Ethics

BUSINESS ETHICS AND CORPORATE GOVERNANCE ASSIGNMENT ON ENRON’S FALL Submitted to Submitted by Dr. Abhishek Ranga Amit Gajera (33) Kaushik Bose (40) Manisha Bansal (46) Nidhi Singh (54) PREFACE When Enron conducted a name-recognition survey in 1996, it found that ordinary people were guessing that Enron was a politician or a science- fiction weapon. Now in 2002, and Enron needs no introduction. Like Watergate, it has entered the collective vocabulary as a one –word symbol of a entire regime. Enron now represents greed and hubris, deceitful accounting and Wall Street favour, and, in short, every-thing that’s wrong with corporate America. As a familiar as the word has become, the accrual story of Enron’s decline from business superstar to embarrassing bankruptcy is still not well understood. How did a $100 billion company collapse in a matter of weeks' What were the partnerships that shocked Wall Street and damaged some of its venerable reputations' Who were the people behind this complex enterprise' This report tried to explain and cover all aspects of story what happened from beginning to end. Other accounts of the Enron scandal have concentrated on the company’s decline but the story really begins with the creation of the company in 1985. The fall of Enron would not be possible were if not for the preceding rise, and the company’s missteps- both international and unintentional- were not possible had it not enjoyed success early on. Those successes were what drew us to the story originally, and then our interest rose as this flourishing company began to encounter great difficulties. When we saw a case about Enron in fall of 2001, we knew it would be a fascinating topic. The drama then intensified at an amazing pace. In quick sessions, Enron’s weakened stock went into freefall, it struck a deal to be acquired, that deal then fell through, and Enron filed to bankruptcy. The story leapt from the business pages to the front pages, and then to everyday conservation. Our research uncovered details of the intense corporate culture and the recklessness with the company pursue strategies. We found an organisation that, in the spirit of the last decade, over- reached: Chairman Kenneth Lay, Jeffrey Skilling, and company believed they could transform a pipeline operator into a virtual corporation that a dizzying array of commodities. To support the underpinnings of that mission, Enron eventually cooked its books. While telling that story, our report highlights the system that allowed such rule breaking. Nearly everyone shares blame, from Republicans to Democrats, from accountants to lawyers, and from Wall Street to Main Street. This striving corporation sat at the epicentre of the most significant trends in finance, energy, and online commerce. As a result, the story continues even as we read this case the dimension of business we found to have changed forever. Politicians are debating the regulations of energy trading. Enron’s bankruptcy continues to frustrate the creditors fighting over the scraps. Mean while, one ex- employee has pleaded guilty to two felonies arising from his action at Enron, and the public awaits criminal charges against other former Enron officials. We haven’t heard the last of Enron, as either icon or business saga. With that in mind, the following pages explain the story behind the symbol. ACKNOWLEDGEMENT Any accomplishment requires the effort of many people and there are no exceptions. The report being submitted today is a result of collective effort. The report has been prepared by us with the purpose of fulfilling the requirements of the course of PGDM (post graduate diploma in management), there are in numerous helping hands behind it who have guided us on our way. First we thank our PGDM program developers for creating such an opportunity for the Students to broaden their frame of skills. I am gratified with their efforts Our sincere gratitude also goes to our guide Dr. Gopal Iyengar as well as our subject teacher and coordinator Dr. Abhishek Ranga who have helped us to perform Group assignment and be familiar to the practical aspect and uses of theoretical knowledge and clarifying the career goals. I would like to thank to all who has provided us the greatest opportunity to perform the assigned work. I am also grateful to all member of institute for providing several documents, papers, data, figures and services and teaching us different techniques to complete the assigned work in more efficient manner. Finally, if we have mistakenly omitted to giving credits, I want to accept the humble apology and I want them to know that without their support there will have differences in this task. EXECUTIVE SUMMARY Let us discuss the history of Enron. Northern Natural Gas Company – the ancestor of Enron – was established in 1930. In 1979, InterNorth Inc bought Northern Natural Gas Company and placed it under a new management. In the 1980s, the United States Congress passed legislation deregulating the sale of natural gas. At the beginning of the 1990s, Congress passed a similar legislation targeted at the sale of electricity. These steps launched a new era in the energy market, allowing companies like Enron to prosper. In 1985, Kenneth Lay, CEO of Houston Natural Gas devised a new company and changed Inter North’s name to Enron Corporation. This newly formed company was at first involved in distributing gas and electricity in the US and in selling power plants and pipelines worldwide. However, the company started to deviate into many non-energy-related fields – i.e. non-core businesses, such as weather derivatives – weather insurances for seasonal business, risk management, and internet bandwidth. Even though Enron’s core business remained gas and electricity, most of the company growth came from those non-core businesses. How fraud happens at Enron' The Enron fraud case was extremely complex. People say that the roots for the Enron