Enron: What Caused the Ethical Collapse?

Introduction
Kenneth Lay, former chairman and chief executive officer (CEO) of
Enron Corp., is quoted in Michael Novaks book Business as a Calling:
Work and the Examined Life as saying, I was fully exposed to not only
legal behavior but moral and ethical behavior and what that means
from the standpoint of leading organizations and people. In an
introductory statement to the revised Enron Code of Ethics issued in
July 2000, Lay wrote: As officers and employees of Enron Corp., its
subsidiaries, and its affiliated companies, we are responsible for
conducting the business affairs of the companies in accordance with all
applicable laws and in a moral and honest manner. Lay went on to
indicate that the 64-page Enron Code of Ethics reflected policies
approved by the companys board of directors and that the company,
which enjoyed a reputation for being fair and honest, was highly
respected. Enrons ethics code also specified that An employee shall
not conduct himself or herself in a manner which directly or indirectly
would be detrimental to the best interests of the Company or in a
manner which would bring to the employee financial gain separately
derived as a direct consequence of his or her employment with the
Company.
Enrons ethics code was based on respect, integrity,
communication, and excellence. These values were described as
follows:
Respect. We treat others as we would like to be treated
ourselves. We do not tolerate abusive or disrespectful treatment.
Ruthlessness, callousness and arrogance dont belong here.
Integrity. We work with customers and prospects openly, honestly
and sincerely. When we say we will do something, we will do it;
when we say we cannot or will not do something, then we wont
do it.
Communication. We have an obligation to communicate. Here we
take the time to talk with one another . . . and to listen. We
believe that information is meant to move and that information
moves people.
Excellence. We are satisfied with nothing less than the very best
in everything we do. We will continue to raise the bar for
everyone. The great fun here will be for all of us to discover just
how good we can really be.
Given this code of conduct and Ken Lays professed commitment
to business ethics, how could Enron have collapsed so dramatically,

going from reported revenues of $101 billion in 2000 and

approximately $140 billion during the first three quarters of 2001 to
declaring bankruptcy in December 2001? The answer to this question
seems to be rooted in a combination of the failure of top leadership, a
corporate culture that supported unethical behavior, and the
complicity of the investment banking community.

Enrons Top Leadership

In the aftermath of Enrons bankruptcy filing, numerous Enron
executives were charged with criminal acts, including fraud, money
laundering, and insider trading. For example, Ben Glisan, Enrons
former treasurer, was charged with two-dozen counts of money
laundering, fraud, and conspiracy. Glisan pled guilty to one count of
conspiracy to commit fraud and received a prison term, three years of
post-prison supervision, and financial penalties of more than $1 million.
During the plea negotiations, Glisan described Enron as a house of
cards.
Andrew Fastow, Jeff Skilling, and Ken Lay are among the most
notable top-level executives implicated in the collapse of Enrons
house of cards. Andrew Fastow, former Enron chief financial officer
(CFO), faced 98 counts of money laundering, fraud, and conspiracy in
connection with the improper partnerships he ran, which included a
Brazilian power plant project and a Nigerian power plant project that
was aided by Merrill Lynch, an investment banking firm. Fastow pled
guilty to one charge of conspiracy to commit wire fraud and one charge
of conspiracy to commit wire and securities fraud. He agreed to a
prison term of 10 years and the forfeiture of $29.8 million. Jeff Skilling
was indicted on 35 counts of wire fraud, securities fraud, conspiracy,
making false statements on financial reports, and insider trading. Ken
Lay was indicted on 11 criminal counts of fraud and making misleading
statements. Both Skilling and Lay pled not guilty and are awaiting trial.
The activities of Skilling, Fastow, and Lay raise questions about
how closely they adhered to the values of respect, integrity,
communication, and excellence articulated in the Enron Code of Ethics.
Before the collapse, when Bethany McLean, an investigative reporter
for Fortune magazine, was preparing an article on how Enron made its
money, she called Enrons then-CEO, Jeff Skilling, to seek clarification
of its nearly incomprehensible financial statements. Skilling became
agitated with McLeans inquiry, told her that the line of questioning
was unethical, and hung up on McLean. Shortly thereafter Andrew
Fastow and two other key executives traveled to New York City to meet
with McLean, ostensibly to answer her questions completely and
accurately.

