Senate Finance Committee Holds Hearing on Enron

Feb. 13, 2003
Senate Finance Committee Holds Hearing on Enron

GRASSLEY:
We really have two items today, our organization meeting, and then we have this very important hearing on Enron Corporation. There's also a members' briefing going on where all members are supposed to be, and, obviously, the three of us that are here, four of us that are here, weren't at that briefing on another matter.
So, what I want to do, if and when we get a sufficient number of people to do our formal organization, we're going to stop the hearing, turn to the committee's business and then I think we can do that very, very quickly. Nobody needs to leave the room or anything, anybody in the audience can stay. And then we'll do that quickly, then return to the hearing.
I want to thank everybody for being here today. I think that we have a very important subject before us, most importantly, almost several months, almost a year since inquiries were first made, so a long period of time by the joint tax committee has gone into this work that we're going to hear today. I believe that you're about to witness shocking event in the history of American corporate tax policy and American corporate financial accounting. We're going to have the veil torn off of the world of tax shelters, and the world of manipulation of accounting.

The report reads like a conspiracy novel with some of the nation's finest banks, finest accounting firms and some of our best attorneys working together to prop up the biggest corporate farce of this century.

Enron was a house of cards and the cards are the schemes that we will hear about today. The joint tax committee report provides us a wealth of information, much of this information has never been seen before, not only by the public, but also the IRS and other government agencies. It includes tax return information, opinion letters from law firms, internal documents, accounting firm correspondence, shelter promotional material and, most importantly, internal Enron documents laying out how the scheme of deception played out.

Not only will we gain a fuller understanding of tax shelters and also of accounting gimmicks, but we're provided with the complete story of the people and the professionals working behind the scenes to make all this happen. The joint tax committee reports it names names and it doesn't pull any punches in telling us about the law firms, accounting shops and investment bankers that were promoting and aiding Enron in all of these activities. The conclusion is very troubling, as you might see as one example here, show me the money. And, by the way, project steal is not misspelled that's a different—anyway, show me the money is in that catch phrase on an internal Enron document for just one shelter.
It is clear that this is what it is all about, this one example, but many others that could be put up there, money, money, money. Money above honesty and financial accounting, money above tax return compliance, money above professional and business ethics, money above common sense, money, money, money.

I'm reminded that back in the 1980s there was a popular phrase that came to us from Wall Street. The phrase was, greed is good, greed cuts through and clarifies. Now, the irony is that in this case greed actually obscured. Greed actually hid the real substance of the business of Enron. The substance is that there wasn't much substance. All of the artifices were designed to make something appear real that was not real.

Enron viewed its tax shop goal in line with this general goal I just described. That is, the tax shop was designed and was managed with the objective of non-compliance with its responsibilities under the Tax Code. Instead Enron viewed its tax shop as its profit center where complexity was an ally and bending the rules was a partner in a search for more paper gains.
In addition to bending the rules, there appears to be a culture of wining and dining amongst the small community of people that helped drive these deals. On small but telling example is the Bankers Trust, one of the participants in this dance of shelters, takes Enron's director of tax research for what was termed, the Potomac capital investment corporate conference. The details can be found starting on B-203 of the report. But, let me just highlight what the conference call all about. Fly to Boca Raton and Sunday night is casino night. Then starting on Monday it's your choice of golf, tennis, fishing, then a golf clinic. And, finally a reception dinner cruise. The next day the real work starts with your choice of golf, tennis, fishing, leisurely lunch and finally a reception dinner. To wind down the last day of the conference is more golf and tennis. Obviously, no amount of lipstick is going to make that pig look very pretty.

The joint committee report describes in detail the structures used by Enron to avoid tax and to inflate earnings. Many of these schemes are not well known and their publication this very day could provide a road map for others to follow.
So, as a matter of public policy I want to be very clear so that these things don't return to haunt us in the future, today, February 13, 2003 will be the effective date for any legislation that we offer to shut down these tax schemes or anything like any of them. Today's date will not move. It will not slip. Senator Baucus and I are unified on this point and we don't care if it takes five years to get the legislation passed, this date will hold.

