Arthur Andersen – Three Strikes and you’re Out

The Big Five Accounting firms seem destined to become the Big Four. Arthur Andersen, long one of the largest and most prestigious, went to trial in Federal Court in Houston on May 6 charged with destroying evidence. David Duncan, the senior partner in the Houston office pleaded guilty to shredding Enron related documents, and is expected to testify against his former colleagues.

After failing to conclude a settlement of the case, Andersen is down to its last out before Judge Melinda Harmon and 12 Houston jurors, who could well call strike three. In addition to the criminal charges Andersen also faces an ongoing investigation by the Securities and Exchange Commission and numerous civil actions. One, also in Houston, filed by the law firm of Milberg, Weiss, Bershad, Hynes & Lerach with the University of California as the lead plaintiff, seeks $25 billion in damages.

The first two strikes were Andersen’s handling of the accounts of the Baptist Foundation of Arizona’s investment fund, and its failure to properly audit the accounts of Waste Management Treatment (WMT). Andersen’s partners had hoped that by engaging ex-Federal Reserve Chief Paul Volker to administer reforms they could avoid the prosecution and some of the fallout from the other investigations, but Volker resigned as the trial began, seemingly bowing to the inevitable.

The SEC, which was rumored to oppose making a deal with Andersen, has maintained silence on its investigation, but it’s clear that the firm’s failure to institute the reforms it had promised after the WMT affair have not been forgotten. Had it adhered to its commitments, it’s quite possible Andersen would have refused to go along with Enron’s dubious accounting techniques, or would have at least refused to sign off on its balance sheet.

Thomas Newkirk, associate director of the SEC’s Division of Enforcement stated when the SEC acted against WMT and Andersen that “Our complaint describes one of the most egregious accounting frauds we have seen. For years, these defendants cooked the books, enriched themselves, preserved their jobs, and duped unsuspecting shareholders.” Given the much larger scope of the Enron debacle, the SEC seems prepared to punish Andersen, even if the Justice Department fails to.

Andersen’s U.S. division (the foreign branches are separate entities) faces the prospect of paying huge civil and criminal penalties, and, while fines may come from the pockets of its partners, the insurance industry may have to pay at least part of the costs of its other liabilities. Paradoxically, if Andersen is found guilty on the criminal charges, the insurers who wrote D&O liability on its partners, will have strong arguments to deny coverage.

Andersen’s own insurance is already insufficient. It backed out of a settlement it had made with the Baptist Trust in April, stating that its Bermuda-based captive, Professional Services Insurance Co. (PSI), was insolvent. However, as the trial started a new agreement was reached to settle the case, when Andersen Worldwide, the company’s global organization, agreed to provide enough additional capital to enable the insurer to pay the $217 million originally agreed to. That amount pales, however, when compared to potential Enron related liabilities. According to a report in the Wall Street Journal, PSI, which also insures other Andersen units as well as the U.S. LLP, has around $700 million in assets, already offset by its liabilities. Andersen had been in talks to settle the civil litigation for around $750 million, but subsequently reduced its offer to $300 million.

Another report in the WSJ indicated that Andersen has around $160 million in excess coverage from insurance companies, including Swiss Re, XL Capital, AIG and Germany’s Gerling Group, that it could tap to help it pay settlement costs. None of these companies have so far confirmed this, however, and even if they do, a third strike is still likely to put it out of the ballgame.