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M I N I - C A S E
The Demise of Arthur Andersen
In 1913, Arthur Andersen, a young accountant who
had denounced the slipshod and deceptive practices
that enabled companies to fool the investing public,
founded his own firm. Up until the early 1980s,
auditing was the most important source of profits
within this firm. However, by the late 1980s, the con-
sulting part of the business experienced high revenue
growth with high profit margins, while audit profits
slumped in a more competitive market. Consulting
partners began to assert more power within the firm,
and the resulting internal conflicts split the firm in
two. Arthur Andersen (the auditing service) and
Andersen Consulting were established as separate
companies in 2000.
During the period of increasing conflict before the
split, Andersen’s audit partners had been under
increasing pressure to focus on boosting revenue
and profits from audit services. Many of Arthur
Andersen’s clients that later went bust—Enron,
WorldCom, Qwest, and Global Crossing—were also
the largest clients in Arthur Andersen’s regional
offices. The combination of intense pressure to gener-
ate revenue and profits from auditing and the fact
that some clients dominated regional offices trans-
lated into tremendous incentives for regional office
managers to provide favorable audit stances for
these large clients. The loss of a client like Enron or
WorldCom would have been devastating for a
regional office and its partners, even if that client
contributed only a small fraction of the overall rev-
enue and profits of Arthur Andersen.
The Houston office of Arthur Andersen, for exam-
ple, ignored problems in Enron’s reporting. Arthur
Andersen was indicted in March 2002 and then con-
victed in June 2002 for obstruction of justice for
impeding the SEC’s investigation of the Enron col-
lapse. Its conviction—the first ever against a major
accounting firm—barred Arthur Andersen from con-
ducting audits of publicly traded firms. This develop-
ment contributed to the firm’s demise.
Conflicts of interest can arise when multiple users with divergent interests (at least
in the short term) depend on the credit ratings. Investors and regulators are seek-
ing a well-researched, impartial assessment of credit quality; the issuer needs a
favorable rating. In the credit rating industry, the issuers of securities pay a rating
firm such as Standard and Poor’s or Moody’s to have their securities rated. Because
the issuers are the parties paying the credit rating agency, investors and regula-
tors worry that the agency may bias its ratings upward to attract more business from
the issuer.
Another kind of conflict of interest may arise when credit rating agencies also
provide ancillary consulting services. Debt issuers often ask rating agencies to advise
them on how to structure their debt issues, usually with the goal of securing a favor-
able rating. In this situation, the credit rating agencies would be auditing their own
work and would experience a conflict of interest similar to the one found in account-
ing firms that provide both auditing and consulting services. Furthermore, credit rat-
ing agencies may deliver favorable ratings to garner new clients for the ancillary
consulting business. The possible decline in the quality of credit assessments issued
by rating agencies could increase asymmetric information in financial markets,
thereby diminishing their ability to allocate credit. Such conflicts of interest came
to the forefront because of the damaged reputations of the credit rating agencies dur-
ing the financial crisis of 2007–2009 (see the Mini-Case box, “Credit Rating Agencies
and the 2007–2009 Financial Crisis.”)
158
Part 3 Fundamentals of Financial Institutions
What Has Been Done to Remedy Conflicts
of Interest?
Two major policy measures were implemented to deal with conflicts of interest: the
Sarbanes-Oxley Act and the Global Legal Settlement.
Sarbanes-Oxley Act of 2002
The public outcry over the corporate and account-
ing scandals led in 2002 to the passage of the Public Accounting Return and Investor
Protection Act, more commonly referred to as the Sarbanes-Oxley Act, after its two
principal authors in Congress. This act increased supervisory oversight to monitor
and prevent conflicts of interest:
• It established a Public Company Accounting Oversight Board (PCAOB),
overseen by the SEC, to supervise accounting firms and ensure that audits
are independent and controlled for quality.
• It increased the SEC’s budget to supervise securities markets.
M I N I - C A S E
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