There’s a bit about Fastow’s hero-to-zero story I still don’t get

I was at the FT’s Camp Alphaville yesterday. It was an excellent event but it was on Britain’s hottest July day on record and the whole thing was in tents. As I don’t much like the heat, I stayed in the main tent, which had big cooling units in it, for much of the day.

I’m glad I did because it was there that I saw the fascinating presentation by Andrew Fastow, the former CFO of Enron. He started off by confessing his guilt, admitting his part in ruining thousands of people’s lives and saying that he deserved to go to prison. Then he began to tell the story of his fall.

First he held up his CFO of the Year award from 2001. Then he held up his prison ID card. Both, he said, he had been given to him for doing the same things. Describing himself as the Chief Loophole Officer, he explained how he had exploited the grey areas of the law to conceal a lot of Enron’s borrowing, thereby presenting a misleading picture of the company’s finances.

Here is an example:

CI14nhRWgAAajpW.jpg-large

(Picture by Neil Hume)

Instead of Enron borrowing $970 million for a pipeline, the bank set up a company which acquires the pipeline. It then allowed Enron to use it for a fee and a guarantee to cover its maintenance, any risks associated with it and its de-commissioning or re-sale afterwards. The bank put up the money and Enron paid it for doing so but legally the transaction was not a loan so didn’t have to be declared as such. It looked and sounded like a loan but, as far as the accounts were concerned, it wasn’t.

“There may be a fundamental difference between a company following the rules and a company presenting a true picture of its financial position,” he said. To illustrate this, Fastow told us the touching story of how he explained his conviction for fraud to his 15-year-old son, during a prison visit.

Let’s say your rule is that you will not drink any alcohol when you go to parties. Other kids try to persuade you to have a drink but you refuse and stick to your rule. Then a friend tells you he has this alcoholic beer-flavoured sweet. If you chewed that, you wouldn’t actually be drinking alcohol so you wouldn’t have broken your rule. Would this be OK? “Of course not,” his son replied. That, explained Fastow to his son, is the difference between breaking the principle and the rule. “I’m the guy who chewed the beer pill.”

The trouble is, in corporate America, lots of people were chewing beer pills. The creative accounting for which Andrew Fastow won his award was accepted practice in may organisations, including Enron’s competitors. If you weren’t doing it, your company would be at a disadvantage. Everything he did, he insisted, was signed off by Enron’s auditors, its lawyers and the board. At one point, Fastow calculated the amount of debt that the company was hiding and took the spreadsheet to the board. Instead of being concerned by the level of debt, the board congratulated Fastow on the great job he was doing keeping it off the books. That, he said, showed the mindset that they were in. No-one thought they were doing anything wrong. Furthermore, he said, a lot of people in large companies still don’t and similar things are still going on.

These days Andrew Fastow lectures on business ethics and he told a great story about a task he set for a group of students. He gave them some company accounts and asked them to work out the debt-to-asset ratio. He then asked them to go through the accounts, find the footnotes, work out how much debt was off-balance sheet and do the calculation again. This time, the debt-to-asset ratio was more than twice that of their original figure.

Asked for their views on the company, the students were clear. There is no way they would invest in it or work for it. They wouldn’t go anywhere near such an unethical organisation. Fastow then told them these were their own university’s accounts. The students were outraged. They would complain to the university authorities and demand that they come clean about the debt. But then Fastow explained that, if they did that, fees would have to go up by 10 percent. At this point, the students’ indignation evaporated and they unanimously decided to take no further action. “It took them 4 minutes to sell out,” he said.

And that’s why so much off-balance-sheet accounting still goes on. The rewards for sticking to the rules while ignoring the principles are too great and if all your competitors are doing it we, you’d be daft not to, wouldn’t you?

It was an interesting and entertaining talk. Andrew Fastow held our attention for well over an hour. He ran over but nobody minded. The FT has a write up of the session here.

I was still left with some nagging questions though.

