unethical leadership at enron case study

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Enron’s Ethical Collapse: Lessons for Leadership Educators

Craig Johnson 10.12806/V2/I1/C2

Craig Johnson Professor of Communication Arts Department of Communication

George Fox University 414 Meridian St.

Newberg, OR 97132

(503) 554-2610

[email protected]

Top officials at Enron abused their power and privileges, manipulated information, engaged in inconsistent treatment of internal and external constituencies, put their own interests above those of their employees and the public, and failed to exercise proper oversight or shoulder responsibility for ethical failings. Followers were all too quick to follow their example. Therefore, implications for teaching leadership ethics include, educators must: (a) share some of the blame for what happened at Enron, (b) integrate ethics into the rest of the curriculum, (c) highlight the responsibilities of both leaders and followers, (d) address both individual and contextual variables that encourage corruption, (e) recognize the importance of trust and credibility in the leader-follower relationship, and (f) hold followers as well as leaders accountable for ethical misdeeds.

Introduction

Enron’s bankruptcy filing in November 2001 marked the beginning of an unprecedented wave of corporate scandals. Officials at Tyco, WorldCom, ImClone, Global Crossing, Adelphia, AOL Time Warner, Quest, and Charter Communications joined Enron executives as targets of SEC probes, congressional hearings, stockholder lawsuits, and criminal indictments. Enron’s troubles, which had been center stage, were soon pushed to the background by subsequent revelations of corporate wrongdoing.

More recent instances of corporate corruption should not diminish the importance of Enron as a case study in moral failure. Enron collapsed in large part because of the unethical practices of its executives. Examining the ethical shortcomings of Enron’s leaders, as well as the factors that contributed to their misbehaviors, can provide important insights into how to address the topic of ethics in the leadership classroom.

Moral Failure at the Top

Events leading up to Enron’s bankruptcy have been chronicled in a host of magazine articles as well as in such books as Anatomy of Greed (Cruver, 2002), Enron: The Rise and Fall (Fox, 2003), What Went Wrong at Enron (Fusaro & Miller, 2002), The Enron Collapse (Barresveld, 2002), and Pipe Dreams (Bryce, 2002). The company’s collapse was ultimately triggered by failed investments in overseas ventures and the unraveling of a series of dubious limited partnerships called Special Purpose Entities (SPEs). These SPEs , backed by Enron stock and illegally run by company insiders, were designed to keep debt off the firm’s balance sheets and helped prop up its share price. However, when the firm’s stock price began to slide, the company was unable to back its guarantees. In addition to charges related to shady partnerships, Enron stands accused of:

• borrowing from subsidiaries with no intent to repay the loans (Wilke, 2002, August 5).
• avoiding federal taxes even though some of its subsidiaries, like Portland General Electric, collected tax payments from customers (Manning & Hill, 2002).
• contributing to the California energy crisis by manipulating electricity prices (Fusaro & Miller, 2002; Manning, 2002).
• bribing foreign officials to secure contracts in India, Ghana and other countries (Wilke, 2002, August 7).
• immediately claiming profits for long term projects that would eventually lose money (Hill, Chaffin, & Fidler, 2002).
• switching account balances immediately before quarterly reports to boost apparent earnings (Cruver, 2002).
• manipulating federal energy policy (Duffy, 2002; Duffy & Dickerson, 2002).

Much of the blame for what happened at Enron (nicknamed the “Crooked E” for its tilted Capital E logo) can be laid at the feet of company founder Kenneth Lay, his successor Jeffrey Skilling, chief financial officer Andrew Fastow, and Fastow’s top assistant Michael Kopper. Each failed to meet important ethical challenges or dilemmas of leadership (Johnson, 2001). Their failures included:

Abuse of Power

Both Lay and Skilling could wield power ruthlessly. The position of vice-chair was known 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. Abdication of power was also a problem at Enron. At times, managers did not appear to understand what employees were doing or how the business (which was literally creating new markets) operated. Board members also failed to exercise proper oversight and rarely challenged management

decisions. Many were selected by CEO Kenneth Lay and did business with the firm or represented non-profits that received large contributions from Enron (Associated Press, 2002; Cruver, 2002).

Excess Privilege

Excess typified top management at Enron. Lay, who began life modestly as the son of a Baptist preacher turned chicken salesman, once told a friend, “I don’t want to be rich, I want to be world-class rich” (Cruver, 2002, p. 23). At another point he joked that he had given wife Linda a $2 million decorating budget for a new home in Houston which she promptly exceeded (Gruley & Smith, 2002). The couple borrowed $75 million from the firm that they repaid in stock. Linda Lay fanned the flames of resentment among employees when she broke into tears on the Today Show to claim that the family was broke. This was despite the fact that the Lays owned over 20 properties worth over $30 million (Eisenberg, 2002).

During Enron’s heyday, some of the perks filtered down to followers as well. Workers enjoyed such benefits as lavish Christmas parties, aerobic classes, free taxi rides, refreshments, and the services of a concierge ( Enron excess , 2002; How Enron let down its employees , 2002).

Enron officials manipulated information to protect their interests and to deceive the public, although the extent of their deception is still to be determined. Both executives and board members claim that they were unaware of the extent of the company’s off-the-books partnerships created and operated by Fastow and Kopper (Eisenberg, 2002). However, both Skilling and Lay were warned that the company’s accounting tactics were suspect (Duffy, 2002). The Senate Permanent Subcommittee on Investigations, which investigated the company’s downfall, concluded, “Much that was wrong with Enron was known to the board” (Associated Press, 2002). Board members specifically waived the conflict of interest clause in the company’s code of ethics that would have prevented the formation of the most troublesome special partnerships (Cruver, 2002).

Employees were quick to follow the lead of top company officials. They hid expenses, claimed nonexistent profits, deceived energy regulators and so on.

Inconsistent Treatment of Internal and External Constituencies

Enron’s relationships with both employees and outsiders were marked by gross inconsistencies. Average workers were forced to vest their retirement plans in Enron stock and then, during the crucial period when the stock was in free fall, were blocked from selling their shares. Top executives, on the other hand, were able to unload their shares as they wished. Five-hundred officials received “retention bonuses” totaling $55 million at the same time laid off workers received only a fraction of the severance pay they had been promised (Barreveld, 2002).

Enron treated its friends royally. In particular, the company used political donations to gain preferential treatment from government agencies. Kenneth Lay was the top contributor to the Bush campaign and officials made significant donations to both Democratic and Republican members of the House and Senate. In return, the company was able to nominate friendly candidates for the Security Exchange Commission (SEC) and the Federal Energy Regulatory Commission (FERC). Federal officials intervened with foreign governments to promote Enron projects, and company representatives played a major role in setting federal energy policy that favored deregulation of additional energy markets (Fox, 2003). Anyone perceived as unfriendly to Enron’s interests could expect retribution, however. In one instance, Lay withdrew an underwriting deal to pressure Merrill Lynch into firing an analyst who had downgraded Enron stock (Smith & Raghaven, 2002). Skilling called one analyst an “asshole” when he questioned the company’s performance during a conference call (Cruver, 2002).

Misplaced and Broken Loyalties

Enron officials put their loyalty to themselves above those of everyone else with a stake in the company’s fate — stock holders, business partners, rate payers, local communities, foreign governments, and so on. They also betrayed the trust of those who worked for them. Employees apparently believed in the company and in Lay’s optimistic pronouncements. In August 2001, for example, he declared “I have never felt better about the prospects for the company” (Cruver, 2003, p. 91). In late September, just weeks before the company collapsed, he encouraged employees to “talk up the stock” because “the company is fundamentally sound” (Fox, 2003, p. 252). These exhortations came even as he was unloading his own shares. The sense of betrayal experienced by Enron employees only added to the pain of losing their jobs and retirement savings.

Irresponsible Behavior

Enron officials acted irresponsibly by failing to take needed action, failing to exercise proper oversight, and failing to shoulder responsibility for the ethical miscues of their organization. CEO Lay downplayed warnings of financial improprieties and some board members did not understand the numbers or the company’s operations. Too often company managers left employees to their own devices, encouraging them to make their numbers by any means possible. After the collapse, no one stepped forward to accept blame for what happened. Lay and Fastow claimed Fifth Amendment privileges against self-incrimination when called before congressional committees; Skilling testified but claimed he had no knowledge of illegal activity.

