Assignment

Case Study Analysis of Enron

Submitted to:

Mr. Yash Thakkar

Submitted by:

Dharit Gajjar

SSB10A07

Subject:

Corporate Governance & Ethics (CGE)

Index

Sr.

No.

Particulars Page

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1. Abstract 1 2. Introduction 2 3. Study 4 4. Conclusion 9 5. Recommendations 10 6. References 11

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Abstract

Enron Corporation was one of the world's leading energy companies based in Texas, USA. Before filing for bankruptcy in the year 2001, Enron employed more than 20,000 people. Its revenue in the year 2000 was more than $100 billion. It was named as "America's most innovative companies for six consecutive years by Fortune. Unethical and illegal business practices at Enron led to the creation of Sarbanes - Oxley Act of 2002. The origins of Enron started with the merger of Kenneth Lay’s company, Houston Natural Gas with Inter North, a Nebraska-based pipeline company in 1985. Initially, from the beginning, Enron began to show some cracks in its structure, as the company started acquiring huge amounts of debt during its foundation, and as a result of the deregulation of gas pipelines, it no longer had exclusive rights to its own pipelines. To solve Enron’s credit and revenue problems, Kenneth Lay, CEO hired Jeffrey Skilling, who eventually became the company’s Chief Financial Officer to the CEO in 1996. Almost overnight, Skilling turned Enron into a major market middleman for energy that would dominate the trading market. After many years of seemingly huge successes, more cracks began to appear in the Enron crown. In the final analysis, the conspiracy of Lay, Skilling and others led to the collapse of the company due to fraud, false reporting of revenue, shoddy accounting practices and a general disregard for virtually every tenet of business ethics. Enron scandal was the one of the biggest downfall in modern history as its cause where lack of vision or over vision and not corrupt but careless officers running company on big commitment. No proper code of conduct in company was major reason for Enron’s downfall. Through this Enron case we need to highlight that how corporate governance and ethics in organization helps to better governing of and smooth drive for an organization.

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Introduction Enron is synonymous with corruption and corporate fraud. The Enron Corporation was one of the largest companies which sold electricity and natural gas, distributed energy and other services like bandwidth internet connection and provided risk management and financial services to consumers the world over. This company became rich because of its initiative marketing and endorsement of power and communications bandwidth services and risk management offshoots. All these services were supervised by the operations management department but there existed other management departments which carried out half of their functions. Though these functions were purely executive in nature, there was lack of integrity, responsibility, creativity and control. The absence of these ethics led to the bankruptcy of the company. In other words, Enron ethics was ignored by the employees while working. In an organization, the functions of the operations management department should consist of ethical values, integrity, competence and clear accountability of term papers. But Enron did not abide by these functions which led to its bankruptcy. We may say that the company's employees lacked Enron ethics. As the company's reputation grew in the global world, the competition within the employees rose and hence individual greed also generated in the atmosphere of the company's egotism. Every employee wanted to make it big, achieve a lot within the company, and thus there was high motivation to succeed and earn more. But in such an atmosphere, the tendency to distrust people around is high as each is only concerned about themselves. With the mistrust among the employees booming, highly confidential term papers got used in trade contracts. Thus, trading contracts were made in secret and its admission was also kept undisclosed. Dealings in the finance section grew rapidly without paying much attention towards the company's goals. Hence, the employees had started to ignore Enron ethics. On the hand Enron doled out huge sums of money to charity, but on the other hand it systematically defrauded its financial statements during the 1990s along with its accounting firm Arthur Anderson. Enron's methods were creative and systematic. Its financial statements and accounting practices were not clear. For example, it had made it a practice of booking costs of cancelled projects as assets. The explanation was that there was no official letter stating that the project was cancelled! These things had "snow ball" effect. Also it had

-3- created special purpose offshore entities in order to avoid taxes and to raise profitability. This also gave freedom to the management to move currency and to hide losses. The then CFO, Andrew Fastow was the brain behind all these arrangements. His creation of these off books companies enabled him and his friends and family members make millions of dollars at the expense of other stake holders. Through "EnronOnline", expected future profits were tabulated as if it was today's. Some of the actions of this responsible and reputed company were almost like gambling. Enron's stock price was at its peak at $90 in the year 2000. But Enron executives who knew what was happening started to sell their stocks. Bethany McLean's article "Is Enron Overpriced" on 5th March 2001 further added to the fall. She played a main role in exposing Enron's huge debt. Gradually the stock prices fell and it was $1 by the end of 2001. Many of the senior executives were sent to prison. This incident also led to dissolution of Arthur Anderson, which was one of the top 5 auditing companies. Employees lost even their pensions. As a result, we cannot say that the problem rose due to the accounting practices only. It is not the financial department which is to be blamed solely. The problem which led to the bankruptcy of the company lay in the operations management department. On one side, Enron was gaining praises from the outsiders and on the other side, it was full of decentralized financial control and decision making structure which gave an illogical and unclear picture of the company's activities and operations. But we cannot say that the managerial performance was poor but the departments were ruining the ethical values and principles of the company. It was the duty of the managers and directors to check whether Enron ethics is being followed in their company or not. If they had supervised properly then they could have escaped from this bankruptcy tragedy.

