Group 5

BA 290 WF 630p-750p

Case 3 : Unethical Leadership In Enron

Point of View:
The group looked at this case from the perspective of a CEO of a top corporation.
Problem Statement:
What lessons can be learned from the Enron case?
Framework of Analysis:
To be able to identify the lessons learned, the group looked into the various factors that led to the Enron’s
downfall. We also looked into the roles of the top management, auditors and regulatory bodies in the
company’s downfall.

I. Factors that Led to Enron’s Downfall

A. In most ways, the culture of Enron was the primary cause of the collapse. The senior executives
believed Enron had to be the best at everything it did and that they had to protect their reputations and
their compensation as the most successful executives in the U.S. When some of their business and
trading ventures began to perform poorly, they tried to cover up their own failures. Enron created an
ingenious series of financial operations in order to inflate its results.
1. Creation of Special Purpose Entities (SPE’s) – These enable assets and risks to be shifted off-balance
sheet to obscure or enhance the impact on the parent entity.
2. Mark-to-Market valuation - The potential problems of marking-to-market accounting were shown
to be susceptible to fraud, particularly when the market price of assets could not be determined
objectively. There is no cash generated but the company can announce a profit.

B. Wrong selection of internal leaders.

1. Enron became notorious for putting the wrong people in the wrong positions for the wrong
reasons. The CEO should be the one to lead by example, requiring high ethical standards from all
executives.
2. Bad business decisions, with even worse implementation by its executives. Enron became known
for a large number of strategic mistakes, overpriced acquisitions and disastrous overseas
investments. Thus, the decision process in its top management has a much larger share of the
blame for its downfall than accounting manipulations.
3. An atmosphere of corporate arrogance. The constant media portrayal as a success story and its
highly valued stocks enhanced the internal atmosphere of superiority shown by Enron executives
regarding its competitors and market in general, leading the company to reinforce its deficient
practices without relevant internal challenge.

II. The Gatekeepers

In addition to internal management flaws, the Enron scandal was brought about by external flaws
related to misconduct by entities that should have safeguarded the interests of its investors.

1. Andersen Consulting (AC)

AC has been the external auditor of Enron since its inception in 1985. Over the years, it has become
common practice for Enron to employ people from Andersen. The Chief Accountant Officer (CAO) and
Enron controllers were all former Andersen executives. David Duncan, Andersen’s lead auditor in charge
of the Enron account, accepted Enron accounting practices without any qualifications until 2001.
According to critics, his pay system – tied to the profitability of the Enron’s account – have been a
crucial factor to avoid tougher questions and to the postponement of qualifications in the auditors
opinion. This even led to the shredding of documents prior to the Enron investigation.
2. Investment Banks and their Stock Analysts

1
 A good relationship with Enron senior management was essential for investment banks to secure access
to highly profitable businesses. As a result, investment banks participated actively in Enron’s financial
engineering operations, some even going so far as to become investors in many of its SPEs. At the same
time, their stock analysts continued to recommend investors to buy the Enron’s shares. No bank clearly
warned their investors about the problems at Enron.
3. Strategic and Legal Consultants
Management and legal consulting firms were paid huge sums by Enron over the years. Enron’s
managerial practices were cited as role models in the McKinsey’s publications including several
“innovations” created by the company as the culture of “loose and tight controls” and the securitization
of most of its debt. The lawyers even prepared the documentation for their SPEs.
4. Credit Rating Agencies
Enron was also rated by the three major credit risk agencies – Moody's,Standard & Poor’s and Fitch.
Despite having frequent access to Enron’s management in order to obtain additional information, none
warned investors of the impending danger.
5. Board of Directors
Despite having several prestigious members, Enron’s board clearly failed by not making crucial
questions and decisions. Enron’s board failed to fulfill its fiduciary duty, allowing the company to engage
in high risk accounting, inappropriate conflict of interest transactions, extensive undisclosed off-the-
books activity, and excessive executive compensation. The board also had its independence impaired
due to several financial ties between the company and its directors deemed as “independent”.

III. Lessons Learned from Enron’s Scandal

A. Financial cleverness is no substitute to good and ethical corporate strategy. The executives of Enron
were focused on quarterly profits and short-term stock valuation instead of long-term value creation.
This culture of greed has led to fraudulent activities.

B. Enron used to be a shining example of an innovative company. However, analysts say that the way you
make money in the new economy is the same way you make money in the old economy - by providing
goods or services that have real value. Based from the famous adage “show me the money”, it is always
wiser to follow the cash and not be caught up with misleading accounting records.

C. Excessive concentration of power. Executives who are paid too much can think they are above the rules
and can be tempted to cut ethical corners to retain their wealth. Further, the attachment of high profile
names has conveyed a false sense of security to investors. At the end of the day, don’t simply trust but
verify and do not invest in a business that you do not understand.
D. The enormous gap between “checklist” governance and effective governance. Although many of
Enron’s corporate governance mechanisms were “on paper” in line with best practices, things worked
very different internally. The two positive legislative outcome of the Enron scandal is the creation of
the Sarbanes-Oxley Act that heightens the consequences for defrauding shareholders and destroying or
altering financial records. The other one is the raising of the levels of ethical conduct dictated by the
Financial Accounting Standards Board.

E. Fraud does not pay. The downfall of Enron destroyed the lives of the executives and companies
associated with it namely Andersen Consulting. Fastow, Skilling and Lay were sentenced to jail with Lay
dying of a heart attack before serving his prison time.

References:
1. “The Enron Scandal: A Decade Later Lessons Learned?” by Alexander DiMiceli da Silveria School of Economics Management and Accounting of the
University of Sao Paolo. 2011.
2. “TRADING INSIDER: The Four Lessons From Enron Every Investor Should Understand” http://www.businessinsider.com.au/trading-insider-the-four-
lessons-from-enron-every-investor-should-understand-2014-8
3. “Lessons from the Enron Scandal” Kirk Hanson interview by Atsushi Nakayama
https://www.scu.edu/ethics/focus-areas/business-ethics/resources/lessons-from-the-enron-scandal/