So, to all lobbyists here and elsewhere, I'd like to have you write that date down, February 13, 2003. If a company does an Enron type deal after today I don't want you to come to me whining that we're not being fair. Just serving notice so that all the lawyers, all the accountants and all the investment bankers that profit so handsomely from these deals know that you're on notice.

Now, in addition to Enron's tax and accounting, the joint tax report gives equal time to the important issue of executive compensation and employee benefits. Somehow it seems to go from bad to worse. I find it very stunning that a Fortune Top 10 company was wholly incapable of answering simple questions about how much executives received in pay. Further, the Enron board seems unaware of its most basic responsibilities, its most basic duties of protecting the shareholder. In addition, I think this joint tax report provides new details of a jaw-dropping amount of executive compensation and benefits. And, I'll just mention what does meet the smell test and that is that Enron had 200 executives, each of whom was being paid over a million dollars while they ran the company to bankruptcy, leaving thousands of dedicated employees, as we know, high and dry. These employees helplessly watched their retirement savings go down the drain when the company's stock tanked from more, as you know, $90 a share in 2000 to 34 cents a share January 2002.

Again, we happen to be able to benefit as policymakers from the joint tax providing an enormous amount of documents detailing executive compensation and employee benefits. Finally, joint tax has much to say of findings and recommendations from their work. The joint tax also raises serious concerns about the ability of the IRS to even find out about these transactions.

These findings and these recommendations deserve serious consideration and will surely inform this Finance Committee, as it compares its current corporate tax shelter legislation against abuses listed in this report.

Now, I'd like to make one last point and it's more of a personal one. We have a person we've all known for maybe two decades for me, or least a decade and a half, Lindy Paull sitting before us, and this is her appearance last time as Chief of Staff of the joint tax committee. I think it's really a tribute to her that she's going out with a report that will cause great shock waves felt among professional people, K Street and elsewhere.

I would like to thank you, Lindy, for all of your dedication, all of your hard work, not only at the joint tax committee, but as I previously indicated, we've had a relationship here as your professional work on the Finance Committee. Your dedication and knowledge will be greatly missed.

I also recognize that your staff has spent nearly a year, as I indicated in the beginning of my remarks, they've spent nearly a year on this report. And have, for the last few weeks, been at this report and this study day and night. And, most importantly preparing for this important hearing. These men and women on your staff who served on this project have done so, I think, at great personal sacrifice that we never give enough thanks for. The travel and demands of this task has kept them away from family and other loved ones. Yet, they've continued to meet the needs of Congress, while at the same time pursuing one of the ugliest and most complicated financial disasters of recent times.

I would ask for members' indulgence while I take a moment to name the dedicated staff primarily responsible for the investigation: Mary Schmitt, Sam Olchyk, Carolyn Smith, Ray Beeman, Nikole Clark, Robert Gotwald, Brian Meighan, David Noren, Cecily Rock, Carol Sayegh, Ron Schultz, Allison Wielobob, in addition, we have to give thank you to the government printing office for getting this major report to us in time for this hearing.

I thank all of you and probably some that I didn't name that needs thank you's and maybe Lindy can fill us in on all the other people that were involved in lesser roles in this job well done. You've given us a very sobering report about corporate tax practices and executive compensation in modern America. And I hope the transparency and the checks and balances of our system that this report highlights were non-existent return in all corporate America benefits from us and our economy's surely going to benefit from it.
Senator Baucus?

GRASSLEY:
Before we start the hearing, I would to introduce the people who are at the table besides Ms. Paull.
We have Dr. George Plesko, Assistant Professor of Management, MIT Sloan School of Management; Dr. Plesko has written extensively about tax book issues that are relevant for today's findings.
Secondly, we have Dr. Edmund Outslay, Professor of Accounting, Information System, Michigan State. He's written about Enron and corporate income tax.

Next we have Dr. James Seida, who is an Assistant Professor of Accountancy at University of Notre Dame. He's a new father and we thank you for your wife having you come here, or letting you come here at this particular day, considering it was just three or four days ago.