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Study Ethical Issues at Enron:-

At Enron, a lack of integrity was built into the foundation of the company from the top to the bottom. The floor traders were heavily involved in the California rolling blackouts and the management team was involved in numerous, non-GAAP accounting practices. No internal controls existed to keep the members of the various teams in check.

Auditors, attorneys, and investment bankers experienced conflicts of interest between their professional duty to shareholders and their revenue generating involvement with Enron management. For instance, all were involved in structuring the illegal SPEs.

Lack of overall auditor independence. The focus at Arthur Andersen had shifted from an ethics based focus to a strict focus on revenue generation. Ultimately, AA was auditing transactions created by AA accountants.

Management reported the SPEs off-balance sheet, even though they were aware that the 3% rule had been breached. Since the focus at Enron was to cash flow, revenue, and increased stock value, decisions we not made with fairness and transparency in mind.

The board failed in their fiduciary duties. It seems they were guilty of general laziness. Also, the board was headed by Enron management – another conflict of interests.

Significance of Key accounting issues at Enron:-

Enron’s Board of Directors failed to provide adequate oversight of the accounting department. This allowed the accountants to misuse SPEs, form bogus partnerships, mislead investors, and falsify accounting statements.The Powers Report cited several examples of fraudulent activity. Among those were:

1. Employees enriching themselves without proper approval

2. Partnerships being established to help with favourable financial results

3. The use of SPEs to hide debt

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Enron established SPEs using Enron stock as owner’s equity. SPEs require that at least 3% fo the total owner’s equity by provided by an owner independent of the company. As Enron’s stock price fluctuated, the percent ownership of both parties changed. At times the stock value forced the equity of the independent to fall below 3%; therefore requiring Enron to consolidate the financial data for the SPE into the Enron financial statements. Often times, this consolidation was not done. Enron executives also conspired with Andersen auditors to establish the SPEs and issue unqualified financial statements. Andersen’s lack of independence allowed Andersen auditors to sign off on the questionable foundation of the SPEs. Andersen employees also did not inform Enron’s audit committee of the conflicts of interest between Andrew Fastow and Enron, nor did they advise the committee of the lack of internal controls.

The failed accounting practices of Enron were not limited to the abuse of limited partnerships and off-balance-sheet financing. The company made extensive use of other accounting gimmicks. For example, Enron also abused the controversial mark-to-market accounting method for its long-term contracts involving various energy commodities. What is mark-to-market? How was it abused by Enron? Mark-to-market accounting is the practice of adjusting forecasted earnings according to the market outlook. Enron abused this type of accounting by raising their earnings expectations when the market was up, but when the market was down, they would not decrease their earnings outlook. This blatant misrepresentation created an inflated earnings forecast and deceived investors.

Corporate Culture at Enron:-

Skilling began to change the corporate culture of Enron to match the company’s transformed image as a trading business. He set out on a quest to hire the best and brightest traders, recruiting associates from the top MBA schools in the country and competing with the largest and most prestigious investment banks for talent. In exchange for grueling schedules, Enron pampered its associates with a long list of corporate perks, including concierge services and a company gym. Skilling rewarded production with merit-based bonuses that had no cap, permitting traders to “eat what they killed”. One of Skilling’s earliest hires in 1990 was Andrew Fastow, a 29-year-old Kellogg MBA who had been working on leveraged buyouts and other complicated deals at Continental Illinois Bank in Chicago. Fastow became Skilling’s protégé in the same way Skilling had become Lay’s. Fastow moved swiftly through the ranks

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and was promoted to chief financial officer in 1998. As Skilling oversaw the building of the company’s vast trading operation, Fastow oversaw its financing by ever more complicated means. As Enron’s reputation with the outside world grew, the internal culture apparently began to take a darker tone. Skilling instituted the performance review committee (PRC), which became known as the harshest employee-ranking system in the country. It was known as the “360-degree review” based on the values of Enron—respect, integrity, communication and excellence (RICE). However, associates came to feel that the only real performance measure was the amount of profits they could produce. In order to achieve top ratings, everyone in the organization became instantly motivated to “do deals” and post earnings. Employees were regularly rated on a scale of 1 to 5, with 5s usually being fired within six months. The lower an employee’s PRC score, the closer he or she got to Skilling, and the higher the score, the closer he or she got to being shown the door. Skilling’s division was known for replacing up to 15% of its workforce every year. Fierce internal competition prevailed and immediate gratification was prized above long-term potential. Paranoia flourished and trading contracts began to contain highly restrictive confidentiality clauses. Secrecy became the order of the day for many of the company’s trading contracts, as well as its disclosures.

