Resisting Corporate Corruption: Cases in Practical Ethics From Enron Through The Financial Crisis

By Stephen V. Arbogast

Resisting Corporate Corruption teaches business ethics in a manner very different from the philosophical and legal frameworks that dominate graduate schools.  The book offers twenty-eight case studies and nine essays that cover a full range of business practice, controls and ethics issues.  The essays discuss the nature of sound financial controls, root causes of the Financial Crisis, and the evolving nature of whistleblower protections. The cases are framed to instruct students in early identification of ethics problems and how to work such issues within corporate organizations.  They also provide would-be whistleblowers with instruction on the challenges they’d face, plus information on the legal protections, and outside supports available should they embark on that course.  Some of the cases illustrate how ‘The Young are the Most Vulnerable,’ i.e. short service employees are most at risk of being sacrificed by an unethical firm. Other cases show the ethical dilemmas facing well-known CEOs and the alternatives they can employ to better combine ethical conduct and sound business strategy.  Through these case studies, students should emerge with a practical toolkit that better enables them to follow their moral compass. Finally, the cases provide an in depth look at how a corporation becomes progressively corrupted (Enron), how the Financial Crisis was rooted in ethical decay at institutions as diverse as Countrywide, Goldman Sacks, Citigroup, Fannie Mae and Moody’s, and at the ethical challenges that persist in the post-Crisis, post-Dodd-Frank environment.

• Language: English
• Publisher: Wiley
• Release date: Oct 12, 2017
• ISBN: 9781119323754

Book preview

Contents

Cover

Title page

Copyright page

Foreword

Preface

Note to Faculty: How to Use this Book

Acknowledgements

Section 1: The Enron Cases

Part 1: Demolishing Financial Control, Neutering the Gatekeepers

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

Natural Gas Pipelines in Crisis

Considering the Options

The Meeting with Internal Audit

Author’s Note

Notes

Essay 1: How to Do an Ethics Case Study

The Solution Framework: Defining the Ethics Issue

Tactical Planning and Alternative Business Plans

Personal Considerations

A Final Word About Financial Control

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

Author’s Note

Notes

Essay 2: How a Corporation Becomes Corrupt

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

Jeff Skilling’s Association with Enron

Serge Goldman Prepares to Meet Jeff Skilling

Author’s Note

Note

Essay 3: Necessary Ammunition: Economic Rationales for Financial Control

Financial Control at the Heart of Business Success: Personal Experience

Summarizing the Controls/Business Success Intangibles

The Economic Consequences of Sound Financial Control

Notes

Part 2: Business Struggles, Accounting Manipulations

Case 4: Adjusting the Forward Curve in the Backroom

Conversation with T.J. Malva

Ethics Assessment and Tactical Options

Author’s Note

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

Enron and Special Purpose Entity (SPE) Vehicles

Chewco Investments

Author’s Note

Notes

Case 6: Court Date Coming in California?

California Decontrols Electricity

Enron’s ‘Star Wars’ Gambits

Political Fallout in California

Enron Legal Investigates

SR Produces a Legal Opinion

Author’s Note

Notes

Part 3: Resisting Corruption at Enron

Case 7: New Counsel for Andy Fastow

Determining a Course of Action

Author’s Note

Notes

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

The Enron Companywide Risk Management Report

Kaminski and LJM

Meeting with Ben Glisan

Elsewhere in Enron

Author’s Note

Notes

Case 9: Lay Back … and Say What?

Problems Deciding What to Say

Skilling Decides to Call it Quits

Assessing the Broader State of Enron

Focusing on the Task at Hand

Author’s Note

Notes

Case 10: Whistleblowing Before Imploding in Accounting Scandals

Welcome Back; Now Meet the Raptors

Pondering an Approach to Ken Lay

A Decision to Go Forward

Author’s Note

Notes

Essay 4: Resisting Corporate Corruption: The Enron Legacy

Tactical Lessons for Internal Resistance

Tactical Lessons for Taking Ethics Issues Outside the Firm

Implications for the Financial Crisis Cases

Essay 5: Underappreciated Origins of the Financial Crisis – A Personal Memoir

Jack Bennett Shakes Up Wall Street

Wall Street Restructures, Consolidates, and Innovates

Trading Dominates Banking and Client Relations Change

Prelude to 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 Goldman Sachs

Banking vs. Trading at Goldman Sachs

Competitive Pressures Change Wall Street’s Business Model

Embarrassment and Unprecedented Losses

Hank Paulson Decides on a ‘Counter to Corzine’

Author’s Note

Notes

Case 2: Juggling Public Policy, Politics and Profits at Fannie Mae

Origins of a Conflicted Government Entity

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

Reconciling Wall Street Performance and ‘Affordable Housing’

Beating Back the Privatizers

Wall Street Mounts an End Run, and Fannie Lowers its Standards

The Year 1998

Guidance for Franklin Raines

Author’s Note

Notes

Case 3: Should Countrywide Join the Subprime ‘Race to the Bottom?’

