Introduction
1
Company Profile
1.1
The Company
2.
The Legal Facts and Findings
2.1 United States of America v. Jeffrey K. Skilling and Richard A.
Causey
2.1.1 Manipulating financial
data & making false public representations
2.1.2 Use of inappropriate
accounting principles and treatments
3. The Ethical Questions in the Enron Case
3.1
The Corporate Culture and the Lack of Corporate Governance
3.2 Abuse of Power
3.3
Fraudulent reporting and complex related party transactions
3.4
The Lack of Transparency and incomplete disclosure
4 The Failure of the
Gatekeepers
4.1 The Failure of the
gatekeepers in the Enron case
4.2 Shortcomings of the
whistle-blowers at Enron
5 Practical Cases after
Enron
Conclusion
Introduction:
In the "Anatomy of Greed: The Unshredded Truth from an Enron
Insider", Brian Cruver, an Enron employee reflects on the fall of Enron
through personal recounts and observations. Cruver quotes one Enron senior
executive saying, "We’re the bad guys. We're the criminals. And don't
think it's just this company. There's hundreds of Enrons out there, a thousand,
cooking the books, inflating the earnings, hiding the debt, buying off the
watchdogs" (Cruver, 2002). On the other hand, Enron's code of conduct
states that "an employee shall not conduct himself or herself in a manner
which directly or indirectly would be detrimental to the best interests of the
Company or in a manner which would bring to the employee financial gain
separately derived as direct consequence of his or her employment with the
Company". In light of the above, the contradiction between the statements
and in hindsight the ultimate bankruptcy of Enron in 2002 raises various red
flags regarding the corporate governance at Enron (thereafter the Company), the
ethics culture adopted by the Company and the reasons behind its ultimate
bankruptcy.
This paper tackles the ethical problems and questions that were raised
after the fall of "The Crooked E". It starts by providing a general
background of the Company, its operations (Part One), the legal questions and facts that were raised by the legal bodies in
light of the Enron collapse while using the indictment provided by the United
States of America v. Jeffrey K. Skilling and Richard A. Causey (2004) and the
Skilling vs. United states case as a reference (Part Two), the ethical
questions and dilemmas raised in the Enron Case along the failure of the
Company watchdogs (Part Three), and concludes by reiterating the importance of
ethics in corporate governance, the role of gatekeepers or guardians (Part
Four), and recent practical cases from our present (Part Five) that raise
questions whether or not the Enron Case has set forth a precedent pertaining
the existential nature of ethics in the modern corporate sector.
1 Company Profile:
1.1
The Company:
Enron Corp. was
an Oregon corporation with headquarters in Houston, Texas
(United States of America v. Jeffrey K. Skilling and Richard A. Causey, 2004).
Founded as a small gas and energy company in 1985, Enron grew into the seventh
highest-revenue generating firm (Skilling v. US, 2010). As such, it was
publicly traded on the NYSE, where before its bankruptcy its stock traded at
USD 90. Furthermore, as a listed entity and since its senior executives have undertaken
fiduciary roles, Enron as well as its executives were subject to the SEC's
requirements for transparency, maintaining a high credit rating, the creation
of an ethical work environment, formulation and implementation of adequate
internal controls that allow the firm to prepare financial statements that are
free from material mistakes due to fraud or error, and the filing of quarterly audited
financial statements. For instance, the indictment filed under "United
States of America v. Jeffrey K. Skilling and Richard A. Causey" in 2004
states that "it was critical to Enron's on-going business operations that
it maintain an investment grade rating for its debt, which was rated by
national rating agencies. An investment grade rating was essential to Enron's ability
to enter into trading contracts with its counterparties and to maintain
sufficient lines of credit with major banks" (United States of America v.
Jeffrey K. Skilling and Richard A. Causey, 2004).
In August 2001,
Enron's CEO Jeffrey Skilling resigned from his position due to personal reasons
as stated in the indictment. Four months later the Company declared bankruptcy
and its share prices plummeted to pennies which deemed them obsolete investments
(United States of America v. Jeffrey K. Skilling and Richard A. Causey, 2004).
