Governance and Ethical Business Practice: Enrons Collapse - Case Study Example

Governance and Ethical Business Practice Name Course Name and Code Instructor’s Name Date Table of Contents Table of Contents 2 Introduction 3 Background 4 Factors that led to the collapse Enron Corporation 5 Corporate governance 5 Mark-to-market accounting 6 Special purpose entities (SPE) 7 JEDI and Chewco 8 Whitewing 8 Executive Compensation 8 Risk management 10 Timeline of Enron’s Collapse 10 Role of Key stakeholders and their violation of corporate ethical standards 11 Boar of Director 11 Audit Committee 12 The executive and senior management 12 Auditors 13 Analysts and Banks 14 Corporate governance 14 Conclusion 15 Bibliography 16 Introduction Successful corporations globally are associated with good corporate governance. Corporate managers are therefore called upon to comply with regulatory standards while avoiding principle-agent conflicts of interest in order for them to enhance the firm’s goodwill. Enron Corporation was initiated in 1986 whereby natural gas pipeline companies merged to become one corporate entity (Chaffin &Fidler, 2002). Like any other corporate firm, Enron diversified its products and services and became one of the most successful companies in the US. However, due to poor and unethical top management practices resulted into the collapse of the company in December 2001. Enron Corporation was one of the World’s largest companies prior to its Collapse. The poor accounting practices and misleading financial statements deprived the company of its financiers, the share market and potential investors. The collapse of Enron raised both political and financial questions resulting into examination of corporate regulations in the US and the world over. In the American capitalism history, Enron failure was devastating causing a major impact on financial market by driving away both local and foreign investors. Prior to its collapse, Enron was positioned as the most innovative company in the United States; it was claimed that the company exemplified the transition away from production to knowledge economy. Owing to this many investors were attracted to invest with Enron. There are many lessons that can be learnt from the collapse of Enron (Chaffin &Fidler, 2002). This paper seeks to present a critical analysis of the factors that contributed to the rise and collapse of Enron, the underlying roles of different stakeholders, and the moral and ethical issues that were not observed. The paper will be summarized by the giving lessons that can be learned in order to prevent another major corporate collapse. Background Enron was an American energy company based in Houston, Texas. The company’s scandal was exposed in October 2001, which eventually led to the corporation’s bankruptcy and dissolution of other renowned companies like Arthur Andersen; then one of the largest audit and accountancy partnerships in the world. Enron was formed in 1985 by merging natural gas pipeline companies of Houston Natural Gas and InterNorth. In early 1990s the company was highly innovative; for instance it initiated the selling of Electricity at market prices thereby causing the United States Congress to pass legislations that allowed deregulation of the sale of natural gas. The company became the largest natural gas seller in the US by 1992. The creation of the EnronOnline trading website in 1999 enhanced the company’s ability to manage its contracts trading business. Through the 1990s the company diversified its dealings; it owned and operated varied assets including gas pipeline, electricity plants, pulp and paper plants, water plants, and also offered broadband services across the globe. With regard to this, Enron’s stock tremendously rose reaching 311% at the end of 1998. In 1999, the stock increased by 56% and an additional 87% increase in 2000 (Hill et al., 2002). By December 2000, the company’s stock was priced at $83.13 with its market capitalization exceeding $60 billion, 70 times earnings and six times its book value which was a prospective indication that high stocks in future (Cowan & Abelson, 2002). The company was rated the most innovative company in America. Enron Corporation failed after the market lost confidence in it with regard to its major profits and asset writ-downs in the third quarter of 2001 financial year. The non-transparency of Enron’s financial statements for instance never depicted the company’s operations and finances with shareholders and analysts (McLean & Elkind, 2002). The company had a complex business model spiced with poor ethical practices that allowed the management to use the company’s accounting drawbacks to misrepresent financial figures thus manipulating and modifying financial statements to portray that it was performing superbly. Enron scandal grew out of a steady accumulation poor habits and values that started years before the ultimate collapse. The company’s financial statements seemed to report only continuous income like increased cash flow, inflated asset values, while liabilities were hardly reported. The company’s top executives; Lay, Jeffrey Skilling, and Andrew Fastow were in the spotlight