The unethical behavior of Enron’s leaders appears to be the product of both individual and situational factors. Greed was the primary motivator of both managers and their subordinates at Enron (Cruver, 2002). Optimistic earnings

reports, hidden losses and other tactics were all designed to keep the stock price artificially high. Lofty stock values justified generous salaries and perks, deflected unwanted scrutiny, and allowed insiders to profit from their stock options. Greed was not limited to top Enron executives, however. Meeting earnings targets triggered large bonuses for managers throughout the firm, bonuses that were sometimes larger than employees’ salaries. Rising stock prices and extravagant rewards made it easier for followers as well as leaders to overlook shortcomings in the company’s ethics and business model.

Hubris was also a major character flaw at the Crooked E, a fact reflected in the company banner that declared: FROM THE WORLD’S LEADING ENERGY COMPANY — TO THE WORLD’S LEADING COMPANY (Cruver, 2002, p.

3). Skilling, who lacked the social and communication skills of Ken Lay, best exemplifies the haughty spirit of many Enron officials. At the height of the California energy crisis he joked that the only difference between the Titanic and the state of California was that “when the Titanic went down, the lights were on” (Fusaro & Miller, 2002. p. 122).

Even the so-called “heroes” of the Enron debacle failed to demonstrate enough virtue to delay or to prevent the company’s collapse. Former company treasurer Clifford Baxter complained about Fastow’s financial wheeling and dealing, but then retired without going public with his complaints. Vice-president of corporate development Sherry Watkins outlined her concerns about the firm’s questionable financial practices in a letter and in a meeting with Lay ( A Hero , 2002). Later she discussed the same issues with an audit partner at Anderson. While these are commendable acts, in her letter she recommended quiet clean up of the problems rather than public disclosure. She stopped short of talking to the press, the SEC and other outside agencies when her attempts at internal reform failed (Zellner, 2002).

The destructive power of individual greed and pride was magnified by Enron’s corporate culture that encouraged creativity and risk taking. Employees invented a host of new commodity products which earned Enron top ranking six straight years on Fortune magazine’s list of most innovative companies (Fusaro & Miller, 2002). Ken Lay was fond of telling the story of how Enron employees in London started its on-line trading business (which later carried a quarter of the world’s energy trades) without the blessing or knowledge of corporate headquarters in Houston (Stewart, 2001). The cost of freedom, however, was pressure to produce that created a climate of fear. Enron’s atmosphere was similar to that of an elite law firm where talented young associates scramble to make partner (Fusaro & Miller, 2002).

Adding to the stress was the organization’s “rank and yank” evaluation system. Every six months 15% of all employees were ranked in the lowest category and then had a few weeks to find another position in the company or be let go (Cruver, 2002). Workers in the next two higher categories were put on notice that

they were in danger of falling into the lowest quadrant during the subsequent review. This system (a harsher variant of one used at many companies) encouraged cutthroat competition and silenced dissent. Followers were afraid to question unethical and or illegal practices for fear of losing their jobs. Instead, they were rewarded for their unthinking loyalty to their managers (who ranked their performance) and the company as a whole (Fusaro & Miller, 2002).

Lack of controls, combined with an intense, competitive, results-driven culture made it easier to ignore the company’s code of ethics which specifically prohibited conflicts of interest like those found in the SPEs and to seek results at any cost (Hill, Chaffin, & Fidler, 2002). Anderson auditors signed off on its questionable financial transactions for fear of losing lucrative auditing and consulting contracts with Enron.

Enron was also a victim of larger social and cultural factors. Publicly traded firms in the United States are judged by their quarterly earnings reports. Obsession with short-term results encourages executives to do whatever they can to meet these expectations. Enron’s explosive growth took place during the economic boom of the 90s. All the major stock indices soared and billions were wasted on Internet start-ups that never had a realistic chance to make a profit. During this period the Cult of the CEO emerged. Business leaders achieved rock star status, gracing the covers of national magazines and best selling biographies (Elliott & Schroth, 2002, p. 125). In this heady climate, government regulators and investors felt little need to study the operations or finances of apparently successful companies led by business superstars. The recent spate of corporate scandals and the accompanying market crash may be the penalty that society must pay for the excesses and inattention of the last decade.

Implications for Leadership Educators

The lessons of Enron extend beyond the accounting and market reforms instituted in the wake of the scandal. Leadership educators can gain important insights about how to treat the topic of ethics in the classroom from the moral shortcomings of Enron’s top executives. The pedagogical implications of Enron include:

Educators Must Share Some of the Blame

Academics find it easy to distance themselves from the sins of Enron. The college and university classroom seems a world away from the high flying, gun slinging mentality of the former energy giant. Few professors can begin to comprehend the level of privilege and influence enjoyed by the company’s C level executives.

Those who study and teach ethics believe that they would exhibit the virtues that Lay, Skilling, and Fastow seemed to lack.

Disassociating oneself from Enron may be comforting, but this maneuver conveniently overlooks the fact educators must shoulder at least some of the blame for the company’s moral failure (Kavanaugh, 2002). As college graduates, Enron managers undoubtedly enrolled in leadership and ethics courses. Many were also products of Harvard and other top MBA programs. Followers armed with bachelor and masters degrees served as willing soldiers in the army of public relations experts who helped the company maintain its veneer of profitability, lobby government official, and attack its critics. What Enron’s top leaders, lower level managers, and front line employees learned in university classrooms was not enough to prevent ethical tragedy.

Strive for Ethical Integration

Enron is a classic example of a company whose ethical pronouncements were “decoupled” from the rest of its operations (Weaver, Trevino, & Cochran 1999). The key values of the company were respect, integrity, communications, and excellence. Enron also had an extensive code of ethics. Unfortunately, these values and policies had little impact on how Lay, Skilling, and their underlings did business. By the time of its collapse in 2001, the company had been manipulating its books and misleading investors for several years.

Unfortunately, the teaching of ethics, like the practice of ethics at Enron, is typically decoupled from the rest of the curriculum. Discussions of ethics often stand alone, limited to a single unit or to one course in the entire leadership curriculum. Further, the placement of ethical material also diminishes its importance. Ethics units and text chapters sometimes appear to be an afterthought, introduced at the end of a course or book and therefore likely to be eliminated if the professor falls behind during the quarter or semester. To be effective, ethical considerations should be part of every unit, class, and set of readings.

Highlight Leadership and Followership Duties and Responsibilities

Many students study leadership in hopes of achieving the kind of heroic stature that, until recently, they saw reflected in press reports about famous business figures and other prominent leaders. Power, perks, financial security, and recognition all seem to come with an executive title. Instructors cater to this motivation when they act as cheerleaders for prominent business leaders like Jack Welch or Kenneth Lay. They overlook the fact that the same qualities and strategies so often praised in business and other leadership literature can lead to disaster. Enron is a case in point. The company’s leaders did many things right according to the leadership and management literature. Lay and his colleagues had a clear vision and values, pursued excellence, and fostered an extraordinary degree of creativity and innovation. Sadly, their vision was unrealistic, their stated values took back seat to unstated ones (e. g., make the deal at whatever the cost and generate constant profits and growth), and their drive for innovation led them into a host of unprofitable markets that even their management team did not

completely understand. Followers also lost sight of their personal values as well as their commitment to society.

Altruism is a universal value that is particularly important to leaders who, by virtue of their roles, are to exercise influence on behalf of others. Leaders cannot articulate the concerns of followers unless they first understand their needs (Kanungo & Mendoca, 1996). Leaders driven by altruism pursue organizational goals rather than personal achievement and are more likely to give power away. Leaders seeking self-benefit focus on personal achievements, and control followers through coercion and reward.

Communitarianism emphasizes the need for individual and corporate responsibility (Etzioni, 1993). Citizens and institutions have obligations to the larger community. When making decisions, leaders and followers must look beyond the immediate interests of themselves and their organizations to the needs of the local community and society as a whole.

Servant leadership is a model that puts the needs of followers first (Greenleaf, 1977; Spears, 1998). Servant leaders continually ask themselves what would be best for their constituents and measure their success by the progress of their followers. Driven by a concern for people, they seek to treat others fairly and recognize that they hold their positions in stewardship for others.

Address Both Individual and Contextual Variables

Training can help individuals develop sensitivity to moral issues and improve ethical reasoning skills (Rest, 1993). To prevent future Enrons, faculty must help current and future leaders and followers equip themselves with the values, principles, and skills they need to make reasoned moral choices. Nonetheless, an individual focus does not address organizational forces – group culture, high forced turnover, reward system – that played a significant role in Enron’s moral failures. In addition, society’s fixation on short term profits and daily market moves also increased the pressure to manipulate results and to hide financial bad news.

• What organizational controls should be put on innovation?
• How can employees be rewarded in a way that promotes ethical behavior?
• What are the dysfunctional consequences of the rank and yank evaluation system?
• What are reasonable limits on executive compensation?
• What is a corporate board’s role in overseeing the operations of an organization?
• What should be the composition of a board’s membership?
• How should the performance of companies be judged?
• How can society develop a long-term perspective on financial results?