Finally, we have Ms. Kathryn Kennedy, Associate Professor of Law, John Marshall Law School, Chicago and she happens to be a graduate of a university in my state (inaudible) law school in Des Moines, Iowa. She is director of both the graduate tax and graduate employee benefit programs. And I think we're going to hear benefit from her knowledge of employees' compensation issues today.

GRASSLEY:
And, then, Lindy Paull, I've already referred to, I won't go into any further introduction. Normally we would go left to right, but obviously, we're going to start with Lindy Paull to present the report. And she will have 30 minutes to do that. And, then we would go from left to right the way you were introduced and we would have five minutes for each person on the panel, although your entire statement, without your asking if you want it, will be put in the record as you have submitted it. And then we will go to questions and they will be in the order that we normally do questions.
Ms. Paull?

GRASSLEY:
I wanted to apologize to Ms. Kennedy I was called down to the committee room down the hall to help make a quorum in judiciary. I may have to called back one more time. But, in the meantime, I would ask questions. Or were you wanting—do you have to go? Does he have to go? OK.

Ms. Paull, your report kind of like what I'd say tells a story about how the Enron structured transactions came about, very broad terms, would you walk us kind of through that process?

PAULL:
Yes. Once again, there was basically a transaction would be brought to either the finance department, treasury department of the company or the tax department. The tax department would look at the transaction and which would be fairly complicated transaction, so they needed people who were capable of analyzing the transaction and then they would, if they thought this was a transaction that might be viable for the company, then they would see if they could get, in essence, a should tax opinion, which means you should prevail. You know, the transaction should comply with the tax laws. And then they would seek approval for entering into the transactions. And then they would engage—enter into an engagement with the promoters and implement the transaction.

GRASSLEY:
I'd like to refer to table three, page 10 of your report it shows that during the years '95 through 2001 Enron reported 651 million in accounting income, all of which comes from questionable tax benefits, the show me the money diagram, and that would be B177 of volume two of the report, talks about how Project Steal was to earn 132.8 million of the pre-tax operating income. So, the question is the significance of that term operating income as opposed to other types of accounting income.

PAULL:
Well, certainly operating income is the kind of income that the—an analysts, the market analysts use to try to evaluate what the worth of the company is and it has a direct bearing on basically market values of the company.

GRASSLEY:
The...

PAULL:
So, certainly that would, you know, being able to produce as two of our transactions at a minimum did, operating income is really a significant factor in the marketplace.

GRASSLEY:
OK. I'd like to turn to an accounting issue for you, Ms. Paull, the report states that Enron did many of these personal transactions to generate accounting income and do it right now based on future tax deductions. Is this a tax problem or is it something that other agencies should be concerned with or maybe it could be both?

PAULL:
Well, I think—at its core, it's a tax problem because at its core it's structuring a transaction that is supposed to yield tax benefits that, as Dr. Outslay said, is a permanent tax difference. When you yield those kind of benefits, then it translates into financial benefits. And, so, I have to say at its core it's a tax issue, but I think, you know, our, you know, recommendation in general is that the accounting bodies should take a look at the FAS 109 statements of accounting for income taxes and see, you know, evaluate whether or not they think they're getting the right result too.

GRASSLEY:
It might be OK if one or the other of the four panelists might want to comment on that from your experience.

OUTSLAY:
Well, I think Ms. Paull does pinpoint, you know, the trend that we've seen in the last decade in terms of how tax strategies are marketed and becoming much more of an accounting oriented marketing strategy, as opposed to sort of just simply looking at cash flows and tax benefits. And, so, you know, I think that, you know, given that we were only able to sort of observe what Enron reported, at least until today, on the financial statements, you know, our frustration has been in trying to sort of determine exactly what kinds of strategies produced these sort of accounting results. And a lot of the—you know, some of the tax benefits that we think should be reported in the income tax note end up getting put in other accounts and so, I think it's fairly, I don't know about easy, but there are ways that you can sort of camouflage some of these things that they don't actually appear where you think they should appear. So, I would support improved disclosure. And, again, you could do that through the SEC or SX149 or something like that.

PAULL:
I would also, Mr. Chairman, I forgot to note to you...

