enron development corporation case study

• 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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How the Enron Scandal Changed American Business Forever

It’s the kind of historic anniversary few people really want to remember.

In early December 2001, innovative energy company Enron Corporation, a darling of Wall Street investors with $63.4 billion in assets, went bust. It was the largest bankruptcy in U.S. history. Some of the corporation’s executives, including the CEO and chief financial officer, went to prison for fraud and other offenses. Shareholders hit the company with a $40 billion lawsuit, and the company’s auditor, Arthur Andersen, ceased doing business after losing many of its clients.

It was also a black mark on the U.S. stock market. At the time, most investors didn’t see the prospect of massive financial fraud as a real risk when buying U.S.-listed stocks. “U.S. markets had long been the gold standard in transparency and compliance,” says Jack Ablin, founding partner at Cresset Capital and a veteran of financial markets. “That was a real one-two punch on credibility. That was a watershed for the U.S. public.”

The company’s collapse sent ripples through the financial system, with the government introducing a set of stringent regulations for auditors, accountants and senior executives, huge requirements for record keeping, and criminal penalties for securities laws violations. In turn, that has led in part to less choice for U.S. stock investors, and lower participation in stock ownership by individuals.

In other words, it was the little guy who suffered over the last two decades.

Americans lost trust in the stock market

The collapse of Enron gave many average Americans pause about investing. After all, if a giant like Enron could collapse, what investments could they trust? A significant number of Americans have foregone participating in the tremendous stock market gains seen over the last two decades. In 2020, a little more than half of the population (55%) owned stocks directly or through savings vehicles such as 401Ks and IRAs. That’s down from 60% in the year 2000, according to the Survey of Consumer Finances from the U.S. Federal Reserve.

That could have had a large financial impact on some folks. For instance, an investment of $1,000 in the S&P 500 at the beginning of 2000 would recently have been worth $4,710, including reinvested dividends. Wealthier people, who often employ professionals to handle their investments, were more likely to stick with their stocks, while middle class and poorer people couldn’t take the risk. Without doubt this drop in stock market participation has contributed to the growing levels of wealth inequality across the U.S.

It became harder for companies to IPO

While lack of trust in the market is a direct consequence of Enron’s mega fraud, the indirect consequences of government actions also seem to have hurt Main Street USA.

Immediately following the bankruptcy, Congress worked on the Sarbanes-Oxley legislation, which was meant to hold senior executives responsible for listed company financial statements. CEOs and CFOs are now held personally accountable for the truth of what goes on the income statement and balance sheet. The bill passed in 2002 and has been with us since. But it has also drawn harsh criticisms.

“The most important political response was Sarbanes-Oxley,” says Steve Hanke, professor of applied economics at Johns Hopkins University. “It was unnecessary, and it was harmful.”

In many ways, the legislation wasn’t needed because the Justice Department and the Securities Exchange Commission already had the powers to prosecute executives who cooked the financial books or at a minimum were less than transparent with the truth, Hanke says.

The direct result of the legislation was that public companies got dumped with a load of bureaucratic form-filling, and executives would be less likely to take on entrepreneurial risks, Hanke says. There is also much ambiguity in the law about what is or what isn’t allowed and what are the ultimate consequences of non-compliance. “You don’t know what you are facing in terms of penalties, so you back off of everything risky,” he says.

Quickly, that meant the stock market underwent two significant changes. First, fewer companies are listed now than since the 1970s. In 1996, during the dot-com bubble, there were 8,090 companies listed on stock exchanges in the U.S., according to data from the World Bank. That figure had fallen to 4,266 by 2019.

That drop was partially a reflection of the regulatory burden of companies wishing to go public, experts say. “It costs a lot of money to employ the securities attorneys needed for Sarbanes-Oxley,” says Robert Wright, a senior fellow at the American Institute of Economic Research and an economic historian. “Clearly, fewer companies can afford to meet all these requirements.”

Companies now wait under they are far larger before going public than they did before the Sarbanes-Oxley rules were introduced. Yahoo! went public with a market capitalization of $848 million in April 1996, and in 1995 Netscape got a valuation of $2.9 billion. Compare that to the $82 billion IPO valuation for ride share company Uber in 2019, or Facebook $104 billion IPO value in 2012.

Now, companies grow through investments that don’t require a public market listing and that don’t involve heavy bureaucratic costs. Instead, startups go to venture capital firms or private equity. The recent rise in the use of Special Acquisition Corporations (SPACs) is seen by some as a relatively easy way to skirt some of the burdensome regulations of listing stocks. However, SPACs do nothing to reduce ongoing costs or burden of complying with the Sarbanes-Oxley rules.

But when companies stay private longer, they spend more time without the public accountability required of listed companies. Former blood testing company Theranos famously remained private in a move some theorized was to avoid publicizing internal data. Because of the high barriers Sarbanes-Oxley placed on going public, the business world is now littered with large, private companies that don’t have to reveal their inner workings.

Delaying going public also affects Main Street because most individual investors cannot buy shares in companies that aren’t public. They haven’t been able to share in the profits from the speedy early-stage corporate growth that is typically seen in companies like Facebook and Uber.

Put simply, the Sarbanes-Oxley regulations have chased away some investing opportunities from the public market to the private ones. And in doing so have excluded small investors from participating—and gaining.

