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Abstract: The year 2011 has marked a decade since the Enron collapse,
considered the most emblematic corporate scandal worldwide. Despite its
importance, few studies provide an integrated analysis of the underlying failures
that allowed Enron’s debacle, going beyond the traditional view that reduces the
case to a mere “accounting fraud”. Few studies also evaluate the main lessons from
the Enron scandal in perspective, by comparing its common causes with corporate
scandals that emerged during the global financial crisis in 2007-2008. These are
the gaps I aim to fill. I conclude that Enron’s accounting manipulations, rather
than being the cause of the problems, were the consequence of managerial failures
and wishful blindness by its stakeholders. I also show that some lessons from
Enron have not been fully internalized by companies worldwide, since most of its
underlying causes are similar to those of several corporate scandals that emerged a
couple of years later.
1. Introduction
A decade ago, the Enron debacle, the most emblematic corporate scandal
associated with corporate governance problems in history, took place. The
company has become the seventh largest U.S. company by revenues in
2001, the same year it went bankrupt after the disclosure of a series of
frauds (Wearing 2005: 67).
The impact of the collapse was disastrous to its shareholders and
stakeholders, including the firing of the approximately 30,000 employees.
The case drew even more attention because of the image of success that
7$6-1,$8''&9"$:&;<=>+>&+&<<+'?=@AB$CD('?&(E$
FGHI$$J5KL,LKJ6M2L116L,$ FGGI$-J4,L-1K-$
316 Homo Oeconomicus 30(3)
the company had built in previous years. By the year 2000, for example,
Enron had received for six consecutive years the award as the most
innovative company from Fortune magazine’s annual ranking of the most
admired companies. Its Chief Finance Officer (CFO) Andrew Fastow has
received in 1999 the award as most creative CFO of the year from CFO
Magazine.1 In September 2001, a month before the eruption of the scandal,
Enron was on the list of the 50 U.S. companies fastest growing, being by
far the largest company in the list.2
The company had also a lot of power and political influence. It is
estimated that three-quarters of U.S. lawmakers have received campaign
donations from Enron.3 In 1999, its lobbyists in Washington included
people like Henry Kissinger and James Baker, both former U.S.
Secretaries of State. In the years immediately preceding the collapse,
Nelson Mandela and Alan Greenspan went at the company's headquarters
in Houston to receive the then prestigious “Enron Prize”. Enron’s
Chairman and founder, Kenneth Lay, was affectionately called “Kenny
Boy” by his then friend George Bush (Wearing 2005: 67, and McLean and
Elkind 2004: 87).
Enron was, therefore, a high-profile company, cited as a role model by
market’s leading experts, including stock analysts, investment analysts,
journalists, consultants and even by business schools professors – its
“success story” was required reading at Harvard's MBA.4 Appendix A
provides a detailed timeline of the events that took place at Enron.
The Enron scandal generated huge repercussions, being the start of a
wave of other corporate governance problems at major American and
European companies (e.g. WorldCom, Tyco, Parmalat, Royal Ahold). It
was a key factor for the enactment of the Sarbanes-Oxley Act in 2002,
whose impacts were felt by companies worldwide.
1
Micklethwait and Hamilton (2006: 36). The award received by the Fastow was
CFO Magazine in 1999 entitled "Excellence Award for Capital Structure
Management."
2
Enron's revenues increased from $ 40 billion in 1999 to $ 100 billion in 2000. If
the year 1996 is taken as the starting point (revenues of $ 13.3 billion, revenues
increased 750% in four years).
3
The Economist, November 30th, 2002 (p.12). Investor self-protection.
4
A report from HarvardWatch, a nonprofit organization formed by Harvard’s
alumni, details the various conflicts of interest between Enron and Harvard
University. According to it, Enron promoted a process of institutional capture of
the university through financial incentives and personal connections, strongly
influencing its research agenda, particularly by promoting the benefits of further
deregulation. “Trading Truth: A Report on Harvard's Enron Entanglements.” The
HarvardWatch Report, January 31, 2002.
Di Miceli da Silveira: The Enron Scandal a Decade Later:… 317
Several studies have been conducted to examine the case under multiple
facets. O'Connor (2002) and Barrett (2005) discuss Enron's relationship
with its auditors. Bratton (2002) analyzes the excessive focus of its
managers on share price maximization and its consequences. Partnoy
(2002) investigates Enron’s wide use of derivatives, while Rosen (2003)
concentrates his attention on the company’s risk management flaws.
