The Enron collapse, occurred in October 2001, consequently caused the bankruptcy of the whole Enron Corporation, the world’s leading energy, commodities and services company, as well as the dissolution of Arthur Andersen, which was one of the top five largest audit and accountancy firms in the world. Noteworthy it was not only the largest bankruptcy proceeding in American history at that time, but also the most serious audit failure, so that one says, “Enron is fraud and fraud is Enron”. The rise of Enron was almost as fast as its failure. Actually, it was an unbelievable failure of a company with 20,000 employees and operations in 40 countries as well as with claimed revenues of nearly 111 billion USD in 2000. And still this failure taught a good lesson both to the companies conducting doubtful accounting practices and activities and government, so that the latter took various steps to improve regulatory environment and prevent fraudulent practices. This case study is aimed to provide a comprehensive case analysis including case background’s description and discussion of problems and key issues raised in the case, and to develop alternative solutions to the respective problems and generate proper management recommendations.
Keywords: Enron case, Enron Corporation, accounting fraud, fraudulent pratcticies, management control model, CEO, derivatives, futures, governance system, audit, commodity products.
2. Case Background
Brief History of the Company:
Birth of Enron and first difficulties
Enron as an interstate natural gas pipeline company with 37,000 miles of pipe was born in July 1985 in consequence of a merger of the Houston Natural Gas Company with InterNorth Inc. Kenneth Lay became the first CEO. In the early years the company endured heavy operating losses and several hostile takeover attacks. Further, some Enron’s pipelines were nationalized by the Peruvian government and as of 1988the company was close to death. The management blamed primarily Enron’s traditional economy business model and called for innovations. Responding to new challenges Enron president Richard Kinder introduce the conception of decentralized decision-making in order to respond properly to customer and investor needs.
Rise of Enron
In 1987, Enron launched its first global advertising company since liberalization of national energy markets provided great opportunities for expansion. As a result, in 1993, Enron became the first American company to construct a power plant in the United Kingdom. Additionally, same year Enron started building in India. Trying to develop innovative business and inspired by Jeffrey Skilling Enron was involved in new practices. Thus, in 1989 the company began trading natural gas commodities as well as futures. In 1994 Enron started selling electricity as a commodity and related financial derivative instruments. In November 1999 the company launched its own web-based system – Enron Online – in order to go global and trade in energy commodities and futures online. In fact, it was the world largest e-Commerce system at that time. The Fortune magazine named Enron as “America’s Most Innovative Company”. In a nutshell, Jeffrey Skilling contributed to a significant Enron’s transformation from a pure natural gas pipeline company to an international marketer player and trader of gas, electric and oil energy. Enron’s stock price was increasing respectively: in 1999 it traded at 45 USD per share, whereas in 2000 the stock price peaked at 90 USD. Moreover, its annual revenues rose from about 9 billion USD in 1995 to over 100 billion USD in 2000
Fall of Enron
Enron’s rapid expansion required larger financing; and as the company’s involvement in trading activities grew, so did the importance of its credit rating, since this determined its financing costs and future loans – and essentially, the company’s image and relations with its trading counter-parties. So, Enron’s abnormal ambitions and high management salaries challenged the company and urged it to hide debts while using fraudulent accounting methods. At the end of 2001 Enron’s institutionalized, systematic and creatively planned accounting fraud was finally revealed. Due to the reduction of corporation's stock price from 90 USD per share in mid-2000 to less than 1 USD per share at the end of 2001, Enron’s shareholders have lost nearly 11 billion USD. Having revised its financial statement for the previous five years Enron confessed there was 586 million USD in losses. Consequently, on December 2, 2001 Enron filed for bankruptcy protection. The collapse of Enron was caused not only by the conflicts with standards for good corporate governance but also by unusually extensive use of sophisticated techniques and transactions to manipulate the firm’s financial reports.
Economy and Industry
Generally, the Enron Corporation evolved from a pure natural gas pipeline company to a global marketer and trader of oil, gas and electric energy. The company was continually looking for new innovative businesses and practices as well as for new opportunities for market expansion. At the beginning following new trends Enron invested in “green” technologies, acquired a leading wind-power company and grounded its own Enron Renewable Energy Corporation. Then from the pipeline and renewable energy sector, Enron began moving into new more innovative fields:
trading natural gas commodities and commodity derivative financial contracts;
trading electricity as a commodity and related financial derivative contracts;
trading energy commodities and derivative contracts online using own web-based system – Enron Online.