“Now smaller investors are shut out and all the big economic profits go to venture capitalists and the like,” Wright says. That, in many ways, is the legacy of Enron.

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Profile of Enron: The Rise and Fall

By: Scott A. Moore

In 1999, Enron was the #1 company in innovation and quality of management. Less than two years later, it filed for bankruptcy in one of the most portent fraud cases of the decade. The story of…

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• Publication Date: Mar 17, 2010
• Discipline: Business Ethics
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In 1999, Enron was the #1 company in innovation and quality of management. Less than two years later, it filed for bankruptcy in one of the most portent fraud cases of the decade. The story of Enron's rise and fall tells a lot about manipulation of accounting and regulatory standards and about the disregard of ethics and law in pursuit of money and excellence. Against the backdrop of the company's history and main players, the case explains the law-bending tactics used by Enron's management and partners, eventually leading to speculations and the resignation of then-CEO Jeff Skilling. The stock price crash and resulting bankruptcy are also discussed, and the profile ends with the main findings of the ensuing SEC investigation. This case is included in Module 3 of the course Business Thought & Action.

Learning Objectives

After discussing this case study, students will be able to:

1.) Describe the corporate history of Enron from its founding until its bankruptcy.

2.) Assess how the company's corporate governance model contributed to the company's eventual failure.

Mar 17, 2010

Discipline:

Business Ethics

Geographies:

United States

Industries:

Energy and natural resources sector

WDI Publishing at the University of Michigan

W90C58-PDF-ENG

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The Enron Scandal (2001)

Both of these buildings in downtown Houston, 1400 Smith Street and 1500 Louisiana Street, were formerly occupied by Enron. A ugust 2021 marked the 20 th anniversary of arguably the most notorious corporate-accounting scandal of all time. It may not have been the biggest in dollar terms, or even the most severe in terms of criminality and personnel held culpable, but the Enron Corp. scandal of 2001 remains perhaps the most impactful of all time. One of the largest companies in the United States collapsed virtually overnight, with the fallout of its malfeasance being billions of dollars stolen, thousands of jobs wiped out, dozens of criminal convictions and even one incident of suicide.

Indeed, when Enron filed for bankruptcy protection on December 2, 2001, it was the largest company to do so in US history until that point in time. It was also once the world’s largest energy-trading company, with a market value of up to $68 billion, before its collapse destroyed thousands of jobs and more than $2 billion in pension plans. The shockwaves the scandal sent across capital markets were seismic, shaking investor confidence to its core and changing the corporate and regulatory landscapes forever.

Jeffrey Keith Skilling was CEO of Enron Corporation at the time of the Enron scandal.

Enron was born in 1985 as a result of the merger between Houston Natural Gas Company and InterNorth Inc., with the chief executive officer (CEO) of Houston, Kenneth Lay, taking the reins of the newly formed entity. By 1990, Lay had hired Jeffrey K. (Jeff) Skilling, a partner at consulting firm McKinsey, which at the time was advising Enron. Two years later, Skilling had created a new accounting technique called mark-to-market (MTM) accounting, which was granted formal approval by the U.S. Securities and Exchange Commission (SEC) in 1992.

MTM accounting enables a company to adjust the value of its balance-sheet assets from their historical value to the current fair market value (FMV), and thus means that income can be calculated as an estimate of the present value of net future cash flow. Should a contract be worth $100 million over the coming 10 years, for instance, MTM accounting would enable a company to write $100 million in its books on the day the contract was signed, irrespective of whether the deal ultimately matched expectations. As such, Enron was able to inflate its present-day worth through its financial statements, substantially over and above what it had actually earned, and thus obfuscate the truth about its business performance.

This was perhaps no more clearly illustrated than when Enron Broadband Services, a subsidiary of Enron, partnered with Blockbuster in July 2000 in a 20-year deal to sell movie-on-demand services through its broadband network. In the pre-Netflix era, the prospect of delivering movies to people’s computers or televisions via broadband was a new and exciting one. And using MTM accounting meant that Enron could book all 20 years of forward projections from the deal—in this case, $110 million of estimated profit—to its financial statements for the mid-year 2000.

But the partnership ended up being terminated after movie studios expressed their opposition to Blockbuster providing such services. The failed deal and Blockbuster’s withdrawal, however, did not stop Enron from continuing to claim future profits and thus sell shares of the company at hugely inflated prices, despite the deal resulting in a loss. Arguably, this was the first major incident to kick off the external scrutiny into Enron’s dealings and its questionable MTM practices.

Eventually, the unit CEO, Joseph Hirko, and vice presidents F. Scott Yeager and Rex Shelby were charged with conspiracy, fraud, insider trading and money laundering related to those practices. And Kevin Howard, the former chief financial officer (CFO), and Michael W. Krautz, a former senior director of accounting, of Enron Broadband Services were charged with conspiracy and fraud tied to the fabrication of earnings stemming from the failed Blockbuster deal.

The company also used accounting tricks to misclassify loan transactions as revenues just before quarterly financial-reporting dates. For instance, they entered into a deal with Merrill Lynch in which the US bank bought Nigerian barges with a buyback guarantee from Enron just before its earnings deadline. Enron misreported this bridge loan as a true sale before buying the barges back a few months later. Merrill Lynch was eventually held culpable in November for its role in assisting Enron in its accounting fraud, with some of the bank’s executives spending almost a year in prison.

