Question

How could the Fall of Enron have been prevented and what are ethical concerns as to why it happened?

Answer 1

How the scandal took place?

Enron was formed in 1985 after a merger between Houston Natural Gas Company and Omaha-based InterNorth Incorporated, with Kenneth Lay (CEO of Houston Natural Gas), as Enron's CEO and chairman. Lay quickly rebranded Enron into an energy trader and supplier. Deregulation of the energy markets reinforced the idea and allowed companies to place bets on future prices, and Enron was poised to take advantage. In 1990, Lay created the Enron Finance Corporation and appointed Jeffrey Skilling. With his help, Enron transformed itself into a trader of energy derivative contracts which acted as an intermediary between natural-gas producers and their customers. The trades allowed the producers to mitigate the risk of energy-price fluctuations by fixing the selling price of their products through a contract negotiated by Enron for a fee. Under Skilling’s leadership, Enron soon dominated the market for natural-gas contracts, and the company started to generate huge profits on its trades.

Enron, further, focused on closing maximum cash-generating trades in the shortest amount of time. Andrew Fastow, a hire by Skilling, rose to become Enron’s chief financial officer. The bull market of the 1990s, also the origin of Dot-com bubble, helped Enron, close some of the wanted deals. Enron traded derivative contracts for a wide variety of commodities—including electricity, coal, paper, and steel—and even for the weather.

With the end of the boom years, Enron faced a tough time due to increased competition in the energy-trading business. As a result, the company’s profits shrank rapidly. Under pressure from shareholders, company executives resorted to dubious accounting practices. One of them was a technique known as “mark-to-market accounting,” which allowed the company to write unrealized future gains from some trading contracts into current income statements, thus creating the illusion of higher current profits. Enron also used special purpose entities (SPEs)  for its troubled assets. In other words, Enron’s books showed losses that were less severe.

However, in mid-2001, a number of analysts raised eyebrows on the details of Enron’s publicly released financial statements.The fraud was soon in front of the stakeholders.The stock price crashed to less than $1 by the end of November 2001. Enron was left with some federal lawsuits and civil suits.

How could it have been avoided?

1. Following the ESG standards: WIth the advent of frauds like Enron, the importance of ESG (Environmental, Social and Governance) is on the rise. This fraud relates to the governance aspect of the standards. The standards should gain even more importance, in aspects like financing ( for venture capitalists).

2. Independence of Auditors: In the case of Enron, the auditors were under the pressure of the management to depict a glossy picture. Hence, they were not independent. Since, equity markets depend on the reliable public disclosure of information, this factor has to be considered to make it as a constraint that could restrict the booming of a fraud at the internal level.

3. Role of the Management: If the management has sought to believe to reward the top management instead of maximizing the profit and the value for the shareholders, the frauds will keep unfolding.The Enron Scandal could have been prevented, otherwise, if the management followed the path of honesty.

4. Financial Innovation and the role of regulator: Here, Enron followed the MTM technique to hide the troubles. Many emerging financing techniques and instruments (like derivatives, etc) have set the stage for a more active role by the regulator.