Bratton (2003) and Catanhach and Rhoades (2003) analyze Enron’s failure
from the point of view of the lack of transparency of its public information
and accounting decisions. Gillan and Martin (2002) and Schwarcz (2006)
focus on the financial engineering operations architected by its CFO
Andrew Fastow. Brickey (2003) and Kroger (2004) investigate the case
under the legal standpoint by discussing the penalties applied, while the
failure of Enron’s gatekeepers such as investment banks, rating agencies,
auditing, etc. was the focus of Coffe Jr. (2003) and Healy and Palepu
(2003).
Despite its relevance, few studies so far have tried to assess in an
integrated way the underlying managerial faults associated with corporate
governance that caused Enron’s collapse. Moreover, as the vast majority of
works about the Enron case has been conducted shortly after the eruption
of the scandals, few studies have evaluated the main lessons from this
scandal in perspective, discussing their degree of internalization among
market players and regulators a decade later as well as providing a
comparison with several corporate scandals that emerged as a result of the
global financial crisis of 2007-2008. These are the gaps that this study
intends to fill and thus contribute to the literature.
This paper is structured as follows. I begin by providing a chronological
summary with the main events that took place at Enron. I then explain the
financial engineering operations between the company and its special
purpose entities that allowed Enron to hide its debt. The real causes of the
Enron failure are then discussed, focusing on the management problems
and ethical decisions that led to wrong business decisions and accounting
fraud. The following section details the role of the gatekeepers of Enron
investors in the case – investment banks, stock analysts, independent
auditors, credit rating agencies, law firms, consultancies and regulators.
The consequences for the main involved are presented subsequently. I then
compare the causes for the Enron collapse with the common causes
associated with ten corporate scandals that emerged together with the
global financial crisis in 2007-2008 and I conclude by presenting the “red
flags” that could have been observed by investors as well as the main
lessons to be drawn from Enron’s case.
318 Homo Oeconomicus 30(3)
5
In addition to allowing the exercise of stock options by its executives, the
financial engineering operations at Enron aimed to reduce the company’s debt in
order to allow new borrowings. The company sought to avoid capital increases,
since the issuance of new shares would decrease its earnings per share, the primary
focus of both its executives and the several analysts covering the company.
6
A Special Purpose Company or Special Purpose Entity is a legal vehicle created
to achieve a specific business purpose, which should be clearly defined in their
corporate documents. In practice, it is usually created by companies or other legal
entities in order to segregate risks, develop specific projects, or make use of tax
advantages.
7
Among the best known SPEs, there are the LJM series (initials of the names of
Fastow’s children and wife), JEDI (named due to Fastow’s devotion of Star Wars
movie), Condor and Raptor. Tonge et al. (2003: 6) describe four examples of
complex SPEs created by Fastow. The authors show how some SPEs were also
managed by Fastow subordinates, as was the case of Michael Kopper in SPE
Chewco. Altogether, it is estimated that Enron has created about 3,000 subsidiaries
and it has paid about $ 300 million to advisers (investment banks, law firms,
auditors, etc.) over the years to create this network of off-balance sheet entities.
For comparison purposes, the Financial Accounting Foundation, an organization
that generates and maintains accounting standards in the U.S., has spent about $ 20
million in its programs in 2001. In the words of University of Chicago professor
Richard Leftwich: “It takes two years the FASB to issue a ruling and two weeks
for investment bankers to figure out a way around it”. For more information, see
http://www.nysscpa.org/cpajournal/2003/0403/features/f042403.htm
8
As an example, LJM2 and Raptors (two SPEs) could in fact be considered part of
Enron, since in both cases there was not an independent entity with risks and
rewards associated with their ownership. Both, therefore, should have been
consolidated into Enron’s financial statements and the shareholdings of Fastow
and other partners should be accounted for as minority interests. For more details
on this issue, see Deakin and Konzelmann (2004: 136).
9
Also known as prepaid forward sale contract.
Di Miceli da Silveira: The Enron Scandal a Decade Later:… 319
10
Enron’s prepaid operations are detailed at:
http://www.sec.gov/litigation/complaints/comp18252.htm
320 Homo Oeconomicus 30(3)
Enron
3 1
$$t+1 Gast+1 $t Gast+1
2 Gast+1
Investment Bank SPE
$t
Figure 1 - Illustration of Enron’s prepaid transactions.
11
For more details on the sale and repurchase transaction, see McLean and Elkind
(2004: 189).