Special purpose entities (SPEs) played a significant role in Enron’s misdeeds. Dubbed as the “Raptors”, these SPEs were created by the company—specifically by CFO Andrew Fastow with the apparent blessing of Skilling, Lay and the board of directors—to protect itself against MTM losses from its equity investments. Once these stocks began performing poorly, Enron “sold” them into the Raptors—LJM Cayman. L.P. (LJM1) and LJM2 Co-Investment L.P. (LJM2)—to shore up the appearance of its financial statements. In other words, LJM1 and LJM2 were created purely for the purpose of acting as the external equity investor required for the SPEs being used by Enron.

Fastow stated much of this when he testified before the U.S. Congress in the aftermath of the scandal and also confirmed that he himself stood to “benefit greatly from the partnerships”; indeed, he ended up pocketing some $45 million in the profit from his activity. In January 2004, he pleaded guilty to two counts of fraud, agreed to a prison term of up to 10 years and forfeited $24 million. “I was being a hero for Enron,” he said repeatedly during the testimony. “We were using this to inflate our earnings.”

According to the US government, Enron’s board also approved moving an affiliated company, Whitewing, off the books while guaranteeing its debt with $1.4 billion in Enron’s stock and helping it obtain funding to purchase Enron’s assets. “From the Raptor transactions, and numerous others described in the Powers Report, Congressional testimony, and newspaper reports, Enron may have paid out well over $300 million—in the form of cash, investments, and Enron stock—to advisors and SPE equity holders in order to sustain its network of off–balance sheet financing entities,” noted The CPA Journal in 2003. “By comparison, the Financial Accounting Foundation spent just $22 million to generate and maintain its FASB [Financial Accounting Standards Board] and GASB [Government Accounting Standards Board] standards-setting programs. As a result, it is not difficult to see how determined companies can run rings around GAAP [generally accepted accounting principles], exploiting technicalities and loopholes to create financial statements that even the most sophisticated investors cannot understand.”

In terms of Enron’s path towards bankruptcy, the failed Blockbuster deal kicked off a gradually expanding wave of scrutiny into the company’s accounts from the financial press. The Texas Journal ran a story in September 2000 about the shortfalls and lack of transparency surrounding the MTM accounting techniques being increasingly adopted by the energy industry. The following March, the Fortune article “Is Enron Overpriced?” questioned the company’s stock valuation and posited that investors were unaware of how exactly Enron made money, while concerns voiced by the article’s author, Bethany McLean, were dismissed by Skilling when she tried to discuss her findings with him before publishing the article. And perhaps most infamously, on a conference call with Wall Street analyst Richard Grubman who pressed him into explaining more about Enron’s accounting practices, Skilling retorted, “Well uh…. Thank you very much, we appreciate it…. Asshole.” The response was met with considerable astonishment from the public.

By late October, following mounting complaints from analysts over the opacity of Enron’s financial statements, ratings agency Moody’s had lowered Enron’s credit rating to just two levels above junk status. A few days later, it was revealed to the public that the SEC had begun a formal investigation into Enron and its dealings with “related parties”.

By late November 2001, Enron’s stock price had plunged to less than $1 per share, in stark contrast to its mid-2000 peak of $90.75. The company was estimated to have $23 billion in liabilities from both outstanding debts and guaranteed loans, raising speculation that it would have to declare bankruptcy. Enron Europe, the holding company for Enron’s operations in Continental Europe, was the first to do so on November 30, a day before the board voted unanimously to file for Chapter 11 protection for the rest of the company.

At $63.4 billion in total assets, Enron’s was the largest corporate bankruptcy in US history until the WorldCom scandal just one year later. Around 4,000 jobs were lost, and almost two-thirds of the 15,000 employees’ savings plans that depended on Enron stock, which had been purchased at $83 at the start of the year, became worthless.

Additional fallout from the scandal was most directly suffered by Enron’s accounting firm, Arthur Andersen, which earned $52 million in audit and consulting fees in 2000, more than one-quarter of total audit fees generated by the company’s Houston office clients. Andersen was accused of failing to apply sufficient standards during its audits of Enron’s books and conducting itself in a way to simply receive its fees without sufficiently examining Enron’s accounting practices.​

“When confronted by evidence of Enron’s high-risk accounting, all of the Board members interviewed by the Subcommittee pointed out that Enron’s auditor, Andersen, had given the company a clean audit opinion each year,” the US Senate found . “None recalled any occasion on which Andersen had expressed any objection to a particular transaction or accounting practice at Enron, despite evidence indicating that, internally at Andersen, concerns about Enron’s accounting were commonplace. But a failure by Andersen to object does not preclude a finding that the Enron Board, with Andersen’s concurrence, knowingly allowed Enron to use high risk accounting and failed in its fiduciary duty to ensure the company engaged in responsible financial reporting.”

Sherron Watkins (left), Vice President of Corporate Development for the Enron Corporation, Skilling attorney Bruce Hiler (middle), and Jeffrey Skilling (right), former CEO of Enron, during the Senate Commerce hearing on the company’s bankruptcy | Photo Credit: Ferrell, Scott J – Library of Congress

It was eventually revealed that several conflicts of interest arose between Andersen and Enron. For example, Andersen’s Houston office, which conducted the audits, had the power to overrule any criticism levelled at Enron’s accounting practices by Andersen’s Chicago partner. It was also discovered that Enron’s management had applied considerable pressure on Andersen’s auditors to meet its earnings expectations. For instance, it would briefly hire other accounting companies to conduct some accounting tasks and thus give the impression that it would replace Andersen. The shredding of almost 30,000 e-mails and other files after Enron’s malpractice was made public also raised suspicion of widespread collusion between the two parties.

