Enron Scandal: Fraud, Ethics, and Securities Regulation

Introduction

Enron was one of the biggest business collapses in history, 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 their composition, but behind each of them was greed — the drive by senior management teams to defraud securities regulators and investors for personal gain. This paper examines the Enron fraud in particular. It was probably the worst of the era, given the bald-faced contempt that Enron management showed toward securities regulators, and the largest in scale, as Enron had been one of the stars of the stock market during its rise and crashed to near worthlessness almost instantly.

Key Players

As with most cases of stock market fraud, the key players were the senior executives. At Enron, they 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 afterward. Skilling replaced Lay as CEO. Fastow served as Chief Financial Officer. Arthur Andersen was Enron's external auditor, and in that role its responsibility was to ensure that the financial statements produced by Enron accurately reflected the company's financial condition (Investopedia, 2017).

Securities Regulation and Fiduciary Duty

In the United States, the Securities and Exchange Commission is tasked with securities regulation. As part of this role, it verifies the financial statements of publicly traded companies to ensure that those statements were prepared according to generally accepted accounting principles and subjected to external audit by a qualified accounting firm. Firms that do not meet these criteria are subject to investigation and, if found guilty, punishments ranging from fines to de-listing. De-listing is considered a severe sanction, as it would all but eliminate a company's equity value — even the possibility of de-listing would likely destroy a company's market capitalization (SEC, 2017).

One of the central tenets governing public companies is that the Board of Directors hires senior executives and guides strategy. The Board hires the CEO, who is then responsible for appointing other executives, setting corporate strategy, and overseeing other initiatives. The senior management team has a fiduciary duty, granted by the Board, to act in the best interests of 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 broadly the shareholder approach and the stakeholder approach. The shareholder approach was articulated most famously by Milton Friedman, who argued that the social responsibility of business is to increase its profits, which are then dispersed to shareholders who may do with their earnings as they please. Underlying the argument is the idea that business serves as a vehicle for financial investment — that is, the creation of wealth. Friedman was careful to specify that business must 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 requires not only that businesses comply with the law in pursuit of profits, but that they respect ethical custom as well. The stakeholder argument, by contrast, holds that businesses affect a wide range of parties beyond shareholders — including workers, local communities, and the environment — and that these interests should be factored into corporate decision-making.

The concept of fiduciary duty is critical in the Enron case because the senior executives had a clear duty to increase shareholder wealth. While their actions succeeded in the short term, Enron's collapse ultimately resulted in shareholders losing their entire investments. Enron's executives therefore failed comprehensively to uphold their fiduciary duty.

Key Facts of the Enron Fraud

Enron was created in 1985 through a merger, with Lay as CEO. The company was an energy trader and supplier that thrived in an era of deregulation, which allowed it to "place bets on future prices" (Investopedia, 2017). Enron prospered in energy trading — both through proprietary trading and by acting as a market intermediary. The company carried a high level of exposure to volatile market segments. While it had succeeded enormously during the stock market boom of the late 1990s, this vulnerability was exposed when the market turned following the bursting of the dot-com bubble (Investopedia, 2017).

One of the major frauds Enron committed involved the misuse of mark-to-market accounting, which is legal for derivative assets but highly questionable when applied more broadly. Investopedia (2017) cites an example in which 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 far exceeded its actual earnings. While the company was in fact losing substantial sums, this accounting technique made its financial statements appear to show healthy profits.

Meanwhile, Enron's stock price was rising, and executives were earning substantial compensation through equity-based pay, which depended on maintaining and increasing share values. CFO Fastow therefore established what became known as special purpose vehicles (SPVs) to conceal debt and other toxic assets off the balance sheet. Enron misrepresented its liabilities and impaired assets by exchanging its stock with SPVs in return for a note; the stock was then used to hedge assets listed on the balance sheet. Enron guaranteed the SPVs' value. This arrangement functioned as long as Enron's stock continued to rise, which it did during the boom years (Investopedia, 2017).

Enron also failed to disclose the inherent conflict of interest built into this structure. The mutual guarantees meant that if Enron's stock fell in value, so too would the SPVs — there were no downside protections, and the SPVs held all the debt and impaired assets that Enron had accumulated.

Arthur Andersen, as external auditor, should have flagged these accounting practices for misleading investors about Enron's true financial condition and risk profile. The company was reporting record profits while actually losing money, and concealing its debts to sustain that fiction. In particular, there was insufficient disclosure of the complex hedging arrangements built around the SPVs, and the disclosures that did exist were poorly described and difficult even for regulators to parse, let alone ordinary investors (Thomas, 2002).

When the dot-com bubble burst and a recession followed, energy prices declined as demand fell. This placed mounting pressure on Enron as losses grew impossible to conceal. Skeptics began to question whether Enron's results were too good to be true — and they were. SEC investigators began probing the company, and its accounting practices were exposed. The stock began to plummet by the summer of 2001. The company recorded a loss and closed one of its SPVs in an attempt to limit further stock devaluation. The SEC investigation intensified, and by December 2001 the company filed for bankruptcy (Investopedia, 2017). In the interim, Enron had undertaken to shred documents sought by the SEC in an attempt to obstruct the investigation.

Conclusion

The key to understanding Enron is recognizing that it was a criminal act, not an ethical lapse. This was a concerted, premeditated fraud. These were not people confronting an ethical dilemma in the philosophical sense, nor even in the sense of the trade-offs that Milton Friedman envisioned. The real story of Enron is that the safeguards normally in place to prevent people from getting away with crimes of this kind broke down for several years. Arthur Andersen did not rotate its auditors, enabling the same individuals to facilitate the fraud on the auditing side. The laws were relatively weak, or at least perceived as such, so Enron's executives did not believe that the costs of their crimes would be significant. They were wrong — but the SEC and Congress did have to act to strengthen the regulatory environment and ensure meaningful prison sentences for the key players.

Even so, there remains the possibility that a fraud of this kind could occur again. There is always an incentive for financial professionals to commit accounting fraud, and where there is a will, there is a way. The appropriate response is to put stronger laws in place, enforce them rigorously, and make the costs so prohibitive that only the most reckless of executives would attempt a fraud of this magnitude. Enron was already a once-in-a-generation event, which means the next such fraud will require even greater complexity, more elaborate execution, and will be even harder to conceal. But someone will try — as long as they believe they can profit from it.

References

Friedman, M. (1970). The social responsibility of business is to increase its profits. New York Times Magazine. Retrieved December 13, 2017 from

Investopedia (2017). Enron scandal: The fall of a Wall Street darling. Investopedia. Retrieved December 14, 2017 from https://www.investopedia.com/updates/enron-scandal-summary/

McConnell, T. (2014). Moral dilemmas. Stanford Encyclopedia of Philosophy. Retrieved December 13, 2017 from https://plato.stanford.edu/entries/moral-dilemmas/

SEC (2017). The laws that govern the securities industry. Securities Exchange Commission. Retrieved December 13, 2017 from https://www.sec.gov/answers/about-lawsshtml.html

Stinson, T. (no date). Arthur Andersen and Enron: Positive influence on the accounting industry. McKendree.edu. Retrieved December 13, 2017 from https://www.mckendree.edu/academics/scholars/issue4/stinson.htm

Thomas, C. (2002). The rise and fall of Enron. Journal of Accountancy. Retrieved December 13, 2017 from https://www.journalofaccountancy.com/issues/2002/apr/theriseandfallofenron.html