12
In 1999, Enron, through an integral subsidiary, owned approximately 65% of a
power plant in Cuiabá, Brazil. The goal of the project was the generation and sale
of electricity. However, the project has proved problematic from the start, leading
Enron to incur into substantial costs. As Enron did not want to consolidate the
Cuiaba project on its balance sheet, it tried to sell its stake. However, the project
was so problematic that no independent entity expressed interest in acquiring it.
Enron then decided to “sell” a 13% stake of the enterprise to Fastow’s SPE called
LJM1 in September 1999 for $ 11.3 million. The sale allowed Enron to
characterize the Cuiaba project as an independent entity to be kept off-balance
sheet. In March 2001, Enron repurchased LJM1’s stake at a substantially higher
price, despite the deterioration of the unit’s performance. More details at
http://www.sec.gov/litigation/complaints/comp17762.htm
13
See http://www.sec.gov/litigation/litreleases/lr17692.htm
Di Miceli da Silveira: The Enron Scandal a Decade Later:… 321
Enron
Buy Bad Asset t+1
$t 3
1
Sell Bad
$$$t+1
4 $$t+1 Asset t
Investment Bank SPE
Enron’s stocks as 2 $t
guarantee
14
See http://www.sec.gov/litigation/complaints/comp17762.htm
15
In January 1987, Enron's internal audit discovered that Louis Borget and Tom
Mastroeni, two oil traders from his office in Valhalla (NY), had diverted company
322 Homo Oeconomicus 30(3)
funds to their personal accounts. In April of the same year, the council - chaired by
Kenneth Lay - was informed that they had operated well above their limits and
destroyed reports trading in order to maintain the appearance that they were getting
steady profits. As the Department of traders had been responsible for much of
Enron's profits in the previous year, Lay made it clear that they were generating
profits too much to be dismissed. The case is described in detail by McLean and
Elkind (2004: 20). According to the authors, Lay ended his letter to the accused
with the following request": “please and keep making us millions ...”.
16
McLean and Elkind (2004: 3).
17
http://money.cnn.com/news/specials/enron/intro1.pdf
18
Mills (2002: 47).
19
Enron’s 1998 Annual Report:
http://picker.uchicago.edu/Enron/EnronAnnualReport1998.pdf
Di Miceli da Silveira: The Enron Scandal a Decade Later:… 323
20
Regarding Skilling’s profile, McLean and Elkind (2004: 28) argue that “Skilling
had a tendency to oversimplify... and he had an active distaste for the messy details
involved in plan execution.”
21
According to McLean and Elkind (2004: 137), “Fastow did not stand out in his
first few years at Enron. Certainly, people would not have guessed that he would
one day ascend to become CFO of a Fortune 500 company”.
22
According to Micklethwait and Hamilton (2006: 52), Fastow had experience in
asset securitization and structured financial transactions, but lacked experience in
accounting and controlling, crucial areas for a CFO of a large company. A former
boss at Continental argument that “Andy did not have the knowledge base required
to be CFO of a major company” (McLean and Elkind: 2004: 140).
324 Homo Oeconomicus 30(3)
23
One of the most notorious business failures at Enron occurred through its
partnership with Blockbuster, a provider of movie rental services. In July 2000,
they signed a 20-year agreement to launch the concept of movies on demand (via a
broadband network to be implemented by Enron). Although conceptually
interesting, operational difficulties undermined its financial viability. This case
also illustrates the problems associated with mark-to-market accounting at Enron.
Initially, it estimated earnings of $110 million for the project, booking it as
operational income. After several problems and the termination of the partnership
with Blockbuster, Enron continued to recognize the “future profits” of this project.
24
In addition to the huge and failed Dahbol energy plant in India, Enron suffered
severe losses in energy investments in Brazil and Bolivia, as well as with
sanitation projects in Argentina. Altogether, these investments have being major
consumers of the company’s cash.
Di Miceli da Silveira: The Enron Scandal a Decade Later:… 325
3.1 Auditors
25
Extract from Enron's Code of Ethics: “Employees of Enron are charged with
conducting their business affairs in accordance with the highest ethical standards.
An employee shall not conduct himself or herself in a manner which directly or
indirectly would be detrimental to the best interests of the Company or in a
manner which would bring to the employee financial gain separately derived as a
direct consequence of his or her employment with the Company”.
Available at http://www.thesmokinggun.com/enron/enronethics1.html
26
Tonge et al. (2003: 10). According to McLean and Elkind (2004: 193), the
board meeting that granted the exemption to Fastow – in which the majority of
directors participated by telephone and including other topics on the agenda –
lasted less than 1 hour.
