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Structural Flaws Brought Andersen Down

It would be easy to blame a handful of venal or foolish people for destroying Arthur Andersen, where I spent the pivotal years of my working life.

It would be comforting to believe that the Justice Department made a disastrous mistake when it brought a criminal case against a company employing 84,000 people over the actions of just a few.

I wish I could say that the thousands of intelligent, dedicated, honest and highly trained professionals who made Andersen a $9 billion business did not deserve what happened.

But my reluctant view is that, even though all of the above may be true, only Andersen ruined Andersen. What worries me now is that there was nothing unique about my former employer. Its fate could be repeated at another leading accounting firm.

Andersen disintegrated because people stopped trusting it. The Justice Department did not trust any promised reforms that were unaccompanied by some acknowledgment of criminal guilt. A hard line, yes, but not surprising when one considers that Justice was looking not only at Andersen’s file-sanitizing response to the collapse of Enron, but also at the accounting firm’s apparent failure to learn from earlier disasters at Sunbeam, Waste Management and the Baptist Foundation of Arizona, among others.

Corporate boards and management stopped trusting Andersen to retain the legal authority to complete its audits. Investors no longer believe they can trust the integrity of financial statements that the firm does audit.

The breathtaking speed with which Andersen collapsed proved just how little is left once a business built on trust loses its good name.

I am writing this in mid-May while the tragicomedy of Andersen’s obstruction of justice trial is being played out in Houston. Under cross-examination, Enron audit partner David Duncan has spent two days explaining that he did not realize back in October 2001 that he intended to obstruct a government investigation when he led Andersen’s massive document-shredding campaign. Somehow, Duncan only came to understand in March 2002, as he moved toward a plea deal with the government, that he intended to obstruct justice last October. Got that?

Well, it doesn’t matter whether the criminal charges against Andersen make sense, or whether Justice indicted Andersen simply because it wanted a quick scalp in the more protracted battle against Enron’s top officials. It doesn’t matter whether Andersen is convicted at this trial, which I suspect is about a 50-50 possibility, or whether the conviction is upheld on appeal, which I think is considerably less likely, assuming Andersen survives long enough to appeal.

It doesn’t matter, because the firm we knew as Andersen is done. The foreign offices are gone, bits and pieces of the U.S. practice are being sold off, and the firm’s management is deluding itself that it can survive somehow as an auditor to mostly private, “middle market” companies.

That will never happen. Few Andersen people signed up for a career to do that kind of work, and not many clients want to hire the rump remnant of a disgraced big firm. The last hope is that some second- or third-tier firm will absorb whatever is left after the current garage sale. Otherwise, the time is coming to mop the floors, turn out the lights and pay the lawyers.

I never envisioned this sorry end when I left Andersen a decade ago. But I did see some of the structural problems that led to Andersen’s demise, and I did make a conscious choice that I would rather be responsible for my own fate than buy into that type of business.

The root of Andersen’s problem, in my view, was its organization as a massive partnership—a structure that is used by every large U.S. accounting firm. In a partnership, senior executives serve at the pleasure of the thousands of partners who own the firm and also make up its middle management. Unless a managing partner holds a controlling stake in the business, which is impossible in these mega-firms, he risks losing his job for making tough decisions that the rank-and-file partners do not like. This is no way to run a large business.

To make matters worse, professionals become partners at firms like Andersen on the basis either of their technical knowledge or of their rainmaking ability. Vital as those things are to the success of the firm, they have nothing to do with the skills needed to actually run a multi-billion-dollar company. As a result, the managers of a major professional firm are almost uniquely unprepared for the challenges of management. They don’t see around corners very well. How else to explain the lunacy of Andersen firing Duncan in January, making him the scapegoat for the shredding, only to try frantically a few months later to keep Duncan from becoming the government’s star witness?

Large partnerships foster a get-along, go-along mentality. You pay your dues, put in the requisite number of years and eventually get admitted to the club. Then, if you are so inclined, you start another climb up the ladder to reach a point where you can influence the direction of the business. By the time you reach that point, you may be out of touch with the latest developments in the field and in the marketplace.

Accountants are forced by the nature of their business to navigate an ethically foggy landscape. In their role as auditors (the “attest” function, in accountant-speak), accountants are hired by company management but are ultimately responsible to shareholders and other users of financial statements. Unlike lawyers, auditors are not supposed to be advocates for the management that hires them; they are supposed to be advocates of full and fair disclosure in the interest of those financial statement users.

Similarly, in preparing tax returns, accountants should not be advocates for every position that a client may want to take. The accountant’s job in the tax preparer role is to classify, quantify and disclose. At the same time, the accountant also must advise the client about how to apply often-vague tax laws. It is in this advisory role that the accountant can suggest alternate interpretations and help the client develop advantageous but supportable positions.

In most other lines of their business, accountants should act as independent advisers to their clients. The line between being an adviser and being an advocate is exceedingly difficult to draw. The difference probably is that an adviser must be fair, recognizing and setting limits. Advocates are hired guns whose job is to help the client do whatever he wants.

I think Andersen lost its way amid this ethical fog. It forgot its primary obligation to financial statement users, not only at Enron but in other recent cases. Some Andersen auditors crossed the line and became advocates for client management, while a great many other Andersen partners and employees, who could have demanded changes in the institutional culture that led to those lapses, did nothing.

Along with its audit failures, Andersen also forgot the importance of maintaining its independence in other areas. A former financial planning colleague who still works for Andersen told me that she was instructed last year to get a license to sell securities. She justified this by arguing that her clients want her to sell them the products she advises them about. Back in my era at Andersen, the firm would have understood that you can be in the product-selling business or the independent advice business, but not both at once.

It is too bad that after Sunbeam, Waste Management and the other cases, the Andersen partners did not create an environment in which it would have been a safe career move for David Duncan to walk away from Enron and its $52 million in annual fees. Andersen might still be thriving today if its top partners had recognized that the key to avoiding expensive lawsuits is to do the right thing, rather than shred the right documents.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.