In February 2004, the Enron Task Force concluded that, Skilling (CEO), Causey
(CAO), Lay (Chairman and former CEO) and other senior executives engaged in
fraudulent schemes to "manipulate financial date, inflate earnings per
share (EPS), engage in complex related party transactions where conflicts of
interest prevailed, and employed variable and Special Purpose Entities (SPEs)
with non-arm’s length transactions all for the benefit of the senior executives
all while not confirming with General Accepted Accounting Principles aka GAAP (United
States of America v. Jeffrey K. Skilling and Richard A. Causey, 2004). The
indictment also stated that the increase in EPS enriched the defendants through
salaries, bonuses, stock options, etc. For instance, "between 1998
and2001, Skilling received approximately USD 200 million from the sale of Enron
stock options and restricted stock, netting over USD 89 million in profit, and
was paid more than USD14 million in salary and bonuses [….]. On November 8, 2001,
Enron announced its intention to restate its financial statements for 1997 through
2000 and the first and second quarters of 2001 to reduce previously reported
net income by an aggregate of USD 586 million" (United States of America
v. Jeffrey K. Skilling and Richard A. Causey, 2004).
2.
The Legal Facts and Findings
For the purpose
of investigating the ethical dilemma in the case of Enron, we will limit the
facts and legal aspect to the indictment filed by the Enron Task Force in United
States of America v. Jeffrey K. Skilling and Richard A. Causey on February 2004
as well as the Supreme Country of the United States ruling in "Skilling v.
United States" which was decided in June 2010. In section 2.1 we will provide
the reader with the major financial findings and continue to summarise the
major legal facts in light of the said cases.
2.1 United States of America v. Jeffrey K. Skilling and Richard A.
Causey Report
In light of the
Enron debacle, the FBI created a multi-disciplinary task force to investigate
the bankruptcy of the energy giant. Deemed the "the most complex white
collar crime investigation in the history of the FBI, the Task Force included a
blend of investigators and analysts from the "FBI, the Internal Revenue
Service-Criminal Investigation Division, the Securities and Exchange
Commission, and prosecutors from the Department of Justice".
The sections below summarise the major findings per the report raised by the
Enron task force on February 18, 2004.
As for a start, the indictment named Jeffrey Skilling the CEO and
COO of Enron and Richard Causey the Chief Accounting Officer, and Ken Lay
(previous CEO) to be the principal conspirators. The charges included but are
not limited to the following items set below.
2.1.1 Manipulating
financial data & making false public representations:
According to
the reported indictment, the CEO and CAO at that time were charged of
manipulating financial information through inappropriate accounting treatments,
non-consolidating Special Purpose Entities (SPEs), and complex related party transactions conducted
at non-arm’s length, all that to present to the SEC, shareholders, and the
public with fictitious and sound financial information. This was used to exceed
investors' expectations, maintain the Company's credit rating, and manipulate
the EPS ratio. "The scheme's objectives were, among other things, to
report recurring earnings that falsely appeared to grow smoothly by
approximately 15 to 20 per cent annually; [….] to increase artificially Enron's
reported cash flow in order to mask a growing disparity between the Company's
reported revenues and its actual earnings from operations; and to artificially
inflate the share price of Enron's stock" (United States of America v.
Jeffrey K. Skilling and Richard A. Causey, 2004).
Furthermore,
the Task Force uncovered dealings in which the conspirers manipulated targets,
budgets, and presented the Company's performance as exceeding analysts' expected
performance. The indictment states that the conspirers set quarterly budget
targets for the Company, its units, and segments, and used deceptive accounting
treatments to attain such targets. As such, earnings were accounting based and
not operational. Furthermore, "when the budget targets were not met
through actual results from business operations, the desired targets were
achieved through the use of various earnings and cash flow "levers". […]These
shortfalls were referred to within Enron variously as the “gap,"
"stretch" or "overview" […]. Often these transactions were
completed in haste near, and at times after, the close of a financial reporting
period (United States of America v. Jeffrey K. Skilling and Richard A. Causey,
2004)".
