In 2001, Arthur Andersen was the fourth-largest public accounting firm in the United States, with global net revenues of more than $9 billion. It audited or provided attest services to around 2,400 US public companies, including some of the largest corporations in the world. Little more than a year later, it had effectively disappeared from public-company auditing.
The immediate cause was Enron. But Andersen’s destruction was the culmination of a relationship in which the boundaries between auditor and client had been eroded over years—and of a frantic episode of document destruction as Enron itself began to unravel.
A client Andersen could not afford to lose
Arthur Andersen had audited Enron’s financial statements for 16 years and was right in the eye of the storm.
David Duncan, the audit partner who led the engagement, and his team had become so entangled with their client, viewing the world through the lens of Enron’s obsession with share price above all else, that they came to see their role as enablers rather than gatekeepers.
The Andersen auditors were given permanent office space in the Enron complex at 1400 Smith Street in Houston, sitting alongside Enron personnel.
With time they started to talk and dress like Enron staff—suits and ties were out, casual office wear was in. They attended office birthday parties and weekend fundraiser events. They even joined the Enron employees’ ski trips to Beaver Creek, Colorado. They had become Enron employees in all but paycheck.
This situation was exacerbated by the constantly revolving door between the audit firm and their client. When Enron outsourced its internal audit function to Andersen in 1993, the firm hired around 40 members of Enron’s existing internal audit staff to perform those outsourced services.
These employees kept doing the same work, in the same office, with the same colleagues—no wonder people could not tell the Arthur Andersen staff from those of Enron.
People also migrated in the opposite direction. Richard Causey was on the Andersen audit team between 1986 and 1991, when he switched sides and took on the post of Assistant Controller of Enron Gas Services Group. By 1998 he had been promoted to Chief Accounting Officer and Executive Vice President. Sherron Watkins, who ultimately blew the whistle on the financial malfeasance at play at Enron, was also an Andersen alumna.
The situation with Enron was such common knowledge at the firm that in 1995, a full six years before the company’s collapse, a partner called James A. Hecker, who was based in Houston but did not work on the Enron engagement, penned a satirical song he called the “Hotel Kenneth-Lay-a,” which he sang to the tune of “Hotel California.”
The song lampooned Enron’s mark-to-market accounting, its special-purpose entities and the pressure on Andersen auditors to accommodate the client. Among its lines were references to the “Hotel Mark to Market,” “3% in an SPE” and finding “the entries back to the GAAP we had before.”
Mirrors on the 10K, makeit look real nice
And she said, “We only make disclosures here of our own device.”
And in the partners’ chambers, cooking up a new deal
Three percent in a S-P-E
But they just can’t make it real.Last thing I remember, I was running for the door
I had to find the entries back to the GAAP we had before.
Relax said the client, we are programmed to succeed.
You can audit any time you like, but we will never bleed.”
The ditty might not have been a creative masterpiece, but it leaves no doubt that concerns about Enron’s accounting were circulating within Arthur Andersen years before the company collapsed.
There had been warnings from within Andersen itself. Carl Bass was a highly technical specialist in Andersen’s Professional Standards Group. He was an expert in Generally Accepted Accounting Principles and had been assigned to support the Enron team. Between 1999 and 2001 he repeatedly drew David Duncan’s attention to the fact that the accounting methods used by Enron—and more specifically, the Raptors—not only violated established rules but also defied basic logic.
He escalated his concerns to the upper echelons of Arthur Andersen when the Enron audit team approved a client transaction that he had vetoed.
However, Enron complained to Arthur Andersen about Bass, and the senior leadership of the firm acquiesced and took him off the engagement, even putting the wheels in motion to get him out of Houston altogether.
Their judgement was likely clouded by the fact that Enron was the firm’s second largest client in the US, paying fees of $25 million for audit, and a further $27 million for tax advisory and consulting services in 2000 alone. Enron had become a client that Arthur Andersen could not afford to lose.
The numbers unravel
Of course, there is only so long a company can get away with inflating its profits, and camouflaging the gaps between unrealistic assumptions and harsh realities.