scandal date back to the beginning of the 1990s. In fact, in 1992, Jeff Skilling, who was the president of Enron’s trading operations, convinced federal regulators to allow Enron to use mark to market accounting. Mark to market accounting is “a measure of fair value of accounts that can change over time, such as assets and liabilities. Mark to market aims to provide a realistic appraisal of the institution or company’s current financial situation”. When market-based measurement - mark to market accounting in our case - does not accurately reflect the underlying asset’s true value, problems can arise. This is what is happening in the economy with fair value FAS 157. Companies can use mark to market accounting unethically, which is what Enron did. Enron used mark-to-market accounting for its energy segment in the 1990s and used it excessively for its trading transactions. Under this accounting rule, when companies have outstanding contracts, energy-related or derivatives ones, on their balance sheets at the end of a quarter, they must appraise them using fair value and record unrealized gains and losses to the quarterly income statement. The subtlety is that there are no quoted prices upon which to base valuations for long- term future contracts in commodities such as gas. Companies with these types of derivatives are free to value those assets or liabilities using their own models and based on their own assumptions and methods. Using mark-to-market accounting allowed Enron to count projected earnings from long-term energy contracts as current income. Those contracts represented money that might not be collected for many years. Investigators found that this accounting method was used to overestimate revenue by manipulation of future revenue. For instance, unrealized gains accounted for a little more than of Enron’s $1.1 billion reported pre tax profit for 2000. The use of this accounting measure, as well as the use of other questionable measures, made it difficult for the public to see the business model of Enron. In fact, the numbers were recorded on the books but the company was not paying equivalent taxes (unrealized gains). Moreover, we know that Enron has been buying a big number of ventures that looked promising. We know that Enron has also been creating off balance sheet entities in order to remove the risk of their financial statements. However, how did the company implement these operations' Because of the use of mark-to-market accounting explained above, Enron recorded all-time high revenues. The company thus wanted to be involved in other areas. For instance, Enron was buying ordeveloping an asset – such as a pipeline – and then was expanding through a vertical integration (buying a retail business around that pipeline for instance). This strategy required huge amounts of initial investments and was not going to generate earning or cash flow in the short term. If Enron elected to present this strategy on its financial statements, it would have placed a big burden on the company’s ratios and credit ratings, and credit ratings investment grade was crucial for Enron energy trading business. In order to find a solution to this issue, Enron decided to look for outside investors who would like to make those deals with them. Those combined investments required Enron to present a guaranty or another form of credit proof. Because of that, Enron decided to organize these investments as Special Purpose Entities (SPE). Also, since Enron’s executives believed Enron’s long- term stock would remain high, they looked for ways to use the company’s stock to hedge its investments in these SPEs. Enron did this through a complex arrangement of special purpose entities the company called the Raptors. The Raptors were created to cover those SPEs losses if their stocks were falling. When the telecom industry experienced its first decline, Enron experienced poor financial performance as well. In fact, when Enron stocks fell below a certain level, it caused the Raptors’ stock to collapse. This is mainly due to the fact that the Raptors’ stocks were back up by Enron’s stock (through the hedging described above). The telecom industry downturn was thus the underlying event that uncovers the fraud scheme at Enron. TABLE OF CONTENTS S. NO. PARTICULARS PAGE NO. I Preface 2-3 II Acknowledgement 4 III Executive summary 5-6 CHAPTERS: IV Identification of ethical issues 8-10 V Who are the stakeholders 11 VI Stakeholder analysis using Power interest model 12- 13 VII Application of ethical test 14 VIII Questions 15-16 IX Bibliography 17 X Appendix 18 Identification of ethical issues In the given case we found out the following ethical issues concerned with the company: 1) Wrong usage of mark to market accounting: According to financial accounting standards board’s rules, it permits energy companies to include in current earnings those profits they expect to earn on energy contracts and related derivative estimate. As a result many energy companies have been posting earnings, quite substantial, for non cash gains that they expect to realize some time in near future. All these earnings are subjective in nature, which are based on some assumptions about energy market expectations. The same thing was done by Enron copr. , it inflated its profits on the basis on these assumptions and these assumptions were not stated in financial statements. As a result investors had no way of knowing the validity of those assumptions and therefore they couldn’t evaluate the profitability of different projects undertaken by Enron. 