CASE 1
ENRON: WHAT CAUSED THE ETHICAL COLLAPSE?
CASE SUMMARY
Kenneth Lay, former chairman and chief executive officer (CEO) of Enron Corp., claimed to be a moral and ethical leader and exhorted Enron’s officers and employees to be highly ethical in their decisions and actions. In addition, the Enron Code of Ethics specified 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 a direct consequence of his or her employment with the Company.” Enron’s ethics code was based on the values of respect, integrity, communication, and excellence. Given this code of conduct and Ken Lay’s professed commitment to business ethics, one wonders how Enron could have collapsed so dramatically? The answer to this question seems to be rooted in a combination of the failure of top leadership, a corporate culture that supported unethical behavior, and the complicity of the investment banking community.
The failure of Enron’s top leadership was evident in the activities of Andrew Fastow, Jeff
Skilling, and Ken Lay, all of whom faced multiple counts of criminal activity with respect to their decisions and actions at Enron. Included among these criminal charges were money laundering, wire fraud, securities fraud, conspiracy, making false statements on financial reports, and insider trading. Some of the activities that led to these criminal charges were: (a) concealing how extensively Enron was involved in trading in order to support a high market valuation of Enron’s stock; (b) setting up and operating related party transactions, called LJM partnerships, to do business with Enron; (c) exempting Fastow from the company’s ethics code regarding the private partnerships he set up; and (d) covering up the nature and extent of Enron’s problems through deceptive accounting practices and deliberate misinformation.
Enron has been described as having a culture of arrogance that led people to believe that they could handle increasingly greater risk without encountering any danger. “Enron’s unspoken message was, ‘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 chance, and you’ll get one.’ ” Enron’s culture of arrogance can be characterized by an emphasis on decentralization with inadequate financial and operational controls, a very rigorous and threatening employee performance evaluation process, and a compensation plan that encouraged people to inflate the value of contracts and to use non-standard accounting practices.
Such transactions were basically smoke and mirrors, reflecting a relationship between the partnerships and the banks wherein “Enron could practically pluck earnings out of thin air.”
A follow-up of Enron’s major officers speaks to the cover-up and false testimony they paid to their ethics code and announced values. A grand jury indicted Lay on July 7, 2004 on 11 counts of securities fraud and related charges. He was found guilty of 10 counts against him on May 25, 2006. A judge dismissed the last count since each count carried a 5 to 10 year maximum prison sentence. Had he not died of a heart attack on July 5, 2006, he could have served between 20 to 30 years in prison. Skilling is still serving a 24-plus year prison sentence, after he was convicted on 19 counts-- “one count of conspiracy to commit securities fraud and wire fraud, 12 counts of securities fraud, five counts of making false statements to accountants, and one count of insider trading.” Recently, it was questionable whether or not he would be temporarily released after his son’s suicide attempt. Fastow was sentenced on conspiracy to commit securities fraud and sentenced from 10 to 6 years after he testified against Ken Lay, Jeff Skilling, and others. His release date is scheduled on December 2011.
Enron, the company’s, aftermath also stands witness to the corruption of its officers,
“Enron Creditors Recovery Corp. is a shell of the former Enron Corp. (once the world's #1 energy trader) and is shelling out the remaining assets of the bankrupt Enron to creditors. Once the largest buyer and seller of natural gas and electricity in the US, Enron also traded numerous other commodities. Following its collapse Enron was forced to sell all of its North American power utility and gas pipeline assets, as well as its global interests in utilities and power plants. Between 2004 and the end of 2010 Enron Creditors Recovery Corp. paid out more than $21.6 billion to Enron's creditors, including $40 million in November, 2010.”
QUESTIONS FOR DISCUSSION
1. What led to the eventual collapse of Enron under Lay and Skilling?
Answer:
affairs “in accordance with all applicable laws and in a moral and honest manner.” Enron’s ethics code was based on the values of respect, integrity, communication, and excellence. The code specified 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 a direct consequence of his or her employment with the Company.” So much for ethics codes with leaders who do not ‘walk the talk.’ Answers to the following questions add to the response given here.
Lay and skilling also created a corrupt elite coalition among themselves, Fastow, and several of the traders in the company. The now classic film , “Enron: The Smartest Guys in the Room” reveals the inside workings of this courrupt subculture that became the dominant engine that drove the company into bankruptcy—without the lower level employees ever knowing. Do values count? Yes, in Enron’s case, the dominant coalition’s values were greed, flamboyance, waste, and win-at-any-cost.
