Twenty years ago, CFO gave Enron finance chief Andrew S. Fastow a CFO Excellence Award in the category of “capital structure management.” In a feature story naming him an award recipient, Fastow said, “Our story is one of a kind.” Little did he know how prophetic those words would soon become.
I remember Fastow well, as I wrote that October 1999 story. It explored his financial wizardry in helping turn a sleepy natural gas pipeline company into a blazing energy trading firm. At its height, Enron was the seventh largest company in America; its market capitalization hit $35 billion. For the story, I interviewed Fastow, Enron’s CEO Kenneth L. Lay, and president and COO Jeffrey K. Skilling. All would soon become notorious.
Two years after the story appeared, Enron became the biggest accounting scandal in American history. The upsurge in market capitalization that Fastow crowed about had been whittled down to nothing. His financial wizardry, as it turned out, was “smoke and mirrors” designed to mask Enron’s true financial performance. The company filed for bankruptcy on December 2, 2001, putting thousands out of work. Most of Enron’s employees had invested their retirement savings in the company’s stock. Other shareholders lost billions.
A U.S. Securities and Exchange Commission investigation followed, as did a criminal investigation by the U.S. Department of Justice. Fastow was charged with 78 counts of fraud for his central role in developing the off-balance-sheet special-purpose entities that led to the company’s collapse. He subsequently entered a plea agreement, forfeited his net worth of $24 million, and served a six-year prison sentence in a federal detention center in Oakdale, Louisiana. He was released from prison in December 2011.
The CFO article on Fastow was the first in-depth piece of journalism to lay out the complex finance and accounting strategies that underpinned Enron’s meteoric rise. In the story, Fastow was lauded. Said one Lehman Brothers analyst, “Thanks to Andy Fastow, Enron has been able to develop all these different businesses, which require huge amounts of capital, without diluting the stock price or deteriorating its credit quality—both of which actually have gone up. He has invented a groundbreaking strategy.”
What I had failed to capture, in a story meant to celebrate Fastow as a CFO wunderkind, was his shrewd manipulation of the accounting rules, which was unbeknownst to me and the impartial panel of CFOs who selected him for the award. He had been the chief engineer of the deals that made Enron’s financial performance and balance sheet appear much stronger than they were.
When Enron blew up in 2001, some of the fallout struck me as the writer of the article. I received anonymous emailed death threats, perhaps from embittered employees and shareholders. Although I was simply the messenger, I still felt guilt and shame.
I write this prologue for a reason. Over the past two years, Fastow has been on the public speaking circuit. A few months ago, I reached out to him on LinkedIn to request an interview. In our subsequent discussions via Skype, two of his comments stood out.
One was his assertion that the factors causing the collapse of Enron are in play at other companies. The other was his contention that the Sarbanes-Oxley Act, created in 2002 to prevent another Enron debacle, will not stop another Enron from happening.
During a Skype interview, he set up his laptop so I could watch a video of his keynote speech on trust and ethics in front of 2,000 people at the “InTheBlack: Accounting & Finance Innovation Summit” in Las Vegas, sponsored by BlackLine.
He had given presentations over the past two years to university business students and organizations of certified fraud examiners, but these were his people—finance and accounting professionals. As one finance executive in the audience later told me, “I wanted to know what the world’s greatest CFO criminal mastermind could possibly have to say about ethics and trust.”
A few minutes into the speech, Fastow walked offstage and came back. In his right hand, he was holding his CFO Excellence trophy. In his left hand was his prison identification card. He then raised both arms and said, “How is it possible to go from a CFO of the year to federal prison for doing the same deals?”
The thesis of Fastow’s presentation is rules vs. principles, his argument that someone can follow the rulebook and still fail to do the right thing. That was Fastow’s wrongdoing, according to him. “I found every way I could to technically comply with the [accounting] rules,” he told the assembled. “But what I did was unethical and unprincipled. And it caused harm to people. For that, I deserved to go to prison.”
In our conversations, Fastow repeated the fact that all his structured transactions were approved by Enron’s accountants, senior management, and board of directors; internal and external attorneys; bank attorneys; and its audit firm, Arthur Andersen. (That Arthur Andersen approved them is not saying much—after the Enron debacle, its auditing business shut down.) “How is it possible to have all these smart people approve these deals and end up committing the greatest fraud in corporate history?” Fastow asked me.
He then answered his own question. “The fundamental problem is this: Virtually all the safeguards that have been built into the system are compliance and legal procedures to catch rulebreakers. But rulebreakers are only part of the problem. The more insidious and dangerous problem is the rule ‘users’—the rule exploiters who find the loopholes.”
Fastow was perhaps the world’s best rule user of his time. All he needed were accounting assumptions and structured finance to transform the appearance of Enron.
There is some truth to what Fastow attests to about using loopholes. Bethany McLean, co-author (with Peter Elkind) of the book, “The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron,” has stated on more than one occasion that what Fastow perpetrated was “legal fraud,” an oxymoron suggesting that a CFO can follow the rules and exploit them to such an extent that the end result is fraud.