Fastow engaged in several activities that challenge the

foundational values of the companys ethics code. Fastow tried to
conceal how extensively Enron was involved in trading for the simple
reason that trading companies have inherently volatile earnings that
arent rewarded in the stock market with high valuationsand a high
market valuation was essential to keeping Enron from collapsing.
Another Fastow venture was setting up and operating partnerships
called related party transactions to do business with Enron. In the
process of allowing Fastow to set and run these very lucrative private
partnerships, Enrons board and top management gave Fastow an
exemption from the companys ethics code.
Contrary to the federal prosecutors indictment of Lay, which
describes him as one of the key leaders and organizers of the criminal
activity and massive fraud that lead to Enrons bankruptcy, Lay
maintains his innocence and lack of knowledge of what was happening.
He blames virtually all of the criminal activities on Fastow. However,
Sherron Watkins, the key Enron whistleblower, maintains that she can
provide examples of Lays questionable decisions and actions. As
Bethany McLean and fellow investigative reporter Peter Elkind observe:
Lay bears enormous responsibility for the substance of what went
wrong at Enron. The problems ran wide and deep, as did the deception
required in covering them up. The companys culture was his to
shape. Ultimately, the actions of Enrons leadership did not match the
companys expressed vision and values.

Enrons Corporate Culture

Enron has been described as having a culture of arrogance that led
people to believe that they could handle increasingly greater risk
without encountering any danger. According to Sherron Watkins,
Enrons unspoken message was, Make the numbers, make the
numbers, make the numbersif you steal, if you cheat, just dont get
caught. If you do, beg for a second chance, and youll get one.
Enrons corporate culture did little to promote the values of respect
and integrity. These values were undermined through the companys
emphasis on decentralization, its employee performance appraisals,
and its compensation program.
Each Enron division and business unit was kept separate from
the others, and as a result very few people in t he organization had a
big picture perspective of the companys operations. Accompanying
this emphasis on decentralization were insufficient operational and
financial controls as well as a distracted, hands-off chairman, a
compliant board of directors, and an impotent staff of accountants,
auditors, and lawyers.
Jeff Skilling implemented a very rigorous and threatening
performance evaluation process for all Enron employees. Known as

rank and yank, the annual process utilized peer evaluations, and
each of the companys divisions was arbitrarily forced to fire the lowest
ranking one-fifth of its employees. Employees frequently ranked their
peers lower in order to enhance their own positions in the company.
Enrons compensation plan seemed oriented toward enriching
executives rather than generating profits for shareholders and
encouraged people to break rules and inflate the value of contracts
even though no actual cash was generated. Enrons bonus program
encouraged the use of non-standard accounting practices and the
inflated valuation of deals on the companys books. Indeed, deal
inflation became widespread within the company as partnerships were
created solely to hide losses and avoid the consequences of owning up
to problems.

Complicity of the Investment Banking

Community
According to investigative reporters McLean and Elkind, One of the
most sordid aspects of the Enron scandal is the complicity of so many
highly regarded Wall Street firms in enabling Enrons fraud as well as
being partners to it. Included among these firms were J.P. Morgan,
Citigroup, and Merrill Lynch. This complicity occurred through the use
of prepays, which were basically loans that Enron booked as operating
cash flow. Enron secured new prepays to pay off existing ones and to
support rapidly expanding investments in new businesses.
One of the related party transactions created by Andrew Fastow,
known as LJM2, used a tactic whereby it would take an asset off
Enrons handsusually a poor performing asset, usually at the end of a
quarterand then sell it back to the company at a profit once the
quarter was over and the earnings had been booked. Such
transactions were basically smoke and mirrors, reflecting a relationship
between LJM2 and the banks wherein Enron could practically pluck
earnings out of thin air.