Nature and Structure of the U.S. Mortgage Business, 1940–85

Wall Street Develops Collateralized Mortgage Obligations (CMOs)

‘Subprime 1.0’ Temporarily Sobers the Market

Countrywide’s Strategy in the 1990s

AmeriQuest Launches a Subprime ‘Race to the Bottom’

Mozilo Reconsiders Countrywide’s Subprime Strategy

Author’s Note

Notes

Case 4: Subprime Heading South at Bear Stearns Asset Management

Hedge Funds Develop on Wall Street

Bear Stearns Forms its Own Hedge Funds

Mortgage Market Trends and HGF Disclosure

Financial Control Issues at HGF

Cioffi and Tannin Respond to Growing Pressures

February 2007: ELF Performance Turns Negative

Matthew Tannin Considers His Response to Barclays Bank

Author’s Note

Notes

Part 2: Consequences for Gatekeepers and Firms

Case 5: Ratings Integrity vs. Revenues at Moody’s Investors Services

RMBS/CDO Ratings: Kolchinsky Protests and is Transferred

Moody’s Becomes a NRSRO

Moody’s Culture Changes, and the Firm Goes Public

Subprime Mortgage Debt: The Ratings Methodology Challenge

The Subprime Market Begins to Unravel

Summer 2008 – Moody’s Prepares to Resume Ratings

Author’s Note

Notes

Case 6: Admission of Material Omission? Citigroup’s SIVs and Subprime Exposure

Citibank’s Subprime Product Flow and its SIVs

Citibank Structures and Launches Subprime SIVs

Citibank’s SIVs Finesse the VIE Rules

Conditions Worsen in the Mortgage and RMBS/CDO Markets

Citibank Reports Second Quarter Results

Third Quarter Events Hammer Citi’s Results

Considering Citi’s 3Q Results and IR’s Proposed Pre-Announcement

Author’s Note

Notes

Case 7: Facing Reputational Risk on Goldman’s ABACUS 2007-AC1

From Subprime RMBS to CDOs to SCDOs

Goldman’s Trading and its Clients, 2006–07

Fabrice Tourre Constructs ABACUS 2007-AC1

Tourre Prepares for the MCC ABACUS Review

Author’s Note

Notes

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

Innovation and Controls on Wall Street

Management and Controls at AIG

Greenberg Takes a Fall for AIG’s ‘Cooked Books’

AIG-FP Confronts a Subprime Market Decline

FP Faces Collateral Calls on Subprime CDS

Ryan and PWC Approach a Decision

Author’s Note

Notes

Part 3: Financial Firms and Resisters

Case 9: Write to Rubin? – Pressure on Underwriting Standards at Citigroup

National City Bank Becomes a Giant Financial Conglomerate

Citi Demolishes Glass-Steagall

Organizational Challenges at Citigroup

Growth and Controls within Citigroup’s Mortgage Operations

Bowen Considers His Next Step – Write to Rubin?

Author’s Note

Notes

Case 10: Lehman Brothers Repo 105

Lehman Gets in Trouble

Repo 105 to the Rescue

Weighing Ethics, Career and Courses of Action

Author’s Note

Notes

Essay 6: Wall Street and the Crisis – Causes, Contributions and Problems to Fix

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

John Mack Returns, Big Trading Comes to Morgan Stanley

Mack Guides Morgan Stanley into and Through the Financial Crisis

Mack Analyzes the Financial Crisis and Revamps MS Compensation

Mack Weights Strategic Alternatives for Morgan Stanley

Author’s Note

Notes

Case 2: Back to the Future on Goldman Sachs Reputational Risk

KMI Moves on El Paso

El Paso Reacts and Goldman Faces its Conflicts

The Business Standards Committee on Client Conflicts

Blankfein Considers Goldman’s Options to Manage its El Paso-KMI Conflicts

Author’s Note

Notes

Case 3: ‘Take Customer Cash to Survive?’ Compliance and Chaos at MF Global

Client Protections and Segregated Accounts

MF Global Courts an Illiquidity Crisis

Corzine ‘Bets the House’ on Euro Sovereign Debt

The Euro Sovereign Debt Crisis Hits

Markets Begin to Close in on MFGI

MFGI’s Final Week and a Decision on Segregated Accounts

Author’s Note

Notes

Case 4: Fix the LIBOR Fix?