“My just asking the question, ‘Am I following the rules?’ was insufficient,” Fastow said. “I should have also been asking the question whether or not my behavior was ethical. I may have been trying to stay within the rules, but I was also, most definitely, trying to be misleading.”
I asked Fastow if he believes other CFOs ever feel compelled to exploit the rules. He responded with an analogy about Bill Belichick, head coach of the New England Patriots, who says he uses obscure football rules to his team’s competitive advantage and to make sure it wins.
If I understand Fastow correctly, he believes human nature leads some people to do whatever they can to win, including bending the rules. The easier that is, the greater the chance of doing it.
Enron’s use of mark-to-market (or fair-value) accounting, instead of the historical cost method, allowed it to recast deals that had resulted in a loss and recognize them as future profit. “Fair value accounting is a good example of where ethics come into play, as it provides you with all these gray areas that allow for creative flexibility,” Fastow said.
Such “creative flexibility” is in play today at many companies, he added, asserting, “All CFOs believe they are really good at identifying, processing, and managing risk, but the reality is that the brain sees what it wants to see. We process risk in a biased way.”
Pressed to elaborate, Fastow offered this example to me, a resident of Los Angeles: “You realize that virtually every seismologist agrees that California is 1,000 years overdue for a catastrophic earthquake. You’re sitting on a major fault line. And yet you don’t wake up every morning worrying about your family dying in a massive quake or your net worth being obliterated. You’re processing risk in a biased way—`it won’t happen to me and even if it does it won’t be that bad.’ Your brain knows the answer you want—that you want to live in L.A. So, it dismisses or minimizes the risk.”
Making company results appear better than they are is actually not dissimilar. “CFOs know the answer they want—hitting the quarterly target,” he said. “So, their brains minimize risk in order to get there. My personal belief is that almost every CFO wants to be ethical and do the right thing, but the problem is identifying you’re in an ethical risk-creating situation to begin with.”
In other words, you can commit fraud and still be technically within the rules. What you can’t do, though, is successfully argue in a court of law that because you didn’t break the rules you are not guilty. Like Fastow, disgraced former CEO Bernie Ebbers of WorldCom learned this the hard way, when the Second Circuit Court of Appeals rejected his argument that the government had to prove violations of generally accepted accounting principles (GAAP) for his conviction on fraud and conspiracy to stand.
As the court stated in 2006, “To be sure, GAAP may have relevance in that a defendant’s good faith attempt to comply with GAAP … may negate the government’s claim of an intent to deceive. [However,] if the government proves that a defendant was responsible for financial reports that intentionally and materially misled investors, the [securities fraud] statute is satisfied.” Simply put, the intent to mislead investors signifies a criminal purpose, irrespective of accounting rule loopholes.
What It’s Worth
It’s not unusual for former convicts to leverage their “expertise” in helping law enforcement. Bank robber Willie Sutton spent his last years consulting with banks on theft-deterrent techniques. Fastow is giving talks about rules vs. principles and consulting with corporate management and non-executive board directors about corporate culture and unrecognized risks—the “dangers of the gray areas.”
These gray areas stain all regulations, claimed Fastow, including the Sarbanes-Oxley legislation. “SOX is only asking `Are you following the rules?’” Fastow said. By now his point is clear: Ethics in corporate governance, an even timelier subject these days, is crucial.
Asked what boards of directors can do to feel confident that they have a clear picture of financial results, Fastow touted the data transparency provided by finance and accounting software. He further noted the possible use of an artificial intelligence (AI) tool developed by software provider KeenCorp that analyzes employee emails for evidence of negative tension in a company.
In 2016, KeenCorp, analyzed several years’ worth of emails sent by Enron’s top 150 executives. Not surprisingly, when Enron approached insolvency, index scores fell precipitously, signaling high amounts of tension among executives. Yet, two years earlier, on June 28, 1999, when Enron seemingly was on top of the world, equally low scores were posted. The firm reached out to Fastow in 2016 for an explanation.
It turns out that on that date in 1999, Fastow had spent hours talking with Enron’s board and senior management about “LJM,” the name given the complex transactions he’d designed to hide the company’s poorly performing assets to spruce up its financial statements. The software’s analysis of emails that day intuited negative tension about the deals.
“The algorithm pinpointed the day when the most existential decision was made,” Fastow said. (Fastow has since become an investor in KeenCorp, it should be noted.)
What is one to make of Andy Fastow today? It’s a difficult question. I reached out to three finance and accounting professionals who attended the “InTheBlack” summit. They said he appeared humbled by his ethical lapses and had something useful to offer. However, none of them had personally suffered from Fastow’s criminal manipulations. And that’s exactly what they were.
His victims might be pleased to know that Fastow appears condemned to forever make his penance. Despite it all, though, his family held together, offering him a measure of solace. As someone linked to him in perpetuity, I’m happy for that.
Russ Banham is a Pulitzer-nominated financial journalist and best-selling author.