Enron Saga – An Ethical Point of View

A sketch of Enron

The Enron financial rout, is fascinating because it reveals that the ‘invisible hand’, which is meant to bring rationality into the market forces, may have no shadow, much like the character of a German novel, who had sold his own shadow to the devil thinking it was of little value, until it made him a monster banned from any human society.

At the time of its filing for bankruptcy in December 2001, there were 2,800 offshore units and 54 page list of people and companies who owed money from Enron. This was a far cry from the firm which, in the 1980s, specialized in the provision of natural gas pipelines and related services. But Enron rapidly expanded into trading activities in 1,800 products or contracts, the great majority of which were not subject to the regulatory oversight of the United States Commodity Futures Trading Commission (CFTC).

Birth of Enron

Enron Corporation was created in 1985, after the federal deregulation of natural gas in North America. It was formed by the merger of two natural-gas pipeline companies from Houston and Nebraska. This merger was primarily debt-financed, which meant that Enron started life with a large level of debt. Enron’s first CEO, Kenneth Lay knew that his firm would have to be innovative to survive. McKinsey & Co. was hired to assist in developing Enron’s business strategy. McKinsey not only gave Enron a business strategy, they also gave Jeffrey Skilling, who officially joined Enron in 1990. Skilling hired Andrew Fastow, a specialist in financial derivatives. Both Skilling and Fastow were MBAs from leading US business schools, having expertise in sophisticated financial instruments but having a dangerous drive of short-term wealth creation. Their ‘ethic’ was very simple and unambiguous; maximize Enron’s short-term stock price appreciation at any cost.

Enron’s corporate culture

The banners hanging in the foyer of Enron’s Head Office in Houston were emblazoned with Enron’s ‘R.I.C.E.’ principles: Respect, Integrity, Communication and Excellence. Anybody may have been fooled into thinking that this RICE acronym in fact had some bearing on Enron’s corporate culture. Given what we now know about Enron, RICE should more appropriately have stood for Risk-taking, Individualism, Contempt and Exploitation.

Enron’s CFO & CEO’s Ambitious Plan

Enron’s rapid growth involved large capital investments not expected to generate significant cash flow in the short term. Maintaining Enron’s credit ratings at an investment grade was vital to Enron’s energy trading business. One perceived solution was to create partnerships structured as Special Purpose Entities (SPEs) that could borrow from outside investors without having to be consolidated into Enron’s balance sheet. SPE 3% rules said, no consolidation is needed if at least 3% of SPE total capital was owned independently of Enron.

Enron’s creation of over 3000 partnerships started about 1993 when it teamed with Calpers (California Public Retirement System) to create JEDI (Joint Energy Development Investments) fund. Enron initially thought of these partnerships as temporary solutions for cash flow problems. But it later used these SPE partnerships under 3% rules to hide bad debts. In Nov 1997, Calpers wanted to cash out of JEDI.  To keep JEDI afloat, Enron needs new 3% partner. It created another partnership with Chewco. Enron’s plan was to back short-term loans to Chewco to permit it to buy out Calper’s stake for $383 million. Chewco got $240 mil loan from Barclay’s bank guaranteed by Enron $132 mil credit from JEDI (whose only asset is Enron stock) Chewco still needed 3% of $383 million (about $11.5 million) from some outside source to avoid inclusion on Enron’s books. Chewco Capital Structure of outside 3% was made of $1.25 mil from William Dodson & Michael Kopper (an aide to Enron CFO Fastow), $11.4 mil loans from Big River and Little River (two new companies formed by Enron expressly for this purpose who get a loan from Barclay’s Bank). Barclay’s Bank begins to doubt the strength of the new companies, Big River and Little River. It requires a cash reserve of $6.6 million to be deposited (as security) for the $11.4 million dollar loans. This cash reserve is paid by JEDI, whose net worth by this time consists solely of Enron stock, putting Enron at risk position for this amount. In first quarter of 2000, the increase in price of Enron stock held by JEDI resulted in $126 million in profits to Enron. But everything fell apart when Enron’s share price started to drop in fall 2000 (Dotcom bubble). In November 2001, Enron admitted to the SEC that Chewco was not truly independent of Enron. Chewco went bankrupt shortly after this admission by Enron. On October 16, 2001, in the first major public sign of trouble, Enron announces a huge third-quarter loss of $618 million. On October 22, 2001, the Securities and Exchange Commission (SEC) begins an inquiry into Enron’s accounting practices. On December 2, 2001, Enron files for bankruptcy.

Accounting and transactional techniques used by Enron

Enron used seven accounting and transaction techniques extensively, which provides an idea of the ways in which the firm pushed against or overstepped the limits imposed by regulation. Not all of Enron’s use of these techniques was in conflict with accepted accounting rules and practice; nevertheless, investigations revealed that it led to the firm’s bankruptcy.

Enron Board of Directors and Nonobservance of Good Corporate Governance

Corporate governance is a relationship between the management and it’s Board of Directors, its shareholders and lenders, and it’s other stakeholders such as employees, customers, suppliers, and the community of which it is a part. Many Enron employees had invested in Enron’s own stock and the active encouragement of this practice by Enron’s own management continuing as late as September 2001. But at the same time, Enron officers and a few directors were themselves selling the firm’s stock on a massive scale – to the tune of US$1.1 billion between January 1999 and July 2001. By contrast, sales of Enron stock in employees’ retirement plans were subject to restrictions.