27
The corporate governance literature often uses the term “gatekeepers”, which are
professionals that provide services of verification, certification and analysis, using
their reputational capital to protect investors. The expression was initially
formulated in the corporate governance context by Professors Ronald Gilson and
Reinier Kraakman in 1984. Among the main gatekeepers, stand out auditors,
investment banks, law firms, credit rating agencies and market analysts. Some
authors also point out advisors and consultants as gatekeepers, since the market
expects these agents to properly guide companies regarding best governance
practices.
326 Homo Oeconomicus 30(3)
28
Tonge et al. (2003: 7) argue that Andersen was aware of some significant losses
in Enron’s off-balance sheet SPEs in early 2001, but decide not to take them to the
Enron’s Audit Committee. Hamilton and Micklethwait (2006: 54) point out that
Andersen internally used to consider Enron as a “high risk” client and that the
political weight of David Duncan at Andersen – an executive who had risen
quickly through the ranks due to the growth of Enron’s account and whose
compensation was tied to the maintenance of the client – always prevailed over the
opinions of Andersen’s technical area. They also note that Duncan used to suffer
internal pressures at Anderson to generate more revenues from the clients.
Di Miceli da Silveira: The Enron Scandal a Decade Later:… 327
1999 (McLean and Elkind, 2004: 163). 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. Tonge et al. (2003: 7) show how
Citigroup and a Morgan Stanley affiliated entity became partners of some
SPEs of the LJM series. Hamilton and Micklethwait (2006: 45) claim that
the LJM2 SPE had renowned banks like Citigroup, Deutsche Bank, GE
Capital and JP Morgan as their partners.
At the same time, their stock analysts continued to recommend investors
to buy the Enron’s shares. On October 9th, when Enron shares were trading
at about one-third of their peak value one year before due to the eruption
of its dismal accounting, a Goldman Sachs report called Enron “still the
best of the best”, indicating a target price for its shares about 45% superior
than its market price, praising the company with sentences such as “We
expect Enron shares to recover dramatically in the coming months… our
confidence level is high… Misconceptions abound and perceptions are far
below reality, in our view… We believe Enron’s fundamentals are still
strong”.29 At that time, 16 out of the 17 analysts that covered the company
continued to post “buy” or “strong buy” recommendations (McLean and
Elkind, 2004: 230).30
No bank clearly warned their investors about the problems at Enron.
According to McLean and Elkind (2004), in fact acted as true partners of
Enron’s shady dealings:
“One of the most sordid aspects of the Enron scandal is the complicity
of so many highly regarded Wall Street firms – a complicity that is
stunningly documented in internal presentations and e-mails…. They show
banks helping Enron mask debt as cash flow from operations and create
phony profits at the end of a quarter. They also show how almost all of
them put money into Fastow’s partnerships because of – not in spite of –
their potential for abuse. Most of all, the documents show that the banks
weren't merely enablers; they were truly Enron's partners in crime.”
29
Goldman Sachs Report. October 9th, 2001. Enron Corp. (ENE): Gas & Power
Convergence. Available at:
http://www.dauphinefinance.com/MFE/ALire/Enron%20The%20best%20of%20th
e%20best.pdf
30
According Tonge et al. (2003: 15) analysts that did not support Enron by
recommending its shares were likely to face problems with their employers.
328 Homo Oeconomicus 30(3)
Enron was advised by highly renowned consultancies and law firms. Its
main strategic advisor was McKinsey, considered “the most renowned
global management consulting firm”. McKinsey has provided continuous
business advisory service for Enron throughout 18 years, by which it is
estimated to have received about $10 million per year in fees.31 Some of
Enron’s managerial practices were cited as role models in the McKinsey’s
publications, including several “innovations” created by the company as
the “asset light strategy”, the culture of “loose and tight controls” and the
securitization of most of its debt (McLean and Elkind 2004: 240). In the
same period, McKinsey advised other companies with governance
problems, such as Swissair and Global Crossing. McKinsey worked so
closely to Enron that its CEO decided to send the head of the legal
department to Houston after the Enron collapse in order to assess possible
legal consequences to the consulting firm.32
Prestigious law firms also received huge sums (often above the market
fees) for their services. Some, like the renowned office Vinson and Elkins,
Enron helped to prepare the legal documentation for its SPEs. For
instance, two of its partners have been designated by Kenneth Lay in
August 2001 to investigate rumors of problems taking place in the
company. At the end, their report did not find anything “fundamentally
wrong” at Enron. Later, the firm they were accused of failing to disclose to
the public problems concerning the SPEs, agreeing to pay $30 million to
avoid prosecution.