Recognize the Importance of Credibility

Since Aristotle, scholars have examined the factors that make a source believable to an audience, an interest based on the strong correlation between credibility and influence (Hackman & Johnson, 2001, chap. 6). The Enron debacle and subsequent scandals demonstrate that credibility, specifically trustworthiness, is more important than ever. Stock values declined nearly 40% from market highs in July1998 due largely to investors’ loss of confidence in the integrity of publicly held corporations. Employees are increasingly skeptical as well. A 2002 survey by the Ethics Resource Center found that 43% of respondents believed that their bosses fail to model integrity and felt pressure to compromise their own ethical standards at work (Wee, 2002). Modern technology, which enables the rapid, worldwide dissemination of information, makes credibility more important now than in the time of Plato and Aristotle. Leadership faculty need to help students consider not only how credibility is built and maintained, but also how trust is destroyed and at what cost to individuals and organizations.

Followers are Also Accountable

Lay, Skilling, Fastow and other high level executives deserve most of the blame for what went wrong at Enron. It was they who created the company’s culture, approved dubious partnerships, attacked critics, and, in the end, abandoned employees while enriching themselves. Nevertheless, followers, ranging from second tier officials down to receptionists and mailroom clerks, share some of the blame. Many willingly bought into the get rich quick mentality of the Crooked E. During the company’s 15 years of rapid growth, few stopped to question the company’s tactics. They were “bought off” by the generous perks and the thrill of being part of one of the most sophisticated and innovative companies in the world. The constant threat of termination undoubtedly convinced others to keep their doubts to themselves and to support their bosses.

According to Chaleff (1995), courage – the willingness to accept a higher level of risk – is the most important virtue for organizational followers. Such courage was sorely lacking at Enron. Few had the courage to challenge authority. Few had the courage to leave when faced with ethical violations. Apparently no member of the firm had the courage to bring the misbehavior of Lay and his subordinates to the attention of the public before the crisis erupted (Cruver, 2002).

Unfortunately, cowardice is not limited to Enron. Nearly two-thirds of those who witness ethical violations in their companies refuse to report them, believing that reporting problems would not do any good ( Chief Executive , 2002). The final lesson of Enron, then, is that both instructors and students have the responsibility to confront moral failure whenever and wherever it appears, regardless of whether they function in a leadership or in a followership role.

In summary, top officials at Enron abused their power and privileges. They manipulated information while engaging in inconsistent treatment of internal and external constituencies. These leaders put their own interests above those of their employees and the public, and failed to exercise proper oversight or shoulder responsibility for ethical failings. Sadly, the followers were all too quick to follow their example.

Numerous implications for teaching leadership ethics can be gleaned from the Eron situation. Educators must share some of the blame for what happened at Enron. It is important to integrate ethics into the rest of the curriculum.

Leadership educators need to highlight the responsibilities of both leaders and followers along with addressing both individual and contextual variables that encourage corruption. The importance of trust and credibility in the leader- follower relationship must be recognized. And, finally, educators must hold followers as well as leaders accountable for ethical misdeeds.

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• Contributors

Twenty Years Later: The Lasting Lessons of Enron

Michael Peregrine  is partner at McDermott Will & Emery LLP, and  Charles Elson  is professor of corporate governance at the University of Delaware Alfred Lerner College of Business and Economics.

This spring marks the 20th anniversary of the beginning of the dramatic and cataclysmic demise of Enron Corp. A scandal of exceptional scope and impact, it was (at the time) the largest bankruptcy in American history. The alleged business practices of its executives led to numerous individual criminal convictions. It was also a principal impetus for the enactment of the Sarbanes-Oxley Act and the evolution of the concept of corporate responsibility. As such, it is one of the most consequential corporate governance developments in history.

Yet a new generation of corporate leaders has assumed their positions since then; for others, their recollection of the colossal scandal may have faded with the years. And a general awareness of corporate responsibility principles is no substitute for familiarity with the governance failings that reenergized, in a lasting manner, the focus on effective and responsible governance. A basic appreciation of the Enron debacle and its governance implications is essential to director engagement.

Enron was formed as a natural gas pipeline company and ultimately transformed itself, through diversification, into a trading enterprise engaged in various forms of highly complex transactions. Among these were a series of unconventional and complicated related-party transactions (remember the strangely named Raptor, Jedi and Chewco ventures) in which members of Enron’s financial leadership held lucrative financial interests. Notably, the management team was experienced, and both its board and its audit committee were composed of a diverse group of seasoned, skilled, and prominent individuals.

The company’s rapid financial growth crested in March 2001, with media reports questioning how it could maintain its high stock value (trading at 55 times its earnings). Famous among these was the Fortune article by Bethany McLean, and its identification of potential financial reporting problems at Enron. [1] In a dizzying series of events over the next few months, the company’s stock price collapsed, its CEO resigned, a bailout merger failed, its credit was downgraded, the SEC began an investigation of its dealings with related parties, and it ultimately declared bankruptcy. Multiple regulatory investigations followed, several criminal convictions were obtained and Sarbanes-Oxley was ultimately enacted to curb the perceived abuses arising from Enron and several similar accounting scandals. [2]

There remain multiple important, stand-alone governance lessons from Enron controversy of which all directors would benefit:

1. The Smartest Guys in the Room . The type of aggressive executive conduct that contributed heavily to the fall of Enron was not unique to the company, the industry or the times. In the absence of an embedded culture of corporate ethics and compliance, there is always the potential for some executives to pursue “edge of the envelope” business practices, especially when those practices produce meaningful near term financial or other operational results. That attitude, combined with weak board oversight practices, can be a disastrous combination for a company.

Even though commerce has made great progress since then on internal controls, corporate responsibility ultimately depends upon the integrity of management, and the skill and persistence of board oversight. [3]

2. The Critical Importance of Board Oversight . As the company began to implode, Enron’s board commissioned a special committee to investigate the implicated transactions, directed by William C. Powers Jr., then dean of the University of Texas School of Law. The Powers Report, as it came to be known, outlined in staggering detail a litany of board oversight failures that contributed to the company’s collapse. [4]

These included inadequate and poorly implemented internal controls; the failure to exercise sufficient vigilance; an additional failure to respond adequately when issues arose that required a prompt and serious response; cursory review of critical matters by the audit and compliance committee; the failure to insist on a proper information flow; and an inability to fully appreciate the significance of some of the information with which the board was provided. [5]

3. Spotting Red Flags . Amongst the most damaging of the governance breakdowns was the failure to question the legitimacy of the related-party transactions for which so many internal controls were required. These deficiencies served to bring a once significant company and its officers to their collective knees and offer many lasting governance lessons. As the Powers Report concluded with brutal clarity, a major portion of the company’s business plan—related-party transactions—was flawed. [6]

These transactions were replete with risky conflicts of interest involving management. There was a significant “forest for the trees” concern—an inability to recognize that conflicts of such magnitude that required so many board-approved internal controls and procedures should never have been authorized in the first place. All this, despite the fact that the individual Enron directors were people of accomplishment and capability who had been recognized by the media as a well-functioning board. [7]

Yet, they lacked the actual necessary independence to recognize the red flags waving before them. Their varied relationships with company leadership made them all-too-comfortable with what they were being told about the company. [8] This connection made it difficult for them to recognize the dangers associated with the warning signals that the conflicted transactions projected. Indeed it was the revelation of these conflicts that attracted media attention and ultimately “brought the house down”. [9]

4. It Can Still Happen . The 2020 scandal encompassing the German financial services company Wirecard offers one of the latest high profile (international) examples of how alleged aggressive business practices, lax internal and auditor oversight, accounting irregularities and limited regulatory supervision can combine into a spectacular corporate collapse that prompted numerous government fraud investigations. It is for no small reason that the Wirecard scandal is referred to as the “German Enron”. [10]

5. A Significant Legacy . Yet the Enron controversy remains fundamentally relevant as the spark behind the corporate responsibility environment that has reshaped attitudes about corporate governance for the last 20 years. It’s where it all began—the seismic recalibration of corporate direction from the executive suite back to the boardroom, where it belongs. It birthed the fiduciary guidelines, principles, and “best practices” that serve as the corridors of modern corporate governance, developed in direct response to the types of conduct so criticized in the Powers Report. [11]

And that’s important for today’s board members to know. [12] Because over the years, the message may have lost its sizzle. The once-key oversight themes incorporated within “plain old” corporate responsibility seem to be yielding the boardroom field to the more politically popular themes of corporate social responsibility. And, while still important, corporate compliance seems to have had its “fifteen years of fame” in the minds of some executives; the organizational initiative has turned elsewhere.

