ENRON, ETHICS AND TODAY'S

CORPORATE VALUES
Enron: The Smartest Guys in the Room

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.
TASK I: HISTORY OF ENRON

Skilling’s vision was to transform Enron into a giant, asset-light operation, trading power
generally and his next target was trading electricity. Lay was lobbying Washington hard to
deregulate electricity supply and in anticipation he and Skilling took Enron into California, buying
a power plant on the west coast.

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.

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 national reputation rested on the rapid expansion of its domestic business and its steadily
growing revenue and earnings from trading. So on the back of his track record, Skilling was
appointed Chief Operating Officer by Ken Lay and he then embarked upon transforming the whole
of Enron to reflect his vision.

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.

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.

At this point, around 2000, Enron’s reputation was still riding high and Lay and Skillingwere
looked up to as visionary thinkers and top business leaders.
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.

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.

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.

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.

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.

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.

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.
TASK II : The second half of this Enron case study assesses business ethics and the impact on
corporate governance, as measured against our Five Golden Rules:

GOLDEN RULE OF BUSINESS ETHICS #01: ETHICAL ASSESSMENT

Enron didn’t start out as an (a)____________________. As we have seen in this case study, what
introduced the virus was the pursuit of (b)_________________via very(c)_________________.
This led to the introduction of quite extreme incentive schemes to attract and
motivate(d)____________________, 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
(e)________________and earnings targets. Since the massaged figures for growth in earnings still
left (f)___________________, Enron quickly maxed out on its borrowing abilities.

But issuing (g)__________________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 (h)____________________to achieve targets. And
the top management, who were rewarding themselves with these same incentive schemes,
boasted that a pure, (i)__________________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
(j)_______________________of its founder and caused it to succumb to bending and suspending
its professional standards, with fatal results.

aggressive revenue unethical business market-driven

strong business ethics tradition personal wealth rapid growth
very bright and driven people more equity a shortfall in cash

GOLDEN RULE OF BUSINESS ETHICS #02: IMPACT ON CORPORATE GOVERNANCE

Our five Rules of Good Corporate Governance (a)____________with the need for
an(b)_______________. Having established that Enron’s culture (c)______________progressively
(d)_______________ in this regard, let’s consider briefly the impact of (e)________________in
business ethics on the other Rules.

ethical culture this failure became

more deficient start
GOLDEN RULE OF BUSINESS ETHICS #03: CLEAR GOAL SHARED BY ALL KEY STAKEHOLDERS

Lay and, particularly Skilling, engendered in all the staff of Enron the goal of
(a)____________________the share price to the virtual exclusion of all else. The goal of
(b)___________________a long term satisfaction from a stable customer base took a distant
second place to (c)________________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 (d)_______________was designed to make him rich at his employer’s
expense.

funding scheme driving up signing up achieving

GOLDEN RULE OF BUSINESS ETHICS #04: STRATEGIC MANAGEMENT

As a McKinsey consultant (a)_______________in strategy, Skilling had a very

(b)_____________vision, at least initially, of what he wanted Enron to achieve. However, he
wasn’t interested in management per se and allowed (c)___________________to wither. But his
vision of a huge (d)_____________________wasn’t carried down to the next level of developing
and implementing practical(e)_________________, 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 (f)__________________of raising the funds required to implement the project

business plans
capability or likelihood

GOLDEN RULE OF BUSINESS ETHICS #05: ORGANISATION RESOURCED TO DELIVER

Skilling became COO on the departure of a very (a)___________________predecessor. Even at

that point, Enron had been expanding at a (b)_________________which outran its ability to set
up appropriate and adequate administrative systems and controls. Added to which it had always
been(c)_______________. 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(d)__________________,
and with inadequate spending controls, created a totally dysfunctional
organisation.Transparency and accountability

From the early stages, Enron’s focus on (e)________________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 (f)_______________to their shareholders for delivering
(g)___________________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.

accountable short of funds tough and experienced

compensation schemes consistent above average growth
rate earnings and share price
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.