Enron Fraud

Enron was one of the biggest business collapses, and one of the most egregious incidents during a period in the early 2000s when investor faith in the securities system was shaken by a series of scandals. The scandals varied in terms of their composition, but behind each of them was greed, the drive by senior management teams to defraud securities regulators and investors for their own gain. This paper will look at the Enron fraud in particular. This was probably the worst, for the bald-faced contempt that Enron management showed to securities regulators, and the biggest, as Enron was one of the stars of the stock market during its ride up, and crashed to worthlessness almost instantly.

As with most cases of stock market fraud, the key players were the senior executives. At Enron, the key players were Kenneth Lay, Jeffrey Skilling, Andrew Fastow and the accounting firm Arthur Andersen. Kenneth Lay was the CEO until 2001, and remained on the Board afterwards. Skilling replaced Lay as the CEO. Fastow was the Chief Financial Officer. Arthur Andersen was Enron’s external auditor. As external auditor, its role was to ensure that the financial statements produced by Enron accurately reflected the company’s financial condition (Investopedia, 2017).

In the United States, the Securities Exchange Commission is tasked with securities regulation, and in this task part of its job is to verify the financial statements of companies that are publicly traded. This verification assures that publicly traded companies have all produced statements according to generally accepted accounting principles, and that these statements have been subject to external audit by a qualified accounting firm. Firms that do not meet these criteria are subject to investigation and, if found guilty, punishment ranging from fines to de-listing. The latter of which is considered a severe punishment, as it would all but wipe out a company’s equity value – even the possibility that a company could be de-listed would probably wipe out its market value (SEC, 2017).

One of the central tenets by which public companies operate is that the Board of Directors hires the senior executives and guides strategy. The Board in particular hires the CEO, and the CEO is responsible for hiring other executives, setting corporate strategy, and other initiatives. The senior management team has a fiduciary duty, granted by the Board, to act in the best interests of the shareholders. This duty often lies at the core of ethical dilemmas in business, and has become the subject of considerable debate. The two sides of the fiduciary duty debate are basically the shareholder approach and the stakeholder approach. The shareholder approach was probably best explained by Milton Friedman, who famously argued that the social responsibility of business is to increase its profits. The profits are then dispersed to shareholders, and the shareholders can do with these earnings as they please. Underlying the argument is the idea that business is a vehicle for financial investment, i.e. the creation of wealth. Friedman pointed out specifically that business had to operate within the bounds of the law: “to make as much money as possible while con­forming to the basic rules of the society, both those embodied in law and those embodied in ethical custom” (Friedman, 1970). Thus, the shareholder argument not only dictates that businesses uphold the law in pursuit of profits, but also ethical custom. The stakeholder argument holds that businesses impact a number of different stakeholders, and therefore should take the needs of those different stakeholder groups into account – workers, the environment, and others that might be impacted by externalities not specifically built into transaction costs.

The concept of fiduciary duty is critical in the Enron case, because the senior executives had a duty to increase shareholder wealth. While their actions succeeded for a short time, Enron’s collapse ultimately brought about a condition where the shareholders lost their investments in Enron. Thus, Enron executives failed to uphold their fiduciary duty.

Enron was created in 1985 via merger, with Lay as CEO. The company was an energy trader and supplier, and thrived in an era of deregulation that allowed it to “place bets on future prices” (Investopedia, 2017). The company thrived in energy trading, both via its own trading and by making markets as an intermediary. The company had a high level of exposure to volatile components of the market. So while it had succeeded enormously during the stock market run of the late 90s, this vulnerability was exposed when the market turned during the bursting of the dot-com bubble (Investopedia, 2017).

One of the major frauds Enron committed concerned the use of mark-to-market accounting, which is legal for derivative assets, but highly questionable for use in other areas. Investopedia (2017) cites an example where Enron would build a power plant and “immediately claim the projected profit on its books, even though it hadn’t made one dime from it.” This misreporting of revenue constitutes accounting fraud, and created a situation where Enron’s reported earnings were much higher than its actual earnings. While the company was actually losing money – lots of it – this accounting technique led to financial statements that showed the company was actually making money.