Maybe I missed it but it wasn’t clear at what point his activities crossed the line from unethical to illegal. Perhaps that was the point he was trying to make – that he isn’t sure either. After all, lots of other people were doing it and Enron’s gatekeepers approved all of it. In which case, either there is something he is not telling us or lots of other people who should have gone to prison never got caught. What is more, if similar deals are still going on, are lots of other CFOs risking prison if their companies collapse and they get found out?

Or is it that Andrew Fastow was the example, the sacrifice, after which people learned to cover themselves more effectively so that they could carry on exploiting loopholes without the risk of prosecution?

He has done similar speeches around the world and I’ve looked at some of the write ups but I’m still none the wiser. I’m also no expert in US corporate law and I have only a superficial knowledge of the Enron case, so there may well be something I’ve missed.

Nevertheless, I’m still left with the question. Could it really be that the very same deals that won Andrew Fastow an award in 2001 got him jailed in 2006? If everything he did was within the rules, if lawyers and accountants approved it, and if lots of other people were (and still are) doing it too, how come he went to prison and very few others did?

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8 Responses to There’s a bit about Fastow’s hero-to-zero story I still don’t get

  1. Sophia says:

    I’m actually writing about a relevant but unrelated topic for Monday. In essence, it’s possible for accounting regulations to be at odds with the law. Many people argue this is the case with IFRS and the flaws in IFRS played a major role in the crisis.

  2. For one thing the authorities do not often actively look for people committing the offences: they charge people after things go wrong because at that point they do not have to.

    Prosecuting a few people makes an example of them and creates an impression that the law is enforced without sending too many important people to jail: the same applies to things like insider trading.

    There is also a matter of the extent of creative accounting: how bad does it have to be to be criminally misleading? If it is a small amount it may not be material.

    Finally, as the university example shows, off-balance sheet accounting is often done quite openly. They are not actually hiding the information, because it is in the notes. If most people cannot bothered reading the notes, it is their fault they do not know what is in them! How can it be a criminal deception if you told everyone what you were doing?

  3. P Hearn says:

    Will be interesting to compare notes when Gordon Brown makes the corresponding speech about his PFI deals in a few years’ time.

  4. alittleecon says:

    You’ve probably already seen it, but The Smartest Guys in the Room can be watched for free on Youtube:

  5. Tobin Pigou says:

    Rick
    The conventional story is that US GAAP is too rule-based, form trumps substance, and Enron successfully exploited that. But the prosecutions weren’t because of that. It was becasue they got the accounting wrong and then concealed it. They didn’t follow all of the technicalities (in particular a rule that required the outside investor contributed 3% of the capital). So, they didn’t follow the rules and various people, including the auditors, missed that. If they had followed the detailed rules, some/all of those deals would have been on balance sheet.
    TB

  6. Phil says:

    I don’t know the specific crimes that Fastow was jailed for, but the details of some of the creative accounting that Enron was doing are astonishing, especially to accountants (of which I’m one) The particular example is of how they accounted for contracts to build power stations. They had one in India that they contracted to build for several hundred million dollars. They valued this in the same way that the shares in a company are valued – the discounted future cash flow of the project. So they counted the revenue they were going to receive from this power station that had not yet been built as a current asset! And this got signed off by the auditors! And in the end the power station didn’t get built, but they’d already recognised income from it.

    The way this was all discovered was that Fortune journalists (from the same magazine that had awarded Enron company of the year 4 years in a row) compared cashflows to reported results and discovered all these manipulations. Assets were created out of nothing, and debts were hidden. Some of this is down to the malaise of quarterly accounting targets, with managers coming up with more inventive ways to meet numbers that the market expects, which can lead to Enron, or indeed the recent Tesco fiasco. Companies essentially borrow from the future, but that can only lead to trouble because it has to be repeated every month and eventually the numbers go against you.

  7. Dipper says:

    Perhaps the values-based approach of the banking regulators with a range of professional and civil sanctions is the right approach to this problem

  8. Pingback: Weekly Roundup, 28th July 2015 - 7 Circles

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