Out of Control at Andersen

Internal memos detail how the firm's unusually lax controls allowed its Enron team to call the shots

Last Oct. 12, as Enron Corp.'s jerry-built financial structure was starting to topple, the Houston office of Arthur Andersen LLP was charging ahead with a clean-up mission--and shredding documents was only part of the task. BusinessWeek has learned from internal Andersen documents that its Enron team was also busy amending four key memos to correct the record of its review of Enron's convoluted and conflicted partnership deals.

While its shredding brought an indictment from the Justice Dept. for obstruction of justice on Mar. 14, the memo changes speak to a more fundamental flaw in how Andersen ran its business. They illustrate how the firm's unusually loose controls and close ties to Enron undermined its role as auditor in what became the biggest bankruptcy in American history.

Indeed, the paper trail documents repeated conflicts between Andersen's expert accountants--known as the Professional Standards Group--and the Enron audit team. Like the other Big Five accounting firms, Andersen employs a team of experts at headquarters and elsewhere to review and pass judgment on knotty accounting, auditing, and tax issues facing its local offices. But unlike other firms, Andersen allows regional partners--the front-line executives closest to the companies they audit--to overrule the experts, according to accounting pros at the Securities & Exchange Commission and elsewhere.

That's what happened with Enron. Andersen e-mails and memos obtained by BusinessWeek from investigators in Washington show that members of Andersen's PSG objected strongly to the Houston energy trader's accounting. Andersen's Enron audit team, led by now-dismissed partner David B. Duncan, overruled those concerns on at least four occasions, siding instead with Enron on controversial accounting that hid debt and pumped up earnings.

That's not all. The documents further allege that to support their decisions, Duncan's team wrote memos in which they falsely stated that PSG partners had signed off on Enron's inventive bookkeeping. And when Enron executives grew angry about PSG's nay-saying, they insisted that one of the group's chief skeptics, partner Carl E. Bass, be barred from advising on Enron issues. Duncan carried the request all the way to Andersen's Chicago headquarters, and Bass was removed from the prestigious PSG, according to congressional and law-enforcement investigators.

Duncan's attorney, Robert Giuffra of Sullivan & Cromwell, says that Duncan "was relaying a request [to remove Bass] from the client. The decision on how to proceed was made by Andersen management." Giuffra refused to comment on the inaccurate memos or the Enron team's accounting decisions. An Enron spokesman refused to comment as well.

Bass, 42, is still at Andersen, but now he audits clients instead of advising on high-level accounting decisions. Reached at his desk in Houston, he refused to comment on his memos or his removal from the PSG. "I've got to get a job after this," he says.

A former Andersen employee says local control over accounting issues was a selling point. The firm would tell potential clients: "We don't have to go to New York to get a ruling--your engagement partner has the authority," the former staffer says. The effect was insidious, says a congressional investigator: "The rainmakers were given the power to overrule the accounting nerds."

That's come back to haunt the firm. Andersen's failure to tighten its lax controls in the wake of several audit failures contributed to the frustration of the Justice Dept., which took the unusual step of slapping the firm--rather than individuals--with a criminal indictment. "It's not a small detail," insists a top federal investigator. "Who's most likely to say `no' to the client--the national office or the local partner who works with the client all the time?"

Andersen referred all questions about the matter to its criminal attorney, Rusty Hardin of Houston's Rusty Hardin & Associates. He refused to comment, citing federal court rules barring him from discussing potential evidence in Andersen's trial, set for May 6. "We'll be happy to discuss these matters in trial," says Hardin.

The pressure of Andersen's system--and Enron's displeasure--seems to have fallen on Bass. Originally a Houston-based auditor who had worked on Enron's audits, Bass was promoted to the PSG in December, 1999. Duncan immediately requested that he devote 500 to 750 hours a year to "Enron-specific consultation," according to a Bass e-mail.

But the relationship quickly went sour. In a Dec. 18, 1999, e-mail, Bass documented a disagreement with Duncan over how Enron should account for the sale of some options owned by one of the partnerships managed by Enron's then-chief financial officer, Andrew S. Fastow. Duncan, citing the $30 million to $50 million charge to earnings that Enron would face under Bass's advice, appealed to Michael C. Odom, Andersen's practice director in Houston. Odom sided with Duncan, according to the Bass e-mail and lawyers familiar with events. Odom's attorney, Peter E. Fleming Jr. of New York's Curtis, Mallet-Prevost, Colt, & Mosle, refused to comment.

Despite Bass's objections, the memo Duncan's team prepared on Dec. 31, 1999, to document the deal claimed that Bass "concurred with our conclusions." And as Enron's partnerships multiplied, it grew increasingly impatient with Bass's objections, according to the PSG member and an attorney familiar with the matter. E-mails from February, March, and December, 2000, documented Bass's frustration with Enron's deals. "I am still bothered with this transaction," he wrote about Enron's proposal to use the LJM partnership to hedge stock in an Internet venture in February. "It looks like they have parked the shares there" to convert stock gains into income, which is not normally allowed.

Finally, in March, 2001, Duncan relayed Enron's request that Bass be removed from reviewing Enron's accounting, according to congressional investigators. In a Mar. 4, 2001, memo to his boss, John E. Stewart, the PSG's director of accounting, Bass wrote that Richard A. Causey--who was terminated as Enron's chief accounting officer in Feb. 2002--had singled him out as "caustic and cynical" about Enron's accounting.

Despite his removal from the PSG, Bass got involved in Enron issues again last fall. As Enron prepared to announce a $1.2 billion writedown in shareholder equity caused by the partnerships, Bass reviewed for the first time the 1999 and 2000 file memos written by Duncan's team that claimed Bass had supported Enron's accounting. On his objections, some of the memos were amended on Oct. 12 to reflect the skepticism he had expressed when the deals were first vetted. But by then, the deals had done their damage. Enron's third-quarter earnings report on Oct. 16 started the company's slide into its Dec. 2 bankruptcy.

The Justice Dept. has not charged Andersen with poor accounting decisions. But disagreements expressed in the memos could provide fodder for the prosecutors' claim that Andersen was shredding documents to hide them from a likely SEC investigation.

The clout Andersen's engagement partners enjoy has also been emerging as an issue in Washington's post-Enron reform drive. "The five big accounting companies--all of them except Andersen--treated their national quality review board with authority to overrule the local partners," says House Energy & Commerce Committee Chairman W.J. "Billy" Tauzin (R-La.). But that's unlikely to stop calls for tighter independent oversight of auditors. If Andersen survives, both the SEC and would-be rescuer Paul A. Volcker insist on what Volcker calls "central and unambiguous authority" wielded by the national office over the front-line auditors. But as Andersen is sucked down into the whirlpool that was Enron, that authority will come far too late for investors--not to mention Bass and his job-hunting partners.

By Mike McNamee, with Amy Borrus, in Washington and Christopher Palmeri in Los Angeles

    Before it's here, it's on the Bloomberg Terminal.