2 questions of ethical financial case

FIN 501 The Enron Collapse – Ethical Analytical Framework – Team A Martin Essenburg

The Enron Collapse

Prepared for:

Professor Martin Essenburg

Prepared By: Team A

Xi Chen

Cristina Jennings

Aditya Kalra

Hongzhi Zhang

FIN 501 The Enron Collapse – Ethical Analytical Framework – Team A Martin Essenburg

Ethical Analytical Framework

¾ Recognize an Ethical Issue The Enron collapse is a classic example of how senior management can abuse their power and privileges to manipulate information to constantly influence the earnings growth and affect the share price. This results in (i) not acting in the best interests of the shareholder’s, (ii) breaching the code of conduct and code of ethics on which a board is setup, and (iii) multiple conflicts of interest. Enron used aggressive accounting policies (mark- to-market accounting) to book revenues that were, more often than not, never realized. Their accountants (Arthur Anderson) failed to properly audit Enron and acted in their own best interests since they were getting paid high fees. Additionally, by creating performance assessment mechanisms driven by greed (the “rank and yank” performance assessment), employees struck deals in order to meet the pressing targets without proper documentation since they were fearful of being fired. Moreover, they also failed to properly disclose truly what was going on with the limited partnerships that were created (the SPEs) to offload their debt on the balance sheets. Overall there were not proper controls in place to prevent the plethora of ethical issues present in the Enron scandal. The issue is more than legal as it involves the violation of integrity at all levels of management. ¾ Get the Facts

9 Using off-balance-sheet financing strategies to manipulate profits

Off-balance-sheet financing is a high risk financing method. Enron aimed at the flaws of off-balance- sheet financing, employing much high level of lawyers and accountants to create some “new” strategies of off-balance-sheet financing. Because of these strategies, the profits of Enron went up from 5% to 84%.

9 The ineffective regulatory mechanisms at Enron

Although Enron’s independent directors came from other companies and non-profit organizations, Enron signed many advising services and sales contracts with them. Furthermore, Enron also contributed lots of money for these independent directors who worked in these non-profit organizations. This led to conflicts of interest and breach of board oversight and regulatory mechanism as now, the independent directors could not provide an independent view. Hence, they got submissive to any recommendations made by the board. For example, the suggestion of high risk investment for customers from directors was ignored by management of Enron.

9 Using SPEs to hide debt

Enron obscured its risk, using SPEs to hide debt in the balance sheet and made profits by selling bad assets to these entities at far below the market value. Enron used to move assets and liabilities off the balance sheets to attract the most attention. The financial involvement of Enron’s officers and employees in the SPEs increased that interest.

FIN 501 The Enron Collapse – Ethical Analytical Framework – Team A Martin Essenburg

9 The flaws of US accounting and auditing system

The accounting and auditing system in the US allows the firms to review the financial situation and engage in the corresponding consulting business at same time. In this case in particular, Arthur Andersen was providing both accounting and consulting services (more than half of its annual revenue was driven by consulting services) to Enron. In such a scenario, it is difficult to ensure a fair and impartial audit report. This motivated Enron to hide more debt.

9 Mark – to Market Accounting By changing to mark –to-market accounting policy, Enron recorded profits prior to realizing them. There are certain groups that have important stake in the outcome. These include and not limited to stakeholders like investors, employees, board, Arthur Anderson, investment banks (dealing with Enron). There are some concerns like the going concern that is important especially from stakeholder’s perspective. Future investments from the investors are based out of the growth initiatives and going concern of the business. Also, regarding the situation with Enron, we feel that finding information on the companies getting affected because of Enron’s unethical operations would be beneficial. A comprehensive research from ethical standpoint could provide valuable insights regarding these companies. ¾ Evaluate Alternative Actions Below are the four options or choices available:

x Do not use mark-To-market accounting since it is our belief that this decision precipitated the majority of the unethical decisions that followed.

x Increase the effectiveness of controls within the company by reducing emphasis on share price movements.

x Increase transparency both inside and outside the firm. x Create an Ethics committee responsible solely for ensuring (i) that the companies code of ethics is

up to par and (ii) that the companies decisions (both inside and outside of the firm) are in-line with that code of ethics.

