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.
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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 to enlarge the image.
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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.

Source: http://www.applied-corporate-governance.com/enron-case-study.html