Senate Investigator to Enron's Lawyers: It's Not Over
from
July/August 2003
by Gary M. Brown
I was part of the investigating team when the U.S. Senate Governmental Affairs Committee launched a wide-ranging inquiry in January 2002 into the causes of the collapse of Enron, then the seventh-largest corporation in America. Enron’s failure remains the most complicated in U.S. business history and, of course, was just the beginning of a series of corporate scandals—WorldCom, Adelphia Communications, and Tyco International among them—that triggered the crisis of confidence in U.S. capital markets whose effects continue to be felt today.
Asked to identify the cause of such failures, Federal Reserve chairman Alan Greenspan, who coined the phrase “irrational exuberance” for the booming stock market of the 1990s, said, “The historical guardians of financial information were overwhelmed.” The guardians of whom he spoke were the supposedly independent auditors and directors of the fallen companies. Other “guardians,” while perhaps not “overwhelmed,” were nevertheless remiss in fulfilling their responsibilities. These included Wall Street securities analysts, investment banks, and lawyers.
“Did anyone do their job?” That was the question put to me early in our investigation by Senator Susan Collins (R-Maine), then the ranking member of the subcommittee that handled much of the inquiry and now chair of the Governmental Affairs Committee. My answer: “No.” As it turned out, not only did many of the guardian angels not do their job—they failed to grasp basic principles both of the law and of right and wrong.
When Enron imploded, the law as it then stood did cut board members some slack, an unintended result of 1985’s Smith v. Van Gorkom. In that case, the Delaware Supreme Court overturned a lower court ruling that a board’s action deserved business-judgment-rule protection. The higher court held the board members of Trans Union, a diversified holding company in Chicago, liable for gross negligence after they signed off on an agreement to sell the company to Chicago’s billionaire Pritzker family without displaying much curiosity about the details of the proposed sale. They didn’t look for other buyers, for instance, hire an investment bank to put a fair price on Trans Union, or even recognize the role of chairman Jerome Van Gorkom in lining up the sale. He had negotiated the deal without the board’s knowledge and had ignored the advice of key managers about the true value of the company. In the words of the court, “The directors . . . breached their fiduciary duty . . . by their failure to inform themselves of all information reasonably available to them.” In simple terms, the Trans Union directors failed to do their job.
Smith v. Van Gorkom introduced a new verb to the language: To Van Gorkomize a board meant to make sure it was fully informed and up to speed. In addition, much as Enron and Sarbanes-Oxley would do 17 years later, the case made directors very sensitive to their potential liabilities and had similar fallout. Directors’ and officers’ insurance coverage became more expensive, for example, and pundits warned that public companies would find it difficult to recruit qualified directors.
And the politicians moved in. But rather than set stricter rules for boards, various new laws had the effect of letting directors off the hook. The legislatures of a number of states, led by Delaware, permitted companies to amend their charters with provisions that directors would have no liability for breaches of their duty of care. It’s like setting the speed limit at 55 but saying that you have no liability if you exceed it. A curious way to address a problem; however, it’s probably fair to say that most companies adopted such provisions.
A director’s basic duty of care is to act in the interests of the corporation and its shareholders with the care of an ordinarily prudent person in a like position. Van Gorkom, however, may have focused board members more on their own liabilities as directors than on their duty to act in the best interests of shareholders. Directors sought and perhaps relied more heavily upon the advice of accountants, lawyers, and other professionals—not necessarily to support a good decision for the shareholders, but to better insulate the directors themselves from personal liability.
These professional advisers also became targets of lawsuits routinely filed by the securities plaintiffs’ bar following “surprise” announcements that were often accompanied by earnings restatements. The lawsuits typically claimed that the advisers had aided and abetted alleged securities fraud. In 1995, however, the U.S. Supreme Court essentially put an end to these suits, ruling in the case of Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A. that such “secondary actors” could not be held liable in private civil litigation about securities fraud. Add the additional hurdles of the Private Securities Litigation Reform Act, and by the late 1990s the score was insulation from liability, 3; shareholder protection, 0.