2.2 Use of inappropriate accounting
principles and treatments:
In his article "Enron and the Use and Abuse of Special Purpose
Entities in Corporate Structures", Schwarcz (2002) addresses the Company's misuse of SPEs, differentiates
them from securitised transactions where the full risk is borne by a third
party, and indicates Enron's adoption of faulty and vague accounting principles
to "minimise financial statement losses and volatility, accelerate
profits, and avoid adding debt to its balance sheet" (Schwarcz, 2002)
through non-consolidating the SPEs into Enron's financial statements.
From an accounting perspective, a Special Purpose Entity (SPE) is
an entity that conducts its activities to meet the Company's i.e. Enron's
specific needs. In essence, the Company has decision making powers, control,
and is exposed to the SPE's risks even if the prior holds a non-controlling
interest in the SPE. As such SIC -12 addresses when a special purpose entity
should be consolidated by a reporting enterprise under the consolidation
principles in IAS 27.
Schwarcz addresses the complexity of the transactions with Enron's SPEs, and
states that Enron would "transfer its own stock to an SPE in exchange for
a note or cash, and also directly or indirectly guarantee the SPE's value. The
SPE, in turn, would hedge the value of a particular investment on Enron's
balance sheet, using the transferred Enron stock as the principal source of
payment" (Schwarcz, 2002). As Enron is exposed to the risk of the SPE,
i.e. if the value of Enron's investment falls, the SPE would "lack
sufficient funds to perform its hedge and ultimately cause the SPE to breach
the requirements for non-consolidation (3% independent equity)"; the
Company's statements should have consolidated the SPEs' results. Also, since
Enron is exposed to the risk of the SPE, and most SPEs were created by one of
Enron's senior executives (mainly Andrew Fastow), by non-consolidating the SPE
into the Company's financial statements, the Company was able to write-off
material liabilities off its balance sheet through transferring them to the
non-consolidated SPEs (Schwarcz, 2002).
Another aspect
which the indictment points out is the improper use of the valuation of several
assets on the Company's balance sheet. For instance, the report states that
Enron held a portfolio of asset investments known as "Merchant Asset
Portfolio" which included interest in various privately held energy
businesses. Since the latter are not publicly traded, Enron valued the book
value of its investments based on skewed internal valuation models to reflect
earnings due to the appreciation of its investments' value. Schwarcz (2002)
states that "for example, in the fourth quarter of 2000, under the
direction of Causey and others, Enron personnel fraudulently increased the
value of one of the largest of Enron's Merchant assets, Mariner Energy, by
$100million in order to help close a budget shortfall" (United States of
America v. Jeffrey K. Skilling and Richard A. Causey, 2004).
As such, we have discussed in general the findings of the United
States of America v. Jeffrey K. Skilling and Richard A. Causey as per its
indictment issued by the Enron Task Force on February 18, 2004. During the
debacle, Lay and Skilling went to trial with a count of 53 charges and a 65
page indictment. In the section below, we will discuss the ethical questions
raised in reference to the Enron scandal perspective from United States of
America v. Jeffrey K. Skilling and Richard A. Causey and Skilling v. United
States.
3.
The Ethical Questions in the Enron Case:
The fall of the
energy giant Enron, later dubbed as the "Crooked E" raised several
questions pertaining the ethical judgment in the company, the lack of proper
corporate governance, the prevailing culture, and the missing system of checks
and balances. In addition, one of the most prominent questions raised tackled
the failure of the Corporate Guard Dogs, such as the independent auditor, the
board of directors, and the internal audit and risk management committees. In
the sections below, we address a sample of the ethical dilemmas and analyse the
corporate conditions that gave rise to such issues.
