Background Information of the Company
Enron is an American power corporation that was established in Houston. Enron started in 1930 as a domestic natural gas pipeline corporation. It began to broaden its horizons into other energy markets in the 1960s. During the period between 1980 and the beginning of 1990, the business shifted from a local firm to a provider of energy products globally (Joint Committee on Taxation, 2003). By mid and late 1990s, Enron further diversified its activities to include products such as financial services, risk management and communication. By the year 2000, Enron was a global corporation that provided the following products and services:
- Energy resources and commodities, which consisted of electrical energy, unprocessed oil, native gas, liquid native gas, and energy generated by wind
- Financial and risk management services which included prevarication, weather conditions, energy costs and managing of chances of loss from fluctuating foreign exchange
- Electronic commerce services, which included trading bandwidth capacity, operating a global internet based transaction system for trading in wholesale and retail energy, providing movies and other forms of entertainment on demand (Taub, 2001).
- Trading in metals
- Provision of water resources (Joint Committee on Taxation (2000).
Most of these products were not regulated. Therefore, Enron got the most out of the situation and diversified its market based on those commodities. The main motivation for the diversification was that it could easily manipulate the prices of the products and services that it handled.
The corporation was ranked among the top five companies by fortune magazine for having quality management, quality products and services and employee talent in 2001, which was the sixth time that the company clinched those awards (Joint Committee on Taxation, 2003). The corporation had competitively scouted for top talent in the academia to fill its team thereby forming a great task force with talent. In addition, the remuneration and benefits also lured many talented employees to join the corporation (Joint Committee on Taxation, 2003).
Enron’s friendly working conditions were due to the company’s desire to attain a reputation for great trading in the stock market. The corporation started various enterprises, which it used to take advantage and exploit the markets that were deregulated. However, the company plummeted at the end of 2002 from its rapid growth in the early to late 1990s setting the largest bankruptcy precedence in America by then. The occurrence led to the enactment of the Sarbanes-Oxley Act.
The Fraud Committed by Enron
The frauds committed by Enron Corporation were several and highly orchestrated by the top management, which was also in charge of a number of committees in the corporation. The corporation’s operations and finances were not clearly and transparently detailed in its financial statements to the analysts and shareholders. The complexity of Enron’s business model pushed accounting limits to the extent of modifying the balance sheet and revenues to portray a performance that was skewed, but pleasant to potential investors.
The company made certain that the leverage proportions fell within acceptable limits, which was attained through lobbying by the corporation’s management to the rating agencies to raise its credit ratings. The action was a fraudulent practice as it created a false impression of the financial credit position of the company.
Enron ensured that its return on assets ratio was within the acceptable limits. It achieved this through the reduction of its hard assets on paper and an increase the revenue from the reduced assets purported to be sold, which had the effect of lowering the proportion of debt with respect to the total assets (Joint Committee on Taxation, 2003). The ratios obtained from these computations amounted to fraudulent practice as the investors and credit rating agencies ended up interpreting superficial and unreal data.
In the late 1990s, companies like Dynegy, El Paso, Williams, and Duke Energy intensified their activities in energy provision (Healy & Palepu, 2003). Entry of the new firms in the energy provision industry posed competition. Enron’s market share reduced thereby lowering the revenue that the corporation expected.
In 2000, the big profit margins that the corporation realized were squeezed further. The company had to increase its leverage causing it to operate like a hedging fund rather than a trading company (Thomas, 2002). The economic downturn and recession of 2001 dampened volatility of the energy market further reducing Enron’s ability to trade rapidly to make gains that were required to keep the company profitable.
The finance division made deals hurriedly without paying attention to the corporation’s strategic goals. Noncompliance with internal risk management policies was common as the employees did not mind about the net present value (NPV) of the deals sealed (Thomas, 2002). These deals were perpetrated by employees out of fear as the internal culture had been altered by the institution of an employee ranking system, which instead of improving performance made fraud go sky-high. The ranking system had been developed by Skilling, who was influential in the corporation’s decisions making.
He set up the performance appraisal board, which was said to have been the most inconsiderate employee-grading scheme. This system was what caused employees to work to please the management to avoid losing their jobs thereby jeopardizing the sustainability and financial extensibility of their deals (Healy & Palepu, 2003). These practices would later cripple the company, as the deals were only perfect on paper, but financially unattainable and economically impossible with the resources available in Enron at that time.
The corporation also made sure that it accessed capital and hedged risk by using Special Purpose Entities (SPEs). SPEs were limited partnerships that a company could use to increase leverage and returns on assets without having to report a liability on its balance sheet (Taub, 2001). Enron, using the SPEs had access to large amounts of money and increased its debts.
