Enron Scandal: Ethics, Fraud, and Corporate Collapse

Background: Enron's Rise and Financial Collapse

Enron was at one time considered to be a highly successful energy firm based out of Houston, Texas. The company was initially formed from a merger of two prominent gas pipeline companies in 1985, and its scope then broadened to include the provision of products and services in the realms of electricity, natural gas, and communications. Enron's reach expanded beyond the United States to the international market, as the company dealt in the management and delivery of energy services and products to customers in both commercial and industrial sectors throughout the world. The financial success of Enron was achieved mostly throughout the 1990s, when the CEO and CFO at that time built Enron into a company worth $150 billion, making it the seventh-largest company on the Fortune 500.

All of this perceived success, however, was later found to be fraudulent due to questionable accounting practices, and 2001 saw Enron implode under enormous debts. The firm was forced to declare bankruptcy, which had devastating effects. Over 4,000 employees were laid off. The stock price of Enron quickly plummeted, resulting in shareholders losing tens of billions of dollars. Furthermore, there was a pronounced shift in public confidence, and throughout the world this scandal led to widespread mistrust of corporate integrity.

The main cause of Enron's financial collapse was faulty and fraudulent accounting. In the year 2000, the company reported a net income totaling $979 million, when in fact it had earned only $42 million. Cash flow reports were also dramatically incorrect: the company reported a cash flow for the year 2000 of $3 billion, while actual cash flow was negative $154 million. At the time, the financial collapse experienced by Enron in 2001 constituted the largest bankruptcy ever to have occurred in U.S. corporate history.

Fraudulent Accounting and the Role of Special-Purpose Entities

The precise nature of Enron's fraudulent accounting was found primarily in the strategies used to conceal losses. In particular, the company developed what were called "special-purpose entities" (SPEs) — partnerships used by the firm to conceal losses. These SPEs functioned by allowing the company to falsely create the appearance of increased cash flow by moving assets and debts off its balance sheet. When the company sold assets, SPEs created the false appearance that funds were flowing through the books, generating a highly favorable financial picture. This was not an accurate representation of the company's financial health, and the use of SPEs to manipulate financial reports was deemed fraudulent. After the fraudulent nature of Enron's accounting practices was exposed, the company provided its true financial statements for the year 2000 and part of 2001, which showed a dramatic collapse in cash flow — from $127 million in 2000 to negative $753 million in 2001. Enron's stock price crashed and the company was forced to file for bankruptcy, resulting in approximately 22,000 claims totaling roughly $400 billion.

How were these fraudulent activities brought to light? In 2001, Sherron Watkins, Vice President of the company, was tasked with locating assets that could be sold off as Enron's stock price began to slip. Watkins noticed the questionable accounting practices being conducted and decided to bring them to the attention of the CEO in August 2001. In response, the CEO had his law firm examine the practices while he simultaneously sold off millions of dollars in stock options — even as he was telling employees that Enron had never been stronger. This claim was false. By October 2001, the questionable accounting practices Watkins had flagged were responsible for a reported third-quarter loss of $618 million and a write-off of $1.3 billion.

Whistleblowing and Legal Consequences

As a result of her whistleblowing, Watkins was demoted to make-work projects, lost access to her computer files, and retained the title of Vice President in name only. She later resigned from Enron and testified before Congress regarding the company's fraudulent accounting and partnership activities. Her whistleblowing ultimately resulted in the indictment of Enron's CFO, Andrew Fastow, by the U.S. Justice Department in 2002. Fastow faced 98 counts for alleged inflation of profits, including charges of fraud, conspiracy, obstruction of justice, and money laundering.