3.1
The Corporate Culture and the Lack of Corporate Governance:
In his article
"At Enron, The Environment was Ripe for Abuse", John Byrne suggests
that the corporate culture, the lack of monitoring, and the image portrayed by
those in fiduciary roles allowed the creation of an unethical work environment
(2002). For instance, Skilling is often quoted describing the culture at Enron
as "loose and tight"; loose in the sense that it allowed innovation,
recruited young MBA holders, and listened to ideas pitched by said members in
reference to new ventures and investments. Yet, a former energy service unit
manager contests by stating that “the environment was ripe for abuse, nobody at
corporate level was asking the right questions. It was completely hands off
management. A situation like that required tight controls. Instead, it was a
runaway train". This is supported by the presence of an internal risk
management group of 180 staff employees who were responsible of screening
proposals, investments, and the review of deals (Byrne, 2002). In reality,
deals were struck and finalised without the proper assessment of the internal
risk management department, SPEs were created by key executive personnel, and the
Risk Assessment and Control Group lacked independence from Management as it
answered to the latter rather than the board of directors. In light of the
abusive corporate culture and the ineffective system of checks and balances,
Steward (2001) recounts Ken Lay's fondness of telling the story of how Enron
employees in the London branch started their own trading business without
having the approval of the headquarters in Houston. In hindsight, the trading
platform carried around 25% of the world's energy trading. But what key
authorities in management and leadership peg as a defective corporate and
environment, key executive officers in Enron viewed as a sense of flourishing
entrepreneurship and flexibility.
A survey
conducted in 2000 by the Ethics Resource Centre found that 43% of the
respondents believed their supervisors do not set good examples of integrity.
The same percentage felt pressured to compromise their organisation's ethics on
the job (Wee, 2002). As such, Enron's employees were pressured to perform by
their supervisors; hence many scholars have dubbed the corporate culture as one
of arrogance and overconcentration of power in the hands of limited senior
executives which facilitated the unethical and fraudulent behaviour that was
widespread throughout senior management. For instance, Byrne (2002) describes
the culture at Enron as a “Yes – Culture". In addition, Schwarcz (2002) states
that Fastow and other key executives in Enron either "overruled or
intimated employees under them who felt transactions (referring to the SPEs)
were detrimental to Enron". As such, Enron's executives adopted a
"rank and yank" policy in evaluating its employees where the least
performing 15% of the employees were laid off on a semi-annual basis (Johnson,
2003). As such, Enron's internal culture
is often describes as "Make the numbers, make the numbers, make the
numbers – If you steal, if you cheat, just don't get caught. If you do, beg for
a second change, and you'll get one".
3.2 Abuse of Power:
Furthermore,
Johnson (2003) in his article "Enron's Ethical Collapse: Lessons for
Leadership Educator" states that Enron's executives ruled ruthlessly and
abused the power granted to them by their fiduciary roles. For instance,
"the position of vice-chair was knows as the "ejector seat"
because so many occupants were removed from the position when they took issue
with Lay or appeared to be a threat to his power. Skilling for his part
eliminated corporate rivals and intimidated subordinates." In addition,
senior executives were granted excessive privileges that were unethical and not
permitted from an accounting point of view. The aforementioned article states
that Lay and his wife Linda borrowed from the firm USD 75 million that they
repaid in stock (Johnson, 2002). Furthermore, Lay was a major contributor to
the Bush campaign and in return the company was able to nominate candidates to
the SEC and the Federal Energy Regulatory Commission (FERC). All in all, these
instances of power abuse helped Enron land several projects with foreign
governments, de-regularise portions of the energy market, and in return earn
millions of in the form of salaries, stock options, bonuses, and accommodations.
3.3
Fraudulent reporting and complex related party transactions:
Auditing
standard AU – Section 316 states that "Management, along with those
charged with governance, should set the proper tone; create and maintain a
culture of honesty and high ethical standards; and establish appropriate
controls to prevent, deter, and detect fraud. When management and those charged
with governance fulfil those responsibilities, the opportunities to commit
fraud can be reduced significantly".
Contrary to the guidance set by the above governing body, Enron's executives
engaged in transactions that are not at arm's length with related parties a
matter which is not compliant with the accounting and reporting framework.
These ambiguous accounting treatments were used to report inflated profits,
growth, as well as remove Company related liabilities through utilising SPEs
that were purposefully not consolidated into the Company's audited financial
statements. The indictment in United States of America v. Jeffrey K. Skilling
and Richard A. Causey stated that the Company engaged 4 SPEs (Raptors) in a
series of complex hedging transactions. The SPEs were used to hedge the
devaluation of the Merchant Asset Investments of the Company and were
purposefully excluded from consolidation. For instance, "the defendant Richard
Causey, Fastow, Glisan, and others manufactured a transaction between Enron and
Talon (related party) that generated a USD 41 million payment to LJM (related
party) but had no legitimate business purpose for Enron" (United States of
America v. Jeffrey K. Skilling and Richard A. Causey, 2004). Furthermore,
Wee recounts that the Company's code of "ethics
has been suspended twice in 1999 to allow two outside partnerships to be led by
a top Enron executive who stood to gain financially from them, according to the
report Houston law Firm Vinson & Elkins prepared for Enron" (Wee,
2002). Such non-arm's length transactions highlight the unethical mind-set
adopted by Enron executives on the expense of the shareholders, investors, and
extended stakeholders.