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. A few weeks before Enron’s
bankruptcy (when the company’s shares were already trading at about $3),
they still assigned an “investment grade” rating for Enron debt.33
31
Business Week Magazine, July 8th, 2002. Inside McKinsey. Cover Story.
Available at
http://www.businessweek.com/magazine/content/02_27/b3790001.htm
32
Business Week Magazine, July 8th, 2002. Inside McKinsey. Cover Story.
33
The “investment grade” rating was a fundamental condition for the viability of
the SPEs and for the very business model of Enron in the broader sense. As
explained by Konzelmann and Deakin (2004: 138), “As Enron’s credit status
declined (eventually falling below investment grade level), debts automatically fell
Di Miceli da Silveira: The Enron Scandal a Decade Later:… 329
due and liabilities accumulated under the terms of its loan covenants… Enron’s
entire strategy depended upon being able to maintain the confidence of the credit
and capital markets."
34
Audit, Compensation, Nominating, Executive and Finance Committees.
35
Tonge (2003: 17) argues that at least six Enron independent directors received
significant funding from the company in the form of sponsorships, donations or
services.
36
Source: Business Week, July 29th, 2002. According to Micklethwait and
Hamilton (2006: 37), the 200 top executives of Enron received about $ 1.4 billion
in total compensation (including salary, bonuses, stock, options, etc.) in the year
2000. Between January 2000 and October 2001, the top three Enron executives
pocket nearly $290 million by selling company stocks (Lay, $184 million;
Skilling, $70 million; Fastow, $33 million).
330 Homo Oeconomicus 30(3)
the board was also substantially above the market. Appendix B details the
consequences for the key people involved with Enron’s case.
The Enron case is rich in red flags for investors and regulators. Among the
warnings signals that could have drawn investors’ attention, the following
stand out:
4.3 The lack of transparency about the company activities and earnings
sources: few people understood Enron’s business and its hypothetical
sources of profit. But that didn’t keep investors from putting money into
the company. In an interview in early 2001, COO Jeffrey Skilling
acknowledged this lack of transparency: “Yes, (the company) is a black
box. But it is a black box that is growing revenues and profits 50 percent.
It’s a good black box”;
4.5 The extraordinary growth in the previous years before the collapse:
between 1996 and 2000, Enron revenue jumped almost eight times from
$13.3 billion to $100 billion. This phenomenon was made possible mainly
by acquisitions, most of them costly and underperforming. Over time, the
37
The focus on social events and reduced interest on Enron businesses, especially
in the last years running the company, was even used by Lay in his defense.
Di Miceli da Silveira: The Enron Scandal a Decade Later:… 331
5. Key lessons
5.2 The risks of perceived success: the high visibility of Enron’s “success”
in the media, stock market and academia enhanced the ambiance of
euphoria and arrogance within the company, lulling its executives into a
feeling of certain invincibility. This diminished critical sense drove people
to stop questioning whether they were really doing the right things for the
company's long-term success.
38
In its 2000 Annual Report, Enron was clear about its exclusive focus on
quarterly earnings per share: “Enron is laser-focused on earnings per share and we
expect earnings to remain strong performance.”
332 Homo Oeconomicus 30(3)
5.6 Blind trust and investors’ greed: although Enron slogan was “Ask
Why”, the truth is that investors, including employees who invested their
retirement money in Enron, failed to do this, not asking themselves simple
questions such as: how could a large company in the commodities industry
grow 50% yearly? How a company trading derivatives could provide a
constant increase of about 15% in its earnings per share quarterly? Is a
500% return on investment within four years a reasonable performance? In
other words, investors were dazzled by Enron's extravagant advantages and
profits and beguiled by prospects of easy short-term gain.
In this section, I compare Enron with ten corporate scandals that emerged
in the 2007-2009 period. If we observe similar causes, then we would have
Di Miceli da Silveira: The Enron Scandal a Decade Later:… 333
an evidence in favor of the argument that the lessons from the Enron’s
collapse have not been fully learned.
There is a previous literature that seeks to identify the causes of
governance scandals. Hamilton and Micklethwait (2006), concluded that
seven scandals from the early 2000s – including Enron –were caused by
six main common causes: 1) poor strategic decisions; 2) over-expansion
and ill-judged acquisitions; 3) dominant CEOs; 4) greed, hubris and a
desire for power; 5) failure of internal controls; and, 6) ineffective boards.