2) Concealment of true figures to stakeholders: As we read in the case that by the time Enron collapsed, it had $38 billion in debt among all the various SPE’s, but carried only $13 billion on its balance sheet. So, we can say that it concealed the actual figures from the stakeholders and misled them. 3) Non-disclosure of “of the book entities”: By the time Enron collapsed, it had about 3000 off the books entities, partnerships, limited partnerships, and limited liability companies( called special purpose entities or SPEs in the accounting profession) that carried Enron debt and obligations that had been spun off but did not have to be in disclosed in Enron’s financial reports( under an Accounting rule FASB 125). It misused this rule and didn’t inform its shareholders about these practices and therefore debt figure was also manipulated. 4) Insider trading: Enron was also involved in the process of insider trading. Many of the management people like Jeffrey skilling, Mr. Baxter etc and employees knew that something wrong is going on in the company, which may endanger its existence. They used this information and sold off their shares before its share price fell to a much down level. They were on relatively profitable side than those who didn’t have any information about it. 5) Accounting practices were faulty: Margaret Ceconi stated in a memo to Kenneth lay that losses from enron energy services were being moved to another sector in Enron in order to make energy service arm look profitable. So these kinds of accounting malpractices were also going on in the company. 6) Punishing the whistle blowers: As we discussed accounting practices were faulty, misleading figures were stated and facts were concealed from stakeholders, some people came forward to bring in light the malpractices followed in company. Some of the examples are Ms. Watkins, Ms. Margaret Ceconi, when these people raised their voices they were fired by the management. People outside the company also raised their voices against Enron like John Oslon, Mc clean and Mr. Chanos; they also had been fired by their respective companies. 7) Tax evasion: Enron had 881 corporations with 700 formed in the Cayman islands and in addition to transferring the debt off its balance sheet, it enjoyed a substantial number of tax benefits because corporations operate tax free there. The result is that Enron paid little or no federal income taxes between 1997 and 2000. It did this intentionally to evade tax amount. 8) Corruption: Enron was having corruption at many levels. People at the management level were supporting these activities. Even before bankruptcy the company paid employees $5million bonus to executives. 9) Termination of employees: Enron was a company with a swagger. It had an aggressive culture in which a rating system required that 20 % of all employees be rated below the performance and encouraged to leave the organisation/company. As a result of this policy, no employees wanted to bearer of bad news. Even the whistle – blowing was not allowed in the company and all those employees who tried to do so were punished/ fired. The company also without stating any reason fired the 5100 employees out of 7500 due to which later the employees were more concerned about their financial futures. WHO ARE THE STAKEHOLDERS''' Those who can legitimately affect or be affected by a company should be stakeholders. In this case following are the major stakeholders: 1. Shareholders: 2. Employees: a. At low and middle level b. At management level 3. Customers STAKEHOLDER ANALYSIS USING POWER INTEREST MODEL For each stakeholder, the degree of his or her interest in the project must be identified, along with the degree of power or influence over the project and within the organization. RELATIVE POSITIONS OF STAKEHOLDERS IN POWER INTEREST GRID MODEL Shareholders – (High power, High interest) Shareholders have the power in the company; they evaluate and take various decisions related for future prospects which will be undertaken by the company. They are highly interested in the strategies of the organization, what practices are going on etc, so they have high interest in the company as well. So share holders come under high interest and high power criteria and as the model says shareholders should be managed closely by the organisation. Employees: At low and middle level – (Low power, Low interest) A lower and middle level employee doesn’t have power to influence company policies, management and practices followed by the company. Their main focus is on their salary not company’s welfare. So they come under low power and low interest criteria and they require minimal effort and monitoring by the management. At management level – (High power, High interest) At management level employee have power to influence company’s profit and also highly interested in the strategies of the organization. The acceptability of strategies to these key players is an important consideration in the evaluation of new strategies. So we can put these people under high interest and high power area, they are also required to be managed closely. Customers – (Low power, High interest) Customer doesn’t have power but highly interested in the profit and strategies of the company. So, company should be kept informed to the customer. They can be important to influence the more powerful stakeholders. APPLICATION OF ETHICAL TEST 1. Smell test – unethical This test applies to all issues. How other people in the society will think about these issues' Like wrong usage of mark to market accounting, Concealment of true figures from stakeholders, Non-disclosure of “of the book entities” etc. are different types of issues in this case. After these issues come out in the public, company will definitely have the feeling of shame, so according to this test company is doing unethical things. 2. Utility test – unethical This test describes whether a particular act is bringing happiness or unhappiness among the people concerned. Enron fired 5100 of its 7500 employees and also terminated few employees. Most of employees are unhappy in this case. So this test is unethical. 