Enron's Collapse: Ethics, Fraud, and Corporate Failure

Introduction

Enron Corporation was an American company that specialized in supplying energy. Prior to its collapse in 2001, Enron was one of the most admired companies in the United States, recording superior profits year after year. However, in 2001, a series of questionable financial transactions were finally exposed when the company's stock price collapsed within a single day. This study investigates several factors that led to the fall of Enron Corporation. The findings reveal that top management did not promote a culture of ethics within the organization, that management was intoxicated with power and manipulated information for personal gain, and that top officials used power ruthlessly to intimidate subordinates. The company also failed to promote a culture of checks and balances by allowing a single entity to perform both internal and external auditing functions. The study recommends that the integration of ethical business practice is an effective method of promoting sound business conduct.

Enron is a natural gas pipeline company established in 1985 that pioneered the deregulation of the energy market. Within 15 years of its establishment, Enron became a leader in international energy, reporting operating revenue of more than $100.8 billion in 2000. In that same year, Enron was rated the most innovative company in America. Between 1990 and 1998, the value of its stock rose by 311% — a model growth rate recognized by Standard & Poor. Before its collapse, Enron was rated one of the most profitable companies in the country, and the market perceived Enron's management as aggressive and talented in applying cutting-edge, innovative business models. In 1990, the Enron stock price stood at $7 and increased to $83 in 2000, with the most substantial increase occurring in 1997. By 2000, Enron stocks outperformed the U.S. NASDAQ composite index, and the company's footprint was everywhere in North America.

Despite Enron's success throughout the 1990s, the company's reputation was shattered after 2000, forcing many executives to leave. In late 2001, Enron's problems compounded because several of its business models were not performing as planned, causing the company to initiate a series of asset write-downs.

Several factors were responsible for Enron's downfall.

Internal Environment: Intermediation and governance failure was one of the major factors that led to Enron's fall. This problem was largely attributed to the activities of Arthur Andersen, which assisted in falsifying the auditing books. Arthur Andersen was a major player in the Enron accounting scandal because the firm approved Enron's accounting practices despite their poor quality. The stamp of approval from Arthur Andersen caused many analysts to begin questioning the transparency of Enron's reported earnings, which ultimately led to both Enron and Andersen being prosecuted for their reckless behavior.

Top management compensation was another contributing factor. Similar to many large U.S. companies, Enron heavily compensated its management through stock options. According to the company's 2001 proxy statement, Enron offered 5.3 million shares to Ken Lay and 824,038 shares to Jeff Skilling. In total, the company offered 12,611,385 shares to all its officers. Although the stock-option program was intended to motivate management, the executives failed to create medium- and long-term value for the company.

Cuong (2011) argued that Enron's Board of Directors failed to fulfill their fiduciary duties toward shareholders because top executives were greedy and acted solely to protect their personal interests. Furthermore, the company did not put an effective internal auditing mechanism in place, instead outsourcing internal auditing in a manner that allowed fraudulent and questionable financial reporting to go undetected.

The poor performance of the audit committee also contributed to Enron's downfall. The corporate audit committee had only modest knowledge of accounting and finance, and thus relied almost entirely on information provided by management and the internal and external auditors to make decisions. This limited knowledge made it nearly impossible for the audit committee to detect management fraud. The external auditor, Arthur Andersen, also contributed to the collapse. In 2000, Enron paid Arthur Andersen $27 million in consulting fees and $25 million in auditing fees — financial incentives that compromised the firm's independence and led it to assist Enron in perpetuating questionable accounting practices.

External Environment: In the United States, accounting standards have historically been both inflexible and mechanical. Financial transactions were governed by strict rules, and Enron was expected to follow them. While the company was able to structure its transactions to technically comply with these rules, its balance sheet nonetheless failed to reflect its true financial risks. The Financial Accounting Standards Board (FASB) is the governing body that oversees accounting standards; however, Enron did not follow the established rules and regulations in its financial reporting.

