Ethical Issues in Business “Enron’s Fall”

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Facts of the Case

Kenneth Lay, an economist, and former undersecretary formed Enron in 1985 by merging two natural gas companies. Lay borrowed to expand the business and after two years the debt was 75 percent of the firm’s total value. In 1989, Jeffery Skilling was hired as head of Enron’s finance department.

Until then, the US government had policies that kept the energy prices fixed. But such regulations were lifted by the time Skilling was hired. With this new policy, energy prices experienced wide fluctuations. Skilling started making contracts with buyers and sellers setting prices fixed over the term of the contract. Enron soon became highly profitable in the energy-trading business. Skilling got the company to diversify in trading and Enron entered into contracts for a wide range of 180 commodities. In this process, they borrowed extensively.

In 1990, Skilling hired a financial analyst Andrew Fastow. The two persuaded US Securities and Exchange Commission to allow them to use the ‘market to market’ method for valuing their contracts. This allowed the company to show a high value of contracts and profits overselling them.

Enron management did not want to report the huge debt that it had gathered during diversification on its financial statements. To tackle this, Fastow created “special purpose entities”, a treatment allowed under accounting rules, to exclude the debt from Enron’s financial statements. These entities borrowed independently and paid to Enron which was reported as sales revenue. Meanwhile, the external auditor Arthur Andersen continued to certify the financial statements as accurate.

In the second half of 2001, Enron’s stock price began to decline. Sherron Watkins, the then vice president of the company, wrote a letter to Kenneth Lay, bringing up the issue of accounting practices of the firm. Lay announce publicly it was safe to invest in the company and that the future growth was very certain, but he and other executives began to sell their stock.

In October 2001 SEC announced the investigation of Enron’s special purpose entities, Fastow was fired then. Stock prices fell to $1 a share as Enron filed for bankruptcy in November. In February 2002, Watkins publicly disclosed information about Enron’s accounting practices. Meanwhile, Arthur Andersen’s accounting firm was convicted of obstruction of justice and forced to cease operations.

Moral Issues raised by the Case

Systematic Issues

First systematic issue that arises is the question of whether the SEC should have or not intervened in the matter when the company’s debt was soaring 75% of the total value. SEC is there to guard to rights of shareholders. Should SEC leave the corporations on their own to borrow extensively and put the stakeholders at risk without their decision? This is a question that is still asked after Enron’s debacle.

Secondly, the question must be raised about the morality and significance of the government’s decision to deregulate the energy industry. The government lifted a ‘protection’ that was in form of fixed prices. This made the industry very risky and the sellers of energy resources were left to rely on a private sector that could easily control the situation owing to the risky nature of the industry. Also, companies like Enron could easily exploit the small gas producers.

A very vital issue that has always been raised regarding this scandal is that how did the Enron managers get SEC to allow them to use market values for contracts? Although the fair value method is allowed under accounting standards, Enron’s method of determining fair value was questionable. Using forecasted cash flows for calculating profits is went on unchecked throughout the years, seriously questioning the role of the SEC in ensuring adherence to rules.

Finally, the most vital question raised in this regard is the allowance to practice as ‘special purpose entities’. How could such a provision be devised in law without considering potential exploitation? In this too, Enron’s creation of numerous such entities went on unchecked. Regulation authorities could not rely simply on external auditor certification. SEC could investigate the matter way before the report about Enron’s financial statements was published in Fortune magazine.

Corporate Issues

Enron’s debacle is in fact more relevant to corporate and individual issues in the context of the accounting fraud. Lay’s plan of business extension by borrowing extensively comes as the foremost activity that seems questionable. Lay plunged the business into huge debt but did not figure out that ultimately such liability will not be manageable. Most owners and managers in quest of wealth maximization forgo the interest of employees and small investors. Enron’s strategy to borrow heavily from time to time seems that managers faced ‘agency problems’; a situation where managers have goals that are not aligned with those of shareholders. Although in Enron’s case Skilling and Fastow were managers and were prone to agency costs, Lay was part owner and why he missed out on the idea is not understandable.

In Enron’s case, corporate issues not only just relate to Enron, but also to its auditor Arthur Andersen. Was Arthur Andersen’s policy to advise Enron against shareholders’ interest (in special purpose entities) and then certify the financial statements as accurately defendable? It seems from later events that not just one person from the audit firm was involved. Arthur Andersen’s staff was caught shredding documents relating to Enron. Why did the firm allow one person as a head auditor for so many years? This is the issue that costs the whole firm in the end.

Individual Issues

Enron as a corporation seems to be dominated by individuals. And, the downfall that it faced after so much success is also discussed on grounds of individual issues most often. First and foremost, Skilling’s pressurized atmosphere where employees were judged merely on financial performance, and not on any ethical grounds produced a mindset that provoked agency costs. Fastow was one of those who were trained in such a system; maximize profit to save your skin at cost of anything.

Although Skilling and Fastow appear as prominent figures in this case of malpractice and deception, they were not alone. There were a whole lot of people covering up the matter. Inside Enron, there were many who knew and kept quiet for their share in the profits and salaries from special purpose entities. Also, the head auditor of Enron seems responsible but there would have been a team of auditors each year from the audit firm.

Adherence to GAAP

Supposing that Enron’s accounting practices were aligned with GAAP, there was still a problem. The accounting treatment of contracts and debts exploited the weaknesses in the rules and deceived the users of financial statements. If Enron’s stock did not fall, the company would plunge into more and more debt, but without disclosing and reporting. The accounting standards prevalent and accepted globally always emphasize the principle of ‘substance over form’. Although Enron’s practices did not violate, if we suppose, the form or letter of the GAAP, they exploited the substance of these rules.

First, as they valued the contracts at the market value, they missed out, probably intentionally, the general spirit of such valuation. Net present value is based on a forecast. A value-based on mere forecasted cash flows cannot be reported as true value. The rule of prudence does not allow that. Market-valuation is carried out through independent experts from time to time, who would use methods that are testified and certified for such purpose. Secondly, how Enron exploited the idea of special purpose entities is against the spirit of such allowance. Even if they were not violating GAAP, they were deceiving the shareholders and investors who read the financial statements of Enron. Fastow and others were acting as independent parties although they were not.

Who was morally responsible for the collapse of Enron?

This is the question that has been asked most often since November 2001. In my view, no one person or individual was responsible alone. It was a corporate culture of wealth and profit maximization that was and is still is prevalent globally.

There is a race of profit-making ignoring many human and ethical issues. The system that Skilling produced of firing low performers had long-term effects. Fastow was a product of a culture that ruthlessly overlooked those who could not perform up to high standards of making profits for the company. From Kenneth Lay and his attorneys who tried to deceive the public by a false announcement to the head auditor for Enron, all did this to take lead in this race of profit maximization.

Still if one is to pick out an individual who was morally responsible, Skilling seems to be the main culprit. He created a system of disregard for stakeholders’ interests and run for making profits. He hired Fastow probably because he had shown alignment with Skilling’s ideology of corporate rules. He tried to quit by resigning as share prices fell so as to avoid any backlash for what he did and also because he knew he did it wrong.

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