For this project I had to work with a group of four other students to observe a case and discuss the legalities and how the crime was committed. This assignment made me think analytically to be able to write a successful paper.
Enron’s Violations of Securities Fraud
November 18, 2010
I pledgethat I have followed the Arizona State University's Student Academic Integrity Policy with respect to this assignment.
Signed:
By: Nicole Wolf, Joan Nguyen, Usman Noon, Andrew Nilon, Amanda Nishikubo
_____________, _____________, _____________, ____________, ___________
Executive Summary
In the year 2000 the company Enron was known worldwide as the leading company in the energy market as well as being Fortune magazine’s most innovative company six years running. Enron was known to treat their employees with the highest quality providing some of the best retirement and 401(k) plans of any company.
Today, Enron is better known for their elaborate accounting fraud scandal that was the largest corporate scandal in U.S. history at the time. The Enron scandal was first recognized when their stocks plummeted from $90 to less than $1 in a year and a half. Due to Enron’s stock plummeting, the Securities Exchange Commission began an investigation. The SEC found that Enron had many partnerships that they used to conceal their debts.
Enron used mark-to-market accounting where they were able to predict false figures about their future earnings, which were violations of securities fraud. Kenneth Lay, Enron founder, Jeffery Skilling, Enron CEO, and Andrew Fastow, Enron CFO comprised a three-headed greedy dragon that broke many laws and destroyed many lives by trying to make earnings goals and an extra dollar.
A highly complex accounting method called mark-to-market accounting (off the book) was designed and used by Enron’s top executives to mislead shareholder’s and the public about Enron’s true worth. Enron and other energy companies were allowed to include projected future earnings from energy contracts in their current earnings. This paved a path for Enron execs to exaggerate earnings to make monthly projecting as well as keep the market share of the company rising.
By concealing how much debt Enron had, shareholders and investors were not aware of just how much risk they were taking on when investing in the company. When Enron’s scandal became public, the stock plummeted and thousands of employees lost their jobs, most of their 401(k), and retirement savings. Shareholders and investors lost just about the entire investments into the company. The Enron scandal has received a lot of attention because it didn’t just affect people who worked for the company or who had invested in the company, it affected the entire nation.
The men responsible for this amazing scheme are currently serving time in prison, or have since passed away. Enron’s name has been changed to Enron Creditors Recovery Corporation and is now working to pay off Enron’s creditors (Wikipedia, 2010, Post-Bankruptcy section).
Situational Analysis
Kenneth Lay founded Enron in 1985 when he merged the Houston Natural Gas and Internorth pipelines. Enron “became the largest energy trader in the world, with $40 billion in revenue in 1998, $60 billion in 1999, and $101 billion in 2000. Its internal strategy was to grow by 15 percent per year” (Jennings, 2008, page 117). The company operated by offering electricity to different companies around the world and would lock in fixed supply contracts. At this point, Enron was able to control utilities pricing by manipulating future weather changes for their benefit. As the energy market increased, more competitors entered the market. Due to this increase in competition, Enron decided to expand company ventures into other markets internationally such as power plants, fiber optics, broadband, and water. Most of these new acquisitions failed almost immediately after they were purchased.
In the public eye, Enron seemed untouchable. During this time, Enron was one of the most innovative companies in the country. Enron was able to conceal their true earnings through mark-to-market accounting, which was pressed by Jeff Skilling. This accounting method “provides insight into the true value of the company through a matching of contracts to market price in commodities with price fluctuations” (Jennings, 2008, pg. 118). Enron was able to control their numbers because market dynamics are based on assumptions, which are not required to be listed in financial reports. Enron took advantage of this method by making the least amount of disclosures about their financial responsibilities to their shareholders and the risks they were actually taking. This is a form of securities fraud because they violated the fair-disclosure rule under Section 10(b) that was put in place in 2000 by the SEC. They are in violation of this rule by not disclosing accurate information that effected the investor’s/shareholder’s decisions.
Enron’s CFO Andrew Fastow was a key player in running over 800 off-the-book partnerships such as LJM, which is a classified investment business. Creating these “partnerships was to allow Enron to transfer an asset from its books, along with the accompanying debt, to the partnership” (Jennings, 2008, pg. 120). During the fall of Enron, only $13 billion in debt was disclosed in the financial statements when their actual debt was around $38 billion. This is another violation of securities fraud under section 10(b) in the form of violating the fair-disclosure rule. These violations are prime examples for business leaders to show that by concealing relevant financial information that is crucial in making a decision of whether or not to invest in their company can result in a violation of securities fraud.
The Enron case is still pending due to Jeff Skilling appealing his 24.4 year sentence. Andrew Fastow is currently serving a six year sentence that he may have reduced to four years because of his “extensive cooperation in the criminal trials of Skilling and Lay as well as the civil suit is still pending” (Jennings, 2008, pg. 125). Kenneth Lay passed away right after his conviction.
Analysis of Ethical and Legal Issues
Many of the problems that Enron faced were due to unethical and immoral decisions made by company CEOs. Kenneth Lay and Jeffrey Skilling made decisions that not only affected themselves, but affected the company, its stockholders, and investors. By carefully looking at the unethical decisions made, there were issues at an individual and company level. On the individual level, Kenneth Lay and Jeffrey Skilling were both charged with multiple counts of securities fraud among other offenses. According to the text fraud is, “the knowing and intentional disclosure of false information or the knowing failure to disclose relevant information” (Jennings, 2008, pg. 434). There are multiple ways one can be charged with fraud. First, failure to disclose or misstate the type of information that would influence someone’s buying decision is considered fraud. If the buyer is relying on the information provided to make a decision or if the information given damages the buyer it is considered fraud. Even if an individual did not give the information but knew that the information given was false, also known as scienter, they have committed fraud. However, if information given was an opinion, also called puffing, fraud cannot be charged.