GRASSLEY:
Then I'll call on Senator Breaux.

PAULL:
... that one of the issues that, and we don't, because I think the accounting profession has struggled with this, is that these benefits that are—tax benefits that are derived well into the future are not present valued for this purpose. And, that I don't know that we know, you know, how to advise anybody on that. But, that is another one of the disconnects that's going on here. Their recording financial statement benefits in earlier years based on tax benefits that are going to be derived in later years and there's no, you know, accounting for the present value notion either.

GRASSLEY:
Senator Breaux?

GRASSLEY:
I think I (OFF-MIKE) follow up with the very question he asked, but not ask it again and not ask it of Ms. Paull, but just kind of as Senator Breaux put the question out, would any of the panelists want to comment on that?

PLESKO:
If I may. I touched on that at the end of my testimony and I think that if the broad question is if there was some level of—I think it depends on how you would structure the dividend really. In the context of, for example, the current proposal, I think what you have to do is step back and say, you know, what managers do is they maximize shareholder value, that's what they're supposed to do and how do they do that? Well, they do that by maximizing the after tax cash flow that they have for the shareholders. So, if you look at the ways in which you would incorporate the individual investors, you know, thoughts into the process of do they want dividends or not, to the extent that you still have long-term—you know, preference is for long-term capital gains, which is deferred and at a rate lower than the current corporate rate, I'm not sure I would want the corporation I'm investing in to pay 35 cents now if I could capital gains taxation on that later, at a much later date at 20 percent.

Second, combined with, again, in the current context, most of my personal equity holdings are through tax deferred accounts. And whether they pay dividend, you know, in that situation the only taxes, the incentive that I have for that corporation is just keep the share price high and the paying of dividends is, again, not going to effect me. And if the tax law changes such that all of that income will eventually be tax-free anyway, then I'm not going to be getting any benefit from, you know, essentially from those dividends being paid out to me tax-free. I'm much better off with the company still, you know, minimizing the amount of taxes it pays.

I think fundamentally if you look at what the code does, if a firm is faced with the possibility of being able to reduce their taxes, the incentive structure we have within the firm of tax, you know, of compensation everything else, maximize your after tax profits. And, I have but a hard time understanding what firms would do otherwise. I don't see firms, for example, all of the sudden deciding to forego accelerated depreciation because to forego accelerated depreciation means we can higher current taxes and therefore pay greater dividends out. And there's a reason why, you know, firms take advantage of those things because it has a cash flow effect. And I don't see—think that we're going to see major, you know, changes in the cash flow effects that will be facing the firm.

GRASSLEY:
I don't want to prolong anything. I've got other questions, but if anybody wanted to comment, I wouldn't cut you off.
OK. I'll go on then. I want to bring up something that I would have liked to have brought up last summer as part of the Sarbanes Oxley bill. And that is an amendment that I could not offer under the procedures of the Senate at that time. I'd like to list these amendments and ask whether they would have been effective in combating the abuses that Enron in these—if these proposals had been in effect.

I guess I'll do these one at a time and ask for a response. In an amendment to establish an independent oversight auditor within the Securities and Exchange Commission to conduct spot check auditing of externally audited financial statements.
Can any of you respond to that? And, you know, you can tell me it's a crazy idea. You're not going to offend me. I just want some reaction because we know we have a problem here. Sarbanes Oxley was about some of these problems and I just wondered if that would. OK. Then there's no reaction.
We'll strike that one off the list.

OUTSLAY:
Well, I would say that a lot of the attention Enron got was from using what were called special purpose entities, off balance sheet financing and accounting and the FASB now has a new exposure draft and the word called variable interest entities and that may have come up in an audit in whether or not they were in fact, you know, they were complying with sort of the FASB rules with regard to those off balance—that may have come up with something like that.

GRASSLEY:
Let me move on because I have two more of those examples. Another would have been an amendment to prohibit public auditors from rendering an audit opinion on the financial statement effects of any tax shelter arrangements that the auditing firm sells to an audit client.