But the pendulum may be swinging back. There is a renewed recognition that compliance programs can atrophy from lack of support. The new regulatory administration in Washington may return to an emphasis on organizational accountability. As Delaware decisions suggest, shareholders may be growing increasingly intolerant of costly corporate compliance and accounting lapses. And there’s a renewed emphasis on the role of the whistleblower, and the board’s role in assuring the support and protection of that role.

So it may be useful on this auspicious anniversary to engage the board on the Enron experience, in a couple of different ways. First, include an overview as part of formal director “onboarding” efforts. Second, have a board level conversation about expectations of oversight, and spotting operational and ethical warning signs. And third, reconsider the Enron board’s critical and self-admitted failures, in the context of today’s boardroom culture. [13]

Such a conversation would be a powerful demonstration of a board’s good-faith commitment to effective governance, corporate responsibility and leadership ethics.

1 Bethany McLean, “Is Enron Overpriced?” Fortune, March 5. 2001. https://archive.fortune.com/magazines/fortune/fortune_archive/2001/03/05/297833/index.htm. (go back)

2 See , Michael W. Peregrine, Corporate BoardMember , Second Quarter 2016 (henceforth “Corporate BoardMember”). (go back)

3 See , e.g., Elson and Gyves, In Re Caremark : Good Intentions, Unintended Consequences, 39 Wake Forest Law Review, 691 (2004). (go back)

4 Report of the Special Investigation Committee of the Board of Directors of Enron Corporation, February 1, 2002. http://i.cnn.net/cnn/2002/LAW/02/02/enron.report/powers.report.pdf. (go back)

5 See , Michael W. Peregrine, “The Corporate Governance Legacy of the Powers Report” Corporate Counsel , January 23, 2012 Monday. (go back)

6 See , Michael W. Peregrine, “Enron Still Matters, 15 Years After Its Collapse”, The New York Times , December 1, 2016. (go back)

7 F.N. 5, supra . (go back)

8 See , Elson and Gyves, “The Enron Failure and Corporate Governance Reform”, 38 Wake Forest Law Review 855 (2003) and Elson, “Enron and the Necessity of the Objective Proximate Monitor”, 89 Cornell Law Review 496 (2004). (go back)

9 John Emshwiller and Rebecca Smith, “Enron Posts Surprise 3rd-Quarter Loss After Investment, Asset Write-Downs”, The Wall Street Journal , October 17, 2001. https://www.wsj.com/articles/SB1003237924744857040. (go back)

10 Dylan Tokar and Paul J. Davies, “Wirecard Red Flags Should Have Prompted Earlier Response, Former Executive Says” The Wall Street Journal , February 8, 2021. https://www.wsj.com/articles/wirecard-red-flags-should-have-prompted-earlier-response-former-execu tive-says-11612780200. (go back)

11 Corporate BoardMember , supra . (go back)

12 See Peregrine, “Why Enron Remains Relevant”, Harvard Law School Forum on Corporate Governance, December 2, 2016. (go back)

13 Corporate BoardMember , supra. (go back)

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What Really Went Wrong with Enron? A Culture of Evil?

The Markkula Center for Applied Ethics convened a panel of four Santa Clara University business ethicists to discuss the Enron scandal.

On March 5, 2002, the Markkula Center for Applied Ethics convened a panel of four Santa Clara University business ethicists to discuss the Enron scandal. Panelists included Kirk O. Hanson, executive director of the Ethics Center and University Professor of Organizations and Society; Manuel Velasquez, Dirksen Professor of Business Ethics, Department of Management; Dennis Moberg, Wilkinson Professor of Management and Ethics, and Martin Calkins, S.J., assistant professor of management. Edited excerpts from their conversation appear below:

Manuel Velasquez: What went wrong at Enron? In ethics, explanations tend to fall into three categories: personal, organizational, and systemic. Personal explanations look for the causes of evil in the character of the individuals who were involved. Did this happen, for example, because the people involved were vicious? Were they greedy? Were they stupid? Were they callous? Were they intemperate? Were they lacking in compassion?

Organizational explanations look for causes in group influences. They take seriously the ways that we influence each other when we do things as a group. These influences include the shared beliefs that groups develop about who is important, what is permissible, and how things are done here in this group. These include also the shared values that we call a group culture, the rules or policies groups develop to govern their interactions with each other and the rest of the world.

Finally, systemic explanations look for causes outside the group, for example in the environmental forces that drive or direct groups or individuals to do one thing rather than another. These include the laws and the regulations that provide the framework in which people act, the economic and social institutions that give meaning and direction to our lives, and the culture that shapes the values and perceptions of people and groups.

I am going to concentrate on the third kind of explanation for what went wrong with Enron-the systemic explanations….

I think that one of the obvious systemic causes of the Enron scandal is our legal and regulatory structure. First, current laws and SEC regulations allow firms like Arthur Andersen to provide consulting services to a company and then turn around and provide the audited report about the financial results of these consulting activities. This is an obvious conflict of interest that is built into our legal structure.

Second, a private company like Enron currently hires and pays its own auditors. This again is a conflict of interest built into our legal system because the auditor has an incentive not to issue an unfavorable report on the company that is paying him or her.

Third, most large companies like Enron are allowed to manage their own employee pension funds. Again, this is a conflict of interest built into our legal system because the company has an incentive to use these funds in ways that advantage the company even when they may disadvantage employees.

And fourth, most companies like Enron have codes of ethics that prohibit managers and executives from being involved in another business entity that does business with their own company. But these codes of ethics are voluntary and can be set aside by the board of directors. Our legal structure today largely allows managers to enter these arrangements, which constitute a conflict of interest. The managers and executives, of course, have a fiduciary duty to act in the best interest of the company and its shareholders, But the law leaves considerable discretion to managers and executives to exercise their own business judgment about what is in the best interests of the company.

A lot of the Enron story developed during the booming '90s. The stock market was shooting upward. Start-ups were rolling in venture capital, established businesses were expanding, consumers were spending, and it seemed like everyone was making lots of money. I would suggest that during periods like these, our moral standards tend to get corrupted. The ease with which we see money being made leads us to cut corners, to take shortcuts, to become focused on getting our own share of the pie no matter what because everybody else is getting theirs. This general boom culture, I believe, was part of what affected Enron and led its managers and executives to think that anything was okay so long as the money kept rolling in. Dennis Moberg: Manny talked about the importance of looking at this case from a lot of different vantagepoints. I'd like to concentrate primarily on the character of the individuals in question: Kenneth Lay, Jeffrey Skilling, and Andrew Fastow. Character ethics focuses on the ethics of the person rather than the ethics of the action in question. It distinguishes between individuals who might be called good or virtuous and individuals who might be called bad-at the extreme, evil people or people who are vice-ridden or vicious….

The best list of vices is the classic seven deadly sins: pride, anger, sloth, avarice, gluttony, lust, and envy. Do we see any of these elements of character displayed among the executives at Enron?

• Pride: Jeffery Skilling once said, "I've never not been successful at business or work...ever!"
• Anger: When interviewed by a Fortune reporter, Skilling said, "The people who ask questions don't understand the company." When this reporter persisted a bit, Skilling called her unethical for even raising the question and abruptly hung up the phone. Later, he called another reporter an "expletive deleted."
• Sloth: One of the most critical board meetings at Enron in 1991-where they were giving approval to set aside their ethics statements on behalf of these shenanigans with partnerships-that meeting lasted one hour. That's barely enough time to get a Coke.
• Avarice: Fastow, the CFO, sold $36 million of his Enron investments before the company tanked. Lay had a whole bunch of sweetheart deals with family members. I'm sure tempted to call that greed….

Add to this…a tendency toward cronyism. Managers at Enron's divisions grew arrogant, thinking themselves invincible. We see this insular tendency of the company to seal itself off from forces on the outside. They had something called a rank-and-yank performance appraisal system, which eliminated anyone who fell behind-a real Darwinist system that took care of anyone who might potentially disagree. All of the internal whistleblowers were rebuffed, humiliated, or treated in an intimidating way by the various players. And finally, one of my favorites-their 1999 annual report in which all of the members of the board of directors are listed by their nicknames, again suggesting that tendency towards cronyism….

In terms of fixing the system from a character viewpoint…, we need reforms that discourage cronyism-this insular tendency in too many American corporations to seal themselves off from the realities beyond themselves. Jeffrey Skilling, Andrew Fastow, and Kenneth Lay all live in the same gated community in Houston, which I think is a great metaphor for what happened at Enron.

