Enron: What Caused the Ethical Collapse? Introduction “Enron, once the nation’s seventhlargest…

Enron: What Caused the Ethical Collapse?

Introduction “Enron, once the nation’s seventhlargest company, crumbled into bankruptcy in December 2001 after years of accounting tricks could no longer hide billions in debt or make failing ventures appear profitable. The collapse wiped out thousands of jobs, more than $60 billion in market value and more than $2 billion in pension plans . . . . Enron founder Kenneth Lay and former chief executive Jeffrey Skilling were convicted in 2006 for their roles in the company’s collapse. Skilling is serving a sentence of more than 24 years. Lay’s convictions for conspiracy, fraud and other charges were wiped out after he died of heart disease in 2006 . . . . Three British bankers were sentenced Friday to just over three years in prison for their roles in a fraudulent scheme with former Enron Chief Financial Officer Andrew Fastow . . . .” The Huffi ngton Post, February 22, 2008. Andrew Fastow was sentenced to six years and agreed to pay back $24 million. Enron may be gone, but it should not be forgotten—especially by a new generation of corporate leaders, and by accounting, finance, and management students who may find themselves working in similar circumstances under leaders with questionable motives and criminal intent. Kenneth Lay, former chairman and CEO of Enron Corp., is quoted in Michael Novak’s book Business as a Calling: Work and the Examined Life as saying, “I was fully exposed to not only legal behavior but moral and ethical behavior and what that means from the standpoint of leading organizations and people.” In an introductory statement to the revised Enron Code of Ethics issued in July 2000, Lay wrote: “As officers and employees of Enron Corp., its subsidiaries, and its affi liated companies, we are responsible for conducting the business affairs of the companies in accordance with all applicable laws and in a moral and honest manner.” Lay went on to indicate that the 64-page Enron Code of Ethics reflected policies approved of by the company’s board of directors and that the company, which enjoyed a reputation for being fair and honest, was highly respected. Enron’s ethics code also specified that “an employee shall not conduct himself or herself in a manner which directly or indirectly would be detrimental to the best interests of the Company or in a manner which would bring to the employee fi nancial gain separately derived as a direct consequence of his or her employment with the Company.” Enron’s ethics code was based on respect, integrity, communication, and excellence. These values were described as follows: Respect. We treat others as we would like to be treated ourselves. We do not tolerate abusive or disrespectful treatment. Ruthlessness, callousness and arrogance don’t belong here. Integrity. We work with customers and prospects openly, honestly and sincerely. When we say we will do something, we will do it; when we say we cannot or will not do something, then we won’t do it. Communication. We have an obligation to communicate. Here we take the time to talk with one another . . . and to listen. We believe that information is meant to move and that information moves people. Excellence. We are satisfi ed with nothing less than the very best in everything we do. We will continue to raise the bar for everyone. The great fun here will be for all of us to discover just how good we can really be. Given this code of conduct and Ken Lay’s professed commitment to business ethics, how could Enron have collapsed so dramatically, going from reported revenues of $101 billion in 2000 and approximately $140 billion during the fi rst three quarters of 2001 to declaring bankruptcy in December 2001? The answer to this question seems to be rooted in a combination of the failure of top leadership, a corporate culture that supported unethical behavior, and the complicity of the investment banking community. Enron’s Top Leadership In the aftermath of Enron’s bankruptcy filing, numerous Enron executives were charged with criminal acts, including fraud, money laundering, and insider trading. For example, Ben Glisan, Enron’s former treasurer, was charged with two dozen counts of money laundering, fraud, and conspiracy. Glisan pled guilty to one count of conspiracy to commit fraud and received a prison term, three years of post-prison supervision, and fi nancial penalties of more than $1 million. During the plea negotiations, Glisan described Enron as a “house of cards.” Andrew Fastow, Jeff Skilling, and Ken Lay were among the most notable top-level executives implicated in the collapse of Enron’s “house of cards.” Andrew Fastow, former Enron chief fi nancial offi cer (CFO), faced 98 counts of money laundering, fraud, and conspiracy in connection with the improper partnerships he ran, which included a Brazilian power plant project and a Nigerian power plant project that was aided by Merrill Lynch, an investment banking fi rm. Fastow pled guilty to one charge of conspiracy to commit wire fraud and one charge of conspiracy to commit wire and securities fraud. He received a six-year sentence and will forfeit $24 million of illegal gains. Jeff Skilling was indicted on 35 counts of wire fraud, securities fraud, conspiracy, making false statements on financial reports, and insider trading, and was sentenced to 24 years. Ken Lay was indicted on 11 criminal counts of fraud and making misleading statements, and died in 2006. The activities of Skilling, Fastow, and Lay raise questions about how closely they adhered to the values of respect, integrity, communication, and excellence articulated in the Enron Code of Ethics. Before the collapse, when Bethany McLean, an investigative reporter for Fortune magazine, was preparing an article on how Enron made its money, she