Perhaps it is no surprise that, when asked, only 10 out of 200 finance professionals at an investment conference believe the word ‘loophole’ is loaded with negative connotation.
But when the question was posed at the CFA Society’s Cayman Investment Forum on Thursday by Andy Fastow, former chief financial officer of collapsed energy giant Enron, alarm bells should have rung.
Fastow was instrumental in Enron’s off-balance sheet financing and structured finance transactions. Between 1998 and 2001 he designed a network of companies and special purpose vehicles, many of them incorporated in the Cayman Islands, not only to raise funds for Enron but also to move debt off the company’s balance sheet.
The structured finance deals, especially, rarely served an underlying business purpose other than to change the appearance of Enron’s financial statements.
Fastow, a securitisation expert, was so good at exploiting loopholes that credit rating agencies rated the company lower-medium investment grade at BBB+. Yet, internally, Fastow assessed Enron’s credit rating as BB-, a whopping five notches lower or ‘junk’ status. While Enron’s balance sheet was debt free, the company had in fact up to $30 billion of debt.
His prowess as chief financial officer gained Fastow both CFO Magazine’s accolade of CFO of the Year and six years in a federal prison.
“They should have called me chief loophole officer. This is literally all I did,” he told delegates. “If I were to write a book about Enron, I would write a book about loopholes.”
The ability to technically follow the rules but to intentionally get around the principles of why the rules were in place, he said, was also the reason why so many gatekeepers could approve his transactions, when they constituted fraud.
In fact, all of his deals were based on audit and legal opinions and approved by the board of directors.
The gatekeepers generally only answer specific questions about rules, he said. Lawyers assess whether rules are technically followed and auditors look at whether there is compliance with the accounting standards US GAAP or IFRS. No one is opining on whether financial statements are fair, not misleading or ethically sound. Chief financial officers, Fastow said, know from the outset what their quarterly earnings should be. If a company’s operations do not hit the numbers, it is the job of the CFO to step in.
All the CFO needs to meet the earnings targets are accounting assumptions and structured finance.
“We used to joke about companies that broke the rules. It is so easy to use the rules to get to the answer that you want,” he said, adding that there was no need to use fake numbers like WorldCom did in America’s largest accounting scandal.
Fastow, who now occasionally teaches ethics classes at US business schools, argued that Enron’s bankruptcy was not a compliance failure, but a cultural failure with one defining characteristic: As long as you follow the rules, you can do anything to make money.
It is laughable now, he said, but he viewed himself as an ethical person. At no point, when he was at Enron, did it ever occur to him that he was committing a crime.
Instead, finding new loopholes was more like a game, a puzzle or brainteaser that would give Enron an advantage over its competitors. If someone had asked him to price the risk associated with his structured finance deals in the Cayman Islands, he would have said: zero. “Obviously that wasn’t the case.”
After Enron’s CEO Jeffrey Skilling resigned in August 2001 citing personal reasons, the Wall Street Journal ran a series of critical articles questioning certain partnerships that Fastow had set up and personally benefitted from. As a result, the Securities and Exchange Commission opened an investigation and the company declared the, at the time, largest Chapter 11 bankruptcy in history – all within only four months.
Fastow spoke at the event, organised by Cayman’s Society of Certified Financial Analysts under the theme ‘The future of human decision making’, about his own personal thought processes at Enron.
He argued that most of the time fraud involves people in the grey area rationalising why they can break the spirit of the rules. Enron’s story was not about a couple of sinister guys, sitting around a table in a conference room, planning to commit fraud. What makes Enron’s case scary, Fastow claimed, “is that it was a lot of people sitting in a bright conference room with their accountants, with their lawyers, with their bankers thinking that what they were doing was right”.
Fastow took pains to stress that this does not exonerate or lessen what he did in any way. Rather, it serves as an indictment of his character. Neither did he blame the auditors or lawyers, who helped him structure the deals.
The lesson learnt from his example of egregiously bad decision making is not to avoid the grey areas, he said. It was also impossible to write rules for every situation as bankers, lawyers and accountants have sufficient resources and financial incentives to find their way around the rules.
“If you are living life, if you are competing in business, you will be in the grey area. I am not suggesting there is anything wrong with that.”
But Fastow advocates more self-awareness. “When people go into the grey area, they tend to not even realise that they are making an ethical or moral decision. They don’t see the risk. They don’t price that risk correctly. They don’t manage that risk correctly.”