Ultimately, Andersen’s involvement with Enron caused the accounting firm to break up, again leading to thousands of job losses. “The evidence available to us suggests that Andersen did not fulfill its professional responsibilities in connection with its audits of Enron’s financial statements, or its obligation to bring to the attention of Enron’s Board (or the Audit and Compliance Committee) concerns about Enron’s internal contracts over the related-party transactions,” according to the (William C.) Powers Committee, which was appointed by Enron’s board to review its accounting practices in October 2001.

The 2002 enactment of the Sarbanes-Oxley Act did strengthen the oversight of accountants; reduced the potential for conflicts of interests faced by auditors, specifically by barring them from providing various consulting services to audit clients; and enhanced the SEC’s enforcement tools.

But it wasn’t until February 2004 that the SEC finally indicted Skilling, charging him with “violating, and aiding and abetting violations of, the antifraud, lying to auditors, periodic reporting, books and records, and internal controls provisions of the federal securities laws”.

“In this scandal, as in others, we are by now all too familiar with executives who bask in the attention that follows the appearance of corporate success, but who then shout their ignorance when the appearance gives way to the reality of corruption,” Stephen M. Cutler, director of the SEC’s Enforcement Division, said at the time. “Let there be no mistake that today’s enforcement action against Mr. Skilling places accountability exactly where it belongs.”

A federal jury in 2006 convicted him on 19 out of 28 criminal counts, including fraud, conspiracy and insider trading. He was sentenced to 24 years in prison and ordered to forfeit $45 million. Lay was convicted of all six counts of securities and wire fraud for which he had been tried, but he died in July 2006 before serving his sentence of potentially up to 45 years behind bars.

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Enron Case study

This Enron case study presents our own analysis of the spectacular rise and fall of Enron. It is the first in a new series assessing organisations against ACG’s Golden Rules of corporate governance and applying our proprietary rating tool.

As we say in our business ethics examples homepage introducing this series, the first and most critical rule is an ethical approach, and this should permeate an organisation from top to bottom. We shall therefore always start with an assessment of the ethical approach of the organisation. The way this creates the culture determines the performance in relation to the other four Rules.

The Enron case study: history, ethics and governance failures

Introduction: why enron.

Why pick Enron? The answer is that Enron is a well-documented story and we can apply our approach with the great benefit of hindsight to show how the end result could have been predicted. It is also a good example to illustrate how ethics drives culture which in turn pushes the ethical boundaries and is a key influence on all the four other key elements of good corporate governance.

Hence, in advance of using our own membership for the survey input we can apply the very detailed findings from the post crash dissection of Enron. Readers who are interested can go to  Wikipedia  and burrow into the history of Enron and its major players. They can also study the various accounts that have been written and which are referred to in Wikipedia. We particularly commend “ The Smartest Guys in the Room ”, the story of Enron’s rise and fall, by Bethany McLean and Peter Elkind, and we gratefully acknowledge the valuable insights we have drawn from this fascinating book in producing our Enron case study.

Below is a brief résumé of Enron’s spectacular rise in fifteen years to a market valuation of nearly $100bn and its precipitous collapse. We have prepared a detailed history (around 20,000 words) with our own annotations, which will soon be available as an ebook for those who would like to draw their own conclusions. We have also applied our proprietary survey tool to Enron and imagined how the various stakeholder groups might have responded to a business ethics survey at a critical time in Enron’s history, mid 2000, eighteen months before it suddenly collapsed. The results of this survey are summarised below.

History of Enron

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

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

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

San Francisco, California. The US West Coast was an early target for its aggressive and misguided expansion.

Skilling’s vision was to transform Enron into a giant, asset-light operation, trading power generally and his next target was trading electricity. Lay was lobbying Washington hard to deregulate electricity supply and in anticipation he and Skilling took Enron into California, buying a power plant on the west coast.

Enron’s national reputation rested on the rapid expansion of its domestic business and its steadily growing revenue and earnings from trading. So on the back of his track record, Skilling was appointed Chief Operating Officer by Ken Lay and he then embarked upon transforming the whole of Enron to reflect his vision.

Observing the dotcom boom, Skilling decided Enron could create a business based on a broadband network which could supply and trade bandwidth and he set out to build this at a great pace.

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

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

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

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

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

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

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

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

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

The second half of this Enron case study assesses business ethics and the impact on corporate governance, as measured against our Five Golden Rules.

Ethical assessment

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

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

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

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

Impact on Corporate Governance

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

Clear goal shared by all key stakeholders

Lay and, particularly Skilling, engendered in all the staff of Enron the goal of driving up the share price to the virtual exclusion of all else. The goal of achieving a long term satisfaction from a stable customer base took a distant second place to signing up deals. In California, the customers were deliberately exploited by the traders to the maximum extent their ingenuity could achieve. Even internally, the Chief Finance Officer’s funding scheme was designed to make him rich at his employer’s expense.