Martin Calkins, S.J.: Corporate governance relies on the state of mind and personal relationships of managers, not a list of empty procedures or principles. In the Enron case, the rules were in place, but were willfully and skillfully ignored.

In the Enron case, we see the result of a growing and pervasive winking at the letter of the law. This winking didn't come out of nowhere. It built up in our society during the 1990s and culminated in 1995 in the Private Securities Litigation Reform Act—a law that eased some of the restrictions put in place after the Great Depression to prevent the sort of behavior we see with Enron. Both the behavior and the rules and laws to prevent it have been around for years. The laws were simply circumvented in the Enron case.

On the issue of character, I agree with Dennis that the Enron debacle seems to be character-based. Unlike Dennis, however, I would be less inclined to judge the character of the Enron people harshly. The Enron people may very well be the good people they present themselves to be. Perhaps it was the corporate culture in which they operated that led to the problem we have today. It may be that we have here an example of the so-called "separation thesis": an incident where individuals, for reasons tied to corporate culture and societal expectations, adopted as their own an ethic associated with their role as manager that was distinct (separate) from their individual ethics. In other words, these may be good people who acted wrongly because they thought their managerial roles demanded they act in a certain unethical manner.

Finally, I would like to make some suggestions and recommendations for reform.

First, I think this issue shows the need for better financial disclosure mechanisms. Perhaps we should institute programs to replace today's peer review process involving the American Institute of Certified Public Accountants. At a minimum, the case seems to show that the Financial Accounting Standards Board, which has responsibility for rule making in this area, needs to establish regulations and standards that are more forthright and understandable to ordinary people such as you and me.

Second, the case illustrates a need for more responsible public servants, not more laws. The 1995 Private Securities Litigation Reform Act relaxed the restrictions that would have checked the behaviors that led to the Enron scandal. Yet government officials now call for more laws. This seems to be a ploy to direct public attention away from what politicians have already done to the law.

For example, Ohio Democratic Representative Dennis "The Menace" Kucinich, former mayor of the city of Cleveland who was almost single-handedly responsible for that city's bankruptcy in 1978-79, is drafting legislation that would create a new independent organization to audit publicly traded companies. Do we really need more legislation and another government office? What about the laws and people to enforce them that are already in place? A proposal such as Kucinich's seems to me to be a smokescreen to protect politicians. In my view, we need to hold these politicians responsible for what they have done, just as we have held the business people to accountability.

Third, the case illustrates a need to amend but not ban all non-audit work. There has been a call lately to eliminate all non-audit services by auditing companies. However, many of these essential non-audit services are so closely linked to the audited information that it does not make sense to ban the auditor from providing these services. Tax advice is one example. The auditor has a familiarity with corporate financial records such that it makes sense for him or her to give certain tax advice.

In addition, there has been a proposal to require firms to change auditors regularly. This seems sensible at first, but it may increase the inefficiencies and risks associated with reporting and thereby reduce financial reporting quality.

In short, I think we ought to go slowly in instituting restrictions on the services auditors can provide. It may be that we should allow them to perform certain services with limitations - such as having a staggered rotation of partners and staff on an audit to assure better financial reporting.

In the end, while the Enron case illustrates a number of flaws in the system of reporting, before we establish new laws and reporting procedures, we ought to look at what, in specific, is wrong with what we are doing now and nuance our responses. Otherwise, we may be creating more harm than good.

Kirk O. Hanson: The collapse of Enron is probably one of the most significant events in the history of American business. Within six months, the company went from one of the most respected in the United States to bankruptcy-an unparalleled failure. What went wrong?

Number one: Enron executives really did believe this is a winner-take-all society-that there was a culture behind them saying, "You're worth nothing if you're not a centi-millionaire."…

One of my friends, a former executive at Enron who resigned in 2000, described what the recruiting process was like…. They recruited just at the major business schools. They wined and dined the prospects. They promised them huge bonuses and fed those young egos as much as they would take.

Once people were hired, it was an up-or-out culture. Those who survived began to think they were gods. And Jeffrey Skilling used to pit them against each other. He knew that as long as he could keep them scared of one another and competing, he would have control. When you create an environment in which, if you want to be among the best and the brightest, you've got to play the game the way the boss has set it up, that's not a culture where people are going to challenge top management.

In addition, the auditors had an incentive not to challenge Enron. Think about your role if you're the manager of the Arthur Andersen audit. Let's say you're the partner in Houston who manages the Enron account. What do you get paid for? You get paid for keeping that client. What do you get fired for? You get fired if you lose that client. The incentives all run in the direction of doing whatever this company demands of you. And if you've got a very aggressive management, like Enron had under Skilling and Andrew Fastow, then it becomes all the harder. You have to give in more and more.

The CEO of one of the big five accounting firms once told me, "My biggest ethical problem is that I incent people to keep clients at all costs. I know that creates ethical pressures on my people. I've got to find a partner who lost an account for the right reason-because it was ethically the right thing to do-and give them the biggest bonus next year."

I saw him a year later, and I said, "How'd it go?"

He said, "Well, I'm still looking for that partner." So you understand the kind of pressures on these auditors. And the pressures are made all the worse if it's not just auditing business but another $10 million in consulting services at stake at the same time. That's why we at least want to get rid of that conflict of interest.

Ten years from now, we'll look back on the Enron debacle and think of it as a morality play on the rights and privileges of the rich vs. the regular employees. One of the most outlandish aspects of the scandal is that the people at the top seem to have gotten their money out, leaving their fortunes intact. In fact, their claim that they were running one of the great risk-seeking enterprises of the new economy was rather hollow. They were running a risk-free company for themselves while the risk was assumed by the people at the lower levels in the organization.

A business journal from the Wharton School of the University of Pennsylvania

Ethical Lessons of the Enron Verdict from Wharton’s Thomas Dunfee

June 7, 2006 • 13 min read.

On May 25, a federal jury convicted former Enron CEO Kenneth Lay and former Enron president Jeffrey Skilling on conspiracy and fraud charges, with sentencing to be decided on September 11. As has been repeatedly noted in press coverage of this trial, Enron is the incredible story of a once powerful company done in by a group of top executives whose greed and fraud was breathtaking even by post dot-com standards. But it is by no means the only high-profile criminal trial in recent days, nor is it likely to be the last case brought by the government against CEOs who abuse their positions, their stockholders, their employees and the public trust. Thomas Dunfee, chairman of Wharton's legal studies and business ethics department, and an expert on social contracts and the social responsibility of business, talked to Knowledge at Wharton's Mukul Pandya and Robbie Shell about the Enron verdict.

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ENRON, ETHICS, & THE DARK SIDE OF LEADERSHIP

July 3, 2016 by Michael David Fry

Ethics is concerned with the kinds of values and morals an individual or a society finds desirable or appropriate. Ethical theory provides us with a system of rules or principles that guide us in making decisions about what is good or bad and right or wrong in a particular situation. In essence, ethical theory provides a basis for understanding what it means to be a morally decent human being (Northouse, 2016, p. 330). As is pertains to leadership, ethical theory is concerned with what leaders do and who leaders are. The choices leaders make and how they respond in a given circumstance are informed and directed by their ethics. In other words, a leader’s choices are influenced by their moral development.

We often read about good kings and bad kings, great empires and evil empires, and strong presidents and weak presidents. But what about good companies and bad companies? Ethical leadership in corporate America is just as important as ethical leadership in a political environment. I thought it would be very interesting to take a closer look at the Enron scandal from the early 2000s and examine the company’s lack of ethical leadership.

For those not familiar with the Enron scandal, most of the top executives were tried for fraud after it was revealed in November 2001 that the company’s earned had been overstated by several hundred million dollars. At the time, Enron was ranked the sixth-largest energy company in the world. Top Enron executives sold their company stock prior to the company’s downfall, whereas lower-level employees were prevented from selling their stock due to 401K restrictions. Enron filed for Chapter 11 protection in December 2001 and instantly became the largest bankruptcy in U.S. history at that time. This left thousands of workers with worthless stock in their pension. The lower-level employees lost their life savings due to the collapse. The U.S. Department of Justice subsequently opened a criminal investigation into Enron’s collapse in January 2002 (CNN Library, 2016).

The dark side of leadership is the destructive and dark side of leadership in that a leader uses leadership for personal ends. Lipman-Blumen suggests that toxic leaders are characterized by destructive behaviors such as leaving their followers worse off than they found them, violating the basic human rights of others, and playing to their basest fears (Northouse, 2016, p. 339). The actions of the executives at Enron leading up to the collapse of the company shows us that they had a lack of integrity, insatiable ambition, arrogance, and reckless disregard for their actions. The executives displayed all of the dysfunctional personal characteristics that are found in destructive leaders.