OUTSLAY:
Well, here again, I think that you'd have to be very specific and I think that's been sort of the issue that you're dealing with with these tax shelter regulations is what is a tax shelter. And, so, for example, if you define a tax shelter in one sense as producing say a book tax difference of 10 million or something like that, then, you know, it really broadened what is considered sort of a tax shelter that certainly would have limited the types of opinions that you would have allowed these auditors to actually have given.

GRASSLEY:
The last one would be an amendment...

PAULL:
Mr. Chairman?

GRASSLEY:
Yes?

PAULL:
On that last point, the first two transactions on the table were done by their—were brought to the company—well, the first transaction was brought to the company by Arthur Andersen and I believe in that particular transaction, they not only did the tax opinion, but they did the audit opinion, or the accounting advice, I'm not sure if it rose to the level of opinion. On the second transaction it was kind of the company—so, that would have had an effect on the first two transactions here basically, just so you know.

GRASSLEY:
Then the last one before I call on Senator Baucus.
Getting back to the amendments of last summer, an amendment that would have clarified that bonuses and other high-dollar compensation of corporate directors and wrongdoers could be brought back into a bankruptcy estate when the company declares bankruptcy, OK?

PAULL:
There was a lot of that going on here, you know, so obviously. So, I don't know what the criteria the bankruptcy court would use for that. There certainly were a lot of high paid people. In fact, the top 200 in the year 2000, the year before bankruptcy all made over a million dollars.

GRASSLEY:
OK. Ms. Kennedy, doesn't this fall into your area of expertise?

KENNEDY:
Yes, and I think the bankruptcy court already has the jurisdiction for payments made within the last year of bankruptcy you can void those transactions and get back that money.

GRASSLEY:
Yes. My staff reminds me that we wrote this amendment with adding the consideration and so we would have gone back, allowed the court to go back more than one year.

KENNEDY:
That would have to be written into the code, then.

GRASSLEY:
OK. Well, listen, Senator Baucus is going to ask his questions. These three questions I just asked and maybe I would like to have a written response if you can take some time to think about them. So, we'll get those to you and, you know, and maybe in a couple weeks write us back something.
Senator Baucus?

GRASSLEY:
OK. Now, here's what the situation is. At the drop of a hat, I may run out the room because of the quorum down the hall. If I do, then whoever's answering a question, answer it and assume I've said thank you and the meeting's adjourned, because I don't know how long that might take and so I don't want to hold you up anymore. And we're just about done anyway.
Ms. Paull, would you talk about Enron doing a couple of transactions in which it was quote, unquote, "an accommodation party" define that term as you think it was—or as you understand it?

PAULL:
Yes. We had—we uncovered two of the 12 transactions that we've discussed here Enron participated in those transactions and honestly kind of when we talked to the staff, the tax department employees, about it they didn't know the whole extent of the transaction. They did not have a lot of information about the transactions. But, they served as an accommodation party, which is a person who is needed to be—to make a transaction work. They're ostensibly an unrelated party. They did this for a fee in one case and for a reduced interest rate in another case. And, it was kind of all part of the circle of advisers that they had, those promoters had served as accommodation parties in some of Enron's transactions and Enron returned the favor, so to speak, for a fee or for a benefit. But, they could not explain to us the rest of the transaction for the most part. So, it was just well, we were doing this for.

So, they didn't have any particular investment—I mean business purpose in getting into this other than they did get a fee for it. And at some point the tax group promoted this activity as a way for them to generate some revenue for the company in the internal memorandum.

GRASSLEY:
Thank you, Ms. Paull.
Professor Kennedy, I think, again, this question falls into your area. First of all, have you seen the executive plans at Enron and do you think that there were abuses inherent in those plans? And, before you answer that follow-up, also, the joint committee has said that there was poor record keeping for these executive compensation plans. Does any federal agency have authority to regulate in that area?

KENNEDY:
Yes, under ERISA, the Department of Labor has reporting and disclosure obligations and these types of plans are subject to that. However, through the regulations the Department of Labor has exempt these types of plans from any and all disclosure. And I believe that that should be corrected. Had we had this type of disclosure, maybe we would have known the volume or the size of benefits under these plans.