to have created an environment that allowed mega scandals at Enron (McLean & Elkind, 2002). Due to comprehensive investigation, it was established that most of the earnings, assets and credits that were reported by the company were illusory. For instance, the company’s aggressive accounting practices and market power ensured that the financial anomalies are not exposed (McLean & Elkind, 2002). Factors that led to the collapse Enron Corporation Corporate governance This is the set of processes, customs, policies, laws and institutions affecting the way the company is directed, administered or controlled. Corporate governance is basically the nature and extent of accountability with regard to particular persons in the organization, and the mechanisms that are aimed at reducing or eliminating the principle-agent problem. Corporate governance entails relationships among the stakeholders involved and the key objectives for which the company is governed (Glater & Brick, 2002).. With regard to well-functioning capital markets, corporate governance creates a network of information, incentives, and governance between managers and investors. Consequently, the process is mandated to be undertaken through a network of intermediaries including assurance professions like external auditors, internal governance agents such as corporate boards. Enron’s board of directors comprised of outsiders who had significant ownership stakes, and extremely talented audit committee. In fact, in 2000 review of best corporate boards, Enron was one of the top five boards in the US (Glater & Brick, 2002). Despite the complex corporate governance and network of intermediaries, the company was able to attract funding its complex business model. This helped to conceal the company’s true performance through many accounting and financial maneuvers hyping its stocks to unsustainable heights. Mark-to-market accounting Traditionally, the Enron’s natural gas business correctly reported accounting processes for instance, actual supply costs and actual revenues were rightly recorded. However, on the arrival of Skilling, the company adopted the mark-to-market accounting that was presumed to display the true economic value of the company (Abelson, 2002). Mark-to-market accounting entails that once the long term contract is signed, the income is estimated as the present value of the net future cash flows. In most cases it was a challenge to judge the viability of these contracts in relation to their costs. The vast discrepancies of trying to match profits and cash culminated into lying to investors by giving them misleading and false reports. Using mark-to-market accounting, income from projects was recorded thus increasing the company’s financial earnings. However, in future years revenues could not be recorded, with regard to this; additional fictitious income from additional fictitious projects was recorded to develop additions growth to appease investors (Glater & Brick, 2002). Consequently, the pressure from outside that if any company accelerates its income, it should persist in extra investments to show that it was really making huge income. Regardless of the vulnerability of the mark-to-market accounting and the pitfalls associated with it, the US Securities and Exchange Commission approved the system. The above explanation can be evidenced by the 20 year contract between Blockbuster Video and Enron, where Blockbuster Video was to introduce on-demand entertainment in the US market by the end of 2000. Enron estimated profits of more than $110 million from the project (Glater & Brick, 2002). The project was a fail and Blockbuster pulled out of the contract, but on the other hand Enron continued to recognize the future revenues. Special purpose entities (SPE) These are limited partnerships that are established to fulfill a temporary or a particular purpose like funding or managing risks associated with specific assets. At Enron the SPEs were created by a sponsor, but independently financed by equity investors and debt financing. By 2001, the company had used hundreds of SPEs in order to cover its debt. Minimal details about SPEs were disclosed. SPEs were used not only to circumvent accounting conventions but also benefit individual interests. With regard to this, Enron’s balance sheet understated liabilities while overstating equity and earnings. The company disclosed to its shareholders that it had hedged downside risk in relation to it investment using SPEs. Investors on the other hand understood that special purpose entities were using Enron’s own stock and finance guarantees to fund the hedges. Owing to this, the company lacked protection from downside risk. The following are some of the SPEs that Enron used. JEDI and Chewco Joint Energy Development Investment (JEDI) was a joint venture in energy investment between Enron and CalPERS; the California state pension fund in 1993. Skilling then the Chief Operating Officer at Enron in 1997, asked CalPERS to join Enron in a different business venture. CalPERS was interested but on condition that it breaks its partnership in JEDI. On the other hand, Enron never wanted to disclose any debt from assuming CalPERS