case summary

Case Study 5 Enter Mark-to-Market (B): Accounting & the Aggressive Client

The meeting had not gone well. In fact, the casual observer might call it a disaster. SERGE GOLDMAN CLOSED HIS OFFICE DOOR, sat down, and leaned back in his chair. Straight ahead on his desk lay the phone. In a few minutes, Goldman, as Arthur Andersen’s (AA) engagement partner on the Enron account, would have to call AA’s Chicago headquarters. There a group of senior partners sat awaiting a report on Goldman’s meeting with Jeff Skilling. On the face of things, Goldman would not have good news to report. As expected, Skilling had pressed AA hard to agree that Enron Finance (EF) could switch from Oil and gas accounting (OGA) to mark-to-market (MtM). Somewhat unexpectedly, the meeting had turned ugly. Near the end, one of Skilling’s lieutenants had turned on Goldman and his colleagues, accusing them of just being stupid. Moreover, Skilling had made it clear that he would carry his battle for MtM past Goldman to AA-Chicago. Clearly, Goldman’s meeting strategy had not worked. Now he would have to scramble to reconstitute his approach Before picking up the phone, Goldman would have to piece together a strategy to regain the initiative. AA’s having the final say over Enron’s accounting decisions was at stake. Although his partners were waiting, Goldman decided that they could wait a few minutes longer. He would take a moment, reflect back on the day’s meeting, and then compose an approach that would allow AA to manage this client and this accounting decision. Only then would the conversation

The Meeting with Skilling

The meeting had convened like a summit conference, complete with advisers from Bankers Trust and lawyers from Vinson & Elkins. Goldman brought along several colleagues, including the young David Duncan. The immediate issue prompting the meeting was the inconsistent treatment afforded by OGA to different sides of a Gas Bank transaction; however, everyone in attendance knew that the real agenda concerned EF’s proposed adoption of MtM. Skilling immediately took over the meeting, presenting EF’s rationale for using MtM. Skilling launched into a broad argument asserting MtM’s superiority to OGA as an accounting treatment. First, he analogized EF to Wall Street trading houses. These, he argued, used MtM as common practice. In doing so, they more accurately reflected the current worth of their business. MtM was obviously the superior accounting system for a trading business. As described by Skilling, MtM had the following desirable attributes: The full expected value of a transaction would be recorded at inception. Any change in the value of the transaction prior to final liquidation would be recorded as profit or loss. The risk of a matched or unmatched position would be reflected more accurately. Firms could not “manufacture” earnings by selling profitable positions and retaining losers. Skilling used a brokerage transaction to illustrate. If a brokerage firm owned a stock and the daily trading price rose, the firm recorded a gain. Should the stock price drop the next day, the firm booked a loss. This, he implied, made MtM both a more accurate and a more consistent accounting system for a trading business. MtM would, for example, eliminate the asymmetric treatment of integrated transactions like those characteristic of the Gas Bank. MtM would simply integrate both sides of the transaction and record the total profit or loss expected from the position over its full life. Skilling then summarized: “That is the beauty of mark-to-market. It reflects market reality” 1 It was at this point that Goldman responded. Skilling had touched on the Gas Bank transaction, the specific issue under discussion. Goldman tried to bring the debate back to the fundamentals of this deal: “Wait. But this is an oil-and-gas transaction. You need to use oil-and-gas accounting.” 2 Goldman thought that putting this position on the table would accomplish two goals. First, it would pin the discussion down to the transaction in dispute. The general matter of MtM might be put off while the group focused on whether the problem of asymmetric accounting could be resolved. More fundamentally, Goldman was setting up his major message. Enron was an oil and gas company, not a Wall Street firm dealing in financial instruments. Virtually all Enron transactions involved oil and gas assets It would be a major departure for any unit of Enron to shift away from OGA. Goldman didn’t plan to play his high card at this meeting, but assuming that Skilling continued to push for MtM, he’d eventually be told that the Securities and Exchange Commission (SEC), and not AA would make the final accounting determination. Enron was a publicly traded firm. Each quarter, it filed financial statements with the SEC. Goldman and his AA colleagues were virtually certain that the SEC would not permit an Enron unit to completely alter its accounting system without securing the commission’s prior approval. It was at this point that the meeting spun out of control. Skilling and his lieutenants insisted that it made no sense to continue OGA for a unit whose business involved buying and selling both sides of a transaction. Goldman maintained that the transactions in question were rooted in oil and gas valuations and that OGA should apply. At last, Lou Pai, one of Skilling’s favorites, threw up his hands in frustration: “You guys are just stupid. You’re frigging stupid.” 3 Goldman realized that his meeting plan was in disarray. The discussion had not settled down to the particulars of the disputed Gas Bank deal. Goldman had failed to establish that EF was not comparable to a Wall Street firm; he also had failed to make clear that EF could not unilaterally be carved out from the rest of Enron for purposes of choosing an accounting method. Skilling and his team continued to argue that EF was different and to push for MtM. The best that could be said was that Goldman had drawn a line over OGA and not yet conceded any ground on MtM. With the meeting stalemated and tempers rising, Goldman tried to diffuse the situation. The opportunity came when Skilling pushed Goldman to consult with AA’s technical experts in Chicago. Goldman readily agreed to do so. Telegraphing his determination to get the result he sought, Skilling emphasized that he was ready to go to Chicago and present his arguments in person. He also pushed several PowerPoint slides (Attachment 1) across the table and told Goldman to send them to Chicago. With this as a go-forward plan, the meeting broke up.