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

LIBOR Fixing Flaws and Incentives to Manipulate

London Banks Begin to Manipulate LIBOR Fixings

The Bank of England Learns LIBOR is Being Manipulated

The Financial Crisis Hits Barclays and LIBOR

Tucker Considers His Messages for Barclays

Author’s Note

Notes

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

Oceanografía Defrauds Banamex

Managing the Global Financial Supermarket

Corbat Confronts the Banamex Scandal in a Post-Financial Crisis World

Author’s Note

Notes

Case 6: Take CitiMortgage to the Feds?

CitiMortgage Ignores FHA Procedures

Citi Fails to Fix its FHA Noncompliance Issues

Hunt Meets Her Attorney

Author’s Note

Notes

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

Proprietary Trading, Market-Making and the Volcker Rule

What Happened in the Market?

Considering an SEC Response

Author’s Note

Notes

Essay 7: ‘And the Young Shall be Thrown Under the Bus’ – Lessons in Resisting Unethical Conduct from Enron Through the Financial Crisis

Essay 8: Resisting Corporate Corruption, 2017 – Improved Conditions, Unresolved Issues

Are the Reforms Enough? What Risks Remain Unaddressed?

Resisting Corporate Corruption – 2016

To Resist Corporate Corruption – One Thing Remains

A Note on Blogs and Law Firms

A Note on Sources

Index

The Financial Crisis Cases

The Post-Financial Crisis Cases

End User License Agreement

Guide

Cover

Copyright

Contents

Begin Reading

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Resisting Corporate Corruption

Cases in Practical Ethics from Enron Through the Financial Crisis

Third Editon

Stephen V. Arbogast

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

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Library of Congress Cataloging-in-Publication Data

ISBN 978-1-119-32334-1

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 well-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 to the success of the accounting and legal fraud that took place at the company. Arbogast’s extensive research in these case studies revealed the subtleties of corporate opposition to the truth and the difficult options middle level executives and managers faced, including me. Careful study of these cases can help young professionals 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 lessons from Enron, but was updated to include real life examples from the corporate and financial scandals that continued throughout the decade of the 2000s, culminating in the financial collapse of large Wall Street institutions in 2008. This 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 complicated 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 rationalization of unethical behavior in leaders and managers.

After nearly two decades of speaking on Enron and the topic of ethical leadership, 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 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 creditor 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 targeted 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 $2 billion each.

What happened? A complete breakdown in moral values? Yes, but the scary part is that the breakdown was not by outright intent, but more by small steps in the wrong direction. Enron employees made wrong choices, choosing unethical paths. Almost all of them never thought they were breaking the law (for the most part, white collar criminals rarely intend to break the law). They rationalized their behavior. Ethical choices as an adult are usually masked. Of course if asked outright to do something illegal, we’d might say no. But if that choice is disguised, and presented in a positive manner, all the psychological tests from Yale’s Milgram shock tests of the 60s, to Stanford’s prison experiment in the early 70s, show that ninety percent of us will choose to act unethically, sometimes extremely unethically.

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 pressures 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 corrected, 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 leadership lessons. It is not my chosen career path. I appreciate that new corporate legislation offers protections 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. Watkins

February 2017

Preface

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 questions: 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.

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 sacrifice controls to address immediate business pressures. Lay also repeatedly promoted 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 resistance 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 fraudulent accounting for Fastow’s partnership deals. Unfortunately, she picked the wrong recipient, sending her letter to Ken Lay. By leaving a paper trail, however, 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 market 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 whistleblowing. However, these improvements were not enough to bring forth effective whistleblowing 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 trying 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 the opportunity to explore these questions—the major post-Crisis scandals are here: MF Global, LIBOR and Banamex. Two cases, Morgan Stanley’s revisions to compensation and Goldman’s handling of the El Paso-Kinder Morgan merger, provide opportunities to consider whether bank CEOs are sorting out the conflicts inherent 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 trajectory to fraudulent demise. Almost all of the Financial Crisis cases return, the omissions 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 on Dodd-Frank is provided to provide context 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 conditions 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 provided 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 thinking 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 accommodate 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.

