Enron Fraud

Tags: accounting business criminal act enron ethical dilemma fraud milton friedman stock market

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Introduction



Enron was one of the biggest business collapses, and one of the most egregious incidents during a period in the early 2000s when investor faith in the securities system was shaken by a series of scandals. The scandals varied in terms of their composition, but behind each of them was greed, the drive by senior management teams to defraud securities regulators and investors for their own gain. This paper will look at the Enron fraud in particular. This was probably the worst, for the bald-faced contempt that Enron management showed to securities regulators, and the biggest, as Enron was one of the stars of the stock market during its ride up, and crashed to worthlessness almost instantly.

Key Players



As with most cases of stock market fraud, the key players were the senior executives. At Enron, the key players were Kenneth Lay, Jeffrey Skilling, Andrew Fastow and the accounting firm Arthur Andersen. Kenneth Lay was the CEO until 2001, and remained on the Board afterwards. Skilling replaced Lay as the CEO. Fastow was the Chief Financial Officer. Arthur Andersen was Enron’s external auditor. As external auditor, its role was to ensure that the financial statements produced by Enron accurately reflected the company’s financial condition (Investopedia, 2017).

Securities Regulation



In the United States, the Securities Exchange Commission is tasked with securities regulation, and in this task part of its job is to verify the financial statements of companies that are publicly traded. This verification assures that publicly traded companies have all produced statements according to generally accepted accounting principles, and that these statements have been subject to external audit by a qualified accounting firm. Firms that do not meet these criteria are subject to investigation and, if found guilty, punishment ranging from fines to de-listing. The latter of which is considered a severe punishment, as it would all but wipe out a company’s equity value – even the possibility that a company could be de-listed would probably wipe out its market value (SEC, 2017).

Fiduciary Duty



One of the central tenets by which public companies operate is that the Board of Directors hires the senior executives and guides strategy. The Board in particular hires the CEO, and the CEO is responsible for hiring other executives, setting corporate strategy, and other initiatives. The senior management team has a fiduciary duty, granted by the Board, to act in the best interests of the shareholders. This duty often lies at the core of ethical dilemmas in business, and has become the subject of considerable debate. The two sides of the fiduciary duty debate are basically the shareholder approach and the stakeholder approach. The shareholder approach was probably best explained by Milton Friedman, who famously argued that the social responsibility of business is to increase its profits. The profits are then dispersed to shareholders, and the shareholders can do with these earnings as they please. Underlying the argument is the idea that business is a vehicle for financial investment, i.e. the creation of wealth. Friedman pointed out specifically that business had to operate within the bounds of the law: “to make as much money as possible while con­forming to the basic rules of the society, both those embodied in law and those embodied in ethical custom” (Friedman, 1970). Thus, the shareholder argument not only dictates that businesses uphold the law in pursuit of profits, but also ethical custom. The stakeholder argument holds that businesses impact a number of different stakeholders, and therefore should take the needs of those different stakeholder groups into account – workers, the environment, and others that might be impacted by externalities not specifically built into transaction costs.



The concept of fiduciary duty is critical in the Enron case, because the senior executives had a duty to increase shareholder wealth. While their actions succeeded for a short time, Enron’s collapse ultimately brought about a condition where the shareholders lost their investments in Enron. Thus, Enron executives failed to uphold their fiduciary duty.

Some Important Facts of the Case



Enron was created in 1985 via merger, with Lay as CEO. The company was an energy trader and supplier, and thrived in an era of deregulation that allowed it to “place bets on future prices” (Investopedia, 2017). The company thrived in energy trading, both via its own trading and by making markets as an intermediary. The company had a high level of exposure to volatile components of the market. So while it had succeeded enormously during the stock market run of the late 90s, this vulnerability was exposed when the market turned during the bursting of the dot-com bubble (Investopedia, 2017).



One of the major frauds Enron committed concerned the use of mark-to-market accounting, which is legal for derivative assets, but highly questionable for use in other areas.

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Investopedia (2017) cites an example where Enron would build a power plant and “immediately claim the projected profit on its books, even though it hadn’t made one dime from it.” This misreporting of revenue constitutes accounting fraud, and created a situation where Enron’s reported earnings were much higher than its actual earnings. While the company was actually losing money – lots of it – this accounting technique led to financial statements that showed the company was actually making money.