2. How did the top leadership at Enron undermine the foundational values of the Enron Code of Ethics?
Answer:
Key players among the top leadership were Andrew Fastow, Jeff Skilling, and Ken Lay. Each of these individuals contributed to undermining Enron’s foundational values; their activities raise crucial questions about how closely they adhered to the values of respect, integrity, communication, and excellence.
Skilling, for example, did not take the obligation to communicate very seriously when he accused an investigative reporter of unethical behavior because she asked him to clarify Enron’s “nearly incomprehensible financial statements” and he refused to do so. A subsequent effort to have three key executives meet with the reporter to answer her questions “completely and accurately” turned out to be more deception than clarification.
The decentralized nature of Enron also created communications barriers and prevented all but a few people in the organization from seeing the “big picture.” The
communication value was also undermined when Fastow tried to conceal how
extensively Enron was involved in trading in order to maintain the high market valuation that was essential to keeping Enron from collapsing. Lay’s assertion that he lacked any knowledge of what was happening is another action that brings into question the commitment of Enron’s leadership to the communication value.
Enron’s commitment to excellence was perverted through the “rank and yank” performance appraisal system and the compensation system that enriched executives, encouraged people to inflate the value of contracts, and promoted use of non-standard accounting practices. Both the performance appraisal system and the compensation system were creations of Enron’s top leadership.
3. In retrospect: given Kenneth Lay’s and Jeff Skilling’s operating beliefs and the Enron Code of Ethics, what expectations regarding ethical decision and actions should Enron’s employees reasonably have had?
Answer:
The employees were kept ‘in the dark’ on the misguided and corrupt strategic and operational dealings of Lay, Skilling, and Fastow. Sherron Watkins (the whistle blower who helped reveal Enron’s illegal activities) warned Lay several times but to no avail. In an August 2001 interview it was noted that, “Sherron Watkins, an Enron vice president, had sent an anonymous memo to Lay that read, ‘I am incredibly nervous that we will implode in a wave of accounting scandals.’Of course, that's exactly what happened. After the company's demise, the investigating U.S. Congress discovered Watkins' memos to Lay and other top executives. (After sending the memos, she had met with Lay with no results)” (Carozza, 2007).
With regard to lower level employees, what could they have reasonably expected regarding Enron’s code about ethical decisions and actions? In hindsight, Enron was continually winning Fortune Magazine’s best-in-class awards, Arthur Andersen (Enron’s auditors) saw no problems year after year with Enron’s accounting procedures, the SEC (Security Exchange Council)—Enron’s regulator—had no problem with Enron’s business practice, so why would lower level employees question the company that was adding to their wealth before the crash? Watkins stated in 2001, “Enron was primarily a financial trading house. A financial trading house lives on its investment grade rating and its reputation. Any hint of trouble and business disappears like water through a sieve. When I met with Ken Lay, I was both optimistic and naive. I not only expected that a thorough investigation would occur but I also expected Enron to establish a crisis management team to address the financial peril Enron would face when the accounting was exposed, which in my opinion was sure to happen. In the long run, companies rarely get away with ‘cooking the books.’ But no other top executives came forward to back me up and Ken Lay gravitated toward good news and didn't quite accept what I was saying. (Carozza, 2007).
4. How did Enron’s corporate culture promote unethical decisions and actions?
Answer:
The succinct and unequivocal answer to this question is that Enron’s corporate culture did little to promote the values of respect and integrity that were articulated in the Enron Code of Ethics. These values were undermined through the company’s emphasis on decentralization, its employee performance appraisals, and its compensation program. By keeping each Enron division and business unit separate from the others, very few people had a holistic perspective of the company’s operations. This decentralization, in
evaluation process utilized peer evaluations wherein employees frequently ranked their peers lower in order to enhance their own positions in the company. Enron’s
compensation plan “seemed oriented toward enriching executives rather than generating profits for shareholders,” and encouraged people to inflate the value of contracts and to use non-standard accounting practices. The performance appraisal system and the compensation systems helped define and reinforce a culture that was rife with the potential for unethical decisions and actions. In short, Enron’s culture encouraged and reinforced unethical decisions and actions. As revealed by whistleblower Sherron Watkins, “Enron’s unspoken message was, ‘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 chance, and you’ll get one.’ ”
