March 15, 2002

Andersen Indictment in Shredding Case Puts Its Future in Doubt as Clients Bolt

In the 212-year history of the U.S. financial markets, no major financial-services firm has ever survived a criminal indictment. Now, Arthur Andersen LLP will either make history -- or be history.

Thursday, federal prosecutors charged the nation's fifth-largest accounting firm with a single felony count of obstruction of justice. A federal grand jury in Houston alleged that for a one-month span in October and early November, "Andersen ... did knowingly, intentionally and corruptly persuade" employees to "alter, destroy, mutilate and conceal" audit-related documents. Alleging "wholesale destruction of tons of paperwork," the indictment said the obstruction wasn't confined to the Houston office that audited Enron Corp. but included activities in Andersen's Chicago headquarters and its offices in London and Portland, Ore.

Andersen, which said it would plead not guilty, accused the department of "a gross abuse of governmental power." Complaining that the firm hadn't been allowed to give its side to the grand jury, the firm's lawyers told the Justice Department that criminal proceedings were tantamount to a "death penalty" against the firm.

Andersen plans to fight the indictment in part by arguing that the destruction was instigated and controlled by its Houston office without either the knowledge or consent of top firm executives. It also said that most of Andersen's Enron documents weren't destroyed, and that much material has been recovered and given to the government. Andersen added that there was no criminal intent and noted that it had itself informed the government of the shredding.

Andersen's fall has come nearly as swiftly as that of the auditing client whose problems brought it down. After Enron filed for bankruptcy-law protection Dec. 2, the energy and trading company's creditors focused on what Andersen knew and when. The accounting firm's fortunes turned markedly worse when it disclosed in January that volumes of Enron-related documents were destroyed by Andersen's Houston office.

Since then, Andersen has sought unsuccessfully to convince federal authorities that wrongdoing was confined to that office. "There is no evidence to support an indictment against the firm," Andersen spokesman Charlie Leonard said Thursday. "The partnership in the U.S. is fired up and they are going to fight this."

For the 89-year-old, 85,000-employee firm -- which long set high standards in the accounting industry -- options are fast dwindling. Intensive efforts in the past week to sell either all or part of the partnership to Big Five rivals, including Deloitte Touche Tohmatsu and Ernst & Young, have failed because of questions about how the buyer might avoid liability stemming from Andersen's Enron audits. The last hopes for a significant bid rest with KPMG LLP and BDO Seidman LLP, the fifth- and sixth-largest accounting firms, respectively, though a wholesale purchase of the firm remains a long shot.

Thursday, Andersen executives were scrambling to piece together a survival plan. But each scenario has big drawbacks. The over-arching problems: legal liability stemming from plaintiff lawsuits, followed by collateral damage from criminal indictment.

It's the blow to Andersen's reputation that will be hardest to counter. More clients will bolt, and partners as well. It will be difficult for clients' boards of directors to justify keeping Andersen, with its future so uncertain. However, the Securities and Exchange Commission moved quickly to reassure Andersen clients that it would continue to accept financial statements audited by the indicted firm.

So far, Andersen has lost about 40 clients, representing tens of millions of dollars in annual revenue. The amount lost is "insignificant today, but it could be very significant next week," said Mr. Leonard, the Andersen spokesman, who said the indictment "is going to be a very substantial hit to the client and revenue base." Even without an indictment, Andersen had been bracing for the loss of as much as 25% of its U.S. revenue.

One rival Big Five partner says his firm has been contacted in recent weeks by at least 50 Andersen clients about switching auditors. Valero Energy Corp. dropped Andersen late Wednesday, appointing Ernst & Young. Thursday, SouthTrust Corp., a Birmingham, Ala., bank, became the first apparent defection after the indictment when it said it was looking for a new auditor. Late last month, the bank, which says it hasn't yet fired Andersen, had said it would stay with the firm. Abbott Laboratories, another once-loyal client, said its audit committee would meet Friday to discuss whether to keep Andersen.

As for personnel defections, a partner at a rival Big Five firm says he will be in New York next week and "I've got a dinner every night with an Andersen partner. It's a free-for-all now."

The indictment may also prompt state licensing boards to initiate hearings to reconsider Andersen's license to practice in their jurisdictions, although an indictment doesn't obligate states to do so. Any state licensing board that decided Andersen had engaged in professional misconduct could suspend its license, barring Andersen from auditing any client's operations within that state. And various federal, state and local governments have the right to suspend Andersen from auditing government entities pending resolution of the criminal case.

