group. And in tax, you should have visibility to all of the all of the bank accounts that are related to those entities and all of the exposures related to those entities. So any derivative contract, every single bank, every single bank account, there should be a centralized comprehensive view across the board for any of the entities that are in this structure or related to it. That way, you could see flows over time. Or you could see transfers, especially if they’re, you know, doing intercompany activities, or they’re trading amongst themselves, you should be able to see all of the cash and liquid assets and core financial liabilities. That’s one aspect. The more on the Treasury side. You want something similar on the accounting side so that, that there’s visibility to what’s going on. You can see the movements between those, hey, take these back assets, give me good assets. Okay, that should be a pretty significant red flag. Why are you doing that there can be good reasons for maybe there’s a entity that has a really long term look and needs some of these assets that will have value over time, but are maybe underwater. Now that could be there could be a legitimate reason for it. But it shouldn’t be. It shouldn’t be secretive. It should be clear and visible, for what’s been done and why.

Jonathan Jeffery  20:26

So you also mentioned keeping your team trained and ready to identify these things ready to spot something that’s going wrong. Secure Treasury is a professional training program offered by strategic treasurer to combat fraud in corporate and banking institutions, educate your staff on common fraud approaches, vulnerabilities and leading security practices. We have various subscription packages for different teams, different sizes, with comprehensive training materials, videos, assessments and reports. You can find more information on this by visiting secure treasury.com. You have any final thoughts on this episode? Craig?

Craig Jeffery  21:03

Well, I appreciate you bringing up Enron and letting us talk about that to a significant extent, the only thing I would say is this whole progress, not only with Sarbanes Oxley becoming much more of a standard, but the idea of companies needing visibility, I think that’s permeated the Treasury area more heavily. If you have accounts, if you have banks, you need to be able to see those on a daily basis. That’s a cost of doing business. It’s just like accounting, having a view to reconciliation, all bank accounts, all accounts should be reconciled on a monthly basis. That’s a cost of doing business. I think those types of standards and principles are becoming more commonplace, there’s still room to grow. But those are positive signs that I think have addressed the issue. The last thing that I would encourage those that are listening to do is make sure that your organization understands the four types of reconciliations one thing to have good visibility, for there’s four types of reconciliation that are really essential. And I’ll just list those briefly. One is cash proof, which is Treasury’s Daily Validation of what’s in the bank accounts. Does that make sense from what we projected yesterday? So it’s not to the penny, it’s very quickly to see what’s happened. Is that different? What’s expected? If it was different? Are those things going to resolve themselves? Or is there something else that standing out that’s one, there’s the bank reconciliation, which is comparing the cash books to what happened at the bank, which is a good daily automated process, there’s general ledger reconciliation, which is reconciling sub ledger accounts, or the sub ledger categories to the details that support those so sub ledger to the control account on the general ledger, that tends to be pretty well thought of, and then file control. So much of businesses transacted digitally making sure that internal and external transfers are well balanced, that the, the totals, the hashing the amounts, the numbers of transactions have to balance, when things move around, as opposed to thinking it’s fine. And then not having a process that determines an issue and you you find it out later. So making sure that that discipline is built in and baked in is appropriate. So the four types of reconciliation seem to be inconsistently applied in many organizations and, and that’s where we see growth happening to detect or to more quickly detect some of these problems, even if multiple people are working to hide it. Some of these methods will will expand it beyond the reach. If everyone’s doing it sure or wants to try to hide it, it’s pretty much impossible to do it until it overflows and third parties can see the difference.

Announcer  23:44

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