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Course Coordinator of 0503605 (Financial Management)
Assignment (2): Individual course work
Read the following case and analyze the issues in detail and make sound professional judgements using all sources of knowledge available to you and communicate your findings in a professional way.
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. Below is a brief résumé of Enron’s spectacular rise in fifteen years to a market valuation of nearly $100bn and its precipitous collapse.
History of Enron
Enron was created in 1986 by Ken Lay to take the opportunity he saw arising out of the deregulation of the natural gas industry in the USA. It started as a pipelines company and then 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 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.
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 ref
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 cash flow, while spending extravagantly on expansion, and eventually it blew up suddenly and dramatically. There was skepticism 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 crystallizing 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 behavior.
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, a dishonorable 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 attitude was pushing Enron to greatness and deluded themselves that this equated to ethical behavior. 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 (Ethical Approach, balanced objectives, decision making process in place, equal concern for all stakeholders, and accountability and transparency) 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 specializing 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 he deteriorated the operational management. 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
Organization resources 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 incentivized by very generous compensation schemes, and with inadequate spending controls, created a totally dysfunctional organization.
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 capitalization. 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.
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.
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 dictatorial 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 didn’t prevent the global financial meltdown in 2008 as the banks gamed the regulatory system.
Questions
1) Summarize the main ethical violations that had done by Enron managers?
2) What are the main role of ethics in corporate governance?
3) The SEC is trying to get companies to notify the investment community more quickly when a “material change” will affect their forthcoming financial results. In what sense might a financial manager of ENRON be seen as “more ethical” if he or she follows his directive and issues a press release indicating that profits will not be as high as previously anticipated?
4) What are the options that were available for ENRON managers to avoid bankruptcy?
5) If you were the CEO of Enron, what are the actions that you would take?
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