What Now?

So, what can Andersen do now? One plan being discussed calls for shrinking the firm to about one-fifth its size to focus on small and medium-size businesses as clients. Yet people close to the firm say it would be hard to retain high-quality partners to work for the smaller fees that would result.

Another plan calls for putting Andersen into Chapter 11 bankruptcy-law protection. But people close to the talks say it would be difficult to reorganize the company, if, as many expect, the current trickle of lost business turns into a flood.

Moreover, such a move by a service partnership would almost amount to an admission that it was finished as an independent firm. The one large accounting firm that has filed for Chapter 11 -- Laventhol & Horwath in 1990 -- and a handful of large law firms that have done so have used their filings merely as a mechanism for liquidation, specialists say. In any case, Andersen isn't likely to file for bankruptcy in the next few days, since any filing could take at least several weeks to prepare.

If a Chapter 11 bankruptcy filing evolved into a liquidation, selling off the assets could be difficult. Aside from computers, leases and other equipment, Andersen's main asset would be receivables from clients. They might be hard to collect if Andersen had stopped work on audits or other long-term tax projects with the clients.

Former Federal Reserve Chairman Paul A. Volcker, who in early February was given sweeping powers to overhaul Andersen's operations, said the future of Andersen is "in jeopardy."

Andersen's overseas offices could strike deals on their own. One plan being discussed calls for dissolving the firm's Swiss-based umbrella company, Andersen Worldwide SC, which is an alliance of many partnerships world-wide, including Arthur Andersen LLP. People close to the Swiss umbrella company say some Andersen partners in Spain, Germany, France, the U.K. and other countries already are entering informal deal talks on their own. Besides KPMG, Deloitte also has indicated interest in possibly acquiring parts of overseas businesses, but no deals appear imminent.

Andersen's European operations aren't the target of the criminal charges, may not be liable in the civil suits and are made up mostly of consultants rather than auditors -- giving them further incentive to leave the firm.

In the end, Andersen's best hope may be to embrace reforms -- such as the ones proposed last week by Mr. Volcker -- in an effort to win support of those who back an industry overhaul. Mr. Volcker hadn't been due to unveil his conclusions until later this month, but when it emerged that Andersen could be facing indictment he hastened a meeting with members of his panel and rushed out his recommendations.

Chief among them: that Andersen separate its auditing and consulting businesses into separate units, to remove the financial incentives that auditors have to go light on clients who also use the accounting firm's lucrative consulting services. The firm now says it will do just that. "We're going to adopt the Volcker reforms and have the best standards in the practice," said Mr. Leonard.

There's even a problem with this tack: The firm acknowledges it hasn't yet figured out a way to carry out a structural separation between the audit work and other business, such as strategic planning and legal work.

"I was hoping they could return to their roots as a first-class auditor. They can't do that if they don't exist," Mr. Volcker lamented Thursday. If Andersen doesn't survive, the prospects for industry reform darkens. "That is the danger," says Mr. Volcker -- that Andersen gets treated as "a scapegoat."

In the past few days, Andersen partners have scrambled to reassure restive clients. In an internal memorandum circulated to U.S. employees Thursday, the firm denied that it had directed the destruction of documents related to its work for Enron and warned that an indictment could destroy the firm. The memo, distributed by Terry E. Hatchett, Andersen's U.S. country managing partner, encouraged employees to remind clients that an indictment wasn't a conviction and that Andersen would continue to be able to sign audit opinions.

Venerable Organization

The obstruction-of-justice indictment marks a remarkable low point for a gilded firm. Originally called Andersen Delaney & Co., the firm was founded in 1913 by Arthur Andersen, a professor at Northwestern University, and quickly shot to preeminence as a hallmark of professionalism and a keeper of the public's trust for taking tough stands against clients. In 1915, Andersen took the position that the balance sheet of a steamship-company client had to reflect the costs associated with the sinking of a freighter, even though the sinking occurred after the company's fiscal year had ended but before Andersen had signed off on its financial statements. This marked the first time an auditor had demanded such a degree of disclosure to ensure accurate reporting.

Mr. Delaney resigned in 1918, at which point the firm changed its name to Arthur Andersen & Co. and soon began expanding across the U.S., including to Washington, D.C., in 1921. Over the next two decades it established a "one-firm" philosophy to unite all offices. It launched innovative training and practice standards for employees and partners.