called Enron’s then CEO, Jeff Skilling, to seek clarifi – cation of its “nearly incomprehensible fi nancial statements.” Skilling became agitated with McLean’s inquiry, told her that the line of questioning was unethical, and hung up on McLean. Shortly thereafter Andrew Fastow and two other key executives traveled to New York City to meet with McLean, ostensibly to answer her questions “completely and accurately.” Fastow engaged in several activities that challenge the foundational values of the company’s ethics code. Fastow tried to conceal how extensively Enron was involved in trading for the simple reason that trading companies have inherently volatile earnings that aren’t rewarded in the stock market with high valuations—and a high market valuation was essential to keeping Enron from collapsing. Another Fastow venture was setting up and operating partnerships called “related party transactions“ to do business with Enron. In the process of allowing Fastow to set up and run these very lucrative private partnerships, Enron’s board and top management gave Fastow an exemption from the company’s ethics code. Contrary to the federal prosecutor’s indictment of Lay, which described him as one of the key leaders and organizers of the criminal activity and massive fraud that led to Enron’s bankruptcy, Lay maintained his innocence and lack of knowledge of what was happening. He blamed virtually all of the criminal activities on Fastow. However, Sherron Watkins, the key Enron whistle-blower, maintained that she could provide examples of Lay’s questionable decisions and actions. As Bethany McLean and fellow investigative reporter Peter Elkind observed: “Lay [bore] enormous responsibility for the substance of what went wrong at Enron. The problems ran wide and deep, as did the deception required in covering them up. The company’s culture was his to shape.” Ultimately, the actions of Enron’s leadership did not match the company’s expressed vision and values. Enron’s Corporate Culture Enron has been described as having a culture of arrogance that led people to believe that they could handle increasingly greater risk without encountering any danger. According to Sherron Watkins, “Enron’s unspoken message was, ‘Make the numbers, make the numbers, make the numbers—if you steal, if you cheat, just don’t get caught. If you do, beg for a second chance, and you’ll get one.’” Enron’s corporate culture did little to promote the values of respect and integrity. These values were undermined through the company’s emphasis on decentralization, its employee performance appraisals, and its compensation program. Each Enron division and business unit was kept separate from the others, and as a result very few people in the organization had a “big picture” perspective of the company’s operations. Accompanying this emphasis on decentralization were insuffi cient operational and financial controls as well as “a distracted, hands-off chairman, a compliant board of directors, and an impotent staff of accountants, auditors, and lawyers.” Jeff Skilling implemented a very rigorous and threatening performance evaluation process for all Enron employees. Known as “rank and yank,” the annual process utilized peer evaluations, and each of the company’s divisions was arbitrarily forced to fi re the lowest ranking one-fifth of its employees. Employees frequently ranked their peers lower in order to enhance their own positions in the company. Enron’s compensation plan “seemed oriented toward enriching executives rather than generating profits for shareholders” and encouraged people to break rules and inflate the value of contracts even though no actual cash was generated. Enron’s bonus program encouraged the use of nonstandard accounting practices and the inflated valuation of deals on the company’s books. Indeed, deal inflation became widespread within the company as partnerships were created solely to hide losses and avoid the consequences of owning up to problems. Complicity of the Investment Banking Community According to investigative reporters McLean and Elkind, “One of the most sordid aspects of the Enron scandal is the complicity of so many highly regarded Wall Street firms” in enabling Enron’s fraud as well as being partners to it. Included among these firms were J.P. Morgan, Citigroup, and Merrill Lynch. This complicity occurred through the use of prepays, which were basically loans that Enron booked as operating cash fl ow. Enron secured new prepays to pay off existing ones and to support rapidly expanding investments in new businesses. One of the related party transactions created by Andrew Fastow, known as LJM2, used a tactic whereby it would take “an asset off Enron’s hands— usually a poor performing asset, usually at the end of a quarter— and then sell it back to the company at a profit once the quarter was over and the ‘earnings’ had been booked.” Such transactions were basically smoke and mirrors, reflecting a relationship between LJM2 and the banks wherein “Enron could practically pluck earnings out of thin air.”

Questions for Discussion

1. What led to the eventual collapse of Enron under Lay and Skilling?

2. How did the top leadership at Enron undermine the foundational values of the Enron Code of Ethics?

3. In retrospect: given Kenneth Lay’s and Jeff Skilling’s operating beliefs and the Enron Code of Ethics, what expectations regarding ethical decisions and actions should Enron’s employees reasonably have had?

4. How did Enron’s corporate culture promote unethical decisions and actions?

5. How did the investment banking community contribute to the ethical collapse of Enron?

6. If the Sarbanes-Oxley law had been in effect, do you believe the Enron debacle would have occurred? Explain.

7. Could another Enron occur now? Why or why not? Explain.


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