So, by the mid-1990 the Enron Corporation was deemed to be a dominant energy company in the United States and one of the major energy players worldwide. The company searched for new fields and industries along with the gas market. In a result, the Enron Corporation soon became the largest trader in the market of electricity; in 2001 the company took the 7th place in the "Fortune 500". At that time, its staff consisted of 21,000 employees in 40 countries. To sum up, Enron was engaged in the following business segments:
transportation and distribution;
whole sale services;
retail energy services;
investment and overall corporate activities.
Enron’s business strategy evolved over the years as well as industries and practices. Thus, during the early period under the leadership of Richard Kinder, Enron set up realistic goals and did not chase for huge profits. All strategic, tactical and operational plans were freely and properly discussed and agreed. The three core pillars of management control system were established:
risk assessment and control;
performance review system;
The strategy implied customary financial structure and old economy model, whereas the next director Kenneth Lay called for innovative business in the environment of “informational capitalism”. Firstly, trying to achieve further growth and gain higher revenues, Enron introduced a diversification strategy. The company owned and operated various assets including gas pipelines, electricity plants (including renewable energy facilities), pulp and paper plants, water plants, and broadband services worldwide. The Enron Corporation also gained extra profits by trading the respective commodity derivative financial contracts. In other words, Enron wanted to be an “asset-light” company because the physical assets do not generate as high of returns as derivatives and other financial instruments. Some experts stated in this regard that the Enron Corporation had de facto stopped operating as an energy company and started functioning as a kind of bank. By 2000, the company has fully transformed into “a full-scale Wall Street trading corporation specializing in the financial engineering of derivatives with trading operations accounting for a large portion of the income”.
Enron Corporation pursued the adherence to standard and comprehensive organizational structure and corporate governance in order to attract shareholders and create a generally attractive image. The governance was organized as follows:
board of directors;
internal audit committee;
office for financial disclosure;
special departments for the respective areas;
qualified experts on certain issues.
Further, Enron outsourced many work and operations. There were the following external corporate governance bodies:
auditor (Arthur Anderson);
legal counsel (primarily the firm of Vinson & Elkins of Houston);
regulators (Federal Energy Regulatory Commission);
equity markets (Securities and Exchange Commission, New York Stock Exchange as well as the other exchanges on which Enron’s shares were traded);
debt markets (Standard & Poors, Moody’s, etc.)
As to the business organizational structure, as of December 2001, the Enron Corporation was structured into the following seven business units:
Energy and commodities services
Energy transportation and upstream services
Commercial and industrial outsourcing services
Project development and management services
Capital and risk management services
Online marketplace services
I strongly believe it was corporate culture that contributed greatly to the Enron final collapse in 2001. In fact, Enron had a comprehensive, state-of-the-art and award-winning management control and governance system during Richard Kinder’s term as president from 1986 to 1996, and was operating with an effective management control system. Richard Kinder, known within the Enron Corporation as “Doctor Discipline”, was equally people and profits oriented, and managed to create an Enron-family atmosphere with a respect for all in the corporation. He held frequent boardroom meetings where business units were able to present their innovative proposals for the further consideration. Noteworthy, that Mr. Kinder preferred realistic proposals to over-ambitious and risky plans.
Enron’s culture was transformed radically with the appointment of Jeffrey Skilling as CEO. He became a passionate promoter of a new postmodern economy combining the company’s intellectual capital company with various intangible resources, such as external accounting services, political connections, experienced financial instrument traders and sophisticated organizational structure. Meanwhile Enron implemented a “Wall Street type financial engineering platform” and was operating in energy futures. Finally, the Enron family collegiate atmosphere disappeared giving way to predatory profit seeking. What is more important, Skilling’s cultural policy was not able to balance the interests within the corporation. There was a tough contradiction between the interests of senior management team receiving earnings as a percentage of the displayed accounting profit and the interests of the corporation as a whole. This conflict of interest made the management of the company to hide losses and inflate profits. Besides, the policy of Performance Review Committees was introduced: these committees should rate their peers on a certain scale, so that employees would be systematically fired each year. The CEO himself described the corporate culture as tough and very aggressive.