Moreover, Moncarz, Moncarz, Cabello, et al. (2006) argued that deregulation of the energy market affected Enron's business transactions because it lowered the price of gas while increasing supply, leading to significant price volatility. This forced Enron to "offer a long-term fixed price contract for natural gas" (Moncarz, Moncarz, Cabello, et al., 2006, p. 25). The company also used financial derivatives such as futures, forward contracts, and swaps to hedge against price fluctuations in natural gas; however, Enron was ultimately unable to manage the sustained volatility. These issues caused the company to lose market value and profitability. In 2001, Enron's stock price fell from $26.05 to $5.40 in a single day. On October 19, 2001, Enron announced a debt of $9 billion and filed for bankruptcy in November 2001.

How Enron's Internal Checks and Balances Failed to Prevent Its Demise

A weak internal control system was one of the strongest factors that led to the collapse of Enron Corporation. After the collapse, it was revealed that Enron's internal control system was deeply vulnerable. For example, Arthur Andersen served as both the internal and external auditor simultaneously. There is, however, a fundamental difference between these two functions. By merging them, the company blurred the division between the methods used to assure the completeness and honesty of its financial reporting.

It is essential that senior management design the structure of the internal control system to ensure its effectiveness. Additionally, a company should never allow the same entity to perform both internal and external auditing functions. Checks and balances can only be effective when the internal auditor is separated from the external auditor, since the external auditor serves as a check on the work of the internal auditor. Because both are professional accountants, they are capable of detecting fraud if operating independently. Enron, however, did not allow this separation to function properly.

Furthermore, Enron's management failed to identify the risks associated with its internal control practices. The management did not understand the importance of effective internal controls and lacked the skills to design adequate systems. As a result, the company was unable to maintain the internal controls necessary to support reliable financial reporting.

As Locatelli (2002) noted, Enron's board "waived the company's conflict of interest policy to allow its CFO to invest in the corporation's special purpose entities, then failed to follow up to ensure the mandated compensating controls were being adhered to" (p. 2).

How Enron's Board and Leadership Undermined the Code of Ethics

Enron Corporation had laid down a comprehensive code of ethics that all employees and management were required to follow. However, management abused its power by manipulating information for personal gain. The company's Chief Executive Officer used power ruthlessly, eliminated corporate rivals, and intimidated subordinates. Management also failed to adequately oversee employee conduct. While board members appeared to exercise oversight of management functions, they rarely challenged management decisions.

Enron's conduct was deeply unethical. Company officials manipulated financial information to deceive stakeholders and protect their personal interests. Although both board members and executives claimed to be unaware of the company's off-the-books activities, a Senate investigation revealed that the full extent of Enron's problems had been made available to the Board before the collapse became public. For example, the Board had the capacity to manage conflicts of interest but was unable — or unwilling — to prevent those conflicts from festering among employees. As a result, employees followed the example set by top management, hiding expenses, deceiving energy regulators, and claiming non-existent profits (Duffy & Dickerson, 2002).

According to Enron's Code of Ethics, company officers and employees were required to conduct business in accordance with applicable laws and in an honest and moral manner. The Code also stated that employees should not conduct themselves in any manner, directly or indirectly, detrimental to the company. The Code of Ethics was grounded in four core values:

Respect: We treat others in a way that we would like to treat ourselves. We do not tolerate disrespectful or abusive treatment. Callousness, ruthlessness, and arrogance do not work here.

Integrity: We work with suppliers and customers with honesty and sincerity. When we affirm that we will do something, it will be done. When we say we will not or cannot do something, then we will not do it.

Communication: Our obligation is to communicate. We take the time to communicate with one another. We believe that information and communication are meant to move information freely among people.

Excellence: We will continue to do the best in everything we do. We will also continue to raise the value delivered to everyone.

Despite the existence of this code, Enron's executives did not integrate it into their business conduct. The corporate culture actively supported unethical behavior. Enron's leadership used hidden payments, complex structures, and secret loans to create the appearance that the company was controlled and funded by entities independent of Enron. This allowed the company to move its financial interests off the balance sheet — interests that should have appeared in the company's consolidated financial statements. As a consequence, Enron's financial statements did not accurately reflect the company's true condition, enabling management to misappropriate millions of dollars in undisclosed fees and other illegal profits.