Governance issues arising from Enron:-

Governance failure at the Board level

Too much trust of management

Incompetence – inadequate awareness and/or understanding of role , control & reporting systems

Lack of motivation, conflicts of interest

Dishonest management, conflicts of interest

Enron’s culture of deception

Manipulation of accounting and disclosure

Poor standard setting

Auditor deficiencies

Regulatory short-sightedness

Ethical Issues by Arthur Anderson:-

Anderson was not independent. They provided consulting service & internal audit whilst serving as Enron’s outside auditor. In other words they audited their own advice. This is not allowed under new Sarbanes-Oxley Act (SOX).

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Anderson did not report concerns to an audit committee but they reported to the board who were the almost the same individuals responsible for the fraud- Ken Lay. CEO who is also Chairman of the Board will essentially be overseeing him or herself, making for a situation that is hard to control. Arthur Anderson, LLP- Incentives: Keep Enron happy and large fees coming in. Actions: Intertwined themselves with creating SPE’s and ignoring irregular accounting practices.

Assessing Andrew Fastow and Jeffery Skilling’s character using Kolhberg’s theory of moral development:-

Kolhberg’s theory can be related to Fastow and skilling’s character as they treated organization as individuals of their own. Here they can be judged as they took care of their personal need and made their career. They did what they thought was right and neglecting the others need.

Audit committee independence was compromised:-

Yes, it was compromised as Enron executives also conspired with Andersen auditors to establish the SPEs and issue unqualified financial statements. Andersen’s lack of independence allowed Andersen auditors to sign off on the questionable foundation of the SPEs. Andersen employees also did not inform Enron’s audit committee of the conflicts of interest between Andrew Fastow and Enron, nor did they advise the committee of the lack of internal controls. More oversight by board of directors and audit committee regarding Andy Fastow’s role in SPE’s- he clearly had a conflict of interest.

Heightened scrutiny of accounting and auditing:-

1. Advantages:

a. The members of private sector rule-making bodies are probably more likely to be practitioners and thus better acquainted with the key issues and problems facing their profession at the practice level.

b. As a general rule, one might expect private sector rule-making bodies to be able to respond to important issues more rapidly than governmental rule-making bodies that are more likely to be slowed by bureaucratic "red tape."

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c. Members of a given profession are probably more inclined to work closely with a private sector rule-making body and less inclined to view the actions of that body antagonistically since its members are representatives of the profession instead of representatives of a government agency.

d. The operating costs of a private sector rule-making body are typically borne by the relevant profession rather than by taxpayers.

Disadvantages:

a. A private rule-making body may be more susceptible to pressure from interest groups within a profession than a public sector rule-making body.

b. The limited resources of a private rule-making body may not provide sufficient funding for needed research projects to analyze the feasibility or reasonableness of proposed standards.

c. A private rule-making body may focus too narrowly on the interests of its profession rather than the broader interests of society.

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Conclusion Enron’s case was one of the worst case and example of bad corporate governance and ethics in modern organization. It takes so long to build an empire like this and just in days the dreams of many people shatter. Through this case I want to conclude that not only top management but employee should be a part of decision making. Never rely upon others judgement. Encourage whistle blowers in the organization though it leads to downfall of the organization. In the whole process Enron cheated the shareholders and its employees. Till the end they kept telling them that everything at Enron was fine and that no one had to worry. People trusted them and invested more. The employees lost their savings and retirement funds to this fraud. Then comes the question of who is responsible for the whole thing? The senior management or the employees that committed the fraud. I feel it is the responsibility of the senior management. They should have created a friendlier environment, an environment where people didn’t trample over each other. If the management had censured fraud the first time they came across it, it would not have escalated to this level. In conclusion, the whole concept of slippery slope came into play here. What started out as being seen “maybe unethical” became an impulsive response and showed no signs of being thought as unethical. The senior management wanted to be the best at everything they did. When losses started hitting them, they wanted to hide it and hence fell. This also has to do with the nature and culture of the company which had become very arrogant and they thought they could only win.

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Recommendations

Examine your ethical climate and put safeguards in place.

Don't just print, post and pray i.e., don’t just print your code of ethics and conducts but also follow them.

Building a robust ethics infrastructure that is self sustaining.

Publically commit being an ethical organization.

Separate auditing from consulting function.

Talk with employees at all level.

Build ethical conduct in organization.

Establishment of the ethics committee to constantly monitory level of ethics in organization.

Keep communication open at all levels.

Choose to live your corporate values.

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References

Documentary: “Enron- The Smartest Guys in the Room”

www.termpaperwarehouse.com