Enron: What Caused the Ethical Collapse?

Introduction Kenneth Lay, former chairman and chief executive officer (CEO) of Enron Corp., is quoted in Michael Novak’s book Business as a Calling: Work and the Examined Life as saying, “I was fully exposed to not only legal behavior but moral and ethical behavior and what that means from the standpoint of leading organizations and people.” In an introductory statement to the revised Enron Code of Ethics issued in July 2000, Lay wrote: “As officers and employees of Enron Corp., its subsidiaries, and its affiliated companies, we are responsible for conducting the business affairs of the companies in accordance with all applicable laws and in a moral and honest manner.” Lay went on to indicate that the 64-page Enron Code of Ethics reflected policies approved by the company’s board of directors and that the company, which enjoyed a reputation for being fair and honest, was highly respected. Enron’s ethics code also 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 respect, integrity, communication, and excellence. These values were described as follows:

Respect. We treat others as we would like to be treated ourselves. We do not tolerate abusive or disrespectful treatment. Ruthlessness, callousness and arrogance don’t belong here.Integrity. We work with customers and prospects openly, honestly and sincerely. When we say we will do something, we will do it; when we say we cannot or will not do something, then we won’t do it.Communication. We have an obligation to communicate. Here we take the time to talk with one another . . . and to listen. We believe that information is meant to move and that information moves people.Excellence. We are satisfied with nothing less than the very best in everything we do. We will continue to raise the bar for everyone. The great fun here will be for all of us to discover just how good we can really be.

Given this code of conduct and Ken Lay’s professed commitment to business ethics, how could Enron have collapsed so dramatically, going from reported revenues of $101 billion in 2000 and approximately $140 billion during the first three quarters of 2001 to declaring bankruptcy in December 2001? 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.

Enron’s Top Leadership  In the aftermath of Enron’s bankruptcy filing, numerous Enron executives were charged with criminal acts, including fraud, money laundering, and insider trading. For example, Ben Glisan, Enron’s former treasurer, was charged with two-dozen counts of money laundering, fraud, and conspiracy. Glisan pled guilty to one count of conspiracy to commit fraud and received a prison term, three years of post-prison supervision, and financial penalties of more than $1 million. During the plea negotiations, Glisan described Enron as a “house of cards.”

Andrew Fastow, Jeff Skilling, and Ken Lay are among the most notable top-level executives implicated in the collapse of Enron’s “house of cards.” Andrew Fastow, former Enron chief financial officer (CFO), faced 98 counts of money laundering, fraud, and conspiracy in connection with the improper partnerships he ran, which included a Brazilian power plant project and a Nigerian power plant project that was aided by Merrill Lynch, an investment banking firm. Fastow pled guilty to one charge of conspiracy to commit wire fraud and one charge of conspiracy to commit wire and securities fraud. He agreed to a prison term of 10 years and the forfeiture of $29.8 million. Jeff Skilling was indicted on 35 counts of wire fraud, securities fraud, conspiracy, making false statements on financial reports, and insider trading. Ken Lay was indicted on 11 criminal counts of fraud and making misleading statements. Both Skilling and Lay pled not guilty and are awaiting trial. 

The activities of Skilling, Fastow, and Lay raise questions about how closely they adhered to the values of respect, integrity, communication, and excellence articulated in the Enron Code of Ethics. Before the collapse, when Bethany McLean, an investigative reporter for Fortune magazine, was preparing an article on how Enron made its money, she called Enron’s then-CEO, Jeff Skilling, to seek clarification of its “nearly incomprehensible financial statements.” Skilling became agitated with McLean’s inquiry, told her that the line of questioning was unethical, and hung up on McLean. Shortly thereafter Andrew Fastow and two other key executives traveled to New York City to meet with McLean, ostensibly to answer her questions “completely and accurately.” 

