Ethics in business are standards of morality that companies are expected by the authorities and the general public to adhere to. Ethical conduct is sometimes mistaken for legal conduct but they are fundamentally different because while legal conduct is always, ethical, ethical conduct may sometimes be illegal (Becker, 2020). This difference between behaving ethically and behaving legally means that ethics is a much wider field than business law. Corporations create a culture that promotes ethical conduct to encourage the integrity of their employees and to court the confidence and trust of the general public. This research paper will explore the fall of Enron at the beginning of the 2000s and the ethical issues that were at play. It will also analyze the legal and corporate governance changes that occurred after Enron declared bankruptcy.
In 2001, it became known that Enron had been using a “mark-to-market” accounting method that exaggerated their earnings and underestimated their losses and thus giving the investors a false illusion that the company was more profitable than it was. When this news became public knowledge and hit the market, there was an immediate reaction by the company’s investors who rushed to liquidate their positions in the company leading to a significant loss of value (Rashid, 2021). Unable to sustain their operations amid an outflow of public trust in the company, the management filed for bankruptcy. At the time, Enron’s bankruptcy was the largest in American corporate culture. At the time of filing for bankruptcy, the company had assets above $63 billion (Eckhaus, & Sheaffer, 2018). An investigation by the Security Exchange Commission (SEC) revealed serious ethical and legal breaches by the company’s executives and its external auditors. Consequently, several executives were sent to jail while the external audit firm lost all its clients and had to cease to operate.
Enron was founded in 1985 after the merger of two gas transporting companies. However, a series of laws deregulating the gas industry leading to the loss of exclusive transportation rights meant that the company had to find ways to remain in business. The company and its executives found a profitable niche trading energy derivative contracts. By revolutionalizing its business model and the nature of its business, the company assumed the role of an intermediary between natural gas producers and their customers (Petra, & Spieler, 2020). These derivatives allowed traders to mitigate potential losses due to price fluctuations through contracts negotiated by Enron for a fee. The company became so good in this type of business that it dominated the market and generated huge amounts in revenues and profits. All these changes were happening under the leadership of Jeffery Skilling.
Due to a desire to earn more profits and engage in total domination in the market, the company under Skilling changes its organizational culture to allow for more aggressive trading. The company soon head-hunted top MBAs in the United States and gave them instructions to close as many cash-generating trades as possible in the shortest time possible. Andrew Fastow who was one of the first to join the company after changing the nature of the business rose quickly to occupy the position of Chief Financial Officer (CFO). He oversaw the financing of the company’s operations through complex instruments while the CEO concentrated on growing the company’s operations. A bull market in the 1990s propelled the company’s growth as it expanded its derivatives trade to include coal, paper, steel, and weather. The company’s online division established during the dotcom era was doing transactions of more than two billion dollars.
The end of the boom years marked the beginning of the end for Enron as it was also facing intense competition from rivals. The company’s profitability decreased significantly forcing executives who were under pressure from investors to increasingly rely on dubious accounting to artificially boost the company earnings. Their method of accounting which came to be known as mark-to-market allowed the company to disclose unrealized future gains from some trades as earned revenue making possible the illusion that the company was profitable. The loss-making operations of the company were removed from the accounting books a special purpose entity was created for them. Special purpose entities (SPE) were common but Enron broke ethical principles by misusing it as a dumpsite for loss-making operations (Eckhaus, & Sheaffer, 2018). The mass transfers of loss-making operations to SPE meant that they would not appear in the company’s financial statements further enhancing the illusion that the company was profitable. Some of the SPE was run by the company’s CFO with Arther Anderson serving both as the external auditor and consultant for the company.
Trouble for the company began in February 2001 when a series of leadership changes occurred. By mid the year, other executives began to raise doubt about the company’s accounting practices and the partnerships of their CFO. News about the company’s suspicious behavior soon reached Wall Street analysts who began to carefully analyze the company’s declared financial statements. A disclosure that the company would be taking a reduction of $1.2 billion in shareholder equity coupled with a loss of $630 million for the third quarter triggered alarm bells of the SEC which opened an investigation into Fastow’s SPEs and their relationship with Enron (Eckhaus, & Sheaffer, 2018). Weary of their complicity, officials at Arthur and Anderson began shredding Enron audit documents. As details emerged and efforts to sell the company failed, the company’s stock became worthless and Enron filed for Chapter 11 bankruptcy protection.
While some of the company’s executives were sentenced to many years in prison and the audit firm went out of business, it is worth noting that ethical breaches played a central role in Enron’s downfall. Specifically, the company did not have an internal control mechanism that would have prevented the abuse of the SPEs by the CEO. In addition, the failure of the company’s external auditors to disclose questionable accounting practices was also an ethical breach and also a breach of duty to the company’s shareholders. While acting as the company’s consultant, the auditors had a conflict of interest that prevented them from being objective in their opinions about the suitability of the company’s financial statements. In addition, the executives at Enron had a fiduciary duty of care to the company’s shareholders to ensure that the company’s assets were prudently applied to generate returns. However, they failed to live up to this expectation as the company’s profits began to falter and the executives manipulated financial data to deceive shareholders. Thus, Enron’s collapse was marked by creative accounting, conflict of interest, and a breach of fiduciary duty of care to the company’s shareholders by the executives and the external auditors.
The collapse of Enron and the ethical issues that led to its collapse prompted the enactment of stringent legal regulations by Congress in the form of the Sarbanes-Oxley Act, This Act required additional financial disclosures by publicly traded companies and empowered the SEC to take adequate steps to ensure full compliance by all publicly traded companies registered in the US (Linzy, 2022). The Act also sought to ensure that external auditors were independent in form and appearance. Conflict of interest had been identified as a major reason why auditors did not raise an alarm despite signs and evidence of creative accounting by Enron and other companies that declared bankruptcy before it did. Thus, Sarbanes-Oxley Act outlined steps to ensure the independence of external auditors to eliminate any chances of a conflict of interest that would impair their impartiality in judging the appropriateness of a company’s financial statements.
The Enron saga marked a shift in the regulations of publicly-traded companies in the US. At the time of its collapse, the company had billions in assets but its stock was worthless. Having lost investor confidence due to fraudulent accounting, its collapse caused suffering for the thousands who lost jobs and their 401K savings. Despite the punishment of some of the company’s executives, the damage was already done and quick and firm solutions were required to protect shareholders’ investment from the unethical behavior of executives. The Sarbanes-Oxley Act was the answer provided by Congress as it strengthened corporate governance by requiring additional disclosures and empowered the SEC to take stern actions against violators. Since then, the number of companies that declare bankruptcy due to unethical behavior being discovered dropped significantly indicating that the law was effective. Finally, the SEC strengthened its regulatory role and has imposed heavy fines on companies found in breach of any regulations, laws, and statutes which discourage any other company from engaging in unethical or illegal behavior.
References
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Linzy, J. (2022). The implications of the Sarbanes-Oxley Act of 2002 twenty years later. Southern University College of Business E-Journal, 17(2), 3.
Petra, S., & Spieler, A. C. (2020). Accounting scandals: Enron, Worldcom, and global crossing. In Corporate fraud exposed (pp. 343-360). Emerald Publishing Limited.
Rashid, M. M. (2021). A case analysis on Enron; Ethics, social responsibility, and ethical accounting. New Innovations in Economics, Business and Management 1, 62–69. Web.