Strategic management

As a McKinsey consultant specialising in strategy, Skilling had a very clear vision, at least initially, of what he wanted Enron to achieve. However, he wasn’t interested in management per se and allowed operational management to wither. But his vision of a huge trading enterprise wasn’t carried down to the next level of developing and implementing practical business plans, as evidenced by his crazy launch into broadband, a field in which he had no personal knowledge or experience and in which Enron had almost no capability or likelihood of raising the funds required to implement the project

Organisation resourced to deliver

Skilling became COO on the departure of a very tough and experienced predecessor. Even at that point, Enron had been expanding at a rate which outran its ability to set up appropriate and adequate administrative systems and controls. Added to which it had always been short of funds. Skilling’s lack of interest in operational management meant that on his appointment at COO, he made a poor situation much worse by making bad managerial appointments. His focus on rapid growth incentivised by very generous compensation schemes, and with inadequate spending controls, created a totally dysfunctional organisation.

Transparency and accountability

From the early stages, Enron’s focus on earnings and share price growth and the related financial incentives led to a necessary lack of transparency as the figures were fiddled.. One could argue that Enron felt very much accountable to their shareholders for delivering consistent above average growth in Enron’s market capitalisation. However, this growth was achieved by subterfuge and deception. Certainly the dealings in California were as far from transparent as it was possible to be.

Finally, we bring a unique perspective to this Enron case study by using our proprietary survey tool, the ACGi, to rate the company, as at June 2000, and drawing conclusions from the results.

Conclusion and rating by our Survey tool

The flaws in Enron should have been spotted from early on, and indeed were periodically commented on by various observers from the early nineties onward. If independent ethical and corporate governance surveys had been conducted by independent parties they would have highlighted the growing problems. To illustrate, consider the hypothetical survey summarised in the following chart.

The scores out of ten (high is good) result from a set of questions which aim at deriving an independent, unbiased view from the interviewees, based on observations of corporate behaviour. What we have called the “sniff test” represents the personal view of the interviewee and would take into account their gut feel about the corporation and its management and owners. The highlighted scores would point the observer to clear problem areas.

Click image to enlarge

One would conclude from this survey in June 2000 that:

• neither customers, suppliers, financiers nor local communities rated Enron’s morality in terms of business ethics
• customers and local communities thought they were breaking regulations
• customers and suppliers thought they were probably bending their own rules
• customers, shareholders, suppliers, financiers and local communities thought they were not truly honest.

It is clear with the benefit of hindsight that what started out as an imaginative and ground-breaking idea, which transformed the natural gas supply industry, rapidly evolved into a megalomaniac vision of creating a world-leading company. Intellectual self confidence mutated into contempt for traditional business models and created an environment in which top management became divorced from reality. The obsessive focus on driving the share price obscured the lack of basic controls and benchmarks and the progressive dishonesty in generating revenue and earnings figures in order to deceive the stock market led to the management deceiving themselves about the true situation.

Right up to nearly the end, Enron complied with all its regulatory requirements. The failings in these regulations led directly to Sarbanes-Oxley. But all the extra reporting in SarBox didn’t prevent the global financial meltdown in 2008 as the banks gamed the regulatory system. Now we have Dodd-Frank. What we actually need is independent Corporate Governance surveys.

If you found this summary useful, you may be interested in our full ebook :

• 52 pages of detailed analysis of the  Enron scandal
• An annotated walk-through of the history and ethics of the company
• Detailed explanations of the governance failures leading to the scandal
• Guidance for students of corporate governance
• Annexe with lessons for setting up stakeholder research 

You will also get a FREE version of our rating tool to adjust the scores according to your own assessment of the information presented in the full Enron Case Study.

If you have any comments or experience of Enron, please leave a contribution using the comments feature at the bottom of this page.

To stay up-to-date with news from Applied Corporate Governance, subscribe to our RSS feed or our mailing list .

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Solutions, Causes, & Conclusion: Enron Case Study

Welcome to our The Fall of Enron case study! Here, you will find the scandal timeline, company background, and a comprehensive conclusion. Enron case study will also reveal who was involved in the company’s downfall and how it could’ve been avoided.

Enron Case Study Introduction

Agency problem is one of the major challenges that shareholders face in their effort to maximize wealth through investment. One source of agency problems is associated with the existence of conflicts of interest. In an effort to increase their earnings, firms’ management teams engage in unethical practices such as financial irregularities. Additionally, they also implement operational strategies that aim at maximizing their firms’ profitability rather than the shareholders’ wealth.

Therefore, to better illustrate how the operational strategies implemented by firms’ management teams can cause a firm to collapse, this paper will evaluate causes, solutions, and conclusion of Enron scandal. More focus goes to the company background, cultural environment and the implemented management control. The paper also conducts an analysis of Enron’s ineffectiveness in implementing a strong organizational culture and its inefficient management control system. In conclusion, Enron case study will provide recommendations for Enron scandal.

Enron Case Study Background

The case illustrates the rise and collapse of Enron Corporation. Some of the salient features evident in the case include:

• Factors that contributed to the rise of the company – These factors are clearly illustrated and explained. The case makes it evident that Enron’s collapse was due to inefficient control by the company’s Chief Executive Officer, Jeff Skilling.
• The leadership style adopted by Jeff Skilling – Leadership style stands out as the major factor that contributed towards the emergence of an inefficient organizational culture.
• Establishment of a “new economy”- Skilling laid more emphasis on transforming the firm from being an “old economy” to being a “new economy”. However, the leadership style he adopted had a negative impact on the firm’s effort to achieve its goal.
• Management control system – The case cites inefficiency in controlling the activities of the employees, which comes out as a major cause that significantly contributed towards the firm’s failure.