stake in JEDI on its balance sheet. In relation to this, Fastow then Enron’s Chief Financial Officer developed a special purpose entity Chwesco Investment L.P. that raised Enron’s debt guarantees and used it to lure CalPERS into another joint venture valued $405 million claiming that the company’s indebtedness would rise by $628 million (Hill et al., 2002) Whitewing Whitewing Association LP was formed in December 1997 whereby Enron contributed $579 million and outside investor contributed $500 million. In two yeas time, Whitewing whose main purpose was to act as a special purpose entity was changed. For instance, Whitewing would no longer be associated with Enron and hence it could not be counted on the company’s balance sheet. Whitewing was later used to purchase Enron assets comprising of stakes in power plant, pipelines, stocks, together with other company investments. For example, between 1999 and 2001, Whitewing purchased assets worth $2 billion from Enron using Enron stock as collateral. Despite transaction approval by Enron board, asset transfers were false (Hill et al., 2002). Executive Compensation Motivation is crucial in employees’ performance and the subsequent satisfaction that eventually makes the employee loyal to the company. The compensation and performance systems at Enron Corporation had been designed to retain and reward the valuable employees. However, the system was later mutilated resulting into a dysfunctional corporate culture that was centered on focusing only on short-term revenues rather than future prosperity (Abelson, 2002). High-volume deals were constantly considered by employees not withstanding the cash flow quality or profits for them to get higher ratings in their performance review that was key in receiving higher bonus packages. Consequently, accounting outcomes were recorded frequently to keep track with company’s stock price. With respect to this, deal-makers and executives earned huge cash bonuses together with stock options. Enron constantly focused on its stock price. The management in particular was highly rewarded using stock options as it is with other US companies. Stock option rewards prompted the top management to have a rapid growth expectation which in caused them to falsely reports earnings that reflected Wall Street’s threshold. Following these heightened expectations, the stock tickers were mounted in lobbies, elevators and on company computers. In addition, Skilling inspired his subordinates to come up strategies that could keep Enron stocks up giving them numbers that at times were not feasible. During the end of 2000, Enron had 96 million shares that were outstanding with regard to stock option plans (Abelson, 2002). However, the company’s proxy statement depicted that within three years the awards were to be exercised. Furthermore, in January 2001, Enron’s stock price was $83.13, the directors’ ownership benefits in 2001 proxy reported $659 million and $174 ownership for Lay and Skilling respectively. Skilling’s believe that if employees were cost centered it would obstruct the initial thinking resulted into unexpected expenditures in the entire company but specifically within the executive. Enron employees had inflated expense accounts; in fact the top management was paid twice as much as compared to other companies at the same status with Enron. For instance, in 1998, Enron’s top 200 highest paid employees pocketed 193 millions from salaries, bonuses, and stock options. In two years time the figure was exponentially integrated to $1.4 billion. Risk management Enron’s strategy was to establish long-term fixe commitments that required to be hedged in preparation for the inevitable fluctuation of future energy prices. With regard to this risk management was an essential factor at Enron; in fact the company was lauded for its complex financial risk management tool prior to its collapse. The tool was not only for environment regulatory but also for business planning. To be more realistic, the risk management tool at Enron contributed greatly to the ultimate collapse of the latter. The hasty use of derivatives and special purpose entities are the main cause of the collapse. By hedging the risks using special purpose entities that the company owned, Enron was exposes to rather it retained the risks related to its transactions. For instance, this model made the company implement hedges with itself. Timeline of Enron’s Collapse It was reported in February 2001 by Enron’s Chief Accounting Officer Rick Causey informed the budget managers that the year was going an easy one for the company. However, in March the same year the company was asked as to how it managed to maintain high stocks values trading at 55 times its earnings. On a close look and analysis of the company’s status by looking at the 10-K report, a myriad of anomalies were discovered ranging form erratic cash flows to huge debts. When the executive was called upon to explain the situation, they virtually declined. April 2001, Skilling then the CEO verbally attacked Wall Street analyst for questioning Enron’s erroneous accounting practices and for meddling in the company’s affairs. Skilling comments