What factors most predominantly formed the basis of the unethical practices at Enron, ultimately resulting in the company's financial collapse and legal charges against high-ranking employees? The corporate culture of Enron undoubtedly played a major role in motivating individuals to engage in such questionable practices. The corporate culture of Enron could be aptly described as "arrogant," which was evident in the general conduct of the company and its employees. The pride exhibited by employees was overwhelmingly inflated, and the company — most likely inadvertently — encouraged employees to bend the rules in order to maximize profits. Decisions and practices within the company often served the interests of executive compensation far more than they served shareholders. Overall, the practices at Enron did not reflect ethical behavior, even though the CEO claimed to value a highly moral and ethical culture; integrity was not exhibited by the company at any level.

The idea that Enron's culture contributed to its demise is supported by research (Kulik, 2005). Kulik (2005) suggested that the culture of Enron was rooted in agency theory and that individuals at the highest management levels were engaged in agency-reasoning. The researcher identified several conditions present during Enron's collapse: a corporate culture characterized by strong agency norms that were collectively non-compliant; an environment that was overly generous in certain respects and did not acknowledge corporate failures; and a tendency to neglect appropriate business ethics training for newly hired staff. Kulik (2005) also argued that the Enron case had deteriorated so severely that implementing any ethics-based recommendations at that point would not have saved the company. The researcher further suggested directions for future business ethics research, including determining the difference between commitment and connivance, clarifying the meaning of "balance" within multi-dimensional legal and ethical theories, and identifying the appropriate balance between agency reasoning and stewardship reasoning.

Corporate Culture and the Roots of Unethical Behavior

The sense of competition within the company was fierce, driven by a system in which the bottom 20% of employees — as ranked by performance ratings each month — were dismissed. This highly competitive environment may have been a significant contributing factor to the company's eventual collapse. Kulik et al. (2008) proposed a grassroots-type model describing the structural factors in organizations that can influence the emergence and spread of unethical behavior. These researchers applied social network theory to predict conditions that are favorable or unfavorable for the emergence and growth of unethical conduct within organizations. Notably, Kulik et al. (2008) demonstrated that network conditions initially favorable for suppressing unethical behavior could paradoxically promote its diffusion once such behavior began to spread.

With regard to stakeholder theory, some researchers have suggested that weaknesses in this area — as it relates to corporate social responsibility — may have contributed to Enron's accounting scandal (Carson, 2003). Stakeholder theory tends to lack explicit prohibitions against deception and fraud, a gap that could be remedied by adding such prohibitions directly. Carson (2003) further argued that events like the Enron scandal reveal how stakeholder theory carries unrealistic and naive expectations about corporate executives acting as moral exemplars or agents of social improvement. Carson (2003) also suggested that "perverse" incentives created by certain payment and reward schemes can actively encourage unethical conduct.

Several additional factors could have significantly undermined an ethical corporate culture at Enron. Webley and Werner (2008) identified three of the most significant. The first was a lack of commitment on the part of upper management. Management commitment is especially important for shaping the scope and orientation of ethics programs; executives must take their roles and potential influence seriously, as their commitment to ethics significantly affects the course of ethics governance throughout a corporation.

The second factor outlined by Webley and Werner (2008) was the absence of a well-designed business ethics policy. The researchers described five traits necessary for a sustainable ethics policy: agreement among organizational members on core ethical values; a stakeholder-based ethical code that explicitly outlines responsibilities and guidelines for all stakeholder relationships; practical guidance for employees on ethical dilemmas arising from those relationships; provisions ensuring that employees can seek ethical advice or raise concerns; and the implementation of ethics training to familiarize staff with ethical standards and expectations.

A third factor identified by Webley and Werner (2008) was the failure to promote an ethical culture. The successful promotion of an ethical culture requires that management behavior and communications align with and reinforce ethical practices. It is also important that ethical considerations be incorporated into corporate strategy so that core ethical values are integrated into the foundation of the company.

A final contributing factor was Enron's failure to seek meaningful feedback and assurance regarding its ethical policies (Webley & Werner, 2008). This is most effectively addressed through a board-level committee dedicated to overseeing the ethics program. Evidence of a company's ethical well-being can be gathered through stakeholder surveys and symptomatic indicators such as staff turnover rates or customer complaint rates.