Preventing the Next Enron … Lessons Learned Presented to the Florida West Coast Chapter IIA December 2, 2003 - T

1. Preventing the Next Enron… Lessons LearnedPresented to the Florida West Coast Chapter IIADecember 2, 2003 - Thomas L. Richardson

2. IIA Standard - Deterrence, Detection, Investigation and Reporting of Fraud • Evaluate the indicators • Know the fraud indicators • Characteristics of fraud • Techniques used to commit fraud • Types of fraud associated with activity • Notify the appropriate authorities and recommend investigation • Take Action (Due prof’l care; follow-up)

3. 1 2 3 Where to Look for Fraud(Follow the Cash) ORGANIZATION 1 Receipts 2 Assets 3 Disbursements

4. Situational Pressures (Motive)Red Flags • High personal debts • Severe illness in family • Inadequate income / living beyond means • Stock market speculation • Loan shark involvement

5. Situational Pressures (Motive)Red Flags(Cont’d.) • Excessive gambling • Involvement with other men/women • Undue family, peer, company, community expectations • Excessive use of alcohol or drugs

6. Revenge Motives • Perceived inequities • Underpaid • Poor job assignments • Resentment of superiors • Frustration, usually with job

7. Personally Developed OpportunitiesRed Flags • Very familiar with operations (including cover-up opportunities) • In a position of trust • Close association with cohorts, suppliers, and other key people

8. Firm Environments Which Foster and /or Create OpportunitiesRed Flags • Rule of conduct/discipline not disseminated • Rapid turnover of key personnel (quit or fired) • No annual vacations of key personnel/execs • No rotations or turnover of key personnel • Not using adequate personnel

9. Firm Environments Which Foster and /or Create OpportunitiesRed Flags(Cont’d.) • Absence of explicit and uniform personnel policies • No record of dishonest acts or disciplinary actions • No documented Code of Ethics

10. History of Enron • July 1985 - Houston Natural Gas merged with InterNorth to form Enron, a natural gas pipeline company • 1989 - Begins trading natural gas • 1994 - Begins trading electricity • 1997 - Announces first transaction using weather derivatives products • 1999 - Launches EnronOnline, global commodity trading web site

11. Besides energy contracts Enron traded industrial commodities... • Steel and wool fiber • Financial derivatives such as default insurance • Broadcast time for advertising • Hedges against bad weather • Internet bandwidth capacity

12. History of Enron (cont’d.) • 1990 - Jeffrey Skilling joins Enron • 1996 - He becomes President & COO • 2000 - Enron stock hit an all-time high of $90.56 • Feb 2001 - Mr. Skilling becomes CEO. Former CEO Ken Lay becomes chairman

13. History of Enron (cont’d.) • Aug 14, 2001 - Mr. Skilling resigns abruptly citing personal reasons; Lay becomes CEO again • Aug 15, 2001 - Sharon Watkins, VP warns Lay that the company’s accounting practices would lead the company to “implode in a wave of accounting scandals” (Anonymously) • Oct 2001 - Reports a $618m (1st qtr’ly) loss and $1.2bn reduction of shareholder equity.

14. History of Enron (cont’d.) • Oct 2001 - Enron admits SEC investigation for COI between Enron and its partnerships. Enron shares lose a fifth of their value • Nov 2001 - Enron says that it overstated profits dating back to 1997 by $600m • Dec 2, 2001 - Enron files for bankruptcy, the largest in US history. • Jan 2002 - Justice Department announces criminal investigation of Enron

15. Jeffrey Keith Skilling • Attended SMU (over Princeton) on an engineering scholarship • Graduated with a BS in Applied Science • Worked in asset and liability management at First City National Bank • Grad School Harvard; MBA, top 5% • McKinsey & Co., consulting firm, advising Houston Natural Gas and Internorth (Enron)

16. The Gas Bank • Skilling realized immediate profits with his Gas Bank concept in 1989 • Industrial customers and power plants paid a premium for guaranteed gas supply • Gas fired plants became attractive; more business for pipelines and trading business • Created a futures market in natural gas