The Enron Board of Directors failed to safeguard Enron shareholders and contributed to the collapse by allowing Enron to engage in high risk accounting, inappropriate conflict of interest transactions, extensive undisclosed off the books activities, and excessive executive compensation. The Board witnessed questionable practices by Enron management, but chose to ignore them. The Enron Board consisted of fifteen members, many of them with more than fifteen years of experience on the Board of Enron and its predecessor companies, and many of them also members of the Boards of other companies. There were five committees of the Enron Board, the key Audit and Compliance Committee had six members, of whom two had formal accounting training and professional experience. The Compensation Committee had five members, three with at least fifteen years of experience with Enron

An increase in revenues from US$40 billion in 1999 to US$101 billion in 2000 should have been more questioned by the Board than was in fact occasioned. Arthur Andersen provided regular briefings to the Board concerning Enron’s accounting practices which were novel and involved a serious risk of non-compliance with generally accepted accounting principles. It drew special attention to the fact that, in 2001, executives received almost US$750 million in cash bonuses for performance in the year 2000, a period in which the company’s entire net income amounted to US$979 million.

Auditor’s and Bank’s involvement

Enron’s external auditor was Arthur Andersen, which also provided the firm with extensive internal auditing and consulting services. Some idea of its relative importance in these different roles during the period leading up to Enron’s insolvency is indicated by the fact that in the year 2000, consultancy fees (at US$27 million) accounted for more than 50 per cent of the approximately US$52 million earned by Andersen for work on Enron.

Enron’s banks were deeply involved in the firm’s recourse to techniques for the manipulation of its reported earnings and balance sheet under the seven major transactions and accounting headings. The court-appointed bankruptcy examiner concludes that there is evidence that the bank had actual knowledge of the wrongful conduct in the transactions giving rise to the breaches of fiduciary duty by Enron’s officers. The bank also gave substantial assistance to certain Enron’s officers by participating in the structuring and closing of such transactions. Finally, injury to Enron was the direct or reasonably foreseeable result of such conduct.

An Ethical Analysis

In order to conduct an ethical analysis of the Enron affair, we need a clear idea of what ethic means. This is tricky, as the word ‘ethics’ has almost as many meanings as it has users. Ethics is all about acting for good, and everyone has his or her own idea.  Ethical principles are not about what induces players to act for good or their motivation but about the rational logic behind their actions. In our turbulent world, the most popular principle is the precautionary principle, which induces us to act without waiting for scientific proof of potential damage. Professional ethics, for its part, have traditionally invoked the responsibility, transparency and fair play principle that dominates the business world. There are countless principles of action, as numerous as the various ways of linking up ends and means, some of which are discussed below:

Perceiving complexity

Perceiving complexity means being able to identify the full range of rationalities in given economic situations. Short-term and longer-term rationality, sociological rationality, and psychological rationality, which is often multiple and sometimes diverges from what instrumental rationality would demand plus the host of conflicting legal references, the bane of auditors particularly when they have to deal with multinational firms.

The limitations of rational self-interest

In its crudest form, from Adam Smith’s famous book The Wealth of Nations (1776) that due to the rational self-interest rather than altruism the baker endeavors to serve his customers to the best of his ability.

Strengthening people’s sense of belonging and solidarity.

People will have fewer ulterior motives if they have ties of affection with their fellow players. In order to achieve this, it is necessary to strengthen their sense of belongingness, affection, solidarity that unites all the players in a market economy despite their diverging interests.

Fostering pride

A second, more positive way of increasing self-esteem would be to foster pride. The most direct way is to set an example. It is not about behavioral management, which teaches to adopt the attitudes expected by the people around them, but which proves counterproductive once their duplicitous attitudes are exposed.

Accepting symbols

The ultimate, and most intimate, degree of motivation is based on the symbolic approach. This approach is based on mutual recognition by people who have never met. This approach leads us to the foundation for good actions through the experience of uniqueness.

Conclusion

There is little point in identifying the foundation of ethics, in the hope that managers and companies that seek to avoid the misfortunes suffered and caused by Enron will be spurred into action. Laws that are upheld by a combination of fear and enticement, feelings that are sustained in the social game of commercial relationships, and the self-esteem that one acquires by showing respect for stakeholders are merely words that cannot replace the actual things they stand for, especially since the foundation of financial ethics cannot be seen in isolation from those who practice it. This very process is part of the practice of ethics, as the foundation of ethics cannot remain frozen in previously tested positions, however valid these may seem. Instead, it has to be reinvented in response to each new dilemma. The practice of ethics is thus rather similar to the practice of science, in which the analytical frameworks and formal models that serve as principles of ethical action are there to be challenged and stretched to breaking point. Once we are aware of the limitations of our own ethics, we can begin to act for good and as we do so, discover who we really are.

When the voyage becomes more perilous, the crew demands more of the captain. As ‘perfect storms’ gather on the horizon of the world economic scene, captains of industry are coming under increasing pressure to live up to the expectations of more nervous and demanding crews.