Epilogue
The Enron Code of Ethics and its foundational values of respect,
integrity, communication, and excellence obviously did little to help
create an ethical environment at the company. The full extent and
explanation of Enrons ethical collapse is yet to be determined as legal
proceedings continue. Fourteen other Enron employeesmany high
levelhave pled guilty to various charges; 12 of these are awaiting
sentencing, while the other two, one of whom is Andrew Fastows
spouse, have received prison sentences of at least one year. Juries
have convicted five individuals of fraud, as well as Arthur Andersen,
the accounting firm hired by Enron that shared responsibility for the
companys fraudulent accounting statements. Three of the convicted

individuals were Merrill Lynch employees involved in the Nigerian

barge deal with Fastow. Ken Lay and Jeff Skilling, along with Richard
Causey, Enrons former chief accounting officer, are awaiting trial. Lay
faces 11 criminal counts, Skilling faces 35 criminal counts, and Causey
faces 31 criminal counts. Five executives from Enrons broadband
division are also awaiting trial. Three bank executives from Britain who
had been involved in a complicated series of deals in a Fastow
partnership are fighting extradition. In addition, there are 114
unindicted co-conspirators in the federal governments case against
Lay and Skilling.

Questions for Discussion

1. What led to the collapse of Enron under Lay and Skilling?
2. How did the top leadership at Enron undermine the foundational values of
the Enron Code of Ethics?
3. Given Kenneth Lays and Jeff Skillings operating beliefs and the Enron
Code of Ethics, what expectations regarding ethical decisions and actions
should Enrons employees reasonably have had?
4. How did Enrons corporate culture promote unethical decisions and
actions?
5. How did the investment banking community contribute to the ethical
collapse of Enron?
Sources
This case was developed from material contained in the following sources:
Elkind, P., McLean, B. (July 12, 2004). Ken Lay flunks ignorance test. Fortune, http://
www.fortune.com, accessed December 15, 2004.
Enron Code of Ethics. The Smoking Gun Web site, http://www.thesmokinggun.com, accessed December 15,
2004.
Enron: Houston Chronicle Special Report. (Dec. 11, 2004). Houston Chronicle, http://
www.chron.com/cs/CDA/story.hts/special/enron/1624822, accessed December 15, 2003.
Enron Timeline. Houston Chronicle, http://www.chron.com/content/chronicle/special/
01/enron/timeline.html, accessed December 15, 2003.
Fowler, T. (October 20, 2002). The pride and the fall of Enron. Houston Chronicle, http://
www.chron.com/cs/CDA/story.hts/special/enron/1624822, accessed November 25, 2003.
Flood, M. (September 10, 2003). Ex-Enron executive going to prison: Glisan plea may speed cases.
Houston Chronicle, http://www.chron.com/cs/CDA/story.hts/special/
enron/2090943, accessed November 25, 2003.
McLean, B. (December 9, 2001). Why Enron went bust. Fortune, http://www.fortune.
com, accessed December 15, 2004.
McLean, B., Elkind, P. (October 13, 2003). Partners in crime. Fortune, http://www.
fortune.com, accessed December 15, 2001.
McLean, B., Elkind, P. (October 13, 2003). Partners in crime, part 2. Fortune, http://
www.fortune.com, accessed December 15, 2001.
Mehta, S.N. (October 14, 2003). Employees are the best line of defense. Fortune, http:// www.fortune.com,
accessed December 15, 2004.
Novak, M. (1996) Business as a Calling: Work and the Examined Life. New York: The Free Press.
Strip clubs, daredevil trips, $1 million paychecks. (October 2, 2003). Excerpt from B. McLean and P. Elkind, The
Smartest Guys in the Room, printed in Fortune, http://www.fortune. com, accessed December 15, 2004.