Mr. Andersen died in 1947, a passing that nearly sunk the firm. It was held together, however, by a disciple of his, Leonard Spacek, who presided over Andersen until 1963. During Mr. Spacek's tenure, the firm continued to take stances in the public interest, insisting on high accounting standards, even if doing so cut into profits for his firm or others. That emphasis on the public interest continued long after Mr. Spacek's departure.

During the 1970s and 1980s, the firm continued its global advance into Asia. It was the only one of the major firms to push for reforms in the accounting for pensions in the 1980s, a move opposed by many corporations, which objected that the changes would hurt their reported profits.

By the middle of last week, Andersen's advisers realized how tough the firm's situation was. The lead plaintiff's lawyer for Enron shareholders had rejected a $750 million offer for a universal settlement of Enron-related civil claims. And by last weekend, with client defections mounting and the Justice Department talking tough, the advisers knew the firm had become "a melting ice cube," in the words of one. The merger scenario -- which seemed to offer a way to hold on to increasingly skittish clients -- seemed like the most optimistic possible outcome. But the firm's advisers had already begun to map out the grimmer alternatives.

Other Scrapes

Andersen has had prior run-ins with regulators, such as a civil-fraud settlement last year related to Waste Management. The Securities and Exchange Commission fined Andersen $7 million for its audits in the 1990s of the waste company, a major client. Andersen settled the complaint without admitting or denying wrongdoing, but consented to a permanent injunction barring it from future violations of securities-fraud regulations. Yesteday's indictment didn't accuse the firm of violating this consent decree nor level a contempt-of-court charge, instead charging Andersen with the single count of obstruction of justice.

Andersen's liability from possibly flawed audit work doesn't end with Enron. Three telecommunications companies whose books it audited currently have accounting practices under review by the Securities and Exchange Commission.

The trio are Global Crossing Ltd., which filed for bankruptcy-court protection in January; Qwest Communications International Inc. of Denver; and WorldCom Inc. At least one shareholder class-action suit against Global Crossing also singles out Arthur Andersen as a defendant. That suit, filed this week in a New York federal court, alleges that the accounting firm violated federal securities laws by issuing unqualified opinions on Global Crossing's allegedly misleading books. (Global, Qwest and WorldCom are sticking with Andersen, with no current plans to seek alternative auditors.) Andersen denies the allegations in the suit. Congressional investigations have opened into the accounting problems of Global, with Andersen's involvement there an object of the scrutiny.

Fate of Partners

If Andersen fails, its 5,000 partners certainly will suffer. But years of salaries that often hit the high six-figures would soften the blow. A typical partner with about 20 years at the firm is probably making more than $500,000 a year and has between $500,000 and $800,000 in capital invested with the firm. That's money the partners already know is gone because it would likely be used to settle lawsuits against Andersen.

Many partners would make attractive hires for rival firms, especially if they can bring their clients with them, something that would be possible if Andersen disappeared. Typically, partners never switch firms because their seniority-based salaries would fall. "If your earnings are at the top of the pile, you wouldn't leave to go to another firm for a lower salary," a former senior partner at Andersen said. Now, "the game has changed," he added.

It's the lower-level employees -- who have survived the years of grunt work necessary to move ahead in the firm but haven't yet reaped the benefits -- who would likely suffer the most. That's particularly true for the firm's consultants, who face a saturated job market.

Inside Andersen's Chicago headquarters, the mood was grim Thursday as many of the 8,000 employees openly discussed their options. Business has dried up and many people expect layoffs to begin soon. "The machine has certainly slowed down if not stopped," one person familiar with the situation said.

Some employees were putting their resumes together for the first time. "A lot of these people have never been in the marketplace, they began their career at Andersen and they've never worked anyplace else," the person said.

Some employees broke the tension with gallows humor. Among jokes being circulated was that of a future employer reviewing a resume that was shredded in parts. The punch line: "I see you worked for Arthur Andersen."

Write to Ken Brown at ken.brown@wsj.com², Mitchell Pacelle at mitchell.pacelle@wsj.com³, Cassell Bryan-Low at cassell.bryan-low@wsj.com⁴, Jonathan Weil at jonathan.weil@wsj.com⁵, Robert Frank at robert.frank@wsj.com⁶ and Susanne Craig at susanne.craig@wsj.com⁷

Updated March 15, 2002