Jeffrey Skilling, the Chief Executive Officer, developed a staff of executives that, by the use of accounting loopholes, special purpose entities, and poor financial reporting, were able to hide billions of dollars in debt from failed deals and projects. Andrew Fastow, the Chief Financial Officer, misled Enron’s board of directors and audit committee on high-risk accounting practices and also pressured their audit and accounting firm to ignore the issues. Enron rewarded their efforts and paid the top 140 executives $680 million in 2001 before the collapse. Enron shares were worth $90.75 at their peak but dropped to $0.67 immediately after the scandal was revealed and the company collapsed. Enron executive Michael Kopper would go on to plead guilty to conspiracy to commit wire fraud and money laundering conspiracy in August 2002. Enron Executive Andrew Fastow was charged with securities fraud, wire fraud, mail fraud, money laundering and conspiracy in October 2002. The Chief Executive Officer, Jeffrey Skilling, was indicted on fraud and conspiracy charges in February 2004. Paula Rieker, the Enron vice president responsible for investor relations, pleaded guilty to insider trading in May 2004 (CNN Library, 2016).

In assessing consequences, there are three different approaches to making decisions regarding moral conduct: ethical egoism, utilitarianism, and altruism (Northouse, 2016, p. 334). Ethical egoism states that people should act so as to create the greatest good for themselves. A leader with this orientation would take a job or career that she or he selfishly enjoys (Avolio & Locke, 2002). Many of the Enron executives made decisions to achieve their goal of maximizing profits. The executives had a very high concern for their self-interests but a very low concern for the interest of others.

On the other hand, Sherron Watkins, the Vice President of Corporate Development, alerted the Enron CEO of accounting irregularities in financial reports in August 2001. She is the whistleblower responsible for bringing the corruption at Enron to light. She reported the fraud to government authorities despite the fact that she knew she was risking her career at the sixth-largest energy company in the world. I would argue that her actions were altruistic. Altruism is an approach that suggest that actions are moral if the their primary purpose is to promote the best interests of others. From this perspective, a leader may be called on to act in the interests of others, even when it runs contrary to his or her own self-interests (Northouse, 2016, p. 335). Sherron Watkins displayed a low concern for her self-interests and a high concern for the interests of others by jeopardizing her job as the Vice President of Corporate Development in order to protect the interests of the lower-level employees at Enron.

In conclusion, leadership is a process of influencing others. Leadership involves values, including showing respect for followers, being fair to others, and building community. Leadership is not a process that can be demonstrated without showing our values. Therefore, when we influence, we have an effect on others, meaning we need to pay attention to our values. Sherron Watkins demonstrated how this moral dimension distinguishes ethical leadership from other types of influence, like those of the other Enron executives that knowingly decided to compromise their morals and values in favor of achieving the greatest good for themselves. The Enron scandal serves as an excellent case study for why their is a high demand for moral leadership in our society today.

Avolio, B.J., & Locke, E.E. (2002) Contrasting different philosophies of leader motivation: Altruism versus egoism. Leadership Quarterly .

CNN Library (2016). Enron Fast Facts. http://www.cnn.com/2013/07/02/us/enron-fast-facts/

Northouse, P. G. (2016). Leadership: Theory and practice. Thousand Oaks, CA: Sage.

July 3, 2016 at 11:51 pm

When I think about large scale breeches of ethics, Enron immediately comes to mind. I wish that we could be confident that leaders have since learned their lesson. However, the financial crash of 2007 was a product of same kind of unethical reasoning. From what I have been told, many banks were issuing extremely large loans, without any proof of stable income or credit. This coined the term “liar loans”. The loan applications were padded to appear legitimate. The objective was to make it look like that there was a high probability for the loans to be repaid. However, the banks knew the likelihood of doing so was nearly impossible. This inflated the housing market, and the banks made their money by packaging the mortgages, into security investments. Those who invested in these assets would never see a dime of their money. Just as with Enron, those who contributed to the financial crisis demonstrated a high degree of ethical egoism and self interest (Northouse, 2016). The unethical behavior persisted as there were large financial rewards. We could relate these situations to the toxic triangle, as they operated with destructive leaders, susceptible followers, and conducive environments (Northouse, 2016). However, part of having a conducive environment is operating under unstable conditions (Northouse, 2016). With such a high degree of instability, the scandal eventually unraveled. Therefore, the wrongdoings were uncovered, and the master plans were exposed.

But, I am left to wonder, did no one fear the consequences? Even at the preconventional level of moral reasoning, people tend to follow the rules to avoid punishment (Northouse, 2016). One would have to assume the consequences, for stealing hundreds of millions of dollars or contributing to decline of national economic conditions, would be quite severe.

Therefore, if these leaders were not affected by the threat of such negative consequences, how do we prevent this from happening again? It doesn’t seem that rewarding ethical behavior would work, as the reward could not possibly surpass the dollar amounts that were being embezzled. And, clearly these are not utilitarian or altruistic leaders that will be motivated by the greater good of the organization (Northouse, 2016). So, where do we go from here? How do we motivate those that are considering such grande displays of unethical behavior? It is definitely a complex issue. This is probably why Northouse (2016) has suggested that the study of leadership ethics is also quite complex.

Northouse, P.G. (2016). Leadership: Theory and Practice (7th ed.). Los Angeles, CA: Sage     Publications.

• © 2006

Enron and World Finance

A Case Study in Ethics

• Paul H. Dembinski (Professor) 0 ,
• Carole Lager (PhD in Political Science) 1 ,
• Andrew Cornford (Research Fellow) 2 ,
• Jean-Michel Bonvin (PhD in Sociology, Professor) 3

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University Paris IV-Sorbonne, Switzerland Department of Sociology, University of Geneva, Switzerland

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Table of contents (16 chapters)

Front matter, overview of the book.

Andrew Cornford

Enron: Origins, Character and Failure

Enron and internationally agreed principles for corporate governance and the financial sector, a revisionist view of enron and the sudden death of ‘may’.

• Frank Partnoy

Who Is Who in the World of Financial ‘Swaps’ and Special Purpose Entities

• François-Marie Monnet

Ethics in Thought and Action

An ethical diagnosis of the enron affair.

• Etienne Perrot

Anonymity: Is a Norm as Good as a Name?

• Edward Dommen

Spaces for Business Ethics

• Domingo Sugranyes Bickel

Corporate Governance and Auditing

The demise of andersen: a consequence of corporate governance failure in the context of major changes in the accounting profession and the audit market.

• Catherine Sauviat

Enron et al. and Implications for the Auditing Profession

• Anthony Travis

Enron Revisited: What Is a Board Member to Do?

• Beth Krasna

How to Restore Trust in Financial Markets?

• Hans J. Blommestein

Corporate Culture and Ethics

Enron: the collapse of corporate culture.

• John Dobson

Ethics, Courage and Discipline: The Lessons of Enron

• Robert C. Kennedy

Developing Leadership and Responsibility: No Alternative for Business Schools

• Henri-Claude de Bettignies

Ethics for a Post-Enron America

• John R. Boatright

'The essays in this book greatly enhance our understanding of the causes of one of the most important events in financial history. The authors examine in notable depth the ethical and governance dimensions of the Enron saga, while providing a fascinating commentary on the nature of modern finance capitalism.' - John Plender, Financial Times and author of Going off the Rail - Global Capital and the Crisis of Legitimacy

'Enron and World Finance addresses the most important issue of our time...This brilliant collection of essays with its remarkably insightful introduction and conclusion require us to consider what might be called the tyranny of economics...Enron is important not only in itself but also as a warning signal of the predictable destructive consequences of the failure of language.' - Robert A. G. Monks, Lens Governance Advisors, USA

'Enron offers an 'ideal' example of using or perhaps misusing financial innovations within modern corporations. The book Enron and World Finance provides a very insightful overview of this memorable case where the ethical dimension of an organization is nonexistent. As professors of Finance, we welcome such a book that illustrates the pitfalls of financial creativity when it ignores or abuses the boundaries of an honest corporate culture and of its management.' - Marc Chesney and Rajna Gibson, Professors of Finance, Swiss Banking Institute, University of Zürich, Switzerland

'The book provides, at once, afresh understanding of the place of ethical thought in financial markets, and a focus on leadership and responsibility for the implementation of ethical duties. I commend this fascinating book to a wide readership in financial and academic institutions.' - Professor Dr. Hans Tietmeyer, Bundesbankprasident i.R., Germany

Paul H. Dembinski

Carole Lager

University Paris IV-Sorbonne, Switzerland

Jean-Michel Bonvin

Department of Sociology, University of Geneva, Switzerland

Book Title : Enron and World Finance

Book Subtitle : A Case Study in Ethics

Editors : Paul H. Dembinski, Carole Lager, Andrew Cornford, Jean-Michel Bonvin

DOI : https://doi.org/10.1057/9780230518865

Publisher : Palgrave Macmillan London

eBook Packages : Palgrave Economics & Finance Collection , Economics and Finance (R0)

Copyright Information : Palgrave Macmillan, a division of Macmillan Publishers Limited 2006

Hardcover ISBN : 978-1-4039-4763-5 Published: 16 December 2005

eBook ISBN : 978-0-230-51886-5 Published: 16 December 2005

Edition Number : 1

Number of Pages : XVI, 257

Topics : Accounting/Auditing , Business Strategy/Leadership , Business Ethics , Finance, general

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What Was Enron?