Enron is a company that reached dramatic heights, only to face a dizzying

collapse. The story ends with the bankruptcy of one of America's largest
corporations. Enron's collapse affected the lives of thousands of
employees, many pension funds and shook Wall Street to its very core. To
this day, many wonder how a company so big and so powerful disappeared
almost overnight. How did it manage to fool the regulators and the Wall
Street community for so long, with fake off-the-books corporations? What is
the overall lasting impact that Enron has had on the investment community
and the country in general?
Tutorial: Introduction To Accounting
Collapse of a Wall Street Darling
By the fall of 2000, Enron was starting to crumble under its own weight.
CEO Jeffrey Skilling had a way of hiding the financial losses of the trading
business and other operations of the company; it was called mark-tomarket accounting. This is used in the trading of securities, when you
determine what the actual value of the security is at the moment. This can
work well for securities, but it can be disastrous for other businesses.
In Enron's case, the company would build an asset, such as a power plant,
and immediately claim the projected profit on its books, even though it
hadn't made one dime from it. If the revenue from the power plant was less
than the projected amount, instead of taking the loss, the company would
then transfer these assets to an off-the-books corporation, where the loss
would go unreported. This type of accounting created the attitude that the
company did not need profits, and that, by using the mark-to-market
method, Enron could basically write off any loss without hurting the
company's bottom line. (Read more about the disastrous implications of
mark-to-market accounting in Mark-To-Market Mayhem.)
Part of the reason the company was able to pull off its shady business for
so long, is that Skilling also competed with the top Wall Street firms for the
best business school graduates, and would shower them with luxuries and
corporate benefits. One of Skilling's top recruits was Andrew Fastow, who
joined the company in 1990. Fastow was the CFO of Enron until the SEC

started investigating his role in the scandal. (Read more in Are Your Stocks
Doomed?)
Fraud: What Was the Scheme?
The mark-to-market practice led to schemes that were designed to hide the
losses and make the company appear to be more profitable than it really
was. In order to cope with the mounting losses, Andrew Fastow, a rising
star who was promoted to CFO in 1998, came up with a devious plan to
make the company appear to be in great shape, despite the fact that many
of its subsidiaries were losing money. That scheme was achieved through
the use of special purpose entities (SPE). An SPE could be used to hide
any assets that were losing money or business ventures that had gone
under; this would keep the failed assets off of the company's books. In
return, the company would issue to the investors of the SPE, shares of
Enron's common stock, to compensate them for the losses. This game
couldn't go on forever, however, and by April 2001, many analysts started
to question the transparency of Enron's earnings. (For more, see The
Biggest Stock Scams Of All Time.)
The Shock Felt Around Wall Street
By the summer of 2001, Enron was in a free fall. CEO Ken Lay had retired
in February, turning over the position to Skilling, and that August, Jeff
Skilling resigned as CEO for "personal reasons." By Oct.16, the company
reported its first quarterly loss and closed its "Raptor" SPE, so that it would
not have to distribute 58 million shares of stock, which would further reduce
earnings. This action caught the attention of the SEC. (Find out how this
regulatory body protects the rights of investors. Read Policing The
Securities Market: An Overview Of The SEC.)
A few days later, Enron changed pension plan administrators, basically
forbidding employees from selling their shares, for at least 30 days. Shortly
after, the SEC announced it was investigating Enron and the SPEs created
by Fastow. Fastow was fired from the company that day. In addition, the
company restated earnings going back to 1997. Enron had losses of $591

million and had $628 million in debt, by the end of 2000. The final blow was
dealt when Dynegy (NYSE:DYN), a company that had previously
announced would merge with the Enron, backed out of its offer on Nov. 28.
By Dec. 2, 2001, Enron had filed for bankruptcy. (Learn more about finding
fraud inPlaying The Sleuth In A Scandal Stock.)
Lasting Effects
Enron shows us what a company and its leadership are capable of, when
they are obsessed with making profits at any cost. One of Enron's lasting
effects was the creation of the Sarbanes-Oxley Act of 2002, which
tightened disclosure and increased the penalties for financial manipulation.
Second, the Financial Accounting Standards Board (FASB) substantially
raised its levels of ethical conduct. Third, boards of directors became more
independent, monitoring the audit companies and quickly replacing bad
managers. While these effects are reactive, they are important to spot and
close the loopholes that companies have used, as a way to avoid
accountability.
The Bottom Line
The collapse of Enron was an unfortunate incident, and it is important to
know how and why it happened, so we can understand how to avoid these
situations in the future. Looking back, the company had incurred
tremendous financial losses as a result of arrogance, greed and
foolishness from the top management, all the way down. Many of the
company's losses started the collapse that could have been avoided, if
someone had had the nerve and the foresight to put a stop to it. Enron will
remain in our minds for years to come, as a classic example of greed gone
wrong, and of the action that was taken to help prevent it from happening
again. (For further reading, see Business Owners: Avoid Enron-esque
Retirement Plans.)