Question

What was the technical/professional problem in the Enron case? Ethics class

Answer 1

Enron was created in 1986 by Ken Lay to capitalise on the opportunity he saw arising out of the deregulation of the natural gas industry in the USA. What started as a pipelines company was transformed by the vision of a McKinsey consultant, Jeff Skilling, who had the idea of applying models used in the financial services industry to the deregulated gas industry.

He persuaded Enron to set up a Gas Bank through which buyers and sellers of natural gas could transact with each other using an intermediary (Enron) whose contractual arrangements would provide both parties with reliability and predictability regarding pricing and delivery. Enron duly recruited him to run this business and he rapidly built up a major gas trading operation through the early nineties.

During this time Enron was extending its pipeline operations into a wider power supply business, initially in the USA and then on an international scale, completing a large plant at Teesside in the UK and contracting to build a huge plant near Mumbai in India. In due course it had deals all round the globe, from South America to China. The hard driving expansion of Enron’s power business worldwide created a global reputation for Enron.

Technically thinking and entering in the dotcom boom, Skilling decided Enron could create a business based on a broadband network which could supply and trade bandwidth and he set out to build this at a great pace was the biggest mistake of Enron from where the company started shrinking.

However, the experiment in deregulation in California didn’t work well and in due course was reversed with recriminations all round. Moreover, the international business expansion wasn’t underpinned by adequate administration and many of the contracts later turned bad.

So Enron then took the decision to build on its international presence by becoming a global leader in the water industry and bought a big water company in the UK, following it up with a big deal in Argentina.

At this point, around 2000, Enron’s reputation was still riding high and Lay and Skilling were looked up to as visionary thinkers and top business leaders.

However, as we see elsewhere in this case study, the rapid expansion had run well ahead of Enron’s ability to fund it, and to address the problem, it had secretly created a complex web of off-balance sheet financing vehicles. These, unwisely, were ultimately secured, and hence dependent, on Enron’s rapidly rising share price.

Also, its hard driving culture was underpinned by incentive schemes which promised, and delivered, huge rewards in compensation packages to outstanding performers. The result was that, to achieve results, aggressive accounting policies were introduced from an early stage. In particular, the use of mark to market valuation on contracts produced artificially large earnings, disguising for some years underlying poor profitability in major parts of the business.

This, of course, meant that Enron was not generating adequate cashflow, while spending extravagantly on expansion, and eventually it blew up suddenly and dramatically. Colleagues of this author who met Lay and had dealings with Enron confirm that there was scepticism in the market about Enron’s profitability and its cash position. Suspicions grew that Enron’s earnings had been manipulated and in late summer 2001 it emerged that its Chief Finance Officer had privately made himself rich at Enron’s expense through the off-balance sheet vehicles. About this time the dotcom boom ended suddenly and for Enron, this coincided with the international power business going radically wrong, the broadband business having to be shut down, the water business collapsing and the electricity services business getting into serious trouble in California. Enron’s share price started to slide and Skilling, appointed Chief Executive Officer in January 2001, resigned in August.

Enron’s share price then rapidly declined, triggering repayment clauses in the financing vehicles which Enron couldn’t handle. Its credit rating went to junk status, which caused the share price to collapse and triggered further crystallising of debt obligations. Banks refused further finance, suppliers refused to supply and customers stopped buying.

At the beginning of December 2001, Enron filed for the biggest bankruptcy the USA had yet seen.

This, in turn, took down one of the largest accounting firms in the world, Arthur Andersen, which was deemed to have so compromised its professional standards in its dealings with its client Enron that it was in many ways complicit in Enron’s criminal behaviour.

Ethical assessment

Enron didn’t start out as an unethical business. As we have seen in this case study, what introduced the virus was the pursuit of personal wealth via very rapid growth. This led to the introduction of quite extreme incentive schemes to attract and motivate very bright and driven people, which, in turn, led to an unhealthy focus on short term earnings.

The next step was, naturally, to look at how earnings could be massaged to achieve the aggressive revenue and earnings targets. Since the massaged figures for growth in earnings still left a shortfall in cash, Enron quickly maxed out on its borrowing abilities.

But issuing more equity would have hurt the share price, on which most of the incentives were based. So schemes had to be created to produce funding secretly and this funding had to be hidden. In this way, an amoral and unethical culture developed in Enron in which customers, suppliers and even colleagues were misled and exploited to achieve targets. And the top management, who were rewarding themselves with these same incentive schemes, boasted that a pure, market-driven ethos was propelling Enron to greatness and deluded themselves that this equated to ethical behaviour. Lay even lectured the California authorities, whom Enron was cheating, that Enron was a model of business ethics.

Finally, the respected Arthur Andersen allowed greed for fees to over-rule the strong business ethics tradition of its founder and caused it to succumb to bending and suspending its professional standards, with fatal results.

Our five Rules of Good Corporate Governance start with the need for an ethical culture. Having established that Enron’s culture became progressively more deficient in this regard, let’s consider briefly the impact of this failure in business ethics on the other Rules.