The SPEs were used to hide the financial deficit of the corporation by handling financial transactions in a complex manner. As the financial obligations rose, the corporation came to the verge of selling additional shares since its asset value was declining. This event compounded the problems that had been building up from the false financial and accounting statements.
The Impact of the Fraud to the Organization
Enron was ranked among the most groundbreaking firms in the 1990s, but between 2000 and 2001, its performance was questioned and brought to the limelight thereby causing the share price to plummet. As a result, there was great panic in the stock market and investors. In 1997 for instance, the planned merger of Enron and Dynegy (a competitor) failed due to the absence of full exposé of the off-balance-sheet debt and the Special Purpose Enterprises (Healy & Palepu, 2003).
In 2001, the corporation stock price fell to $60 from $80, which further dropped to $40 and $30 during the year because of the loss of investors’ confidence in the corporation. Enron’s workers were not allowed to sell their stock from the company for a period of one month, and their pension plan was changed.
Employees make a crucial component of an organization. Therefore, the success of any organization is dependent on the ability to have a workforce that works as a team, which was not the case at Enron especially after the introduction of the performance review committee. The committee did not promote a spirit of teamwork, but enhanced rivalry and competition among the workers. As outlined, the company had the best talent in its labor supply.
With the high demands of the company, the employees did anything at their disposal to impress the management regardless of the outcome of their actions. For instance, in 1997, Enron formed Chewco Investment, which was directed by Michael Cooper. Cooper also worked at Enron during the period of his appointment at Chewco Investment.
The formation of the company had an ulterior motive as it was used to attain fake financial reports (Thomas, 2002). The motive was revealed by Enron in 2001 when it violated accounting standards that required at least 3 percent of resources to be in the possession of autonomous stockholders or investors. As Thomas asserts, the ignorance of this requirement made Enron avoid consolidating its special purpose entities, thus the liabilities in them were understated (2002). In return, its equity and earnings were overstated, which greatly increased the liability of the company as it created a temporary solution by displaying itself as a blue chip.
The corporation eventually collapsed in November 2001 after its stock plummeted to $1 from the high of $90 per share in the mid-2000 (Healy & Palepu, 2003). The U.S. Securities Exchange Commission (SEC) opened investigations, and Dynergy offered to purchase the company. The purchase never took place because the corporation filed for liquidation on the second day of December 2001 as stipulated by chapter 11 of the United States Bankruptcy Code (Taub, 2001).
Impact of the Fraud to the Stakeholders
The company stakeholders suffered from the fraud as the corporation’s employees lost jobs. The stockholders lost value of the stock they held due to the corporation’s insolvency. The agencies hired to give financial and other services that were related to informing the public on the performance of the company suffered as their images were tarnished. The company’s customers, on the other hand, constantly suffered from high service charges on energy.
The fraud was orchestrated by top talented and skilled employees who had used the deregulation channel to commit accounting crimes. The ease with which the fraud was committed was largely due to the use of complex accounting systems that were created to ensure that the analysis and interpretation of the corporation’s statements was impossible.
The corporation’s top executive used a mark-to-market accounting method that was centered towards portraying the corporation as a trading the company. It was unethical to falsify the accounting information and illegal to mislead the public and stakeholders of the corporation’s financial performance.
Enron had a policy of allowing its employees invest in private accounts with it from their retirement money. Thus, part of the social security payments of the employee went to the corporation for reinvestment (Joint Committee on Taxation, 2003). This deal was lucrative for the employees as their retirement savings would grow more than in the ordinary social security funds.
The privatization of social security saw the corporation get more funds to invest in the short term. In 1992, Enron began a project in the Indian state of Maharashtra, which was the leading foreign direct outlay in India during that time. The project was valued at three billion dollars and was to be the principal electricity producing plant in the world (Healy & Palepu, 2003).
The project was highly criticized for lacking economic feasibility due to high cost and lack of transparency as the project was rushed by the Indian officials. In addition, potential environmental impact and human rights violations were cited (Taub, 2001). The people of Maharashtra State demonstrated against the establishment of the project in their area, but no action was taken. Instead, the citizens were punished by ensuring that the project started without them being compensated (Joint Committee on Taxation, 2003).
The project continued regardless of all efforts to stop it locally and internationally. By the year 2001, nearly 90% of it was complete, but it came to a standstill due to poor business practices and environmental issues that agitated human rights advocates. After Enron’s liquidation in December 2001, the Indian government, Bechtel and General Corporation, which were in partnership made efforts to revive the company by selling it to recover part of their incurred losses.