Understanding enron, the enron scandal.

• Mark-to-Market Accounting

What Happened to Enron

• The Role of Enron's CEO

The Legacy of Enron

The bottom line.

• Company Profiles
• Energy Sector

What Was Enron? What Happened and Who Was Responsible

Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master's in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

Investopedia / Daniel Fishel

Enron was an energy-trading and utility company based in Houston, Texas, that perpetrated one of the biggest accounting frauds in history. Enron's executives employed accounting practices that falsely inflated the company's revenues and, for a time, made it the seventh-largest corporation in the United States. Once the fraud came to light, the company quickly unraveled, filing for Chapter 11 bankruptcy in December 2001.

Key Takeaways

• Enron was an energy company that began to trade extensively in energy derivatives markets.
• The company hid massive trading losses, ultimately leading to one of the largest accounting scandals and bankruptcy in recent history.
• Enron executives used fraudulent accounting practices to inflate the company's revenues and hide debt in its subsidiaries.
• The SEC, credit rating agencies, and investment banks were also accused of negligence—and, in some cases, outright deception—that enabled the fraud.
• As a result of Enron, Congress passed the Sarbanes-Oxley Act to hold corporate executives more accountable for their company's financial statements.

Enron was an energy company formed in 1986 following a merger between Houston Natural Gas Company and Omaha-based InterNorth Incorporated. After the merger, Kenneth Lay, who had been the  chief executive officer  (CEO) of Houston Natural Gas, became Enron's CEO and chair.

Lay quickly rebranded Enron into an energy trader and supplier. Deregulation of the energy markets allowed companies to place bets on future prices. In 1990, Lay created the Enron Finance Corporation and appointed Jeffrey Skilling, whose work as a McKinsey & Company consultant had impressed Lay, to head the new corporation. Skilling was then one of the youngest partners at McKinsey.

Enron provided a variety of energy and utility services around the world. Its company divided operations in several major departments, including:

• Enron Online : In late 1999, Enron built its web-based system to enhance customer functionality and market reach.
• Wholesale Services : Enron offered various energy delivery solutions, with its most robust industry being natural gas. In North America, Enron claimed to deliver almost double the amount of electricity compared to its second tier of competition.
• Energy Services : Enron's retail unit provided energy around the world, including in Europe, where it expanded retail operations in 2001.
• Broadband Services : Enron provided logistical service solutions between content providers and last-mile energy distributors.
• Transportation Services : Enron developed an innovative, efficient pipeline operation to network capabilities and operate pooling points to connect to third parties.

However, by leveraging special purpose vehicles, special purpose entities, mark-to-market accounting, and financial reporting loopholes, Enron became one of the most successful companies in the world. Upon discovery of the fraud, the company subsequently collapsed. Enron shares traded as high as $90.75 before the fraud was discovered but plummeted to around $0.26 in the sell-off after it was revealed.

The former Wall Street darling quickly became a symbol of modern corporate crime. Enron was one of the first big-name accounting scandals, but uncovered frauds at other companies such as WorldCom and Tyco International soon followed.

Before coming to light, Enron was internally fabricating financial records and falsifying the success of its company. Though the entity did achieve operational success during the 1990s, the company's misdeeds were finally exposed in 2001.

Pre-Scandal

Leading up to the turn of the millennium, Enron's business appeared to be thriving. The company became the largest natural gas provider in North America in 1992, and the company launched EnronOnline, its trading website allowing for better contract management just months before 2000. The company also rapidly expanded into international markets, led by the 1998 merger with Wessex Water.

Enron's stock price mostly followed the S&P 500 for most of the 1990's. However, expectations for the company began to soar. In 1999, the company's stock increased 56%. In 2000, it increased an additional 87%. Both returns widely beat broad market returns, and the company soon traded at a 70x price-earnings ratio.

Early Signs of Trouble

In February 2001, Kenneth Lay stepped down as Chief Executive Officer and was replaced by Jeffrey Skilling. A little more than six months later, Skilling stepped down as CEO in August 2001, with Lay taking over the role again.

Around this time, Enron Broadband reported massive losses. Lay revealed in the company's Q2 2001 earnings report that "...in contrast to our extremely strong energy results, this was a difficult quarter in our broadband businesses." In this quarter, the Broadband Services department reported a financial loss of $102 million.

Also, around this time, Lay sold 93,000 shares of Enron stock for roughly $2 million while telling employees via e-mail to continue buying the stock and predicting significantly higher stock prices. In total, Lay was eventually found to have sold over 350,000 Enron shares for total proceeds greater than $20 million.

During this time, Sherron Watkins had expressed concerns regarding Enron's accounting practices. A Vice President for Enron, she wrote an anonymous letter to Lay expressing her concerns. Watkins and Lay eventually met to discuss the matters, in which Watkins delivered a six-page report detailing her concerns. The concerns were presented to an outside law firm in addition to Enron's accounting firm; both agreed there were no issues to be found.

By October 2001, Enron had reported a third quarter loss of $618 million. Enron announced it would need to restate its financial statements from 1997 to 2000 to correct accounting violations.

Enron's $63.4 billion bankruptcy was the biggest on record at the time.

On Nov. 28, 2001, credit rating agencies reduced Enron's credit rating to junk status, effectively solidifying the company's path to bankruptcy. On the same day, Dynegy, a fellow energy company Enron was attempting to merge with, decided to nix all future conversations and opted against any merger agreement. By the end of the day, Enron's stock price had dropped to $0.61.

Enron Europe was the first domino, filing for bankruptcy after close of business on Nov. 30. The rest of Enron followed suit on Dec. 2. Early the following year, Enron dismissed Arthur Andersen as its auditor , citing that the auditor had yielded advice to shred evidence and destroy documents.

In 2006, the company sold its last business, Prisma Energy. The next year, the company changed its name to Enron Creditors Recovery Corporation with the intention of repaying any remaining creditors and open liabilities as part of the bankruptcy process.

Post Bankruptcy/Criminal Charges

After emerging from bankruptcy in 2004, the new board of directors sued 11 financial institutions involved in helping conceal the fraudulent business practices of Enron executives. Enron collected nearly $7.2 billion from these financial institutions as part of legal settlements. The banks included the Royal Bank of Scotland, Deutsche Bank, and Citigroup.

Kenneth Lay pleaded not guilty to eleven criminal charges. He was convicted of six counts of securities and wire fraud and was subject to a maximum of 45 years in prison. However, Lay died on July 5, 2006, before sentencing was to occur.

Jeff Skilling was convicted on 19 of the 28 counts of securities fraud he was charged with, in addition to other charges of insider trading. He was sentenced to 24 years and four months in prison, though the U.S. Department of Justice reached a deal with Skilling in 2013. The deal resulted in 10 years being cut off of his sentence.

Andy Fastow and his wife, Lea, pleaded guilty to charges against them, including money laundering, insider trading, fraud, and conspiracy. Fastow was sentenced to 10 years without parole to testify against other Enron executives. Fastow has since been released from prison.

Causes of the Enron Scandal

Enron went to great lengths to enhance its financial statements, hide its fraudulent activity, and report complex organizational structures to both confuse investors and conceal facts. The causes of the Enron scandal include but are not limited to the factors below.

Special Purpose Vehicles

Enron devised a complex organizational structure leveraging special purpose vehicles (or special purpose entities). These entities would "transact" with Enron, allowing Enron to borrow money without disclosing the funds as debt on their balance sheet.

SPVs provide a legitimate strategy that allows companies to temporarily shield a primary company by having a sponsoring company possess assets. Then, the sponsor company can theoretically secure cheaper debt than the primary company (assuming the primary company may have credit issues). There are also legal protection and taxation benefits to this structure.