Utilitarian Approach: (Option #1) – Which option will produce the most good and do the least harm? Arthur Anderson, upper management at Enron (Lay, Skilling, Fastow, etc.), Enron’s risk department, and the SEC should have understood how inappropriate mark-to-market account was for a company such as Enron. In our opinion the decision to use this accounting treatment paved the way for the majority of the other unethical actions that took place within the firm. Without this accounting treatment they would not have been able to book the majority of the profits they did and it perhaps would have forced Enron re- evaluate the excessive risk taking they were engaging in and seek alternative and more legitimate ways to increase profits. We believe that it would have done the most good and least harm to the majority of

FIN 501 The Enron Collapse – Ethical Analytical Framework – Team A Martin Essenburg

people involved if Enron was never given the ability to use Mark-to-Market accounting for their financials. Rights Approach: (Option #2) –Which option best respects the rights of all who have a stake? The upper management at Enron has a responsibility to protect all its stakeholders. This includes but is not limited to its shareholders, its employees (who were also its shareholders), other companies for which it conducted business with, and the analysts assigned to the company. To protect the rights of all those who have a stake, Enron should have implemented better controls. As the case stated, “the controls as designed were not rigorous enough, and their implementation and oversight were inadequate at both management and board levels.” It seems as though the controls were ineffective because those in charge of the controls were looking out for their best interest and not the stakeholders. This is largely driven by the culture at Enron which was very much tied to ‘what is the stock price doing.’ Most compensation was based off the stock price so everyone was incentivized to ensure the stock price was going up in the short- term and not what was good for the company in the long-term. If the company did a better job of placing less focus on the short term movements of the stock price and more emphasis on the long-term goals and overall financial health of the company, it may have made the controls in place more effective. Fairness or Justice Approach (Option #3) –Which option treats people equally or proportionately? The best and most effective way to treat everyone equally is to ensure that there is more transparency within and outside of the company. It would have been helpful to all parties involved if Enron has been transparent from the early days of the company. It seemed as though Enron couldn’t even clearly identify to the public what they do as a company and how they generate revenue. Had Enron done things such as provided clear comprehensive financials including a balance sheet and cash flow statement, adequate disclosures regarding all their investment strategies, etc., that would have helped increased their transparency tremendously. By labeling transparency as an important and necessary task for the company from its early days, this may have caused them to make better decisions from the start and perhaps Enron would not have entered bankruptcy. This is because it would not have been as easy for them to justify and/or hide all the unethical activities that were going on if transparency was one of their main objectives. Common Good Approach (Option #3) –Which option best serves the community as whole and not just some members? We view this approach as similar to the fairness and justice approach. Not being transparent served the needs of the upper management who benefited from big bonuses as the share price of the company kept increasing. However, they knew what was going on behind the scenes where other people did not. This allowed them to sell out of their positions early while other investors lost the majority, if not all, of their savings because they were not informed of the true financial situation at Enron. Increasing transparency would have helped analysts make better recommendations on the company which would trickle down to the investors who may not be as financially savvy but are relying on the opinions of others to make their investment decisions. As such, increased transparency would have benefited the community as a whole.

FIN 501 The Enron Collapse – Ethical Analytical Framework – Team A Martin Essenburg

Virtue Approach (Option #4) –Which options leads me to act as the sort of person I want to be? The virtue approach would require Enron to have various safeguards in place to ensure that the company was acting in the best interests for all parties involved. It seemed as though everyone was on Enron’s pay scale and there was no unbiased third party, board or committee specifically hired to evaluate Enron’s decisions on an ethical basis. It would have been beneficial if Enron had an Ethics committee that continually evaluated the company to ensure that the decisions they were making were ethically sound and in line with their established code of ethics and that ensured that the code of ethics in place was both comprehensive and appropriate. It looks like Enron’s board members were also in charge of overseeing the code of ethics at the time but that creates a conflict of interest since many of the board members were likely more concerned about profit generation rather than abiding by the code of ethics. A specific board /committee meant to evaluate Enron solely on an ethical basis may have proved helpful. This may have discouraged some of the aggressive practices like the “rank or yank” performance assessment process which encouraged employees to perform well by using any means possible, whether or not it is an ethically sound decision.