Enron Online, the web-based system launched in late 1999, played crucial role in the development of the company’s IT architecture. Actually, it became the first web-based transaction system which made it possible for sellers and buyers to sell, to buy and trade energy commodity products globally. Before the system had been developed a potential buyer should negotiate the terms directly with an energy trader. Enron Online simplified the procedure significantly by allowing market participants to see prices on their computer screens and conclude contracts online. This online system was widely used by various traders and energy companies in the United States. To the essential commodities offered on Enron Online belonged electricity and natural gas, although there were about 500 other products including bankruptcy swaps, credit derivatives, TV commercial time, pulp, plastics, paper, steel, metals and freight.
Generally Enron’s online marketplace services encompassed:
EnronOnline (commodity trading platform)
EnronStrommarkt (B2B pricing and information platform)
DealBench (online business services)
ClickPaper (transaction platform for pulp, paper, and wood products)
Enron Direct (sales of fixed-price contracts for gas and electricity; Europe only)
EnergyDesk (energy-related derivatives trading; Europe only)
NewPowerCompany (online energy trading)
Enron Weather (weather derivatives) and others.
3. Problems and Key Issues Raised in the Case
1. How did Enron’s culture foster fraudulent practices?
It should be pointed out that Enron’s corporate culture was inspiring and effective in the earlier stage during the period of Richard Kinder’s term as president (1986 to 1996) and complied with the company’s Code of Ethics, however everything changed with the appointment of Jeffrey Skilling as CEO and it affected the business badly. In fact, a counter-productive system of incentives and sanctions for Enron’s workers was created. The corporation’s corporate culture was widely known as “cut-throat” combining high pressure on employees and aggressive competitive atmosphere with its Performance Review Committees mentioned above. Additionally internal competition was established between Enron Men and Enron Women as well as within different business units.
Along with unfavorable business climate and constant tension in the air Enron’s remuneration system also contributed to the fraudulent practices since it was linked directly to a company’s share performance. Indeed, remuneration is a strong incentive for the employees devoting their time energy to the corporation; however their work and decisions should not be driven by profits or greed. The company’s success, recognition and fair growth should constitute the main motivation. Top management at the Enron Corporation should have encouraged its staff to collective ambition of working in a reputable and prosperous company instead of stimulating heavy competition, misunderstanding and tension. As a result, a collective ethical behavior was not fostered and employees were pursuing exceptionally high revenues and consequently higher salaries.
Finally, Enron’s hiring policies were improper and shortsighted preferring university graduates or recent undergraduates recently rather than more experienced however costly professionals employees.
2. What fraudulent practices took place? Could they be prevented? If yes, how and by whom? If no, why not?
One believes Enron’s collapse was the failure of a company that had been built on lies and deceit. The focus was made on accounting fraud which encompassed two main fraudulent practices: new “mark to market” system and “special purpose entities”.
Being a publicly traded company, Enron was subject to various external regulations and rules including oversight by government regulators as well as by private entities such as equity analysts, auditors and credit rating agencies. In general, Enron had to provide its evaluation of assets and liabilities on a regular basis. Skilling introduced to the Enron Corporation a new form of accounting known as “mark to market”. Essentially a newly implemented accounting system enabled internal accountants to value assets and liabilities of the company at any value they considered suitable since “mark to market” allowed accounting for the fair value of an asset or liability to be calculated on the current market price as well as using any other objective process. Notable, that external regulatory body and external audit - the Securities and Exchange Commission and Arthur Andersen, Enron’s accounting firm - themselves approved Enron’s adoption of Mark to Market Accounting. Since then no matter how much profit Enron was earning, it could speculate with its commodity derivative financial contracts – futures, in particular. Experts repeatedly described such accounting system as very subjective and open to manipulation. No wonder as soon as Mark to Market Accounting was approved the Enron Corporation did not hesitate to post huge earnings and issue large bonuses to the management team.
The growing deficit in internal capital generated an urgent need in external capital flows, and in order to enable the latter the company required to hide the huge debts and get an excellent credit rating. It was the moment when Andrew Fastow, eventually the Chief Financial Officer, presented the concept of special purpose entities (hereinafter - SPEs). As a result most of Enron’s transactions involved SPE’s accounting structure. The SPEs created by Fastow served the following two crucial purposes: (1) by selling troubled assets to the “independent” SPEs, Enron removed them from its own balance sheet, both decreasing the firm’s total indebtedness and hiding underperforming investments; (2) by selling troubled assets to the its SPEs, Enron generated incomes which were declared quarterly earnings commitments to the external regulatory bodies.