GRASSLEY:
Now, you, in regard to the first question, you probably haven't seen the executive plans, but from what you've heard today do you think that there were abused inherent in those plans?

KENNEDY:
Well, I have actually seen the '94 and the '98 plans. I don't know, since I haven't checked the report whether there's others. The abuse, with respect to the haircut provision, allowing the 54 million to come out in the first two months right before bankruptcy is an abuse really though of the insider knowledge that they had, not a per say abuse because of the haircut provision. I'd recommend that haircut provisions not be permitted for insiders for that very reason.

GRASSLEY:
OK.
Now, I think this one would be to Ms. Paull. Did you, Dr. Plesko—OK. The Finance Committee spent considerable time addressing issues relating to tax favored retirement plans, what kinds of qualified retirement plans did Enron have and what general observations can be made about those plans?

PAULL:
Well, they had, in terms of their qualified retirement plans, they had the employee stock option plan and ESOP. They had a retirement plan that was a defined benefit plan that was converted into the cash balance style of a plan. And they had the 401(k) savings plan. I think that basically those plans that they were pretty diligent about updating the plans whenever there was a change of the law and things like that. I think that we have called into some question kind of a few issues here, one dealing with the diversification issue of investments with a high concentration of investments in the Enron stock. And, perhaps, the issue over the fiduciaries having a clear understanding of what their duties are, especially when you have a situation where there's a high concentration of stock in one of the plans and the stock is falling throughout the year.
And, on the participant side, you know, education with respect to that. So, I mean, when they converted to the cash balance type of approach they didn't do it in a manner that would lead it to the kind of criticism that we read about. They did not have a where away that actually their plan cost them more money in almost the first decade after that than it would have if they had stayed with the other plan. So, I think generally when it came to the qualified plans, you know, our comments really centered around the investment in the company stock and what happens when there's a big decline in the stock values and the responsibilities of the fiduciaries are during that period.

GRASSLEY:
Well, I don't have any more questions. I might have some in writing. I didn't explain this to the other panelists, Ms. Paull understands, not very many members because of conflicts with other committees, were able to be here today. But, any member of this committee may have questions that they want to submit for an answer in writing and to any of you, I don't know who, there may not even be any. But, if they do we'd appreciate it if you would respond to those in writing.
I'd like to close with just an observation or two. Now, maybe I should not have been shocked by what I've heard here today. But, I want to tell you I am. These business deals probably legally don't fall into racketeering, but it's just a little bit short of that, not too short of it. I think I referred to a conspiracy novel in my opening comments and I think the testimony, particularly from Ms. Paull and the year's work, reinforces my feeling about that. And, I hope that this hearing and information that comes from the study is helpful in criminal prosecutions.

What hit me the most was the moral fiber of the people involved in this Enron disaster, both inside the company and outside. It seems like they acted with this sort of unbridled greed and a blatant disregard for the laws of fairness. Obviously, checks and balances that we thought were out there weren't working. Hopefully, those are back in place now, not just because of congressional action, but because of an awareness among everybody to be overly cautious and be open and transparent in the checks and balances working. It seems to me that this disregard for law or fairness they simply didn't care about the effect of phony profits on investors, many of whom were just everyday people investing for retirement.
They could care less, it seems, about the dedicated or unsuspecting employees who worked at Enron. By the way, a couple of hundred of a little subsidiary in my state of Iowa is an example who got hurt by this. It seemed like for these employees, all employees in Enron, that their futures were expendable. The almighty dollar seems to have blinded people that there was no sense of ethics left. But, if they're blind, then it's time for us to let them see the light and that's beyond just this hearing.
We know that Enron is not the only one. And this hearing, as Senator Baucus and I have suggested, won't be the last one. But, the day of reckoning has come, I think, for shelter promoters. We have to hunt them down. We have to shut them down and do whatever it takes to purge that cancer from our system. It may take years, as I indicated when we put this date of February 13 out there, but—and hopefully it only takes a matter of months. But, I think it's fair for me to say, and hopefully I speak for many other Senators and I don't pretend that I can, but I hope that the game is over.
I thank you all very much. Meeting adjourned.