Johnson (2003) argued that Enron's top officials abused their power and privileges by engaging in activities that were inconsistent with the interests of both external and internal constituencies, manipulating information, and placing their personal interests above those of stakeholders. Enron management also engaged in failed international investments and unraveled a series of dubious partnerships known as Special Purpose Entities (SPEs). These SPEs were backed by company stock and were illegally managed by senior officials with the goal of keeping short- and long-term debts off the balance sheet in order to artificially stimulate share price growth. When share prices began to slide, management was unable to support their guarantees. In addition, Enron was accused of borrowing from its subsidiaries with no intention of repaying the loans and of attempting to avoid federal taxes through subsidiaries such as Portland General Electric.

Enron also colluded with analysts to portray a false image of the company's financial performance. Enron's founder and other top officials failed at every level of ethical leadership. They behaved inconsistently toward employees and suppliers alike. Ordinary workers were not paid retirement benefits in cash; instead, they were vested in the company's own stock for their retirement savings. When the stock declined, employees were blocked from selling their shares. Top executives, by contrast, were free to do as they wished with their own holdings, and 500 senior officials received retention bonuses of $5 million each while laid-off workers received only a fraction of the severance they had been promised.

Enron's management also cultivated political relationships lavishly. The CEO was among the top contributors to a presidential campaign, and the company made significant donations to both Republican and Democratic members of the Senate and House of Representatives, in part to influence appointments to the Federal Energy Regulatory Commission and the Securities and Exchange Commission. In doing so, Enron's officials placed their personal loyalties above the interests of all stakeholders — including business partners, shareholders, local communities, and ratepayers — and betrayed the trust of their own employees.

In the aftermath of Enron's collapse, numerous executives were charged with criminal offenses including money laundering, fraud, and insider trading. Enron's Treasurer faced 24 counts of fraud, money laundering, and conspiracy, ultimately pleading guilty and receiving a three-year prison sentence and a financial penalty of $1 million. The CEO faced 98 counts of fraud, money laundering, and conspiracy in connection with the Nigerian and Brazilian power plant projects aided by Merrill Lynch. The CEO pleaded guilty to securities and wire fraud and was sentenced to 10 years in prison and fined $29.8 million.

Conclusion

Enron was an American organization that specialized in the energy business. The company recorded strong financial performance before 2001; however, its collapse was ultimately caused by pervasive unethical business practices. The evidence shows that Enron's management failed to exercise ethical management functions at every level. Before 2001, management was deeply unethical — officials manipulated financial information to deceive shareholders and protect their own interests. There were no effective checks and balances, as the same entity performed both internal and external auditing functions. Management raised its own compensation at the expense of the company, and executives engaged in shady business transactions that culminated in Enron's bankruptcy in 2001. The case stands as a lasting reminder that the integration of ethical standards, independent oversight, and transparent reporting are not optional features of good governance, but essential conditions for long-term business survival.

References

Cuong, N. H. (2011). Factors causing Enron's collapse: An investigation into corporate governance and company culture. Corporate Ownership & Control Journal, 8(3).

Duffy, M., & Dickerson, J. F. (2002). Enron spoils the party. Time, pp. 18–25.

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Healy, P., & Palepu, K. (2008). The fall of Enron. Harvard Business School Case 109-039. (Revised May 2016.)

Johnson, C. E. (2003). Meeting the ethical challenges of leadership. Thousand Oaks, CA: Sage.

Kanungo, R. N., & Mendoca, M. (1996). Ethical dimensions of leadership. Thousand Oaks, CA: Sage.

Locatelli, M. (2002). Good internal controls and auditor independence. The CPA Journal.

Moncarz, E. S., Moncarz, R., Cabello, A., et al. (2006). The rise and collapse of Enron: Financial innovation, errors and lessons. Contaduria y Administracion (218).