17. Mark-to-Market Accounting • Mark-to-market accounting was Skilling’s brainchild. The SEC approved mark-to-market with Enron Gas Services on natural gas trading • Enron became the first non-financial company to use mark-to-market accounting • Enron implemented mark-to-market accounting a full year earlier than the SEC expected • Used mark-to-market accounting in every part of the business, not just Enron Gas Services

18. Enron Online • The toast of cyberspace • Sold electricity, natural gas,coal, plastics, oil, paper, petrochemicals, and clean air credits among over 800 products • Traded over the web instead of fax and phone • Largest energy marketer in the world; made the rules

19. Material Adverse Change Clause • Created protection in derivative contracts • If counterparty experienced material adverse change to its business, collateral could be demanded • It worked both ways; Enron couldn’t lose • Rich Kinder: Enron was “smoking its own dope”

20. The Exemption • Board was asked to waive the Ethics Policy • Fastow reported that each transaction would be approved by CAO and CRO • Also, Board Audit Committee would review all transactions annually • Arthur Andersen had objected; relented if Board and CEO approved each transaction • Board was told that Andersen approved

21. Deregulation of Securities and Investments Market • Glass-Steagall Act of 1933 kept banks, ins cos and brokerage houses from merging • In 1999 Graham-Leach-Bliley Services Modernization Act repealed Glass-Steagall • J.P. Morgan offered an array of services to Enron • Advisor (Merger talks with Dynergy - $45m) • Lender (Helped raise $1B in loans) • Investor (Invested in Fastow’s LJM2 scheme) • Source of Research (Guided investors)

22. Operating Near the Edge • Off-balance-sheet entities - created to eliminate losses • Rather than face write-offs, they tried to hide them with accounting • Related-party transactions (suspended COI policy) • Off-balance-sheet loans collateralized by Enron stock • Inaccurate, incomplete or misleading disclosures • Aggressive,questionable accounting methods

23. Operating Near the Edge (cont’d.) • Complex, high-risk trading activities (derivatives, special purpose entities, hedging, etc.) • Form over substance reporting • Arrogant corporate culture - took big risks

24. Where Was Management? • Ken Lay - CEO and Chairman • Jeff Skilling - President and COO • Accounting staff came from Andersen • Questions raised by Enron executive was referred to and cleared by in-house counsel • Enron’s executives were dumping stock while encouraging employees to buy • Employees could not sell during “blackout” • (Michael Kopper plead guilty to conspiracy to commit money laundering and wire fraud. 8/21)

25. Where Were the External Auditors? • Andersen decided to maintain Enron as a client • Andersen collected $25M for year-end auditing services and $27M for consulting • Andersen provided internal auditing services • Difficult to distinguish between Andersen’s external and internal audit services

26. Where Were the External Auditors? • Local partner did not stand up to the client • Concurring partner overridden • Allegations that documents were destroyed • Andersen was ultimately convicted for obstruction of justice • (Chicago firm was on probation re Waste Mgt) • Waste Mgt inflated profits by $1.4bn • Andersen paid $700m to settle charges; no further wrongdoing • (David Duncan, former Andersen Partner, admitted to obstruction of justice, 5/13/02)

27. Where Were the Internal Auditors? • Enron outsourced internal audit to Andersen • First major organization to totally outsource its internal audit services (same people, now paid by Andersen) • About 40 auditors went to Andersen • The CAE was made an Andersen partner • Enron began to bring in internal audit • CAE was from PwC; reported to CAO at HQ • Internal auditors were housed in the business units • CAE did not control performance or compensation • Sensitive issues were left to external auditors

28. Where Were the Internal Auditors? • CAE developed a risk assessment process • CAE identified some high risk areas • CAE questioned some transactions in high risk • Mgmt told CAE that these were being handled by the financial auditors. CAE chose not to audit - it would be redundant