Fastow engaged in several activities that challenge the foundational values of the company’s ethics code. Fastow tried to conceal how extensively Enron was involved in trading for the simple reason that trading companies have inherently volatile earnings that aren’t rewarded in the stock market with high valuations—and a high market valuation was essential to keeping Enron from collapsing. Another Fastow venture was setting up and operating partnerships called related party transactions to do business with Enron. In the process of allowing Fastow to set and run these very lucrative private partnerships, Enron’s board and top management gave Fastow an exemption from the company’s ethics code. 

Contrary to the federal prosecutor’s indictment of Lay, which describes him as one of the key leaders and organizers of the criminal activity and massive fraud that lead to Enron’s bankruptcy, Lay maintains his innocence and lack of knowledge of what was happening. He blames virtually all of the criminal activities on Fastow. However, Sherron 

Watkins, the key Enron whistleblower, maintains that she can provide examples of Lay’s questionable decisions and actions. As Bethany McLean and fellow investigative reporter Peter Elkind observe: “Lay bears enormous responsibility for the substance of what went wrong at Enron. The problems ran wide and deep, as did the deception required in covering them up. The company’s culture was his to shape.” Ultimately, the actions of Enron’s leadership did not match the company’s expressed vision and values. 

Enron’s Corporate Culture 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. According to 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.’” Enron’s corporate culture did little to promote the values of respect and integrity. These values were undermined through the company’s emphasis on decentralization, its employee performance appraisals, and its compensation program. 

Each Enron division and business unit was kept separate from the others, and as a result very few people in t  he organization had a “big picture” perspective of the company’s operations. Accompanying this emphasis on decentralization were insufficient operational and financial controls as well as “a distracted, hands-off chairman, a compliant board of directors, and an impotent staff of accountants, auditors, and lawyers.” 

Jeff Skilling implemented a very rigorous and threatening performance evaluation process for all Enron employees. Known as “rank and yank,” the annual process utilized peer evaluations, and each of the company’s divisions was arbitrarily forced to fire the lowest ranking one-fifth of its employees. 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 break rules and inflate the value of contracts even though no actual cash was generated. Enron’s bonus program encouraged the use of non-standard accounting practices and the inflated valuation of deals on the company’s books. Indeed, deal inflation became widespread within the company as partnerships were created solely to hide losses and avoid the consequences of owning up to problems. 

Complicity of the Investment Banking Community According to investigative reporters McLean and Elkind, “One of the most sordid aspects of the Enron scandal is the complicity of so many highly regarded Wall Street firms” in enabling Enron’s fraud as well as being partners to it. Included among these firms were J.P. Morgan, Citigroup, and Merrill Lynch. This complicity occurred through the use of prepays, which were basically loans that Enron booked as operating cash flow. Enron secured new prepays to pay off existing ones and to support rapidly expanding investments in new businesses. 

One of the related party transactions created by Andrew Fastow, known as LJM2, used a tactic whereby it would take “an asset off Enron’s hands—usually a poor performing asset, usually at the end of a quarter—and then sell it back to the company at a profit once the quarter was over and the ‘earnings’ had been booked.” Such transactions were basically smoke and mirrors, reflecting a relationship between LJM2 and the banks wherein “Enron could practically pluck earnings out of thin air.” 

Epilogue The Enron Code of Ethics and its foundational values of respect, integrity, communication, and excellence obviously did little to help create an ethical environment at the company. The full extent and explanation of Enron’s ethical collapse is yet to be determined as legal proceedings continue. Fourteen other Enron employees—many high level—have pled guilty to various charges; 12 of these are awaiting sentencing, while the other two, one of whom is Andrew Fastow’s spouse, have received prison sentences of at least one year. Juries have convicted five individuals of fraud, as well as Arthur Andersen, the accounting firm hired by Enron that shared responsibility for the company’s fraudulent accounting statements. Three of the convicted individuals were Merrill Lynch employees involved in the Nigerian barge deal with Fastow. Ken Lay and Jeff Skilling, along with Richard Causey, Enron’s former chief accounting officer, are awaiting trial. Lay faces 11 criminal counts, Skilling faces 35 criminal counts, and Causey faces 31 criminal counts. Five executives from Enron’s broadband division are also awaiting trial. Three bank executives from Britain who had been involved in a complicated series of deals in a Fastow partnership are fighting extradition. In addition, there are 114 unindicted co-conspirators in the federal government’s case against Lay and Skilling.