Did the legislative response to Van Gorkom enable directors to abdicate their duties? It undoubtedly did. Our hearings made it all too clear that among other things, Enron’s directors:
• Authorized high-risk accounting, extensive off-the-books transactions, conflict-of-interest transactions, and excessive compensation plans
• Failed to monitor conflict-of-interest waivers that allowed executives, such as CFO Andrew Fastow, to reap tens of millions of dollars in profits
• Were unaware that Enron paid its executives bonuses of $750 million in 2001, a year in which the company’s net income was $975 million
• Didn’t know that then-CEO Kenneth Lay sold some $77 million of Enron stock back to the company over a 12-month period, while touting the shares to employees for their 401(k) plans.
As we soon learned, directors weren’t the only ones who were derelict at best, and sometimes worse. To put it gently, Central Bank had allowed professional advisers to be less diligent than they should have been in adhering to securities laws.
The hearings showed that at least three major financial institutions—Citigroup’s Salomon Smith Barney, JP Morgan Chase, and Merrill Lynch—had helped Enron manipulate its numbers and mislead investors. Among the evidence that caught wide media attention was an internal e-mail at JP Morgan Chase that described what was essentially a disguised loan known as a “prepay.” It said, “Enron loves these deals as they are able to hide funded debt from their equity analysts because they (at the very least) book it as deferred [revenue] or (better yet) bury it in their trading liabilities.”
As Enron began to implode in late 2001, another internal e-mail expressed alarm: “Five [billion] in prepays!!!!!!!!!!!!!!!”
The reply? “Shut up and delete this email.”
Salomon Smith Barney, meanwhile, had done some number-crunching and concluded that Enron had billions more in obligations than were reflected on its books or than credit rating agencies knew about. Even so, we found internal memos that showed the bank felt no obligation to inform the credit agencies of what it had found out. Instead, it continued to market securities backed by Enron credit, using part of the proceeds to reduce the Enron credit exposure of Citibank, the brokerage firm’s commercial banking affiliate. Maureen Hendricks, senior advisory director of Salomon Smith Barney, insisted that there was no need for supplemental disclosure of these facts because “even after adding that on, Enron was still an investment-grade company.” (Translation: You don’t have to tell investors the truth as long as you think it’s a good deal.) David C. Bushnell, managing director of global risk management at Salomon Smith Barney, expressed Wall Street’s position another way while answering questions put to him by Senator Carl Levin (D-Michigan), the subcommittee chairman. “But would you agree,” Levin asked, “that you have a responsibility not to participate in a deception?”
Part of Bushnell’s reply: “It depends on what the definition of a deception is.”
Yet another view of Wall Street’s perspective was revealed when representatives of Merrill Lynch appeared to defend, among other things, what we had come to call the Nigerian barge deal. In late 1999 Enron pressured Merrill to purchase an interest in three Nigerian power barges for a price that allowed Enron to record $28 million in revenue and $12 million in pretax profits. Documents indicated there was an understanding that Enron would arrange for the barges to be bought back from Merrill within six months at a specified sum. That’s what transpired, so the transaction was at best a bridge loan rather than a true sale, because the risk of ownership of the barges did not pass to Merrill. This, in turn, made the revenue and profit that showed up on Enron’s books improper.
We believed that Merrill agreed to the deal solely to ingratiate itself with Enron in order to garner a larger portion of the enormous investment-banking fees the company generated. Significantly, in an e-mail reference to the deal before it went through, one of Merrill’s executives involved in the transaction referred to the “reputational risk (i.e. aid/abet Enron income stmt [statement] manipulation . . . ” Obviously, the risk was not great enough to deter the firm from executing the transaction.
After the July hearings, we briefed the government’s Enron Task Force on the evidence of wrongdoing that we had uncovered, including the Nigerian barge deal. This past March the Securities and Exchange Commission announced that it had settled with Merrill Lynch on charges that the firm had aided and abetted Enron’s earnings manipulation through participation in the barge “sale” and one other energy trade. Without admitting any wrongdoing, Merrill agreed to pay an $80 million fine. The SEC, in addition to announcing the Merrill settlement, promised that “the Commission’s investigation into Enron is ongoing.”
So it is today. But early in 2002, investigative zeal as well as demands for corporate reform began to wane, while the argument that Enron was just “one bad egg” gained ground. By early May 2002 many close observers, including former SEC chairman Arthur Levitt, predicted that accounting reform—key to any meaningful change—would not become law. Senator Jon Corzine (D-New Jersey) remarked that it was “unlikely that we will get strong reform unless there is a new event that captures the [public’s] imagination.”