When the numbers got so big that it was no longer possible to hide them, Chief Financial Officer Andy Fastow created a series of special-purpose entities to shift debt and losses away from Enron’s balance sheet.
By the autumn of 2001, the structures that had helped Enron present a far healthier picture of its finances were beginning to unravel.
On October 16, Enron issued its third-quarter earnings press release—with a shocking $1.01 billion non-recurring charge that turned reported recurring profits into a net quarterly loss of $618 million.
Two hours later, Kenneth Lay casually dropped another bomb during a conference call with investors and analysts:
“In connection with the early termination, shareholders’ equity will be reduced approximately $1.2 billion…”
What was left unsaid was the fact that this $1.2 billion wipeout—representing roughly 10–12% of Enron’s previously reported shareholders’ equity—was not merely a side effect of terminating deals. It was a correction for massive overstatements in the company’s balance sheet in prior periods, stemming from improper accounting for special-purpose entities that had artificially inflated assets and equity over the previous years.
The genie was out of the bottle.
The very next day, the SEC opened an inquiry into Enron, requesting documentation explaining the write-offs. Two days later, the company informed their auditors that the regulator was investigating the special-purpose entities set up by Andrew Fastow.
On October 17, the SEC notified Enron that it was investigating the company and requested information and documents. The regulator had already begun an informal inquiry in August; a formal SEC investigation would follow on October 30. Enron forwarded the October 17 letter to Andersen on October 19. According to the US government’s later account, Andersen’s efforts to purge Enron-related material intensified after the SEC inquiry became known.
“More help”
A few days earlier, on October 12, Andersen in-house lawyer Nancy Temple had written:
“It might be useful to consider reminding the engagement team of our document retention policy.”
The recipient, Michael Odom, Andersen’s Houston practice director, forwarded the message, which included the policy in question as an attachment, to David Duncan, Enron audit lead, with the cryptic message: “more help.”
The news set off plate tectonic reactions at Andersen. David Duncan called an urgent meeting and initiated a massive document destruction and email deletion operation, claiming it was to comply with the firm’s document-retention policy. Instructions to destroy documents were also sent to audit teams working on Enron matters in Portland, Chicago and London.
The policy in question stated that only the information necessary and relevant to support the firm’s final audit opinion and conclusions should be retained in the engagement file. Everything else—including drafts, preliminary notes, superseded memos, duplicates, internal correspondence and personal notes—were to be destroyed once the audit was complete.
Crucially, however, the policy contained an explicit exception: routine destruction must cease and no materials could be altered or deleted if litigation was threatened or pending, or if there was a reasonable anticipation of a regulatory agency investigation, government inquiry or other legal action in which the files would be necessary or useful.
Andersen would later argue that employees had simply been following a legitimate document-retention policy and that the destruction stopped once the firm was formally subpoenaed. Instructing employees to comply with a valid document-retention policy is not, by itself, criminal.
The shred room
The shredder in Andersen’s office in the Enron building was working on overdrive, but it was not even making a dent in the mountain of paperwork the auditors wanted to destroy.
The subsequent Justice Department indictment alleged that the shredder ran “virtually constantly”. Employees were told to work overtime if necessary, while dozens of large trunks filled with Enron documents were moved from Andersen’s office inside the Enron building to its main Houston office. The government alleged that tons of paper were destroyed and huge volumes of electronic information were purged.
Staff depositions subsequently provided an even more vivid picture. Andersen normally used an external professional shredding service, but an “abnormal volume” of Enron material prompted the firm to move document destruction in-house. A commercial-grade shredder was brought over from Enron’s headquarters and a dedicated “shred room” was used to process the material. One office manager recalled 25 trunks of Enron papers arriving for destruction in late October.
The destruction was not confined to Houston. The indictment alleged that Andersen personnel working on Enron matters in Portland, Chicago and London were also instructed to destroy documents, with a parallel effort taking place in London within days of the SEC inquiry becoming known.
On November 8, the SEC served Andersen with a subpoena in relation to its work for Enron.
The shredders were still whizzing away at full blast. The next day, Shannon Adlong, Duncan’s assistant, sent an email to the other administrative staff saying: “stop the shredding.”