Goldman Plans to Brief his Partners Once his head cleared a bit, Goldman took stock of the situation. Some things were instantly clear. Goldman was now personally at risk of seeming to have mismanaged the client. EF and AA were at loggerheads. EF’s top executive had not only refused to accept the engagement partner’s advice, but also made clear his intent to appeal over Goldman’s head. Unless Goldman simply capitulated, his senior partners would have to become involved. At a minimum, they would wonder why their involvement was necessary. Tempting as capitulation now seemed, it was a recipe for long-term trouble. If Goldman rolled over, EF would have established that AA could be pushed around by hard charging plus some huffing and puffing. Word would spread rapidly within Enron. AA already regarded this client as among its more aggressive managers of accounting results. Any quick “give” on MtM would surely encourage other Enron units to press for their preferred accounting positions. AA’s position as Enron’s accounting gate-keeper could be fundamentally compromised. Moreover, the real issues involving EF’s switching to MtM had not gotten out on the table. Goldman had hoped to use the Gas Bank transaction to illustrate the risks associated with MtM. However, Enron’s line of attack had never given him the chance. This posed a complication. Goldman was guessing that his senior partners would not want to lead a technical accounting discussion. EF seemed not to be interested in having one. How, then, to get the risk and abuse buried in EF’s version of MtM out on the table? This point was especially bothersome. EF’s version of MtM went well beyond that practiced by Wall Street firms. EF’s transactions were also less transparent, less easy to value than anything traded at Morgan Stanley or Lehman Brothers. It was precisely in the accounting details that the potential lurked for Enron to distort financial statements and manufacture profits. Somehow, AA had to make EF see its concerns and hold to a position that avoided the pitfalls of EF’s approach. Talking accounting theory or even financial control with Skilling was not likely to work. Nothing about the way Skilling behaved in the meeting suggested that he was open to a discussion on the merits. Goldman suspected that Skilling had another, perhaps several, agendas. It would take some rock that Skilling couldn’t move with a slick presentation to force him to consider another perspective. As Goldman mulled over the debris left by the meeting, he came to an especially awful realization. It was going to take a near flawless communications strategy with his partners to salvage the situation. If he dialed them up and began to recount the meeting, they instantly would conclude that a disaster had occurred. At that point, they might stop listening and start thinking about what they would have to do to salvage the situation. Some would start thinking about how to placate a valued client Others might begin thinking about replacing him as the engagement partner. Most likely, the discussion would turn toward finding an answer to satisfy Skilling before he came to Chicago. Some partners might try to minimize the damage by visualizing how AA might retreat from the position Goldman had staked out during the meeting. In the face of Skilling’s determined and confrontational style, it was not clear that mere tactical retreat would salvage much of AA’s gatekeeper role. Somehow, Goldman was going to have to position the meeting’s outcome within the context of a strategy for managing both the client and the issues. The meeting’s outcome was going to have to appear anticipated, a necessary stage to pass through on the way to a sound answer Goldman had worked out in advance. If Goldman could convey to his partners that he had such a plan, that it anticipated hardball tactics from the client, and that he still remained two or three steps ahead of the client, there was a chance that the Chicago partners would be willing to play their roles; any such plan would also need to reroute Skilling away from Chicago and back to Goldman and his team. But did he have such a plan? If so, was it still intact, and would it withstand Skilling’s presenting his arguments, charts, and implied threats in Chicago? Goldman decided that his partners could wait a few minutes more while he attempted to sketch an outline of how AA might manage this particular client.

Author’s Note

Many ethics issues come to a head at meetings. This case depicts such an instance. As is often the case, those advocating a questionable change are not debating the matter on the merits. They are interested only in getting the result they desire; verbal browbeating and going over the head of AA’s engagement partner are permissible tactics in this cause. AA, as Enron’s accounting gatekeeper, must decide how to manage this client eruption, the technical accounting matters at issue, and its own role as the arbiter of acceptable accounting methods. This case relies on the account of the MtM controversy as provided in Conspiracy of Fools. Pages 54– 61 of that work offer an account of: (1) the meeting between AA and Skilling and his team, (2) a subsequent conversation on MtM between David Woytek and Skilling’s then CFO, George Posey, and (3) Skilling’s presentation to the SEC on September 17, 1991. The case’s back-and-forth arguments at the Skilling/ AA meeting are as presented in this Conspiracy of Fools account. Lou Pai’s quote has been altered to sanitize the obvious obscenity. While Goldman held a line on using OGA at the EF meeting, it is not clear whether this was the result of any planned approach. The flavor of the account in Conspiracy of Fools suggests more of a meeting that quickly polarized because the client was interested only in getting the answer it wanted and AA was not ready to say yes. There is no historical record of what Goldman thought about or communicated after the meeting. Goldman’s post meeting reflections are thus a creation intended to lay out possibilities for managing both the meeting’s fallout and his AA partners. However, Goldman was an engagement partner for a major client. To reach such a position, he likely would have had considerable experience managing meetings with aggressive clients and his political position in the firm. It is therefore reasonable to assume that as such, he would have sought to align his senior partners prior to turning down an important client’s request. To help illustrate the challenges aggressive clients can present to gatekeepers, the case attributes to Goldman considerable post meeting reflection. To sharpen his dilemma, it also presents Goldman as doubting the resolve his senior partners would muster. Given AA’s subsequent very accommodating stance toward Enron, such doubts were probably not unrealistic. Attachment 1 is an HRC. However, it accurately reflects the key arguments Skilling used in his meeting with the SEC (see Conspiracy of Fools, pp. 59– 61). There is no evidence that Skilling gave these graphs to Goldman at the conclusion of their meeting, nor is it clear exactly what materials Skilling used when he did subsequently visit AA-Chicago. It is unlikely, however, that his line of argumentation was materially different from what’s in the attachment. Since the SEC arguments are recounted and are the ones that ultimately carried the day, they have been incorporated here to allow students to analyze the case using Skilling’s final position.