Coffee Jr. (2005, 2006) listed the “gatekeeper failure” as another reason
for the emergence of corporate scandals. More recently, a OECD report
(2009) concluded that four main problems have caused the governance
failures at financial institutions that collapsed in the 2007-2009 period: 1)
inadequate incentive systems; 2) deficient risk management practices; 3)
poor board practices; and, 4) the tendency for shareholders – especially
institutional investors – to act reactively rather than proactively.
Building upon these works, I propose an expanded framework with
fourteen possible interrelated common causes associated with corporate
governance scandals:
1. Excessive concentration of power: corporate decisions coming
from the single views of specific individuals without the appropriate
counterbalances.
2. Ineffective Board of Directors: boards do not satisfactorily
performing their role of monitoring managers and providing the right
strategic direction.
3. Passivity of investors: investors do not correctly exercising their
role as active shareholders and end up wrongly rewarding firms with
unsustainable practices by inflating their stock prices.
4. Failure of gatekeepers: reputational intermediaries – such as
auditors, stock analysts, credit rating agencies, attorneys, investment
banks, and consultants – who pledge their reputational capital to vouch for
information that investors cannot verify failing in their duties.
5. Poor Regulation: deficient or nonexistent regulation allowing the
occurrence of governance problems.
6. Illusion of success of the business: people inside and outside the
organization believing that the company is an absolute success, ignoring
contrary evidence and generating a feeling of invincibility.
7. Internal atmosphere of greed and arrogance: an internal
atmosphere of euphoria and hubris creating an inner sense of superiority to
people outside the company.
8. Lack of ethical tone at the top: leaders clearly failing to promote
high ethical standards within their organizations, not treating the issue as
something essential and priority.
334 Homo Oeconomicus 30(3)
39
The author thanks the anonymous referee for highlighting the need to reflect on
the positive aspects resulting from the Enron’s case.
Di Miceli da Silveira: The Enron Scandal a Decade Later:… 335
Table 1: Enron case vs. selected corporate scandals from the 2007-
2009 period.
Panel A. Common causes associated with corporate governance
scandals from the first decade of the 21st Century on a 0-3 scale40
# 1 2 3 4 5
Société Lehman Bear
Company Enron Siemens AIG
Générale Brothers Sterns
Year 2001 2007 2008 2008 2008 2008
Excessive
1 Concentration of 2 2 3 3 3
Power
Ineffective Board
2 3 3 2 3 3 3
of Directors
Passivity of
3 3 1 2 2 2
Investors
Failure of
4 3 2 1 3 3 3
Gatekeepers
Poor Regulation
5 3 3 1 2 2 2
Illusion of
6 Success of the 3 1 2 3 3 3
Business
Atmosphere of
7 Greed & 3 3 3 3 3
Arrogance
Lack of Ethical
8 3 3 3 3 3 3
Tone at the Top
CG seen as a
9 3 3 2 3 3 3
Marketing Tool
Overexpansion of
10 3 3 2 2
the Business
Biased Strategic
11 3 3 3 3
Decisions
Inflated Financial
12 3 1 1 1 1
Statements
40
The qualitative scale aims to analyze the different relevance of each common
cause associated with corporate scandals. “1” indicates that the factor was relevant
for the emergence of the scandal. “2” indicates that the factor was highly relevant
and “3” indicates that it was critical for the eruption of the scandal. Void cells
indicate that the respective factor was not relevant to the case at hand.
336 Homo Oeconomicus 30(3)
Weak Internal
13 2 2 3 2 2 2
Controls
Inadequate
14 Compensation 3 1 2 3 3 3
System
# 6 7 8 9 10
Pana-
Sat-
Company Enron Sadia Aracruz Madoff meri-
yam
cano
Year 2001 2008 2008 2008 2009 2009
Excessive
1 Concentration of 2 1 1 3 3 3
Power
Ineffective Board
2 3 3 3 3 3 3
of Directors
Passivity of
3 3 2 2 3 2 3
Investors
Failure of
4 3 3 2 2 3 3
Gatekeepers
5 Poor Regulation 3 3 3 2 1 2
Illusion of
6 Success of the 3 3 3 3 2 2
Business
Atmosphere of
7 Greed & 3 1 2 3 1 3
Arrogance
Lack of Ethical
8 3 3 3 3 2 3
Tone at the Top
CG seen as a
9 3 3 3 2 3 3
Marketing Tool
41
The qualitative scale aims to analyze the different relevance of each common
cause associated with corporate scandals. “1” indicates that the factor was relevant
for the emergence of the scandal. “2” indicates that the factor was highly relevant
and “3” indicates that it was critical for the eruption of the scandal. Void cells
indicate that the respective factor was not relevant to the case at hand.