raised questions in the press and the public sector at large (Abelson, 2002). Through the subsequent months the company faced a lot of operational challenges like logistical hurdles in running the broadband communication trading unit, the losses fro developing the Dabhol Power project and a large power plant in India. The company stocks started falling and by the end of August 2001, investors had lost interest in the company. The departure of Skilling and the opacity of Enron’s accounting books put the company on the verge to collapse. Role of Key stakeholders and their violation of corporate ethical standards Boar of Director Across the globe, the board of directors is responsible to the shareholders for the company’s trading. They are required to protect the company’s properties including assets and finances. Consequently, it is mandatory for them to create and safeguard the company’s ethical code. With regard to Enron Company, the board of directors failed in many ways; they were never fully committed to get information about the company’s fictitious partnerships and dubious transactions that led to the surge of earnings (Cowan & Alberson, 2002). For instance, in June, 1999 the board violated the code of ethics by allowing Andrew Fastow to manage the partnerships, October the same year without observing the code they allowed another larger partnership to be formed. The Audit Committee review of partnerships in February 2000 with regard to their status did not follow up the recommendations that were to be put in place, consequently, the Finance Committee that was tasked with monitoring Fastow’s compensation never came up with anything (Alberson, 2002). Audit Committee This committee has powers to discover any financial malpractices given the fact that they have access to all company accounting records. Given the power magnitude of this committee they were in position to stop Enron’s collapse. The committee failed in its mandate despite having an arguably an elaborate and strong constitution of well versed accounting professionals. The committee for instance never involved itself in operations and exercises linked to risk management. Nevertheless, the Board’s recommendations were not followed by the committee to scrutinize Fastow’s compliance with Enron’s policies in relation to his business conduct (Peel & Hill, 2002). The Audit committee never had the technical capacity to question the auditors particularly accounting questions with regard to SPEs. The executive and senior management Ethical culture in any organization is primarily determined by the top management and Enron is no exemption. Enron had ethical principles that were morally worthy; these included respect, integrity, communication, and excellence as they were centrally placed in the mission statement. However, these ethical were overridden by the executives and senior management as they were accustomed to lying, bullying and manipulation. As aforementioned, the company’s code of ethis was waived to allow Fastows to run partnerships using company resources as collaterals. In addition, Lay lied to the staff about the status of the company (Goodley, 2002). According to Fidler and Chaffin (2002), the insider accounts demonstrated the risk taking culture of the Company and how bonus incentives allowed employees to manipulate profit estimates. The unethical culture was encouraged throughout the organization. The employee’s appraisal scheme, the performance review committee were complete frauds; this resulted into promotions and bonuses for top employees and dismissal of the bottom ones. Chaffin and Fidler (2002) pointed out that the main factor that discouraged questioning Enron’s business practices was a ruthless and reckless culture that lavished rewards on those who plaid the game while persecuting those who raised objection. Enron’s executives profited form compensation packages, share options, private investments, and management fees from SPEs. Consequently, they benefited from dubious business operations, for instance they lied to the public that the company was a good investment opportunity while in really sense the company was bound to collapse. In addition, some executives used company resources to involve with Southampton place partnership. It is also claimed that, Andrew Fastow’s family invested $25,000 in LJM1 and earned back $4.5 million after only six weeks (Goodley, 2002). Using company confidential information and valuable resources for personal dealings is wholly unethical with regard to the above discussed principle. The top leadership at Enron comprised of Kenneth Lay, Jeffrey Skilling, and Andrew Fastow. Their executive negligence and failure to observe the relevant moral codes as required by their positions allowed unethical business operations at Enron leading to the eventual bankruptcy of the company. For instance, the decision making style embraced by Skilling, Fastow, and Kopper in most cases suppressed the overall moral integrity only focusing on short term financial gains. The executive manipulated prices in Quaker Oats, Quest, and Blockbuster to make and influence markets (Stevenson, 2002). Inappropriate price manipulations