3. Rights test – unethical It explains about rights essential to a person’s freedom because human rights have become popular across the world for showing respect for people. In this case Wrong usage of mark to market accounting, Concealment of true figures to stakeholders, Non-disclosure of “of the book entities”, Insider trading and faulty accounting practices are some major issues, which affects to human rights. These issues deprived stakeholders the right to get correct information. So this test is unethical in the given case. 4. Exceptions test - unethical This test asks a simple question if I am doing something it is ethical and when some other person is doing the same thing is it unethical' If answer is yes this test is ethical otherwise not. In this case this test applies to all the issues. If all these acts had been done by other company then also it would have been wrong. So this test is unethical. Questions Ques. 1 Do you think that Enron’s financial reports gave a false impression' Yes, Enron financial report were giving the false impression as we can see in the case that though the company was following the financial accounting standards board (FASB) rules for energy traders, which permit such company to include such earning that they expect to earn on near futures on energy contract. Making wrong use of Mark to MARKET ACCOUNTING they showed their profit on assumptions, which were based on market factors and these assumptions were also not stated clearly in their financial reports. The Mark to MARKET ACCOUNTING was hazardous because their profit and performance ratings were tied to meeting earning goals. Even by the time Enron collapsed it had $38 billion debt among all the various SPEs, but carried only $13 billion in its balance sheet. These all events show that the Enron’s financial Report were totally showing fuzzy numbers and try to give shareholders the misleading view of company. Ques. 2 Do you think Enron was fair in its financial reporting and with its employees' The Enron’s was not fair in its financial reporting and with its employees as we can see in the question above that the financial report given by it was totally misleading and was presented in the manner to show the energy sector more profitable by transferring the various debts to its Off- Books Entities. Even when the various employees tried to present the true picture of whatever is going inside the organisation they were fired by saying that they had breached the company security. Thus we can say that the company was neither fair with its shareholders nor with its employees. It was seemed the sole motive for the company was just to earn profit. Ques. 3 Evaluate Enron’s culture' Enron was a company with a swagger. It had an aggressive culture in which a rating system required that 20 % of all employees be rated below the performance and encouraged to leave the organisation/company. As a result of this policy, no employees wanted to bearer of bad news. Even the whistle – blowing was not allowed in the company and all those employees who tried to do so were punished/ fired. The company also without stating any reason fired the 5100 employees out of 7500 due to which later the employees were more concerned about their financial futures. Ques.4 Was Ms. Watkins a whistle blower' Ms. Watkins was a former Andersen employee who had been hired into the executive ranks by Enron. When Ms. Watkins tried to tell the Kenneth Lay, chairman by writing memo and telling him about the accounting scandals going on in the organisation. She also warned that Mr. Skilling’s, CEO Swift departure would raise questions about accounting improprieties but at last the result for that she had done for the organisation by telling about all the things going inside organisation was that she had to pay for it by losing his job. BIBLIOGRAPHY Journal Journal of Economic Perspectives- The fall of Enron -Paul M. Healy and Krishna G. Palepu MAGAZINES www.businessweek.com/magazine/content/.../b3762001.htm SPECIAL REPORTS Chron.Com Special Report- www.chron.com/news/specials/enron/ www.npr.org/news/specials/enron/ www.pbs.org/newshour/bb/infrastructure/.../enron_time.htm WEBSITES www.enron.com http://www.econ.iastate.edu/tesfatsi/ www.wikipedia.org/wiki/Enron_scandal APPENDIX Derivative A derivative is an instrument whose value is “derived” from the underlying value of something else, such as a stock, a bond, or in the case of Enron’s derivatives, a unit of electricity. Derivatives are useful because they enable an investor to hedge against a decline in value. Example: Enron could enter a contract with a purchaser of electricity, such as a utility, guaranteeing that the purchaser would pay a certain price for a certain amount of electricity at a certain date in the future. Whistle Blower The technical term for these often brave people is "whistle blower," as in the expression "blowing the whistle on corruption (or on government lies, etc)." Whistle blowers are people who reveal generally harmful or very unfair activities, often of which they have become aware because of their employment position within their employer's organization and, or their access to otherwise unavailable communications from within the organization. 401k Plan Pension Plans- Employee 401k contributions are automatically deducted from their paycheck each pay period. This money is taken out before the employees’ paycheck is taxed. The contributions are invested at the employees’ direction into one or more funds provided in the plan. Employers often "match" employee contributions, but are not required to do so. While the investments grow in the employee’s 401k account, they do not pay any taxes on it. Special Purpose entities (SPE’S) The special purpose entities are those entities ( off- book entities, partnerships, limited partnerships, limited liability companies) that carry on debt and obligations that had been spun off but did not have been disclosed in financial reports under the accounting rule of financial accounting standards and board(FASB) so long as ownership interest in the entities never exceed 49%