Enron’s stock was flying, and the executives were earning substantial sums from equity-based compensation, which is dependent on maintaining high share values, and increasing them. So CFO Fastow set up what became known as special purpose vehicles to hide debt and other toxic assets off the balance sheet. Thus, Enron misrepresented its debt and its bad assets on the balance sheet. It did this by exchanging its stock with the SPV for a note, and the stock would then be used to hedge an asset listed on the balance sheet. Enron guaranteed the SPV’s value. This worked fine as long as Enron’s stock kept rising, which it did during this boom (Investopedia, 2017).



Enron also failed to disclose the apparent conflict of interest that was built into this structure. The mutual guarantees basically meant that if the value of Enron fell, the value of the SPV would fall – there were no downside protections, and the SPVs held all of the debt and bad assets that Enron had.



The auditor, Arthur Andersen, should have red-flagged these accounting practices, for the fact that they misled investors about the financial condition of Enron, and the risk that the company had. It was reporting record profits when it was actually losing money, and hiding its debts in order to cover up this lie. In particular there was insufficient disclosure of the complex hedges that the company had built around its SPVs, and was disclosure that existed was poorly described and difficult even for regulators to parse, let alone casual investors (Thomas, 2002).



When the dot-com bubble burst, a recession was spurred. With this came declining energy prices as demand was reduced. This put an increasing amount of pressure on Enron, as its losses mounted. It was no longer able to hide. Skeptics emerged, believing that Enron’s results were too good to be true, and they were. Investigators from the SEC began probing the company, and its accounting practices were revealed. The stock began to plummet by the summer of 2001. It recorded a loss, and closed one of its SPVs, an act that prevented further devaluation of its stock. The SEC began to investigate and by December the company filed for bankruptcy (Investopedia, 2017). The company had undertaken to shred documents sought by the SEC in an attempt to cover up the crime.

Ethical Issues



It must first be understood what constitutes an ethical issue. The decision of whether to commit a crime or not does not constitute an ethical dilemma, at least not in the instance of securities fraud. An ethical dilemma is a decision where there must be negative consequences, yes, but choosing between a legal action and an illegal one is not an ethical dilemma in any meaningful sense (McConnell, 2014).



Thus, the decision to commit the fraud itself is no ethical dilemma by the fundamental standards of what an ethical dilemma actually is. Beyond the realm of philosophy, one might prefer to use the Friedman argument. The directors of Enron did have some success in increasing shareholder value in the short run. However, Friedman did not say that the social responsibility of business is to increase shareholder value in the short run knowing that it would all be blown up in the long run. The complete and total evisceration of shareholder value as the result of this fraud runs counter to anything Friedman argued. Moreover, Friedman’s argument was set within the bounds of legal and ethical activity. As long as it is accepted that where securities fraud is concerned that legal and ethical are roughly the same thing, then Enron acted far beyond the….....

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References

Friedman, M. (1970) The social responsibility of business is to increase its profits. New York Times Magazine. Retrieved December 13, 2017 from https://www.colorado.edu/studentgroups/libertarians/issues/friedman-soc-resp-business.html

Investopedia (2017) Enron scandal: The fall of a Wall Street darling. Investopedia. Retrieved December 14, 2017 from https://www.investopedia.com/updates/enron-scandal-summary/

McConnell, T. (2014) Moral dilemmas. Stanford Encyclopedia of Philosophy. Retrieved December 13, 2017 from https://plato.stanford.edu/entries/moral-dilemmas/

SEC (2017) The laws that govern the securities industry. Securities Exchange Commission. Retrieved December 13, 2017 from https://www.sec.gov/answers/about-lawsshtml.html

Stinson, T. (no date). Arthur Andersen and Enron: Positive influence on the accounting industry. McKendree.edu. Retrieved December 13, 2017 from https://www.mckendree.edu/academics/scholars/issue4/stinson.htm

Thomas, C. (2002) The rise and fall of Enron. Journal of Accountancy. Retrieved December 13, 2017 from https://www.journalofaccountancy.com/issues/2002/apr/theriseandfallofenron.html
 

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