The company, during its operational time, charged energy consumers extremely high prices that were far above other local companies, which was a clear indication of greed by the management of the company. Consequently, consumers incurred high-energy costs, and the Maharashtra state was burdened with huge electricity bills causing the electricity board to become bankrupt.
Enron’s use of special purpose entities made it conceal its fraudulent accounting method. The corporation’s external auditor was not independent in decision-making. It appeared that he was bribed to approve non-consolidation of the special purpose entities. Special purpose units were used to cover Enron’s debts and in return, they accumulated a large debt that was more than what the corporation could absorb (Thomas, 2002).
The worth of the resources in the entities fell, and Enron had to incur huge debt from 1999 to July 2001. The entities were used to pay Fastow (an executive) more than $30 million as management fees, which negatively affected the liquidity of the entities and the entire company (Joint Committee on Taxation, 2003). The effect of this coupled with the economic downturn saw Enron’s assets decline into bankruptcy. Creditors and investors lost their money causing them to sue the corporation for compensation.
Internal Controls of Enron’s Company to Deter Fraud
Enron, as a corporation, was headed by a chief executive officer. The corporation lacked any external control to ensure that internal fraud was deterred. The top managers in the company formed SPEs to get funds from the corporation with a reason to invest, which was not the case. The management ensured that the employees got the profits realized by any means possible due to lack of internal controls. The employees worked hard to get a good rating and to keep their jobs, which replaced the attitude of corporate working to the extent of having a competitive workforce. In short, it was survival of the fittest.
Enron operated in autonomy that gave the executives freedom to operate without regulation due to deregulation. The support the corporation accorded political leaders and political parties also worsened the misconduct of the executives. The corporation had no internal control because the executive was still part of the board of directors. The external auditor to the corporation had a close relationship with the executive, and the auditor gave opinions that pleased the executives.
When the corporation became bankrupt, various controls were laid down. The federal government came up with legislation to ensure that corporation published their accounts and were to be regulated by the federal government. This legislation was known as the Sarbanes-Oxley Act enacted in 2002. Enron ran as a financial institution. However, unlike other financial institutions it never got any federal regulation and had no capital, margin or collateral requirements.
In addition, there were no reporting, licensing or registration requirements. There was no obligation for a dealer to maintain a bid and ask for quotes as specialists on stock exchanges normally did (Joint Committee on Taxation, 2003). The absence of regulations to guide Enron gave the corporation a loophole to mislead investors.
The corporation needs to be controlled just like any other financial company to ensure that the internal procedures are well adhered to and that the principle of disclosure is observed with accuracy. The Sarbanes-Oxley Act requires that the topmost management and the financial officers in a company must certify the financial statements. This clause ensures that the certifying parties are well acquainted with the reliability and validity of the financial statements.
Corporate Governance In Relation to the Enron Fraud
The management of Enron had successfully utilized the shortcomings of the accounting loopholes and used poor financial reporting methods due to deregulation. The fact that Enron was not regulated gave it leeway to continue with its operation for several years while making losses that were reported as profits. The payment of workers partly in stock motivated them to be unethical.
Consequently, they did not have a problem raising the price of the company stocks because they knew that they would earn more in return. The mark-to-market method, the competitive working environment and the use of special purpose entities were undisclosed shady deals that led to the collapse of the corporation (Joint Committee on Taxation, 2003). Therefore, there should be checks to ensure that all accounting is done in an understandable manner following full disclosure.
Deregulation of the corporation gave it extensive autonomy. The autonomy was used to the disadvantage of the corporation’s clients, investors and employees. The top executives of the corporation failed to perform their duty of protecting the investors as well as safeguarding the corporation’s assets. The executive also failed to steer the corporation financially in the required direction. The use of special purpose entities and derivatives to cover up debts was against acceptable ethics as it led to the corporation’s bankruptcy.
The Wall Street analysts did not fully advise the investors and the executives on the repercussions of the danger that was waiting. The board of directors acted together with the executive in the same spirit by approving major decisions and untrue financial statements to be used in the stock market. The board failed to oversee that the work of the executive was done with professionalism. The auditor who performed the internal and external inspection was constrained in making his judgment. Therefore, his actions led to the falsifying of the audited reports and misled the investors as well as the public.
Healy, P. M. & Palepu, K. G. (2003). The fall of Enron. Journal of Economics Perspectives 17(2), 3-26.
Joint Committee on Taxation. (2003). Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, Etc., Volume I: Report. Washington, DC: Diane Publishing.
Taub, S. (2001). Angry employees sue Enron. Web.
Thomas, W. C. (2002). The rise and fall of Enron: When a company looks too good to be true, it usually is. Web.