Enron’s stock was flying, and the executives were earning substantial sums from equity-based compensation, which is dependent on maintaining high share values, and increasing them. So CFO Fastow set up what became known as special purpose vehicles to hide debt and other toxic assets off the balance sheet. Thus, Enron misrepresented its debt and its bad assets on the balance sheet. It did this by exchanging its stock with the SPV for a note, and the stock would then be used to hedge an asset listed on the balance sheet. Enron guaranteed the SPV’s value. This worked fine as long as Enron’s stock kept rising, which it did during this boom (Investopedia, 2017).

Enron also failed to disclose the apparent conflict of interest that was built into this structure. The mutual guarantees basically meant that if the value of Enron fell, the value of the SPV would fall – there were no downside protections, and the SPVs held all of the debt and bad assets that Enron had.

The auditor, Arthur Andersen, should have red-flagged these accounting practices, for the fact that they misled investors about the financial condition of Enron, and the risk that the company had. It was reporting record profits when it was actually losing money, and hiding its debts in order to cover up this lie. In particular there was insufficient disclosure of the complex hedges that the company had built around its SPVs, and was disclosure that existed was poorly described and difficult even for regulators to parse, let alone casual investors (Thomas, 2002).

When the dot-com bubble burst, a recession was spurred. With this came declining energy prices as demand was reduced. This put an increasing amount of pressure on Enron, as its losses mounted. It was no longer able to hide. Skeptics emerged, believing that Enron’s results were too good to be true, and they were. Investigators from the SEC began probing the company, and its accounting practices were revealed. The stock began to plummet by the summer of 2001. It recorded a loss, and closed one of its SPVs, an act that prevented further devaluation of its stock. The SEC began to investigate and by December the company filed for bankruptcy (Investopedia, 2017). The company had undertaken to shred documents sought by the SEC in an attempt to cover up the crime.

It must first be understood what constitutes an ethical issue. The decision of whether to commit a crime or not does not constitute an ethical dilemma, at least not in the instance of securities fraud. An ethical dilemma is a decision where there must be negative consequences, yes, but choosing between a legal action and an illegal one is not an ethical dilemma in any meaningful sense (McConnell, 2014).

Thus, the decision to commit the fraud itself is no ethical dilemma by the fundamental standards of what an ethical dilemma actually is. Beyond the realm of philosophy, one might prefer to use the Friedman argument. The directors of Enron did have some success in increasing shareholder value in the short run. However, Friedman did not say that the social responsibility of business is to increase shareholder value in the short run knowing that it would all be blown up in the long run. The complete and total evisceration of shareholder value as the result of this fraud runs counter to anything Friedman argued. Moreover, Friedman’s argument was set within the bounds of legal and ethical activity. As long as it is accepted that where securities fraud is concerned that legal and ethical are roughly the same thing, then Enron acted far beyond the bounds where even a pure Friedmanian view would hold up.

A further issue worth noting is that while the executives of Enron had a clearly stated fiduciary duty to shareholders, they also have a duty, if unstated, to uphold the integrity of the financial markets. This duty was violated in the sense that committing the fraud not only served to enrich themselves, but when they were caught there were more victims than just the shareholders and employees of Enron – the entire market suffered from reputational and trust loss. This duty was more clearly expressed in the Sarbanes-Oxley Act, which was passed in part as a response to Enron, that stated explicitly that the CEO and CFO have to sign off on the financial statements or face prosecution – they are personally liable for the accuracy of those documents.
The Arthur Andersen angle is one where there might be some grounds of ethical analysis. Arthur Andersen had a couple of key duties in the Enron case. The first was the fiduciary duty to the shareholders to ensure that the financial statements accurately reflected Enron’s financial condition. The second fiduciary duty that Arthur Andersen had was with Enron, which paid Andersen for its auditing services. There is some question as to whether the duty of Arthur Andersen to Enron is to complete the audit in good faith, or to approve of Enron’s financial statements. Andersen ultimately did the latter, and it should not have. But Andersen fell into a moral hazard of a sort because all auditing companies at that time were also consultants for enterprise clients. They made more money on the consulting side of the business than the auditing side – by far. Arthur Andersen was active with Enron both on the auditing side and the consulting side. This created a conflict of interest because an accounting firm had motivation to go easy on the audit if going hard would put the lucrative consulting business at risk. Thus, the more significant moral quandary in the Enron case was with Arthur Andersen. That company ultimately chose to preserve the consulting fees at the cost of performing an honest audit (Stinson, no date). This conflict of interest was one of the main issues identified in the subsequent post-mortem of the Enron collapse to be addressed in law.

