See discussions, stats, and author profiles for this publication at: https://www.researchgate.

net/publication/332247240

The Enron Case Study: History, Ethics and Governance Failures

Technical Report · April 2019

DOI: 10.13140/RG.2.2.16562.86723

CITATIONS READS
0 13,339

1 author:

Syed Abdul Rehman Bukhari

Mohammad Ali Jinnah University
25 PUBLICATIONS   5 CITATIONS   

SEE PROFILE

Some of the authors of this publication are also working on these related projects:

The Enron Case Study: History, Ethics and Governance Failures View project

Strategic Management View project

All content following this page was uploaded by Syed Abdul Rehman Bukhari on 06 April 2019.

The user has requested enhancement of the downloaded file.

SP19-MSMG-0032 Corporate Governance S A Rahman Bukhari

The Enron Case Study: History, Ethics and Governance Failures

Introduction
Why pick Enron? The answer is that Enron is a well-documented story and we can apply our
method with the great advantage of retrospection 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.

History of Enron
Enron was created in 1986 by Ken Lay to take advantage of the opening he saw coming 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 via a regulator (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
around 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 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.

1
SP19-MSMG-0032 Corporate Governance S A Rahman Bukhari

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 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

2
SP19-MSMG-0032 Corporate Governance S A Rahman Bukhari

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 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 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 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

Organizational failure at Delivery

3
 SP19-MSMG-0032 Corporate Governance S A Rahman Bukhari

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.

Conclusion
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.
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 Sar-Box Act didn’t
prevent the global financial meltdown in 2008 as the banks gamed the regulatory system.

View publication stats