¾ Make a Decision and Test It

We think the Fairness or Justice/Common Good Approach (Option #3) would be the most appropriate for this situation. If we promote increased transparency (including adequate disclosures of their investments, proper financials, clear statements of cash flows, and an overview of upper managements compensation structure) investors will have be ability to make well informed decisions and identify any potential conflicts of interest. I also think increased transparency would have prevented many of the unethical decisions that did take place within Enron because the company would have been forced to think ‘if fully disclosed to the public how this would affect the company?’ Similar to other approaches, increasing transparency may have also forced the company to look at the long term financial health of the firm rather than the short term gains. We think if we told someone we respect or a TV audience of this decision they would agree. Reduced transparency inadvertently creates conflicts of interest and can cause people to behave in an unethical manner because they feel like it is more likely that they can get away with this behavior. Increasing transparency can, in a way, hold people accountable for their actions.

¾ Act

In order the promote transparency, the company needs to disclosure more information. Such information should be beneficial for all stakeholders of the company. The company needs to provide more detail and accurate information to the market. They can increase transparency by providing adequate disclosures of their investments, proper financials, clear statements of cash flows, and an overview of upper management compensation structure to all relevant parties, etc. This will help all stakeholders get a better picture of the financial health of the company and if there are any potential conflicts of interest notable through above average compensation being given to upper management. Being transparent with the employees of the company about the true financial condition and making sure you are educating the

FIN 501 The Enron Collapse – Ethical Analytical Framework – Team A Martin Essenburg

employees on what is ‘best practices’ will only help the company in the long run as well. They could communicate things such as this through the companywide meetings. Being honest and transparent with your employee’s only helps them gain a since of loyalty and devotion to the company over the long run.

¾ Comparison with Business Evaluation Option 1 – Do not use Mark-To-Market accounting since it is our belief that this decision precipitated the majority of the unethical decisions that followed. This action is legal. If Enron stops using mark-to-market accounting will have a significant impact on profitability in short term as the company generates the most profit by adapting this method. However, it will force the company move to a more ethical and less risky business model since they will be forced only book revenues for which they truly have received. The company will be profitable from this in the long run because their revenues will be sustainable. Though there may be some resistance to this at first, I think the long term benefits outweigh the short term losses. Option 2 – Increase the effectiveness of controls within the company by reducing emphasis on share price movements. This action is legal. Increasing the control of the company will move some of the management focus from the day to day share price movement to long term profitability. Similar to option 1, the shot-term profitability will be decrease. However, the efficiency of the company will increase since because the controls in place that are meant to safeguard employees, investors, etc. will be effectively implemented. Again, though there may be some resistance to this at first from upper management who is benefiting from ineffective controls, I think the long term benefits outweigh the short term losses. Option 3 – Increase transparency both inside and outside the firm.

This action is legal and it is encouraged by law. More disclosure on every transaction and clear cash flows, etc. should not have theoretically affected the profitability; however, since Enron was engaging in such fraudulent activities, it may have reduced profitability from the standpoint that they would have been forced to think about their actions and how the general public would view such actions if fully disclosed. This may have stopped some of the illegal profits they generated in the short term but, like all the other options, would only help the company in the long term. It would have also increased efficiency because all relevant parties would have access to the same information. Another great benefit of this approach is that it would certainly help the company’s reputation if they are more forthright and this would have helped maintain the strong public confidence in Enron.

FIN 501 The Enron Collapse – Ethical Analytical Framework – Team A Martin Essenburg

Option 4 – Create an Ethics Committee responsible solely for ensuring (i) that the companies code of ethics is up to par and (ii) that the companies decisions (both inside and outside of the firm) are in-line with that code of ethics. This action is legal. This action is a great way to deal with the ethical issues in the company. Creating a new committee will cause an extra cost, which will lower the profitability; however, the long term benefits outweigh the short term cost. From an outsider’s perspective, it would help the company’s reputation because people would view the addition of an Ethics committee as a step in the right direction. Hopefully the ethics committee would work to also improving the Enron culture so that there is not so much pressure put on the employees which causes conflicts of interest. Even evaluating the options from a business perspective we would still chose to increase transparency both inside and outside of the firm. We think this will be the most effective way to address the issues Enron’s is facing and has the most long term beneficial impact for the company.