3.4
The Lack of Transparency and incomplete disclosure:
Another key
ethical issue that was raised by scholars states that although more than a
decade has passed since the collapse of "The Crooked E" Management
transparency and complete or sufficient disclosures by both Management and the
company's external and internal auditors remains an imperative ethical requisite.
In his Article "Understanding Enron: It's about the Gatekeepers,
Stupid", John Coffee Jr. states that several years after the Enron
collapse, investors, stakeholders, and the general public's demands for full
disclosure and transparency have become a key requirement for financial
reporting as the prior have no longer confidence in the representations
provided by the corporate guardians. In light of the indictment referenced, we
note that " Enron’s publicly reported financial results and filings and its
public descriptions of itself, including in public statements made by or with
the knowledge of Skilling and Causey, did not truthfully present the financial
position, results from operations, and cash flow of the company and omitted to
disclose facts necessary to make the disclosures and statements that were made
truthful and not misleading. As a consequence, the financial appearance of
Enron that SKILLING, CAUSEY and their conspirators presented to the investing public
concealed the real Enron" (United States of America v. Jeffrey K. Skilling
and Richard A. Causey, 2004).
4 The Failure of the Gatekeepers:
A professional
gatekeeper or watchdog is an independent body external or internal to the firm
that is capable of providing a thorough system of checks and balances.
Prominent examples of such bodies include internal and external auditors,
financial analysts, and risk management committees. The gatekeepers' roles
include providing assurance regarding the appropriateness and accuracy of the
financial, operational, and organisational information provided by Management
to investors, stakeholders and the public in general. In light of the Enron
case, several scholars including John Coffee Jr. (2002) state the failure of
Enron can be partially attributed to the failure of the gatekeepers in keeping
management in check. In the section below, we discuss the failure of Enron's Watchdogs
or gatekeepers in challenging management and amending the ethical inconsistencies
within the firm as well as the role of the whistle-blowers such as Sherron Watkins
and their shortcomings in bringing the ethical and financial dilemmas at Enron
to public scrutiny.
4.1 The Failure of the gatekeepers in the
Enron case:
Auditing
Standard (AS-1001: Responsibilities and Functions of the Independent Auditor)
the role of the independent auditor "is the expression of an opinion on
the fairness (of the financial information) with which they present, in all
material respects, financial position, results of operations, and its cash
flows in conformity with generally accepted accounting principles".
Furthermore, (AS-1005 – Independence) states that "it is of utmost
importance to the profession that the general public maintain confidence in the
independence of independent auditors. [….] To be independent, the auditor must
be intellectually honest; to be recognized as independent, he must be free from
any obligation to or interest in the client, its management, or its owners.
Coffee (2002) states that "Arthur Andersen", the auditors, failed at
maintaining their independence from their audit and consulting client "Enron".
After all, several academic journals state that the audit partner on the Enron
job was the best friend of Enron's Chief Accounting Officer, Causey, who
himself was an ex-Arthur Andersen auditor. On the other hand, the auditing firm
provided both internal and external audit services as well as consulting
services with total annual fees amounting to USD 100 million (Coffee, 2002).
This clearly represents a state of conflict of interest and without placing
controls to address these conflicts of interest, Arthur Anderson auditors were
bound to cross the ethical line. Furthermore, the fact that Andersen employees
shared offices with Enron employees and right before the Enron scandal shredded
around one tonne of papers relating to the audit and consulting services
provided to the collapsing company indicated the impaired auditors'
independence and failure to act as a guardian of public interests.