Company attributes

Enron Corporation was energy and commodities trading company, which was formed in 1985 by Kenneth Lay. Its headquarters were located in Houston, in the US. The firm owned the most extensive natural gas pipeline in the US. In a quest to maximize its profitability, the firm ventured into the international market. In addition to its energy business, Enron also positioned itself as a giant with regard to water and wastewater management having ventured into the industry in 1998.

Upon its market entry, the firm gained global recognition courtesy of its strategic move with regard to its adoption of the “new economy” strategy. Enron’s management team appreciated the importance of diversification in an effort to maximize profitability. Consequently, the firm established numerous divisions.

Some of these divisions included online marketplace, transportation, wholesale, and broadband services. The firm’s decision to incorporate the concept of product and service diversification emanated from its founders’ focus on steering it towards maximizing the shareholders’ value.

Business strategy

The success of a firm depends on the effectiveness with which it formulates and implements business strategies. In the course of its operation, Enron adopted a business strategy that focused on attaining a high rate of expansion. Consequently, Enron incorporated a number of business strategies, which included internationalization and formation of mergers and acquisitions.

The firm’s success in the international market emanated from its ability to implement strategic practices such as acquisitions. For example, in 1987, Enron acquired Zond Corporation, a leader in wind-power, which provided an opportunity to venture into the renewable energy sector. The firm was very effective in venturing into the international market. In its internationalization strategy, one source of the firm’s success was its ability to formulate and implement effective international marketing campaigns.

Industry analysis using Porter’s five forces

Understanding industry characteristic is paramount in a firm’s efforts to formulate and implement competitive strategies. The porter’s model is one of the frameworks that are suitable in analyzing the intensity of competition, buyer and supplier bargaining power, degree of rivalry, and threat of entry of a particular industry.

The industry was experiencing an increment in threat of entry due to its profitability potential. New firms especially firms dealing in production of renewable energy were considering the possibility of venturing into the industry to exploit the presented profitability. The threat of entry was minimal given that there were minimal legal barriers. The emergence of renewable forms of energy significantly increased the threat of substitute.

Consumers were switching to renewable forms of energy. The intensity of competition led to an increment in the degree of industry rivalry. The various alternatives with regard to forms of energy significantly increased the buyers’ power. This aspect emanated from the fact that they could switch at a minimal cost. On the other hand, the suppliers’ bargaining power was low due to the large number of suppliers.

The Fall of Enron Case Study: SWOT Analysis

Pipeline infrastructure -The firm established an elaborate natural gas pipeline network in the United States. The firm’s name attained a relatively high credibility given that it ranked 7 th on the Fortune 500.

Positive reputation -In the course of its operation, Enron managed to attain and sustain positive reputation. Its strength also emanated from the fact that it had attained a monopolistic advantage over its competitors emanating from its large size. The firm achieved this goal by positioning itself as the largest energy provider in the US.

Human capital pool- A f irm’s ability to attain high competitive advantage relative to its competitors is directly impacted by the quality of its human capital. In its operation, Enron had been very effective in enhancing its employees’ skills, abilities, knowledge, and capabilities by undertaking comprehensive training and development.

Innovation- Enron’s management team appreciated the fact that it operated in a very dynamic industry. Consequently, it laid great emphasis on innovation in an effort to thrive. Its innovation ability enabled Enron to shift from natural gas and energy transportation to being a trading company. The firm specifically focused on other areas such as pulp and paper production, coal, steel, and communication business lines.

Marketing and value delivery- Since its establishment, Enron had been committed towards meeting the customers’ needs. Its ability to identify and deliver customer values played a significant role in enabling Enron to attain an optimal market position.

Failed board of directors- The firm’s board of directors did not execute its oversight role effectively, which stands out clearly in the face of its inability to monitor the firm’s operations through its committees. Additionally, the firm’s board of directors failed in enhancing moral and ethical practices within the firm. As a result, its auditors and employees engaged in unethical practices such as deceit.

Conflict of interest- The firm’s weakness also stands out given the inability of the management team to control conflicts of interest that occurred in various transactions that the firm engaged in during its existence. This aspect pushed the firm into great losses due to the persistent fraud, which further necessitated the firm’s collapse.

Opportunities

Public reputation -In the course of its operation, Enron developed a strong public reputation, which presents an opportunity that the firm could have exploited in the course of its operation. Consumers associated Enron with its ability to provide quality energy. Consequently, Enron could have exploited such public perception to expand its pipeline and other businesses. Additionally, Enron could have exploited the move by the government to deregulate the energy industry by venturing in other energy sectors. For example, the firm should have considered the possibility of venturing into production of clean energy. This move would have played a significant role in dealing with climate change challenges of the 21 st century and thus the firm’s reputation would have improved significantly.

Formation of mergers and acquisitions – Considering the prevailing economic environment, Enron should have improved its competitive advantage by seeking reputable firms in the industry to form mergers and acquisitions. Some of the potential partners that the firm should have focused on included firms dealing in production of clean energy. In the course of its operation, Enron gained sufficient experience informing mergers and acquisitions.