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 [e-mail].

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 provide 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 programs include:

New Counsel for Andy Fastow (SEC disclosure, use of outside counsel)

Court Date Coming in California (Severe legal exposure, unhelpful counsel opinion)

Lay Back … and Say What? (SEC Rule 10b-5 exposure & CEO public remarks)

Whistleblowing before Imploding in Accounting Scandals (Whistleblowers pre-SOX)

Take CitiMortgage to the Feds? (False Claims, Dodd-Frank Acts’ whistleblower incentives)

Specific cases recommended for internal business practice/ethics training include:

Enron Oil Trading A & B (Audit irregularity investigations & management political support)

Enter Mark-to-Market: Exit Accounting Integrity? (Manipulative accounting and interaction with firm’s CPA)

Adjusting the Forward Curve in the Back Room (Manipulative accounting tied to Mark-to-Model assumptions)

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 of major violations)

Too Big to Know What’s Going On at Banamex? (Financial control, fraud and collusion at an overseas affiliate, FCPA implications)

Finally, faculty needs to strike a certain balance in the perspective brought to teaching this material. When discussing how to resist unethical behavior, there is a need to impress upon students that they enjoy more tactical options than is widely imagined. Conventional wisdom often argues that tough cases distill down to go along or go. This mentality needs to be challenged. The cases provided here should convey that many more options exist, and that individuals have already used them successfully. Individual resistance can make a difference, even in pretty dire circumstances.

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, knowing 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 conditions portrayed in this book.

Acknowledgements

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 whistleblowing. 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 recognition. 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 inadequacies in the SOX whistleblower protections, a reality recognized by the fact that such protections were enhanced by Dodd-Frank.

The new cases for this third edition were compiled with the help of Kenan-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 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

Case 1

Enron Oil Trading (A): Untimely Problems in Valhalla

This environment is hardly giving us room to breathe. The last thing we need is a public scandal.

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 following 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 opening undisclosed bank accounts to conduct unauthorized transactions.

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 engaging 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 perhaps 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 current 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 levels, 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 carriers increasingly found themselves burdened with gas purchased earlier at higher prices under take-or-pay contracts. Pipeline company financial conditions deteriorated. 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 immediate economic straits. Profitability was miserable. The natural gas glut seemed to produce ever-lower prices. Enron had 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: earnings 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 long-term rating to below investment grade, i.e., to junk status.

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 created 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 established 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 headquarters 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 illegal. They altered quarterly results, but that’s not uncommon: Everybody 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

Personnel discipline

Organizational reform

Transactional rules

Process reform

Organizational oversight

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 shaping any resolution of the incident.

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 compensation, responsibilities, and title.

Possible organizational reforms

Revise Houston’s oversight of EOT, either changing out current management and/or intensifying oversight in terms of stewardship 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 indefinite future.

Transactional rules

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

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.

Process reform

Reconsider established EOT trading limits and Enron’s process for obtaining exceptions; ensure that limits are proportionate to unit profit objectives

Organizational oversight

Decide whether EOT merits a full-time Internal Audit presence; determine also the frequency and timing of audits and the role of Arthur Andersen as external auditor.

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 position to absorb public scandal. This will have to be handled carefully.

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 something 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. 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 profits. 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 profitable 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 attention and complicating Enron’s year-end statements. Their intention was to return all funds to Enron in 1987.

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 provided 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 anticipated year-end bonus was not paid. After some discussion, a close-out settlement 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 discussion 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?

Attachment 1—Historical Recreation (HRC)

MEMORANDUM

January 25, 1987

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 transactions 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 contact executives in Houston. They advise that since 1985, EOT has, at their request, taken actions to move accounting profits from one reporting period to another. Apparently, the actions involved are twinned trades, i.e., simultaneously negotiated sale/buy oil trades having different time periods. In the typical transaction, EOT would sell oil one month forward at a price attractive to the buyer and contract to purchase the oil back two months forward at an equally 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 represent legitimate EOT business transactions, trades done solely for accounting 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 reporting of all new bank accounts to corporate headquarters. To the extent that these transactions are irregular, they may represent theft of corporate funds. To the extent that the transactions are found to be legitimate, their off-the-books nature could require restatement of financial records and reported results for 1986.

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.

Attachment 2

Enron Corporation

Summary Financial Statements, 1985–86*

* Figures may not be additive because of other items, charges and rounding.

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 describing 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