5. How did the investment banking community contribute to the ethical collapse of Enron?
Answer:
Investment banks were not found legally liable in actively contributing to the Enron scandal. “In what may have been the final blow to plaintiffs’ attempt to hold several investment banks liable for their involvement in the Enron scandal, the United States District Court for the Southern District of Texas granted summary judgment in favor of the investment banks after several years of litigation. In re Enron Corp. Sec., Derivative & “ERISA” Litig., No. H-01-3624, 2009 WL 565512 (S.D. Tex. Mar. 5, 2009),” (David O'Neal (2009). “No Liability under Stoneridge for Investment Banks That Did Business with Enron.” Securities Litigation Blog, http://securities.litigation.alston.com/blog.aspx? entry=2004 May 5, 2009, accessed March, 2011). However, the debate continues with regard to whether or not J.P. Morgan and Citibank, in particular, violated their ethical responsibilities to shareholders and the public in continuing to loan Enron funds while the company lied and defrauded all who were involved during the scandal. An Economist article described the role of these banks this way, “Might J.P. Morgan and Citi have let their lending standards slip in order to win investment-banking business from Enron, allowing the company to become over-leveraged? Did being both a creditor of Enron and an adviser create acute conflicts of interest as the company approached bankruptcy? As creditors, the banks may have had an interest in preserving whatever value Enron had left to maximise their chance of being repaid. As advisers, they may have had reason to promote riskier strategies in a bid to keep Enron alive and stop its shareholders being wiped out. An article in the Economist stated the issue this way, “Both banks vehemently deny lowering lending standards to win investment-banking business. J.P. Morgan had lent to Enron for many years. The banks also deny that they took advantage of their advisory role by getting Enron to pay off unsecured loans to the company with money raised during a secured refinancing late last year.”( “Commercial banks after
Enron,Conflicts, conflicts everywhere” (2002). The Economist. http://www.economist.com/node/954024 Accessed March, 2011.)
6. and 7. If the Sarbanes-Oxley law had been in effect, do you believe the Enron debacle would have occurred? Explain. 7. Could another Enron occur now? Why or why not? Explain.
Unfortunately, it seems that the answer to these two questions is “Yes.” As stated in the response to the previous question, the subprime lending crisis that continues to negatively affect the national and global economies recently occurred and involved many more financial institutions and companies, including banks. The problem appears to be multifaceted: (1) the deregulation of the financial industry, including banks and a lack of federal laws, some of which have been repealed, to regulate this industry; (2) a lack of enforcement of laws like Sarbanes-Oxley; (3) a lack of ethical leadership of CEOs and boards of directors to safeguard their corporations from scandals such as Enron and the subprime lending crisis; and (4) Congress members receiving large campaign
contributions from companies and industry lobbies to “water down” and even repeal regulations and laws that would prevent such scandals as Enron and the subprime lending crisis. For example, corporations and their lobbies help passed The Reform Act of 1995, which was called the ‘Securities Rip-off Act.’ This Act offered substantial loopholes and decreased the power of the Securities & Exchange Commission to act as a watchdog over brokerage and financial firms (Moore, Hank, 2011. “The Big Picture of Business – Business Lessons to be Learned from the Enron Scandal.”
http://www.strategydriven.com/2011/03/11/the-big-picture-of-business-business-lessons-to-be-learned-from-the-enron-scandal/ Accessed March, 2011).
Sources: Carozza, D. (2007). Interview with Sherron Watkins, Constant Warning. Fraud Magazine. http://www.fraud-magazine.com/article.aspx?id=583 Accessed April, 2011.
Mulligan, T. and Bustillo, M. (July 6, 2006). "Death Puts Lay Conviction in Doubt". Los Angeles Times. http://www.latimes.com/news/printedition/front/la-fi-lay6jul06,1,4669506.story?coll=la-headlines-frontpage; CNNMoney.com. Corporate convicts: Where are they now? Andrew Fastow. (2009, June 25). http://money.cnn.com/galleries/2008/fortune/0805/gallery.convicts.fortune/4.html; Yahoo! Finance (2011, March 8). Enron Creditors Recovery Corp. Company Profile. http://biz.yahoo.com/ic/10/10521.html, March 8.
Rufca, S. (2010, Mar.1). Update: Supreme Court hears former Enron CEO Skilling's arguments. http://culturemap.com/newsdetail/03-01-10-supreme-court-hears-enron-exec-arguments/. Kristen, C. (2004, Jul. 7). "Lay surrenders to authorities". CNN Money.
http://money.cnn.com/2004/07/08/news/newsmakers/lay/.
Pasha, S. and J. Seid (2006, May 25). "Lay and Skilling's day of reckoning". CNN Money.