Well, we got several new events—at Adelphia, Tyco International, and WorldCom. One indicator of how the problem was widening could be seen in Washington Morning Update, a news summary sent by e-mail to all of us working for the Governmental Affairs Committee. When I first joined the staff, one of the sections in Update was called “Enron News.” It was renamed “Corporate Scandal News” to reflect the growing number of companies whose “events” it covered.
All this provided the impetus for the passage of the Sarbanes-Oxley Act, a law that put the heat on independent directors, audit committees, and accounting firms. What Sarbanes-Oxley has also done is federalize—some would say intrude upon—what previously were solely matters of state corporate law. This includes setting standards for how directors should exercise their business judgment in making certain decisions. State corporate law does not require “independent” audit committees, prohibit loans to executives, require certification of financials by officers, or include the myriad of other requirements imposed or “suggested” by Sarbanes-Oxley. Nevertheless, when directors, say, fail to do their job, Sarbanes-Oxley steps in and does it for them. In these areas, the traditional discretion afforded directors has been eliminated or severely limited.
And “reform” was not confined to the legislative branch. The hearings shone spotlights on some very bad actors among investment banks, accounting outfits, and law firms. Although Central Bank protected those in supporting roles from liability for aiding and abetting securities fraud, many forgot the Supreme Court’s admonition that lawyers, accountants, and bankers could be liable as “primary violators” if they engaged in manipulative activity that presented a false and misleading picture to and was relied upon by the investing public. Indeed, the trial judge in the pending Enron securities class action recently drove this point home to several secondary actors when she refused to dismiss securities claims (based upon their participation in Enron’s financial manipulations) against several of them.
Some bankers and accountants have certainly paid for their wrongdoing. But what of the lawyers? They seem to have dodged the bullet of congressional investigation. But that doesn’t mean we didn’t have them in our sights. Shortly after the indictment of Andrew Fastow, Senator Levin’s staff asked whether my team would support an investigation into the role of law firms in Enron’s collapse. I said we would, but faced with the end of the legislative session and constraints on time and resources, no one had the stomach for what would undoubtedly have been a messy fight with various law firms. However, after we briefed the court-appointed examiner in the Enron bankruptcy, the examiner began his own investigation into the role law firms had played. Many lawyers may yet have some explaining to do.
The public rightly continues to look to a company’s directors to represent it in the boardroom, and expects them to make sure top management does more than stick to the letter of the law while doing so. The new chairman of the SEC, William Donaldson, has indicated that public trust in the financial markets will not return so long as executives use legal limits as the test of right and wrong. Donaldson called on corporate America to put honesty and integrity at the heart of every business decision. Neither the Securities Act of 1933 nor any of the other post-Wall-Street-crash statutes of the ’30s eliminated fraud and wrongdoing. Neither did later statutes, such as the Foreign Corrupt Practices Act. Likewise, Sarbanes-Oxley and the host of regulations that have followed will not eliminate fraud. The HealthSouth scandal is the first proof positive of that. Its top executives signed the Sarbanes-Oxley certifications.
New and enhanced civil and criminal penalties, however, have raised the stakes for those who participate in corporate wrongdoing. For example, the penalty for wire fraud and mail fraud has increased from five to 20 years. More transparent accounting and more vigilant directors may also eliminate some chicanery, though if the past is any indication, greed and self-interest will rise to the occasion. Perhaps now, however, the threat of stiffer punishment (and maybe hard time for convicted white-collar criminals, rather than Club Fed) will cause top executives and directors to think twice before succumbing to temptation.
The director’s role in the post-Enron world is clear. The stacks of new laws and regulations can be summarized very simply: Do your job and do the right thing. This means you must ensure that you understand the companies on whose boards you serve. You must insist on a higher standard of personal conduct on the part of top executives. If more boards had taken their jobs more seriously in recent years, would things have been different? Some of us think so.
Gary Brown, a partner at Dinsmore & Shohl in Nashville, served as special counsel (minority) to the U.S. Senate committee that investigated the Enron collapse. An adjunct professor at Vanderbilt University School of Law, he adapted this article from one he wrote for the school’s Vanderbilt Lawyer.