The gatekeepers'
shortcomings are not restricted to the auditing firm Arthur Andersen. Craig
Johnson in "Enron's Ethical Collapse: Lessons for Leadership
Educators" states that the board of directors failed at exercising checks
and balances by challenging Management, contesting to their plans, operations,
and engaging Management in the decision making process (Johnson, 2003). In addition, the United States Senate’s Permanent Subcommittee
on Investigations stated that "Enron’s board of directors failed to
monitor, ensure or halt abuse. Sometimes the Board "chose to ignore"
problems, other times it "knowingly allowed" Enron to engage in high risk
practices. In so doing, the Board breached its duties to safeguard Enron
shareholders" (Rosen, 2003). As such, the board of directors to properly
serve as a gatekeeper, must set the direction of the company, engage Management
and challenge their decisions, financial results and undertakings while
ensuring the latter's alignment with the overall Company’s objective.
4.2 Shortcomings of the whistle-blowers at
Enron:
Johnson (2002)
states that although there were some whistle-blowers within Enron, the act to
bring the Company's transgressions to public came in late and barely spared the
various shareholders from economic and financial losses. Johnson recounts that
Clifford Baxter (former Company treasurer) complained about Fastow's financial
wrong doings but did not go to public with them. Similarly, Sherron Watkins
(vice president of corporate development) raised her concerns to Lay in a
letter that was released to the public only after 5 months from the Enron
bankruptcy. "While these are commendable acts, in her letter she
recommended quiet clean-up of the problems rather than public disclosure
(Johnson, 2002). It is thus those gatekeepers who are expected to guard the
shareholder and stakeholders' interest who participated in the unethical
environment within Enron.
5 Practical Cases after Enron
Fourteen years
later, Enron stands as a long living case of moral failure. The unethical
approach adopted by its senior executives carried repercussions through the
employees and what was deemed as unethical abuse of power by senior executives
was translated into an unethical culture that focused on earnings, putting
personal gains before those of the stakeholders as well as rigging the books.
Fourteen years later, one might believe that the fall of the seventh largest
revenue generating company would drive management, board members, gatekeepers,
and whistle-blowers to conduct themselves based on ethical and legal manners.
But the present outstanding cases beg to differ.
The
manipulation of LIBOR (London Interbank offering Rate), the bankruptcy of the
Lehman brothers, Deutsche bank's scandal of making more than USD 10 billion
dollars of liabilities and risky financial instruments disappear from its
books, GlaxoSmithKline bribery case in China, Olympus Corporation's fraud
scandal and the LUX – Leaks Scandal set up by PricewaterhouseCoopers to help
some of its clients benefit from advance tax rulings and avoid tax payment and
others contest otherwise. It might be an exaggeration to state that "there's
hundreds of Enrons out there, a thousand, cooking the books, inflating the
earnings, hiding the debt, buying off the watchdogs" (Cruver, 2002).
Conclusion:
Thorough the
sections above, we discussed the major legal and ethical aspects of the
collapse of "the crooked E". In addition, we have inspected that even
14 years after the downfall of the energy giant, Enron will remain a long
lasting evidence of corporate and moral failure. Furthermore, through our
inspections, we noted the failure of the system of checks and balances through
the compromise of the gatekeepers who are responsible of monitoring and
challenging management's operations and decisions .This was a major factor in
ensuring that Management had the leeway to rig the books. Finally, we concluded
by stating that based on present empirical data, ethical and financial continue
to flood the public and shake the financial markets and the only victims are
the stakeholders.
In light of all
that was presented, one cannot help but wonder about the secondary role that
ethics has undertaken in the modern corporates, what can educators do to
re-instil or redirect the younger generation's moral compasses and whether or
not the current legal system is capable of attending to the rapidly changing
contemporary needs of businesses and international economies.
Resources:
Coffee, John
C., "Understanding Enron: It's About the Gatekeepers, Stupid" (July
30, 2002). Columbia Law & Economics Working Paper No. 207. http://ssrn.com/abstract=325240
Rosen, R., Risk
Management and Corporate Governance: The Case of Enron. Connecticut Law Review,
Vol. 35, No. 1157, 2003. Available at SSRN: https://ssrn.com/abstract=468168
United States
of America v. Jeffrey K. Skilling and Richard A. Causey, 2004