Undoubtedly, SPEs constituted a solution, but only a temporary one. Since these entities were largely funded from equity in the form of Enron shares, a drastic reduction of corporation's stock price in 2001 made it impossible for SPEs to meet accounting guidelines for remaining off balance sheet. Finally, the SPE’s scheme failed.
3. Enron managed to disguise or otherwise hide a large portion of its debt in off-balance sheet entities called Special Purpose Entities or SPEs. If Enron’s accountant (Arthur Andersen) said that a particular business transaction is within accounting guidelines, should an investment banker question the legitimacy of the transaction before agreeing to help raise funds for it? Did banks play a role in the Enron scandal?
In fact, Arthur Anderson, Enron’s external auditor, was then one of “Big Five” firms and regarded as a very reputable institution, so it is no wonder that generally any investment banker did not question the legitimacy of the transaction before agreeing to help raise funds for it having learnt the Arthur Anderson’s approval. The job of the external auditor was to determine and testify whether the Enron Corporation had followed generally established accounting practices in the submissions of its financial results. Arthur Anderson was hired by Enron and paid by the corporation as well. Moreover, the audit firm also provided a variety of consulting services to the firm what made Enron one of the biggest Arthur Anderson’s clients. Additionally to audit’s approvals, several reputable legal firms failed to report on malfeasance and were continually confirming the company’s compliance.
It goes without saying, that bankers and banks played an essential role in the accumulating of Enron’s debts and consequently in the Enron scandal. Normally, a responsible investment bank should inspect several times the credit standing and general situation of a company before assisting in raising funds. It emerges from bank’s fiduciary duties as all banks, especially investment ones, should act in good faith towards their client. In Enron’s case, bankers and banks pursuing higher revenues provided Enron an access to the debt capital without decent inspection and so indirectly enabled further speculations. Thus Enron’s SPEs were largely funded from large quantities of debt from major banks. As a matter of fact most of these banks made millions of dollars on interest and fee income as a result of leading and managing debt issuances for Enron.
Many experts state that by the beginning of 2001 the major transnational banks were aware that Enron was engaging in unethical and moreover illegal accounting practices, but they preferred to take their share of the profits before the scandal exposed. Eventually, the bankers and banks jumped ship as soon as the scandal broke, while mostly claiming ignorance.
4. How management control models can change with the leadership at the top?
As far as it is evident from the Enron case, management control models can change dramatically with the leadership at the top. The management control model under Richard Kinder’s presidency was comprehensive, balanced and structured, whereas Jeffrey Skilling called for overall changes and challenged the company greatly. The lameness of the newly introduced management control model of Enron is also known as “failure of people”.
Firstly, the executive officers of the Enron Corporation pursued their own goals while managing the Board of Directors. Thus, management itself had moved the company into different new markets, often emerging ones, where the Enron Corporation suffered substantial losses, resulting in new attempts to raise funds by all means to meet the Wall Street’s unquenchable thirst for profitable growth. Next, the Board of Directors failed in its obligations and fiduciary duties to protect Enron’s shareholder interest because of lack of due diligence and a strong faith in the competence and integrity of the company’s senior officers. Besides, it was the management who paid large sums to the external companies (auditors, legal advisors) to make them and general public easily believe Enron was doing well. It is the company’s management to blame for the application of highly risky policies and strategies, which at the end resulted in huge indebtedness und led to bankruptcy. I believe the management control model totally failed since the shareholders did not have effective mechanisms to control the managers and so to ensure the stability and security of their investments.
5. How the Enron fraud shattered the ‘myths’ in the regulatory environment?
Generally, many factors contributed to Enron's failure, in particular such factors as fraudulent accounting practices, extreme and tough corporate culture, unreasonably high expectations from the CEO, unprecedented market conditions, and so on. To be more exact, the incompliance with generally accepted accounting principles (GAAP), biased approvals from external auditors and extensive use of off-balance sheet schemes (such tools as “mark to market” system and “special purpose entities”) had played crucial roles. As the collapse of Enron was reported, the general public started identifying who was to blame for along with company’s management. And it was US Security and Exchange Commission that allowed the Enron Corporation to implement a highly controversial “mark to market” accounting method. So, government regulation in the field failed to secure economic safety and prevent fraudulent practices.