Terrorist threat – The threat of terrorism had become real to firms in different economic sectors. Terrorists were increasingly targeting major infrastructure in the US such as energy plants in an effort to sabotage the country’s economy. Therefore, the extensive natural gas pipeline that Enron had developed in the US could have attracted terrorists, and such an occurrence could have a significant impact on Enron’s operation.

Economic crisis- Due to the high rate of globalization, the US could not shield itself from the occurrence of another economic recession. The occurrence of a recession could have directly affected Enron because it derived a significant proportion of its revenue from household consumption.

Competition – In the course of its operation, Enron faced competition challenges emanating from the numerous firms in the US energy industry. The intense competition significantly increased the degree of rivalry within the industry. Consequently, most firms in the industry focused at formulating and implementing strategies that enhanced their ability to increase their market share. One of the strategies that the industry players were focusing on entails research and development.

Organizational culture

An organization’s culture has a significant impact on how its employees act. This aspect arises from the fact that the culture nurtured by a particular organization affects its traditions and customers coupled with how employees execute their duties and responsibilities. Firms develop their culture over time. Upon his entry into the company, Jeff Skilling intended to transform the company’s culture into a “New Economy”, and to achieve this goal, he focused on transforming the company into becoming an exemplary intellectual capital firm that would greatly delight the shareholders and stakeholders.

Consequently, Enron developed a culture that was characterized by intense regulation. This move significantly contributed towards the firm’s collapse. The firm’s management team believed that the culture it developed would foster its innovativeness and capacity to adapt.

Consequently, the firm recruited the most talented employees mostly composed of new university graduates such as MBA holders. The decision to recruit employees of such caliber hinged on the management teams’ emphasis on entrepreneurial thinking and risk taking, which made the firm’s managers to become overconfident.

Enron nurtured an aggressive culture that led to a high rate of employee turnover. This scenario arose from the fact that the firm laid more emphasis on attaining short-term results. The firm’s management team formulated an employee evaluation program that was conducted after every six months. The objective of the evaluation was to enhance the integrity and creativity amongst the employees.

However, this move stressed most of the employees thus reducing their operational efficiency. Employees who succeeded in attaining the set targets received extensive monetary rewards such as salary increments, stock options, and bonuses. Skilling’s focus on development of such culture did not succeed. Instead, a culture of arrogance, fierce internal competition, and extreme decentralization became the norm.

The firm’s manager was mainly concerned with transforming the institution into a postmodern, hyper-flexible, and a firm that continuously re-invents in order to align with changes in the external business environment. According to Skilling’s opinion, this would enable the firm to increase its profitability. Conversely, the ever-changing characteristic of the firm made employees to perceive a significant decline in their job security.

Due to its extensive expansion, Enron ventured into unfamiliar territories. The inexperience of the firm’s executives significantly contributed towards the occurrence of mistakes.

Additionally, the management team’s emphasis on generation of ideas from the employees led to accumulation of information, which the firm could not process adequately. Its over-emphasis on risk taking made the firm to ignore the costs associated with such risks. Additionally, putting pressure on the employees to be creative stimulated most employees to take shortcuts, which were in most cases unethical.

The firm’s employees laid more emphasis on creativity because it attracted great rewards compared to integrity. This aspect led to the occurrence of agency problem between shareholders and managers. Employees were mainly concerned with their personal welfare rather than attaining the shareholders’ wealth maximization goal.

Enron Case Study Problems and Key Issues

The case illustrates a number of problems and key issues that Enron experienced in the course of its operation. One of the major problems evidenced in the case touches on the accounting system used by the firm.

Enron adopted an aggressive accounting style whereby the accounting officers inflated figures in the firm’s financial statements. Additionally, special partnerships were formed with the objective of defrauding the firm. The partnerships rendered the process of accounting very complicated. The accounting officer did not record the actual values in the firm’s accounting books.

The records were made to look attractive, which was not the case. The management team engaged in fraudulent reporting by manipulating the firm’s revenue and earnings in order to sustain the firm’s credit rating. Consequently, most investors perceived the firm as a solid and reliable investment partner. The auditors colluded with the management team in return of huge financial gains.

Approximately, the auditors and consultants earned between $25 million and $27 million in audit and consulting fees. In the course of executing its oversight duties, Enron ignored the firm’s financial capacity, which made its shares to rise significantly during the 1990s.

Enron relied on the “mark to Market” accounting system, which enabled it to succeed in adjusting the value of its stocks and shares by reflecting the prevailing market value. By using this method, Enron comfortably reported its expected future earnings as current earnings.

Therefore, Enron disregarded its codes of ethics, which is based on integrity, respect, excellence, and communication. The existence of conflict of interest between managers and shareholders comes out clearly given the fact that the executive mainly focused on maximizing their earnings. In August 2001, the company Chief Executive Officer Jeff Skilling resigned from the company and immediately disposed off his stocks, which were valued at more than $33 million.

In addition to the accounting fraud, another key issue that is evident in the case study relates to the firm’s overdependence on making deals. Despite the fact that Enron had developed a professional risk assessment and control committee, the committee did not execute its duties effectively.

For example, the committee was reluctant to reject projects that were evidently risky. Its inability to execute this role was necessitated by the fact that the management team mainly focused on making deals that would contribute to increment in the firm’s cash flows, hence necessitating the firm’s ability to attain high growth.