There was another ethical issue with the case, and that was with the shredding of the documents. There is a line here – in a sense it's not an ethical dilemma because it is illegal. However, where the original crime was a crime committed by people who thought that they were not going to be caught, shredding the documents during the investigation was a situation where the people involved knew that they'd been caught, and were actively trying to destroy evidence in the hopes of either escaping prosecution or at least of getting a lighter sentence for lack of a stronger case – they were trying to put themselves in a position to plead out and maybe avoid jail time. This is a different form of ethics, one relating to cultural norms. In most cultures, the norm is really that if you do something wrong, that is one thing, but if you get caught you at least have to accept that reality and live with it. To try to cover up your actions, and avoid punishment when you know you did something illegal is often considered to be almost a more egregious ethical violation. Furthermore, this violation of ethical norms is different from the original act because there are no shareholder interests whatsoever, as the stock price had already been gutted at that point. The reality is that the document shredding signified would could be viewed as a new ethical low – if not worse than securities fraud then at least compounding it.

The first thing to consider is what could have prevented Enron in the first place. Effective internal auditing is unlikely, given that the fraud was committed at the very top of the company. That leaves external auditing, which is supposed to be a key safeguard for the integrity of the financial markets. The SEC sort of whiffed on the conflict of interest that accounting firms had, apparently not thinking it would actually manifest in a company being complicit in fraud. And most of Arthur Andersen wasn't; it was just one or two people that were and those people brought down the whole company. The auditing work would have had to be duplicated in order to provide adequate safeguard – can be done, but expensive, and requires doubling manpower as well.

At the end of the day, there is no real way to prevent criminals from being criminals. There needs to be a robust legal system that allows for the prosecution of offences, but in no country in the world is there a lack of crime. There is no meaningful way to wash away the risk of executives committing fraud simply by making it illegal, or offering up some corporate ethics training or whatever absurd panacea you can think of. The reality is that Enron itself cannot actually be prevented from repeating, at least not by addressing it as an ethical issue. That's because it's not an ethical issue, but a criminal one.

Sarbanes-Oxley was a good first step, because it put the CEO and CFO squarely in line with their fiduciary duty to capital markets as a whole. That needed to happen, to make clear that they do not just have a duty to shareholders, as clearly that line of thinking, distorted from Friedman's original view, contributed to Enron in the first place. Increasing the punishment risk and punishment costs is one way of at least shifting the payoff math for criminals in positions of power. If they think they are going to get caught, they are less likely to commit fraud in the first place and if they know that getting caught means hard time, more the better. Lay died before he was sentenced, Fastow served six years and Skilling is still in prison.

Several things were done on the regulatory side in the aftermath of Enron. There was the part of Sarbanes-Oxley for the CEO and CFO to verify the accounting statements. Another regulatory change was the ban on an accounting company having a consulting and auditing relationship with the same client. By removing this conflict of interests, and creating an oversight board in the PCOAB, the regulatory environment changed the accounting and auditing business to ensure that this would never happen again – without the help of Arthur Andersen Enron could never have concealed its fraud for so long. Today, an accounting firm will audit a company, and a different accounting firm will have the consulting business for that company. So there are still the same business lines, but the accounting companies had to shuffle their clients around in order to meet the new regulations.
Legal enforcement on the document shredding would have been a better approach. The investigators focused on the executives, in part to make a statement, but it would have been beneficial if there were stricter punishments for many of the other people involved in the fraud. Preventing such instances from occurring means nobody gets away with getting rich, yet there were many Enron employees who benefitted from this fraud, that were never prosecuted or if they sold their stock were allowed to keep the proceeds of those ill-gotten gains. In other words, there were still winners from the Enron side.

The SEC has taken its role as the regulator of financial markets seriously, and recognized the threat that Enron in particular posed to the integrity of the markets. As such, the SEC focused on making sure that both the executives and auditors involved faced punishment. Arthur Andersen went out of business, such was the damage to its reputation, and the same happened to Enron, which of course had been losing money for some time. Executives can look to Enron as an example of the mighty falling – they can see from this case, which is well-known, that if they truly wish to preserve and enhance shareholder value they have to do it on the right side of the law. Fraud, investigations and criminal charges will ultimately destroy shareholder value. There are always going to be unethical people, but the culture around business has hopefully changed as the result of the Enron collapse – it's only worth if it if you can get away with it, but you never will.