Being challenged by the Enron’s unexpected collapse, the US government bodies have taken some significant steps to improve the system:
Adoption of Sarbanes-Oxley Act, a United States Federal Law for Public Company Accounting Reform (the act introduced the set of enhanced and effective standards for all American publicly traded companies and for their boards, management and internal audit departments, in particular);
American Institute of Certified Public Accountants was obliged to draft proper financial reporting models as well as to introduce new policies for preventing fraud, e. g. more effective internal control proceedings for management and audit committees;
US Securities and Exchange Commission constituted a special disciplinary board to foster the investigation of alleged fraudulent companies or non-compliant organizations; and some other measures.
4. Case Analysis
First of all, I would question the earlier legal strategy – an aggressive market expansion conducted by the Enron Corporation after the energy markets had been significantly liberalized worldwide. Taking into account potential political (or non-commercial) risks only, I would have advised Enron not to enter Peruvian or Indian market so quickly but wait for the first experience of other foreign energy companies. Instead, the Enron Corporations could have concentrated on other industries or fields (shale gas or renewable energy), strengthen its positions in Europe. On the one hand, such steps could have prevented the nationalization of Enron’s pipelines in Peru and the company would not have spent so huge sums maintaining its business in India. On the other hand, the Enron Corporation wouldn’t have widely recognized as the first energy company which had went globally, and so wouldn’t have built the outstanding reputation and even admiration.
Secondly, it is obvious that the company should not have used tough, over-challenging and aggressive corporate culture. I assume that it boosted competitiveness but subsequently led to constant tension and failure to create collective ethical behavior and ambition to promote company’s interests. I believe the system established by Richard Kinder and his decentralized decision-making should have been maintained, although improved taking into account new IT possibilities. In this regard I would have advised the company to employ Strategic Framework for Building an Enterprise Information System designed by US Government Accountability Office: (1) Information Technology → processes → (2) Information → enables → (3) Decisions → guides → (4) Business Processes → accomplishes → (5) Strategic Goals. The introduction of progressive information technologies to Kinder’s traditional scheme would be the best option for Enron’s stable and continual development. One should admit that Enron Online, the web-based system launched in late 1999, was a great achievement and even after the Enron’s collapse it is still operating in changed form.
Thirdly, the corporate governance system proved to be inefficient. The shareholders relied too much on the Board of Directors and failed to inspect suspicious practices and transactions. From my point of view, to prevent company’s crisis, investors should demand to disclose all the accounting information, as well as the strategy to have new SPVs created. An extraordinary general meeting should be held to find out the real position of a company. Alternatively, the more effective management could have been chosen by the investors to run the corporation. The whole corporate governance system created by Jeffrey Skilling should have been revised and modified, so that the management would become more responsible and report full and orderly to the shareholders. As a possible solution I assume a comprehensive contract should have been concluded between the top management and Enron’s shareholders in order to make parties adhere to agreed rules and principles as well as to include financial fines and penalties for breaking fiduciary duties by the managers. Further, the management should have considered such integral part of governance system as information and technology governance. I believe it is essential because companies should have available and easy ways to concentrate on value creation efforts as well as on setting strategic objectives. IT Governance could help to manage the performance of the respective responsible better and so act in the best interest of all stakeholders. The company can make use of the already developed guides to the implementation of information and technology governance, such as
Australian Standard for Corporate Governance of Information and Communication Technology;
Corporate governance of information technology (International Organization for Standardization (ISO);
Control Objectives for Information and related Technology (Information Systems Audit and Control Association).
Finally, any reasonable person would have advised the Enron Corporation not to use fraudulent practices since constant over reporting of profit and under reporting of debts will inevitably lead to collapse. Of course, the Enron Corporation could not have accumulated so huge profits without using accounting fraud and SPE’s tools, but what is more important a 38 billion USD debt wouldn’t have been accumulated either.
5. Management Recommendations
All substantial recommendations which could have helped the Enron Corporation to avoid bankruptcy were stated above. Additionally, I would recommend to the Enron managers to implement the following information management framework: