February 1, 2002

Enron Audit Panel Is Scrutinized For Its Cozy Ties With the Firm

By JOANN S. LUBLIN
Staff Reporter of THE WALL STREET JOURNAL

When the board audit committee of Enron Corp. gathered for a regular meeting at its Houston headquarters a year ago, the session should have been anything but routine.

After all, Enron management wanted a blessing for every transaction during 2000 between the energy-trading company and two partnerships run by then-Chief Financial Officer Andrew Fastow. The controversial partnerships kept significant debt off the books, pumped up profits -- and earned Mr. Fastow more than $30 million.

Yet committee members, all of them outside directors, didn't challenge a single transaction, according to knowledgeable people and excerpts of the Feb. 12 meeting's minutes. Their indifference wasn't a complete surprise. The full board twice had taken the rare step of suspending the corporate-ethics code, so Mr. Fastow could head the partnerships.

Subsequent disclosure of losses related to the partnerships hastened Enron's collapse. Now, amid finger-pointing at top management and the company's outside auditors at Arthur Andersen LLP, the audit committee is under harsh scrutiny from a slew of civil, criminal and congressional investigations -- and the board itself.

A special board committee looking into the debacle is expected to partly blame the six-member audit panel in a report to be issued as early as this weekend. The report will cite slick presentations by sophisticated financial people along with lethargy on the part of audit-committee members, says an individual close to the situation. The panel discovered significant defects in procedures for monitoring financial results and controls, the individual adds.

Critics who contend Enron's audit panel fell short cite several key reasons: Several members held cozy ties with the company, they say. The panel's chairman -- Robert K. Jaedicke, retired accounting professor and former dean of Stanford University's business school -- preferred a relatively passive role. And Andersen auditors apparently weren't persuaded that they should be answerable to the audit committee as their client. "It's the worst audit committee I have ever seen," asserts John Nash, president emeritus of the National Association of Corporate Directors.

"This audit committee worked pretty well based on the information it was provided," retorts W. Neil Eggleston, counsel for Enron's outside directors and a partner at Howrey Simon Arnold & White in Washington. Andersen signed off on accounting practices and didn't alert members about "any impropriety or irregularity" until November, Mr. Eggleston adds. Audit-committee members either declined to comment about their role or didn't return calls.

An Andersen spokesman, asked to respond to Mr. Eggleston's critique, said the notion that "the audit committee or senior management wasn't aware of the risks of the business decisions they were making is entirely implausible." Regarding criticism of its auditing work, Andersen says Enron withheld crucial information and misled the auditors about the partnerships; Enron fired Andersen last month.

At first glance, Enron's pivotal audit panel, made up of prominent executives, looks well-qualified. But in reality, governance specialists contend, the committee's makeup is far from ideal.

For one thing, half its members live abroad -- an uncommon practice at audit panels, which meet often and require a keen grasp of business practices here. As an American citizen, Hong Kong billionaire property developer Ronnie Chan may understand U.S. business. But he has the worst recent attendance record of any Enron director. He missed more than 25% of board and committee meetings during 1996, 1997 and 2000, according to proxy statements. (In 1998 and 1999 he missed fewer meetings, though the percentage wasn't reported because it was less than 25%.)

Corporate-governance experts doubt some other audit-committee members are truly independent. Lord John Wakeham joined the board in 1994, four years after the then-British energy secretary approved plans for Enron to build a power plant in the United Kingdom. Since 1996, proxy statements show, he has earned $72,000 a year advising its European unit -- more than his $50,000 annual stipend for being a director. In a statement last week, Lord Wakeham's office said it "would clearly be wrong of him" to make any comments about his position at Enron while the matter is being investigated.

John Mendelsohn is president of University of Texas M.D. Anderson Cancer Center, which has received nearly $1.6 million in donations from Enron and related entities since 1985, the year his predecessor Charles A. LeMaistre became an Enron director. Dr. Mendelsohn has said the center doesn't depend heavily on Enron philanthropy.

Dr. Jaedicke, who is 73 years old, is the most important -- and, to corporate governance experts, perhaps most problematic -- member of Enron's audit panel. The unpretentious retired academic commands respect for his meticulous thoroughness. But he has led the Enron audit panel since he obtained his board seat in 1985. Big-business boards typically switch committee heads every three to five years to maintain distance from management.

Dr. Jaedicke feels his lengthy tenure never crimped his outside perspective, Mr. Eggleston says. But some question whether Dr. Jaedicke's long service to Enron may have contributed to his approach.

He took a relatively passive role, for example, when the board first waived the ethics code in mid-1999. To form a private partnership called LJM Cayman LP, Mr. Fastow needed a special board ruling that his activities wouldn't violate policies intended to protect against executives being involved in activities that might pose a conflict of interest or harm Enron.

The audit committee's charter, disclosed in the latest proxy statement, describes its responsibility for overseeing ethics-code compliance. Yet the panel took no action about suspending the code before the full board met; nor did Dr. Jaedicke propose an audit-committee review during that board meeting, Mr. Eggleston reports.

"The audit committee should have made the code suspension part of their work, especially since the partnership would involve the CFO," says Charles Elson, director of the Center for Corporate Governance at the University of Delaware's business school. And Dr. Jaedicke, as the committee's chairman, "should have been upset over the proposed waiver of the code."

To the contrary, according to excerpted minutes from Enron's board meeting on June 28, 1999, it was Dr. Jaedicke who seconded the motion suspending the ethics code when directors approved a resolution that Mr. Fastow's partnership participation "will not adversely affect the interests of the Company."

He saw the partnership as a "one-off, isolated transaction. It didn't look like there was much risk at that time," Mr. Eggleston explains. In addition, the lawyer continues, committee members "believed that Arthur Andersen was involved in blessing the LJM partnerships."

Also raising eyebrows is the audit committee's lack of involvement in deciding which law firm would conduct the nearly two-month probe into a letter warning of questionable accounting last August by Enron Vice President Sherron Watkins. Her letter raised alarms about the unorthodox partnerships and their potential danger to Enron's finances and public image.

At numerous companies, the audit-committee chairman decides which law firm should probe a serious whistle-blowing complaint. "That's the only way you maintain the integrity of the company," says Roderick M. Hills, a former Securities and Exchange Commission chairman who has led more than six audit committees.

Instead, at Enron, management made the decision to retain Houston law firm Vinson & Elkins to explore concerns described in the letter Ms. Watkins sent and discussed with then-chairman Kenneth Lay. Her letter cautioned against using Vinson & Elkins as investigators because it had issued legal opinions endorsing some of the partnerships.

Dr. Jaedicke didn't learn about the Watkins letter or the outside lawyers' inquiry until it ended, when Vinson & Elkins briefed him about the finding, Mr. Eggleston says. He maintains this didn't bother Dr. Jaedicke because he knew corporate policy required that in-house attorneys review employee complaints from any level and decide whether to seek outside legal help. Critics say that the Vinson & Elkins Oct. 15 report in effect ignored the accounting problems, by concluding that Enron's practice of forming special-purpose entities to keep debt off its books was "creative and aggressive" but wasn't "inappropriate from a technical standpoint."

Enron's auditors also knew about the Watkins allegations long before the audit committee did. An Aug. 21 Andersen memo summarizes a conversation in which the whistle-blowing executive, a former Andersen auditor, shared her concerns about Enron's questionable accounting with an Andersen audit partner not assigned there. The partner passed along what he termed "a very troublesome scenario" to several Enron auditors at Andersen and to the firm's lawyers. Andersen says it also informed Enron management.

By Oct. 9, Andersen analysts had determined there was "a red alert: a heightened risk of financial-statement fraud" at Enron, according to an Andersen e-mail. The Andersen spokesman says the financial-statement test described in the e-mail was conducted on an "experimental basis" using software later found to be flawed and doesn't know what actions auditors took to address the "red alert."

Again, however, Enron's audit committee didn't immediately learn of this. Not until Nov. 2, when the company's financial condition had seriously deteriorated, did Andersen tell the Enron board of "possible illegal acts within the company" concerning one partnership, Andersen Chief Executive Joseph Berardino told lawmakers. Six days later, the complex partnerships caused Enron to restate nearly $600 million in earnings reported over five years.

Some suspect Andersen auditors failed to keep Enron's audit committee well-informed because they saw their main responsibility as serving the company's management, and not the full board or the audit committee. "It's usually the comptroller that recommends to the audit committee who the auditors should be," a former Enron official observes. Andersen auditors worked "with the company day by day. They saw the audit committee once a quarter."

Yet at some companies audit-panel chairmen aggressively try to reverse that misconception, thereby protecting auditors against management mischief. "You're there to make sure [auditors] report to you" and that only directors can fire them, Mr. Hills says. So, he occasionally spends all day at auditors' offices making sure they consider conservative accounting methods. "Enron is emblematic of a culture in corporate life that needs to be rooted out," he maintains.

-- Christopher Cooper, Peter Wonacott, Matt Pottinger and Jonathan Karp contributed to this article.

Write to Joann S. Lublin at joann.lublin@wsj.com3


Who's Who on Enron's Audit Committee

Name and Title Prior or Related Roles Other Enron Links
Robert K. Jaedicke Former dean and accounting professor, Stanford University's Graduate School of Business He has headed committee since 1985; critics say such long tenure impedes independence.
Ronnie C. Chan / Billionaire chairman of Hang Lung Group, Hong Kong property conglomerate Also a director of Motorola and Standard Chartered He missed more than 25% of board and committee meetings in 1996, 1997 and 2000.
John Mendelsohn / President, M.D. Anderson Cancer Center, University of Texas Also a director of ImClone Systems Enron or related entities have donated $1,564,928 to M.D. Anderson since 1985.
Paulo V. Ferraz Pereira / Brazilian investment banker and executive vice president of Grupo Bozano Former head Banco Bozano Simonsen; former president and CEO State Bank of Rio de Janeiro He won his Enron directorship through a personal relationship there.
Lord John Wakeham* / Member, U.K. House of Lords and prominent Conservative politician Former leader House of Commons and House of Lords He has earned $72,000 a year as a consultant for Enron's European unit since fall 1996.
Wendy Gramm / Director, Regulatory Studies Program, Mercatus Center, George Mason University Former chairman Commodity Futures Trading Commission Enron has given Mercatus Center $50,000 since 1996.

*Thursday, he temporarily resigned as head of U.K.'s Press Complaints Commission due to Enron investigations

Source: WSJ reporting and Enron proxy statements


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Updated February 1, 2002 11:59 p.m. EST





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