Enron collapses
On December 2, 2001, Enron Corporation filed for bankruptcy. It was, at the time, the largest corporate collapse in US history.
The company’s shares, worth more than $80 apiece a year earlier, had fallen to less than $1.
Arthur Andersen had by now become part of the investigation.
On March 7, 2002, a federal grand jury indicted the firm for obstruction of justice. The indictment was publicly unsealed on March 14. Prosecutors alleged that the document-destruction initiative had begun as Andersen foresaw government investigations and civil litigation, continued after the SEC investigation became known, and stopped only after the subpoena arrived.
The indictment alone inflicted enormous commercial damage. An audit firm depends on boards, investors and regulators trusting both its judgement and its ability to continue signing public-company accounts. Clients began leaving in large numbers.
At the time of its indictment, Andersen performed audit and attest services for about 2,400 public companies in the United States. Between October 2001 and the end of 2002, the US Government Accountability Office identified 1,085 former Andersen public-company clients that switched auditors.
Of those, 938—87%—went to one of the remaining Big Four.
The conviction that finished Andersen
On June 15, 2002, a federal jury in Houston convicted Arthur Andersen LLP of obstruction of justice.
The SEC announced that same day that Andersen had informed the regulator it would cease practising before the Commission by August 31. Temporary arrangements allowed Andersen to continue making certain required filings during the transition, but the firm’s future as a major public-company auditor was effectively over.
The firm imploded, with tens of thousands of employees losing their jobs.
The Big Five had become the Big Four.
But the conviction was overturned
There is an important final chapter to the legal story.
On May 31, 2005, the US Supreme Court unanimously overturned Andersen’s obstruction conviction. It did not find that documents had not been destroyed, nor did the judgment vindicate Andersen’s audits of Enron.
The Court instead held that the jury had been given defective instructions about what the government was required to prove. The obstruction statute required “knowingly” and “corruptly” persuading another person to withhold or alter documents. In the Supreme Court’s view, the jury instructions had allowed conviction without requiring the necessary consciousness of wrongdoing.
It was a fundamental legal victory—and a commercially useless one.
By 2005 Andersen’s clients had gone, its people had dispersed and the global audit market had already reorganised itself around four dominant networks. The Supreme Court could reverse the conviction. It could not put Arthur Andersen back together.
From the Big Five to the Big Four
The surviving firms went into crisis mode, issuing a flurry of press releases, white papers and letters to reassure clients, regulators and employees that what had happened to Arthur Andersen would not happen to them.
It was now glaringly obvious that the checks and balances that had been put in place to regulate the activities of the audit firms were woefully inadequate.
The Enron collapse and the destruction of Andersen accelerated the political momentum for sweeping reform of US corporate reporting and auditing.
The result was the Sarbanes-Oxley Act, signed into law on July 30, 2002. It tightened restrictions on the non-audit services accounting firms could provide to audit clients, strengthened corporate-governance and financial-reporting requirements, and created the Public Company Accounting Oversight Board, bringing public-company auditors under a new system of independent oversight.
Arthur Andersen’s disappearance also produced an unintended consequence. It made an already concentrated audit market even more concentrated. The GAO found that 87% of the Andersen public companies it studied moved to Deloitte, EY, KPMG or PwC; among the largest former Andersen clients, almost all moved to one of the four.
Arthur Andersen’s disappearance therefore did considerably more than reduce the Big Five to the Big Four. It helped redraw the regulatory architecture of auditing, further concentrated the market for large-company audits, and left behind a question that remains relevant more than two decades later: what happens when the firms responsible for acting as independent gatekeepers become too important—and too few—to fail?
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This article is part of the Big Four History series, tracing the firms, mergers, scandals and regulatory changes that shaped Deloitte, PwC, EY and KPMG.
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About Claudine Cassar
I’m a corporate anthropologist and former Deloitte equity partner. I sold my technology business to Deloitte in 2016 and led the Malta Consulting team for five years. I am the founder and editor of Big4News, which provides independent, clear analysis of PwC, Deloitte, EY, and KPMG — free from corporate spin.
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