29. Where Was the Audit Committee? • Some members of the audit committee were also members of the Finance team • BOD waived the COI policy, thus allowing insider trading • Audit committee had 5 main meetings lasting only one hour each, regardless of the topic • Compensation - > $400K

30. Where Was the Audit Committee? • Meetings with the Internal Auditors were joint with Andersen Consultants • Only executive summaries or reports were read by the audit committee

31. Wendy Graham • Wife of Senator Phil Graham (Chr Banking Cmte) • Exempted energy derivatives contracts from federal oversight • Shortly thereafter, joined Enron’s Board • Enron contributed to think tank at Geo. Mason Univ, where Graham was Dir.of regulatory studies • Attorney advise Graham that she could have a material conflict of interest • Discontinued stock options; accepted cash • Other directors were consultants and vendors

32. Oh, By the Way • Wendy Lee Graham, former chair of the Commodity Futures Trading Commission • Exempted energy derivative contracts from federal regulation • Lame duck chairman with 2 vacancies of 5 person commission • Enron did not have to get a securities license, register with the SEC or report to anyone (cash supporting derivatives)

33. Board Members • Joe Foy was a retired partner in law firm which did legal work for Enron • Lord John Wakeham received $6,000 per month for consulting in addition to salary • Chartered accountant, had served as Britain’s secretary of state for energy • Member of Audit Committee • Robert Belfer gained a seat after selling the family’s oil and gas exploration business to Enron

34. Board Members (cont’d.) • John Mendelsohn and Charles LeMaistre, two medical doctors’ M.D.Anderson Cancer Center received millions in donations from Enron • Three other members were employees of the company (Ken Lay, Jeff Skilling, Rebecca Mark)

35. Items of Interest for Boards? • Off balance sheet transactions • Treatment of related-party transactions • Related partnership issues, derivatives and other complex issues • Risk management policies (ERM) • Adequacy of internal and external auditing • Independence issues for external auditors (amount of consulting fees)

36. Others Have Joined the Mix • Tyco • Spent $8bn on over 700 acquisitions in 3 years • May have spent $135m to enrich former CEO • WorldCom • Reported $4bn in improper accounting • Internal Auditors found another $3.8bn • Adelphia • Inflated number of subscribers • Owners used company as their personal piggybank and were charged with fraud (Dad/Son led off in handcuffs)

37. Common Themes • Sacrifice of long-term strategy to buttress short-term strategy • Conflicts of Interest - personal enrichment • “Specific deniability” by top management • Attempt to inflate stock prices • Some are now charged with tax evasion • Common denominator - GREED!

38. Stock Sales (Gross Proceeds) • Ken Lay (Chairman) $184,494,426 • Joe Sutton (Vice Chairman) $ 42,231,283 • J. Clifford Baxter (Vice Chairman) $ 34,734,854 • Robert Belfer (Board Member) $111,941,200 • Jeff Skilling (CEO) $ 70,687,199 • Andy Fastow (CFO) $ 33,675,004 • Rick Causey (CAO) $ 13,386,896 • Rebecca Mark CEO, Azurix) $ 82,536,737 • Lou Pai (CEO, Enron Energy Svcs) $270,276,065

39. Stock Sales (Gross Proceeds) • Ken Rice (CEO, Broadband Svcs) $ 76,825,145 • Mark Frevert (CEO, Enron Europe)$ 54,831,220 • Ken Harrison (Board Member) $ 75,416,636 • Joe Hirco, (CEO, Enron Comm’ns $ 35,168,721 • Stan Horton (CEO, Enron Transp’n)$ 47,371,361 • Rich Buy (CRO) $ 13,386,896 • James Derrick (General Counsel) $ 12,563,928 • Wendy Graham (Board Member) $ 278,892 • Bryce, Robert, PipeDreams, PublicAffairs, 2002

40. GreedExcessive desire for getting or having, esp. wealth; desire for more than one needs or deserves; avarice; cupidity

41. Epilog“Fish rot at the head”