Kenneth Lay was charged with falsifying financial records, 11 counts of securities and wire fraud as well as misrepresenting Enron’s performance. Lay claimed that Enron’s collapse happened because of the news media scaring investors into selling their stock and from lower Enron executives who acted outside of his knowledge. However, the greedy lay planned this scheme long before hiring CFO Jeffery Skilling. When the FASB changed its rules allowing energy companies to add profits they expect to earn on energy contracts into their current earnings, Lay saw an opportunity to manipulate numbers and cheat the system as well as investors. Energy companies began to report inflated earnings for projects they had not received cash for yet, also known as mark-to-market accounting. “This practice of mark-to-market accounting proved to be particularly hazardous for Enron management because their bonus and performance ratings were tied to meeting earnings goals” (Jennings, 2008, pg. 119). Greedy executives such as Skilling wanted bonus performance ratings, which is one of the reasons they mislead investors about Enron’s numbers. According to BBC News, Lay sold over $70 million in stock back to Enron in order to repay cash advances. He also sold an additional $20 million dollars in Enron stock. Lay’s sales profits were deemed illegal because they were gained by defraud (Lay, 2002).
CNN reported that Jeffrey Skilling was charged with numerous counts of fraud and insider trading: 10 counts of insider trading, 15 counts of securities fraud, 4 counts of wired fraud, and 6 counts of making false statements to auditors. Skilling was the type of person that would know the right things to say at the right time, making him a perfect candidate to be Ken Lay’s right hand man. By inflating the company’s numbers and withholding valuable information investors were misguided as to the true success of the company. Skilling was accused of selling over 500,000 shares in Enron stock worth more than $21 million, which allowed Skilling to profit by cashing in stock before the collapse of Enron. Because Lay and Skilling sold their shares with the knowledge that the stock price was going to plummet they broke inside trading laws. All charges faced by Lay and Skilling make a clear indication that they were trying to achieve personal profits. Based on the unethical acts of these corporate leaders, their characters are questioned because they put Enron, its employees, and stockholders at risk.
On the group level many individuals are influenced to make decisions based on fellow group members. Communication among group members caused groupthink. Groupthink is where members of a group to yield to the desire for consensus or unanimity at the cost of considering alternative courses of action (Business Dictionary). For managers to become part of organizational culture, they would tie or adopted their ethics to the organization’s ethics. Managers can feel pressured by their managerial roles, which can cause them to act in an unethical manner. Due to the pressures they face managers feel inclined to commit these acts.
Over time, relationships between corporate executives and the board of directors grew superior. They started to believe they were invincible, and could get away with anything. This tough mentality began to create a hostile, competitive environment within the organization. First, there was the idea achieve profitability and success, no matter what the cost. As a result various players, such as managers, would mistreat whistle-blowers. Second, Enron’s organizational culture promoted vicious competition. People would be pinned against each other to achieve the greatest amount of productivity. This created scared employees, and in turn made for the use of ruthless tactics. With this competition, executives and board of directors would have power over Enron’s success and future. On top of breaking many laws, the Enron executives ruined countless lives. “The 21,000 employees of Enron lost both their jobs and their retirement savings; the average employee had 62 percent of his or her 401(k) tied up in Enron stock. Every lost job and every lost dollar was the result of fraudulent accounting” (howstuffworks, 2010).
Conclusion
Enron was once a world leader in energy, innovation, and employee satisfaction, but today the company is better known in law classrooms across the U.S. for committing one of the worst frauds in history. Managers and executives need to take every caution possible and set up effective internal control systems that keep employees and executives honest. First when each employee is hired he or she should be put through fraud prevention training. This would educate new employees about the dangers of fraud and the ways to prevent it.
A company can also put a code of ethics into place with strict rules and punishment for breaking company code. This will let everyone in the company know how seriously fraud is taken and even a single offense will not be tolerated. A hotline can also be put into place to handle calls regarding unethical behavior so anyone that has a complaint can call to report unethical acts. Also, if unethical acts are reported on a certain individual, companies should be in full support of any investigation done by authorities. Companies want to decrease any incentives or motives employees could possibly have to commit fraud and provide benefits or incentives for any employee that has knowledge of fraud being committed by another worker.
If such codes and rules are put into place it will greatly benefit companies internal structure as well as keeping shareholders confident that the company is acting ethically. Enron could have prevented violating securities fraud by revealing their accurate financial information from the beginning. If this were done, investors and shareholders would have had a better understanding of the risks involved with investing in the Corporation.
What happened to the Enron employees that lost their jobs and retirement plans was devastating. However, something can be learned from all of this. Top executives and employees need to think about the personal legal issues they can get themselves in, as well as thinking of how many people’s lives are affected when committing fraud.
Works Cited
“Enron.” Wikipedia. <http://en.wikipedia.org/wiki/Enron>.
"HowStuffWorks "How Insider Trading Works"" Howstuffworks "Business & Money" Web. 17 Nov. 2010. <http://money.howstuffworks.com/insider-trading.htm>.
Jennings, Marianne M. Business: Its Legal, Ethical, and Global Environment. Mason: Cengage Learning, 2008.
“Kenneth Lay: A fallen hero.” BBC News: Business. January 24, 2002.
“Skilling indicted for fraud.” CNN Money. <money.cnn.com/2004/02/19/news/comp anies/skilling/>.