Di Miceli da Silveira: The Enron Scandal a Decade Later:… 337
Overexpansion of
10 3 1 2
the Business
Biased Strategic
11 3 2 3 2 1 2
Decisions
Inflated Financial
12 3 3 3 3
Statements
Weak Internal
13 2 3 3 3 3 3
Controls
Inadequate
14 Compensation 3 2 X 3 3
System
Among the papers that emerged after the Enron case calling for new
approaches toward corporate governance by questioning and widening the
agency theory concept, there are Charreaux, (2005), Van Ees et al. (2009),
Cuevas-Rodríguez et al. (2012), Martin et al. (2012), Wiseman et al.
(2012) and da Silveira (2012).
Enron scandal also induced the enactment of the Sarbanes-Oxley (SOX)
Act in July 2002, impacting companies worldwide. The main goal of the
Law was to improve the accuracy of the financial statements. Although
there has been much debate about SOX’s overall cost-benefit for the
companies and the U.S. market as a whole, the analysis of the ten selected
corporate scandals presented in Table 1 indicates that inflated financial
statements have not been a key component for the majority of the
governance scandals that emerged from 2007 to 2009.
Specifically, fraudulent statements with elements of a Ponzi scheme
were at the core of only three scandals of this period: Madoff42 (a U.S.
investment fund), Panamericano Bank43 (a Brazilian bank), and Satyam44
(an Indian IT company). Since Madoff was not subject to the stricter
accounting standards of Sarbanes Oxley (because it was an investment
advisor and not a U.S. listed company) and the two other companies were
from emerging markets and also not subject to this Law, it is possible to
infer that the enactment of Sarbanes-Oxley as a result of Enron have had a
positive impact on the market by avoiding the emergence of new scandals
based on inflated financial statements. Therefore, although it is not
possible to estimate the number of companies that have been saved by
Enron’s fate due to the improved regulatory and market vigilance after its
collapse,45 the analysis of ten selected scandals from the 2007-2009
indicates that financial inflated statements have not been as relevant as a
42
In 2008, founder and CEO Bernard Madoff confessed that a Ponzi scheme had
been running for decades at his asset management company, resulting in losses of
around US$ 65 billion for his approximately 4,800 investors.
43
In 2009, the Panamericano bank, which had successfully made its IPO just two
years earlier, announced a hole of about $ 2.0 billion on its balance sheet, about
2.5 its equity and half of its total assets.
44
In 2008, Ramalingam Raju, Chairman and founder of Satyam (India's fourth
largest IT company), sent a letter to both the board of directors and to the country's
regulator confessing that the company had inflated its revenues by 76% and its
profits by 97% in the previous year.
45
The conjecture about the number of companies that could have ended up with
fraudulent statements if Enron collapse had not happened if obviously something
not possible to be done.
Di Miceli da Silveira: The Enron Scandal a Decade Later:… 339
key factor as it has been with Enron and other scandals from the early
2000s.46
7. Conclusion
46
The author thanks an anonymous referee for pointing out that perhaps many
companies have been saved from Enron’s fate due to increased vigilance after
Enron’s debacle.
340 Homo Oeconomicus 30(3)
As those who don’t know history are sometimes doomed to repeat it, the
lack of knowledge and reflection on an episode that left so many lessons
like this can make investors and society at the mercy of the occurrence of
similar scandals in the coming years.
References
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Los Angeles: Foundation Press.
Bratton, W. (2002), “Enron and the Dark Side of Shareholder Value,”
Tulsa Law Review 76: 1275–1361.
Bratton, W. (2003), “Enron, Sarbanes-Oxley and Accounting: Rules
Versus Principles Versus Rents,” Villanova Law Review 48: 1023–
1056.
Brickey, K. (2003), “From Enron to WorldCom and Beyond: Life and
Crime After Sarbanes-Oxley,” Washington University Law Quarterly
81: 357–401.
Catanach, A. and Rhoades, S. (2003), “Enron: A Financial Reporting
Failure,” Villanova Law Review 48: 1057–1076.
Charreaux, G. (2005), “Pour une Gouvernance D’entreprise « Comporte-
mentale »: une Réflexion Exploratoire…,” Cahiers du Fargo working
paper No. 1050601, available at http://ssrn.com/abstract=740946
Coffee Jr., J. (2003), “What Caused Enron? A Capsule Social and
Economic History of the 1990’s,” Cornell Law Review 89: 269–309.
Coffee Jr., J. (2005), “A Theory of Corporate Scandals: Why the USA and
Europe Differ,” Oxford Review of Economic Policy 21: 198–211.
