Enron Case

ABSTRACT

Ethical litercy is about recognizing and acting on potential ethical issues before they became legal problems. Enron and Auther Anderson could have avoided the ethical and accounting breakdown by developing and incorpating an ethics based corporate culture. This paper is intended to provide the reader with an obersevation on the legal and ethical ramifications that happen when regulations on adequate ethical behavior ignored.

The most common form of market failure is information asymmetries. The business decision maker knows something that the person at the other end of the transaction does not. Usually this situation is not an issue, but there are circumstances where unfairness of this asymmetry exceeds simple competitive advantage and is a threat to the rights of others and to the effective operation of the free market as a whole. This happened to be the circumstances of the Enron Corporation. Insider trading is one of the indefensible exploitations of information asymmetries. Since the U.S Supreme Court's Texas Gulf and Sulfur case in 1969 it has been unlawful for directors, such as the Enron chairman was, who had inside price sensitive information to trade in stocks.

The fall of Enron was and is the one of the largest securities fraud scandals in U.S history. In direct relation to unethical financial practices of Enron the 107th Congress created the Sarbanes-Oxley Act of 2002. That law created a new oversight body for corporate auditors, imposed new disclosure requirements on corporations, including a mandate that CEOs personally certify the accuracy of their firms' public financial reports, and increased criminal penalties for a number of offenses related to securities fraud.

History of Enron

The Enron Corporation was once the seventh largest company in America. Enron was formed in 1985 when Intermonth acquired Houston Natural Gas (McLean, & Elkind, 2004). The company branched into many non-energy re-lated fields over the next several years, including such areas as Internet bandwidth, risk management, and weather derivatives. Although their core business remained in the transmission and distribution of power, their exceptional growth was occurring though their other interests. Enron employed more than 20,000 people. Its revenue in the year 2000 was more than $100 billion (McLean, & Elkind, 2004). It was named as "America's most innovative companies for six consecutive years by Fortune 500 magazine. Enron made millions due to its initiative marketing and endorsement of power and communications bandwidth services and risk management offshoots (McLean, & Elkind, 2004).

The demise of Enron is entrenched in the fact that in 1992, Jeff Skilling, then president of Enron's trading operations, convinced federal regulators to permit Enron to use an accounting method known as "mark to market" (McLean, & Elkind, 2004). This was a technique that was previously only used by brokerage and trading companies. Through "mark to market" accounting, the price or value of a security is recorded on a daily basis to calculate profits and losses. Using this method allowed Enron to count projected earnings from long-term energy contracts as current income (McLean, & Elkind, 2004. This technique was used to inflate revenue numbers by manipulating projections for future revenue.

Use of this technique along with some of Enron's other dubious practices, made it difficult to follow how Enron was really making capital. The figures were on the books so the stock prices remained high, but Enron wasn't paying high taxes. Robert Hermann, the company's general tax counsel at the time, was told by Skilling that their accounting method allowed Enron to make capital and grow without bringing in a lot of taxable cash (McLean, & Elkind, 2004).

Enron had been buying any new venture that looked promising as a new profit center. Their acquisitions were growing exceptionally (McLean, & Elkind, 2004). Enron had also been producing off balance sheet entities (LJM, LJM2, and others) to move debt off of the balance sheet and transfer risk for their other business ventures (J., & Joint, 2003). Given that the executives believed Enron's long-term stock values would remain high, they looked for ways to use the company's stock to circumvent its investments in these other entities. They did this through a complex arrangement of special purpose entities or SPE's (J., & Joint, 2003).

The SPE's were established to keep Enron's credit rating high, which was very important in their fields of business (C., & M., 2002). In addition Raptors were established to cover their losses if the stocks in their start-up businesses fell.

Enron sold services to SPEs for large amounts in order to inflate its sales revenue and

income. Because Enron did not use the equity method of accounting, the cost to the SPE was not reflected by Enron. The cash payment from the SPE to Enron for the "services" could be borrowed cash. Thus Enron would report cash flow from operations rather than from borrowing.

One Enron unit would sell energy to a SPE that would then resell the energy to another Enron unit. The SPE would borrow money to pay for the energy; banks often collaborated by helping to set up offshore SPEs to disguise the transaction. The cash was transferred to the selling unit of Enron that reported an increase in revenues, although not necessarily in profits.

In addition, by doing this, Enron manipulated cash flow to report positive cash flow from operations.

When the telecom industry suffered its first downturn, Enron suffered as well. Business analysts began trying to unravel the source of Enron's money. The Raptors would collapse if Enron stock fell below a certain point, because they were ultimately backed only by Enron stock. Accounting rules required an independent investor in order for a hedge to work, but Enron used one of their SPEs (Eichenwald, 2005).The deals were so complex that no one could really determine what was legal and what wasn't (C., & M., 2002). Eventually, the walls begin to cave in. When Enron's stock began to decline, the Raptors began to decline as well. When Enron's stock fell below a certain point, the Raptors' losses would begin to appear on Enron's financial statements. On October 16, Enron announced a third quarter loss of $618 million. During 2001, Enron's stock fell from $86 to 30 cents (J., & Joint, 2003).

On October 22, the SEC began an investigation into Enron's accounting procedures and partnerships. In November, Enron officials admitted to overstating company