The primary issue with Enron was the lack of transparency surrounding the use of SPVs. The company would transfer its own stock to the SPV in exchange for cash or a note receivable. The SPV would then use the stock to hedge an asset against Enron's balance sheet. Once the company's stock started losing its value, it no longer provided sufficient collateral that could be exploited by being carried by an SPV.

Inaccurate Financial Reporting Practices

Enron inaccurately depicted many contracts or relationships with customers. By collaborating with external parties such as its auditing firm, it was able to record transactions incorrectly, not only in accordance with GAAP but also not in accord with agreed-upon contracts.

For example, Enron recorded one-time sales as recurring revenue. In addition, the company would intentionally maintain an expired deal or contract through a specific period to avoid recording a write-off during a given period.

Poorly Constructed Compensation Agreements

Many of Enron's financial incentive agreements with employees were driven by short-term sales and quantities of deals closed (without consideration for the long-term validity of the deal). In addition, many incentives did not factor in the actual cash flow from the sale. Employees also received compensation tied to the success of the company's stock price, while upper management often received large bonuses tied to success in financial markets.

Part of this issue was the rapid rise of Enron's equity success. On Dec. 31, 1999, the stock closed at $44.38. Just three months later, it closed on March 31, 2000 at $74.88. With the stock hitting $90 by the end of 2000, the massive profits some employees received only fueled further interest in obtaining equity positions in the company.

Lack of Independent Oversight

Many external parties learned about Enron's fraudulent practices, but their financial involvement with the company likely caused them not to intervene. Enron's accounting firm, Arthur Andersen, received many jobs and financial compensation in return for their services.

Investment bankers collected fees from Enron's financial deals. Buy-side analysts were often compensated to promote specific ratings in exchange for stronger relationships between Enron and those institutions.

Unrealistic Market Expectations

Both Enron Energy Services and Enron Broadband were poised to be successful due to the emergence of the internet and heightened retail demand. However, Enron's over-optimism resulted in the company over-promising online services and timelines that were simply unrealistic.

Poor Corporate Governance

The ultimate downfall of Enron was the result of overall poor corporate leadership and corporate governance . Former Vice President of Corporate Development Sherron Watkins is noted for speaking out about various financial treatments as they were occurring. However, top management and executives intentionally disregarded and ignored concerns. This tone from the top set the precedent across accounting, finance, sales, and operations.

In the early 1990s, Enron was the largest seller of natural gas in North America. Ten years later, the company no longer existed due to its accounting scandal.

The Role of Mark-to-Market Accounting

One additional cause of the Enron collapse was mark-to-market accounting. Mark-to-market accounting is a method of evaluating a long-term contract using fair market value. At any point, the long-term contract or asset could fluctuate in value; in this case, the reporting company would simply "mark" its financial records up or down to reflect the prevailing market value .

There are two conceptual issues with mark-to-market accounting, both of which Enron took advantage of. First, mark-to-market accounting relies very heavily on management estimation. Consider long-term, complex contracts requiring the international distribution of several forms of energy. Because these contracts were not standardized, it was easy for Enron to artificially inflate the value of the contract because it was difficult to determine the market value appropriately.

Second, mark-to-market accounting requires companies to periodically evaluate the value and likelihood that revenue will be collected. Should companies fail to continually evaluate the value of the contract, it may easily overstate the expected revenue to be collected.

For Enron, mark-to-market accounting allowed the firm to recognize its multi-year contracts upfront and report 100% of income in the year the agreement was signed, not when the service would be provided or cash collected. This form of accounting allowed Enron to report unrealized gains that inflated its income statement, allowing the company to appear much more profitable than it was.

The Enron bankruptcy, at $63.4 billion in assets, was the largest on record at the time. The company's collapse shook the financial markets and nearly crippled the energy industry. While high-level executives at the company concocted the fraudulent accounting schemes, financial and legal experts maintained that they would never have gotten away with it without outside assistance. The Securities and Exchange Commission (SEC), credit rating agencies, and investment banks were all accused of having a role in enabling Enron's fraud.

Initially, much of the finger-pointing was directed at the SEC, which the U.S. Senate found complicit for its systemic and catastrophic failure of oversight. The Senate's investigation determined that had the SEC reviewed any of Enron's post-1997 annual reports, it would have seen the red flags and possibly prevented the enormous losses suffered by employees and investors.

The credit rating agencies were found to be equally complicit in their failure to conduct proper due diligence before issuing an investment-grade rating on Enron's bonds just before its bankruptcy filing. Meanwhile, the investment banks—through manipulation or outright deception—had helped Enron receive positive reports from stock analysts, which promoted its shares and brought billions of dollars of investment into the company. It was a quid pro quo in which Enron paid the investment banks millions of dollars for their services in return for their backing.

Enron reported total company revenue of:

• $13.2 billion in 1996
• $20.3 billion in 1997
• $31.2 billion in 1998
• $40.1 billion in 1999
• $100.8 billion in 2000

The Role of Enron's CEO

By the time Enron started to collapse, Jeffrey Skilling was the firm's CEO. One of Skilling's key contributions to the scandal was to transition Enron's accounting from a traditional historical cost accounting method to mark-to-market accounting, for which the company received official SEC approval in 1992.

Skilling advised the firm's accountants to transfer debt off Enron's balance sheet to create an artificial distance between the debt and the company that incurred it. Enron continued to use these accounting tricks to keep its debt hidden by transferring it to its  subsidiaries  on paper. Despite this, the company continued to recognize  revenue  earned by these subsidiaries. As such, the general public and, most importantly, shareholders were led to believe that Enron was doing better than it actually was despite the severe violation of GAAP rules.

Skilling abruptly quit in August 2001 after less than a year as chief executive—four months before the Enron scandal unraveled. According to reports, his resignation stunned Wall Street analysts and raised suspicions despite his assurances that his departure had "nothing to do with Enron."

Skilling and Kenneth Lay were tried and found guilty of fraud and conspiracy in 2006. Other executives plead guilty. Lay died shortly after his conviction, and Skilling served twelve years, by far the longest sentence of any of the Enron defendants.

In the wake of the Enron scandal, the term " Enronomics " came to describe creative and often fraudulent accounting techniques that involve a parent company making artificial, paper-only transactions with its subsidiaries to hide losses the parent company has suffered through other business activities.

Parent company Enron had hidden its debt by transferring it (on paper) to wholly-owned subsidiaries —many of which were named after Star Wars characters—but it still recognized revenue from the subsidiaries, giving the impression that Enron was performing much better than it was.

Another term inspired by Enron's demise was "Enroned," slang for having been negatively affected by senior management's inappropriate actions or decisions. Being "Enroned" can happen to any stakeholder, such as employees, shareholders, or suppliers. For example, if someone lost their job because their employer was shut down due to illegal activities they had nothing to do with, they have been "Enroned."

As a result of Enron, lawmakers put several new protective measures in place. One was the Sarbanes-Oxley Act of 2002, which enhances corporate transparency and criminalizes financial manipulation. The Financial Accounting Standards Board (FASB) rules were also strengthened to curtail the use of questionable accounting practices, and corporate boards were required to take on more responsibility as management watchdogs.

What Did Enron Do That Was So Unethical?

Enron used special purpose entities to hide debt and mark-to-market accounting to overstate revenue. In addition, it ignored internal advisement against these practices, knowing that its publicly disclosed financial position was incorrect.

How Big was Enron?

With shares trading for around $90/each, Enron was once worth about $70 billion. Leading up to its bankruptcy, the company employed over 20,000 employees. The company also reported over $100 billion of company-wide net revenue (though this figure has since been determined to be incorrect).

Who Was Responsible for the Collapse of Enron?

Several key executive team members are often noted as being responsible for the fall of Enron. The executives include Kenneth Lay (founder and former Chief Executive Officer), Jeffrey Skilling (former Chief Executive officer replacing Lay), and Andrew Fastow (former Chief Financial Officer).

Does Enron Exist Today?

As a result of its financial scandal, Enron ended its bankruptcy in 2004. The name of the entity officially changed to Enron Creditors Recovery Corp., and the company's assets were liquidated and reorganized as part of the bankruptcy plan. Its last business, Prisma Energy, was sold in 2006.

At the time, Enron's collapse was the biggest  corporate bankruptcy  ever to hit the financial world (since then, the failures of WorldCom, Lehman Brothers, and Washington Mutual have surpassed it). The Enron scandal drew attention to accounting and corporate fraud. Its shareholders lost tens of billions of dollars in the years leading up to its bankruptcy, and its employees lost billions more in pension benefits. Increased regulation and oversight have been enacted to help prevent corporate scandals of Enron's magnitude.

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