Questions for Discussion1. What led to the collapse of Enron under Lay and Skilling?2. How did the top leadership at Enron undermine the foundational values of the Enron Code of Ethics?3. Given Kenneth Lay’s and Jeff Skilling’s operating beliefs and the Enron Code of Ethics, what expectations regarding ethical decisions and actions should Enron’s employees reasonably have had? 4. How did Enron’s corporate culture promote unethical decisions and actions?5. How did the investment banking community contribute to the ethical collapse of Enron?

SourcesThis case was developed from material contained in the following sources:Elkind, P., McLean, B. (July 12, 2004). Ken Lay flunks ignorance test. Fortune, http://www.fortune.com, accessed December 15, 2004.

Enron Code of Ethics. The Smoking Gun Web site, http://www.thesmokinggun.com, accessed December 15, 2004.Enron: Houston Chronicle Special Report. (Dec. 11, 2004). Houston Chronicle, http://www.chron.com/cs/CDA/story.hts/special/enron/1624822, accessed December 15, 2003.

Enron Timeline. Houston Chronicle, http://www.chron.com/content/chronicle/special/01/enron/timeline.html, accessed December 15, 2003.

Fowler, T. (October 20, 2002). The pride and the fall of Enron. Houston Chronicle, http://www.chron.com/cs/CDA/story.hts/special/enron/1624822, accessed November 25, 2003.

Flood, M. (September 10, 2003). Ex-Enron executive going to prison: Glisan plea may speed cases. Houston Chronicle, http://www.chron.com/cs/CDA/story.hts/special/enron/2090943, accessed November 25, 2003.

McLean, B. (December 9, 2001). Why Enron went bust. Fortune, http://www.fortune.com, accessed December 15, 2004.

McLean, B., Elkind, P. (October 13, 2003). Partners in crime. Fortune, http://www.fortune.com, accessed December 15, 2001.

McLean, B., Elkind, P. (October 13, 2003). Partners in crime, part 2. Fortune, http://www.fortune.com, accessed December 15, 2001.

Mehta, S.N. (October 14, 2003). Employees are the best line of defense. Fortune, http:// www.fortune.com, accessed December 15, 2004.

Novak, M. (1996) Business as a Calling: Work and the Examined Life. New York: The Free Press.Strip clubs, daredevil trips, $1 million paychecks. (October 2, 2003). Excerpt from B. McLean and P. Elkind, The Smartest Guys in the Room, printed in Fortune, http://www.fortune. com, accessed December 15, 2004.

Enron is a company that reached dramatic heights, only to face a dizzying

collapse. The story ends with the bankruptcy of one of America's largest

corporations. Enron's collapse affected the lives of thousands of

employees, many pension funds and shook Wall Street to its very core. To

this day, many wonder how a company so big and so powerful

disappeared almost overnight. How did it manage to fool the regulators

and the Wall Street community for so long, with fake off-the-books

corporations? What is the overall lasting impact that Enron has had on the

investment community and the country in general?

Tutorial: Introduction To Accounting

Collapse of a Wall Street Darling

By the fall of 2000, Enron was starting to crumble under its own weight.

CEO Jeffrey Skilling had a way of hiding the financial losses of the trading

business and other operations of the company; it was called mark-to-

market accounting. This is used in the trading of securities, when you

determine what the actual value of the security is at the moment. This can

work well for securities, but it can be disastrous for other businesses.