Additionally, the committee was reluctant to express its opinion regarding illegal businesses and practices that the firm was undertaking. This scenario arose from the fact that making such opinions would herald their career’s death. The firm’s management team rewarded blind loyalty to employees and quashed those who portrayed dissent.

Enron situation fits perfectly in the theory of planned behavior. The theory explains that there exist reasons behind the occurrence of a particular situation.

It asserts that unethical practices such as corruption mainly hinge on specific values and intent. Enron’s employees mainly focused on engaging themselves in extreme competitive actions and favored unethical practices in order to achieve their desired operational efficiency. The behavior thrived because the employees observed the optimal treatment to individuals who engaged in shortcuts to attain the desired level of creativity.

Enron Scandal Conclusion and Recommendations

In summary, the fraud in Enron Corporation was a result of failure in the firm’s leadership system, management control, and ineffective organizational culture. Its focus on positioning itself as a “new economy” stimulated employees to engage in unfair activities in order to achieve the desired objective.

Additionally, the management team developed a culture that focused on attainment of results rather than nurturing integrity. Consequently, employees engaged in unethical practices and disregarded the codes of ethics implemented by the firm. Therefore, to deal with these challenges, we suggest the following recommendations for Enron scandal.

• Enron should have adopted a progressive-adoptive culture. This culture focuses on generation of new ideas and openness to new ideas. However, it does not force employees to implement the ideas hence it does not enhance unhealthy competition. It would also have been important for the firm to consider nurturing a community-oriented culture, which mainly seeks to ensure a high level of collaboration and cooperation amongst employees. Adoption of such cultures would have played an important role in providing employees with direction.
• To ensure effective reporting, Enron should have incorporated accrual method of reporting to ensure accurate description of the company’s value.
• With regard to control issues, the firm should have adopted a more current control system by reviewing its policies, procedures, and rules. The policies and procedures should have focused on nurturing integrity and ethics. The firm should have remained strict in implementing ethical policies and procedures to refrain employees from unethical behavior.

Action plan on how to implement the recommendations and the expected time duration

• Chicago (A-D)
• Chicago (N-B)

IvyPanda. (2023, August 27). Solutions, Causes, & Conclusion: Enron Case Study. https://ivypanda.com/essays/enron-case-study/

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Bibliography

IvyPanda . "Solutions, Causes, & Conclusion: Enron Case Study." August 27, 2023. https://ivypanda.com/essays/enron-case-study/.

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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.

U.S. Joint Committee on Taxation. " Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations, Volume 1: Report ," Page 56.

U.S. Joint Committee on Taxation. " Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations, Volume 1: Report ," Pages 59-63.

University of Chicago. " Enron Annual Report 2000 ."

U.S. Joint Committee on Taxation. " Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations, Volume 1: Report ," Pages 77 and 84.

Wall Street Journal. " Enron Announces Acquisition of Wessex Water for $2.2 Billion ."

University of Missouri, Kansas City. " Enron Historical Stock Price ."

The New York Times. " Enron Chairman Kenneth Lay Resigns, Company Says ."

University of Chicago. " Enron Reports Second Quarter Earnings ."

U.S. Securities and Exchange Commission. " SEC Charges Kenneth L. Lay, Enron's Former Chairman and Chief Executive Officer, with Fraud and Insider Trading ."

U.S. Securities and Exchange Commission. " Form 10-Q, 9/30/2001, Enron Corp. "

U.S. Joint Committee on Taxation. " Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations, Volume 1: Report ," Page 85.

GovInfo. " Enron and the Credit Rating Agencies ."

United States Bankruptcy Court. " Enron Corp. Bankruptcy Information ."

Blackstone. " Enron Announces Proposed Sale of Prisma Energy International Inc. "

GovInfo. " Enron Creditors Recovery Corp ."

JournalNow. " Judge OKs Billions to Enron Shareholders ."

United States Department of Justice. "Federal Jury Convicts Former Enron Chief Executives Ken Lay, Jeff Skilling on Fraud, Conspiracy and Related Charges ."

Federal Bureau of Investigation. " Former Enron Chief Financial Officer Andrew Fastow Pleads Guilty to Commit Securities and Wire Fraud, Agrees to Cooperate with Enron Investigation ."

U.S. Joint Committee on Taxation. " Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations, Volume 1: Report ," Page 62.

University of North Carolina. " Enron Whistleblower Shares Lessons on Corporate Integrity ."

U.S. Joint Committee on Taxation. " Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations, Volume 1: Report ," Pages 5-6 and 79.

George Benston. " The Quality of Corporate Financial Statements and Their Auditors Before and After Enron ."

U.S. Joint Committee on Taxation. " Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations, Volume 1: Report ," Pages 2, 44, and 70-75.

The New York Times. " Jeffrey Skilling, Former Enron Chief, Released After 12 Years in Prison ."

U.S. Joint Committee on Taxation. " Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations, Volume 1: Report ," Page 72.

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Enron Development Corporation: The Dabhol Power Project in Maharashtra, India (A)

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V. Kasturi Rangan

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• Enron Development Corporation: The Dabhol Power Project in Maharashtra, India (B)  By: Krishna G. Palepu, V. Kasturi Rangan and Sarayu Srinivasan
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Enron Corporation: A Case Study

This paper provides a study on the overview of Enron Corporation & the facts for its collapse. It gives a detailed discussion of Enron's formation to its ends.

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The Case of Enron

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