are evident in the electricity supplies in California (Hirch, 2001) Auditors Andersen ware the main Auditors at Enron whereby they undertook, internal audit and consultancy work. This automatically raises the conflict of interest question. Andersen work at Enron has received criticism particularly for not doing their mandated audit work and succumbing to the bullying tactics. The former employees raised questions about the accounting procedures and methods that Andersen used (Schmidt, 2002). At one point Andersen signed off financial statements without qualification regardless of the closes concerns on to account for Enron’s transactions with interested parties like LJM. Andersen also had a document shredding policy and only retaining formal audit papers. When Andersen was found guilty with regard to its own documents in a previous case they established the policy mentioned above. This action is legally and morally wrong, as it obstructs justice (Peel & Hill, 2002). Analysts and Banks Analysts are fundamentally concerned with making or creating markets in shares. This is a significant duty in that they can make or break a company based on their judgment. It is evident that analysts positively supported Enron and contributed greatly to giving buy rating even when the company’s stocks were falling. During Enron’s market reign, any analyst who failed to cooperate with the company faced problems with their employers specifically those who were concerned with networking banks with investors selling Enron shares and making inflated commissions. With regard to this, it was paramount that analysts lie and report false information that Enron business was good and worth investing in. This is a direct violation of the code of ethics. Corporate governance With regard to the above discussion it true that Enron that the company’s corporate governance was trapped in many fields including code of ethics and audit committee. For instance investor communication was basically lying, relationship with regulatory authorities was manipulative, code of conduct was completely waived, audit committee was ineffective and had many conflicts of interest, regulations of conflicts of interest were presumably ignored, definition of roles and responsibilities of directors was kept in the dark and failed in oversight responsibilities, and there virtually no rules enforced at Enron (Hill &Fidler, 2002). Conclusion In conclusion, good corporate governance practices are essential and add up to the ultimate success of the company. Enron Corporation was a successful company, with regard to its initial diversification strategies; the company’s business success was eminent in the US market. However, due to personal interests particularly by the executives culminated into eroding the company’s good governance practices and replacing them with unethical culture that led to the final collapse of the company. Greed, lies, and poor management practices led to satisfying personal interests rather than working to fulfill the company’s objectives. The executives and senior management officials at Enron embraced a culture that benefited a few individuals. The collapse of Enron raised both political and financial questions resulting into examination of corporate regulations in the US and the world over. In the American capitalism history, Enron failure was devastating causing a major impact on financial market by driving away both local and foreign investors. All stake holders of the company failed to take their ethical responsibilities thus leaving the company to crumble down Bibliography Abelson, R. 2002 `Enron's board quickly ratified far-reaching management moves' New York Times Retrieved of 29/10/2011; from: http://www.nytimes.ac/2002/02/22/business/22BOAR.html Chaffin, J. and Fidler, S. 2002 `Enron revealed to be rotten to the core' FT.com Retrieved of 29/10/2011; from: http://specials.ft.com/enron/FT3L4NIOSCZ.html Cowan, A.L. and Abelson, R. 2002 `Professor who led audit panel failed to spot smoke and mirrors' New York Times Retrieved of 29/10/2011; from: http://www.nytimes.ac/2002/02/07/business/07PROF.html Glater, J.D. and Brick, M. 2002 `Ex-official says Enron employees shredded papers' New York Times Retrieved of 29/10/2011; from: http://www.nytimes.ac/2002/01/22/business/22ENRO.html Goodley, S. 2002. Andersen employee's Enron fear’. Daily Telegraph, Retrieved of 29/10/2011; from: http://www.telegraph.co.uk/money/main Hill, A. Chaffin, J. and Fidler, S. 2002 `Enron: virtual company virtual profits' FT.com Retrieved of 29/10/2011; from: http://specials.ft.com/enron/FT3648VA9XC.html Hill, A., and Fidler S. 2002. Enron ties itself up in knots, then falls over. FT.com Retrieved of 29/10/2011; from: http://specials.ft.com/enron/FT3A5RP52XC.html Hirsch, J. 20012. Energy execs gain millions in stock sales' Common dreams. Retrieved of 29/10/2011; from: http://commondreams.org/headlines01/0613-01.html McLean, B; Elkind P. 2002 The Smartest Guys in the Room. New York; Willey J & Sons inc. p. 357. Peel, M. and Hill, A. 2002. Enron audit committee now faces criticism. FT.com Retrieved of 29/10/2011; from: http://specials.ft.com/enron/FT3AMEZ8ZWC.html Read More