In Enron's case, the company would build an asset, such as a power plant,

and immediately claim the projected profit on its books, even though it

hadn't made one dime from it. If the revenue from the power plant was less

than the projected amount, instead of taking the loss, the company would

then transfer these assets to an off-the-books corporation, where the loss

would go unreported. This type of accounting created the attitude that the

company did not need profits, and that, by using the mark-to-market

method, Enron could basically write off any loss without hurting the

company's bottom line. (Read more about the disastrous implications of

mark-to-market accounting in Mark-To-Market Mayhem.)

Part of the reason the company was able to pull off its shady business for

so long, is that Skilling also competed with the top Wall Street firms for the

best business school graduates, and would shower them with luxuries and

corporate benefits. One of Skilling's top recruits was Andrew Fastow, who

joined the company in 1990. Fastow was the CFO of Enron until the SEC

started investigating his role in the scandal. (Read more in Are Your

Stocks Doomed?)

Fraud: What Was the Scheme?

The mark-to-market practice led to schemes that were designed to hide

the losses and make the company appear to be more profitable than it

really was. In order to cope with the mounting losses, Andrew Fastow, a

rising star who was promoted to CFO in 1998, came up with a devious

plan to make the company appear to be in great shape, despite the fact

that many of its subsidiaries were losing money. That scheme was

achieved through the use of special purpose entities (SPE). An SPE could

be used to hide any assets that were losing money or business ventures

that had gone under; this would keep the failed assets off of the company's

books. In return, the company would issue to the investors of the SPE,

shares of Enron's common stock, to compensate them for the losses. This

game couldn't go on forever, however, and by April 2001, many analysts

started to question the transparency of Enron's earnings. (For more,

see The Biggest Stock Scams Of All Time.)

The Shock Felt Around Wall Street

By the summer of 2001, Enron was in a free fall. CEO Ken Lay had retired

in February, turning over the position to Skilling, and that August, Jeff

Skilling resigned as CEO for "personal reasons." By Oct.16, the company

reported its first quarterly loss and closed its "Raptor" SPE, so that it would

not have to distribute 58 million shares of stock, which would further

reduce earnings. This action caught the attention of the SEC. (Find out

how this regulatory body protects the rights of investors. Read Policing The

Securities Market: An Overview Of The SEC.)

A few days later, Enron changed pension plan administrators, basically

forbidding employees from selling their shares, for at least 30 days. Shortly

after, the SEC announced it was investigating Enron and the SPEs created

by Fastow. Fastow was fired from the company that day. In addition, the

company restated earnings going back to 1997. Enron had losses of $591

million and had $628 million in debt, by the end of 2000. The final blow

was dealt when Dynegy (NYSE:DYN), a company that had previously

announced would merge with the Enron, backed out of its offer on Nov. 28.

By Dec. 2, 2001, Enron had filed for bankruptcy. (Learn more about finding

fraud inPlaying The Sleuth In A Scandal Stock.)

Lasting Effects

Enron shows us what a company and its leadership are capable of, when

they are obsessed with making profits at any cost. One of Enron's lasting

effects was the creation of the Sarbanes-Oxley Act of 2002, which

tightened disclosure and increased the penalties for financial manipulation.

Second, the Financial Accounting Standards Board (FASB) substantially

raised its levels of ethical conduct. Third, boards of directors became more

independent, monitoring the audit companies and quickly replacing bad

managers. While these effects are reactive, they are important to spot and

close the loopholes that companies have used, as a way to avoid

accountability.

The Bottom Line

The collapse of Enron was an unfortunate incident, and it is important to

know how and why it happened, so we can understand how to avoid these

situations in the future. Looking back, the company had incurred

tremendous financial losses as a result of arrogance, greed and

foolishness from the top management, all the way down. Many of the

company's losses started the collapse that could have been avoided, if

someone had had the nerve and the foresight to put a stop to it. Enron will

remain in our minds for years to come, as a classic example of greed gone

wrong, and of the action that was taken to help prevent it from happening

again. (For further reading, see Business Owners: Avoid Enron-esque

Retirement Plans.)