Coffee Jr., J. (2006), Gatekeepers: The Role of the Professions and
Corporate Governance, 1st ed. USA: Oxford University Press.
Cuevas-Rodríguez, G., Gomez-Mejia, L. and Wiseman, R. (2012), “Has
Agency Theory Run its Course?: Making the Theory more Flexible to
Inform the Management of Reward Systems,” Corporate Governance:
An International Review 20: 526-546.
Da Silveira, A. (2012), “Corporate Scandals of the 21st Century:
Limitations of Mainstream Corporate Governance Literature and the
Need for a New Behavioral Approach,” Working paper available at
http://ssrn.com/abstract=2181705
Deakin, S. and Konzelmann, S. (2004), “Learning from Enron,” Corporate
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Di Miceli da Silveira: The Enron Scandal a Decade Later:… 341
• July 1985: Enron is born from the merger of two natural gas companies:
Houston Natural Gas (based in Houston) and Internorth (based in
Nebraska).
• 1986: Kenneth Lay, PhD in economics from the University of Houston
with humble origins is appointed Enron’s Chief Executive Officer
(CEO) and Chairman of the Board. As one of his first initiatives, he
hires McKinsey, a consultancy firm, to help him develop a new business
strategy. McKinsey allocates a consultant named Jeffrey Skilling, a
Harvard MBA with background in banking and finance, to lead the
work. His recommendation was simple: to transform Enron into an
“energy bank” by bringing together buyers and sellers of energy
products and taking advantage of the beginning of the energy market
deregulation.47
• 1989: Enron starts trading natural gas, becoming the largest marketer of
gas distribution in the U.S. and in the U.K.
• 1990: Lay creates a new division entitled Enron Finance Corp. Skilling
is hired as its managing director. His acceptance is conditioned on the
adoption by Enron of mark-to-market as accounting method.48
47
Skilling was responsible for Enron’s “asset light strategy”, which prompted the
company to shift its focus from holding physical assets towards the trading of
energy contracts (Wearing: 2005: 68).
48
The mark-to-market or fair value accounting aims at accounting for the fair
value of an asset or liability based on: i) its current market price, ii) similar assets
and liabilities, or iii) on another objectively assessed “fair” value. In contrast to
traditional accounting system based on historical prices, the value of assets and
liabilities subject to mark-to-market tends to change more frequently. It is,
therefore, a tradeoff between a stable and generally outdated accounting method by
a more volatile and updated one. However, the mark-to-market accounting can
become very inaccurate when prices deviate from their “fundamental” value due to
incorrect inputs in valuation models.
Di Miceli da Silveira: The Enron Scandal a Decade Later:… 343
• June 11th, 1991: Enron lobbies in Washington for the Securities and
Exchange Commission (SEC) to authorize it to adopt mark-to-market
accounting.
• January 30th, 1992: SEC grants permission for Enron’s adoption of the
mark-to-market accounting, only present in financial institutions at that
time.49
• 1990s: Enron is transformed from a natural-gas pipeline company into
an energy-trading powerhouse. As a result, it hires the “best and
brightest” traders, with extremely aggressive and potentially astronomic
compensation packages. Skilling is promoted to Chief Operating
Officer (COO) in December 10th, 1996.50 Andy Fastow, a Kellogg
MBA hired in 1990, becomes CFO in 1998. Inspired by working
practices of its former consultancy, Skilling installs the Performance
Review Committee (PRC), a harsh evaluation system aimed at to fire at
least 10% of the staff annually, fomenting strong internal rivalry in the
company.
• June 28th, 1999: The Board of Directors exempts the CFO Fastow from
Enron’s Code of Ethics, allowing him being the fund manager of special
purpose companies created to carry out business with Enron.
• November 1999: Enron begins to trade exotic products such as weather
derivatives.51 The company launch Enron Online, an Internet based
49
The mark-to-market accounting naturally does not bring with itself a corporate
governance problem. However, it depends on minimally reasonable criteria for
determining the fair value of an asset, something that according to McLean and
Elkind (2004: 42) had often not happened at Enron. In practice, the company
seems to have discovered that mark-to-market was an easy way to generate fraud,
especially when market prices of assets could not be objectively determined. As a
result, many assets seem to have been marked-to-models by value estimates
derived from financial models frequently manipulated to achieve certain values. In
the natural gas market, traditional accounting for long-term contracts was very
simple: in each period, the company booked the supply costs and revenues from
gas sales. With mark-to-market, the accounting became more complex: whenever
the contract was signed, its profit throughout the period were estimated and
booked by applying the net present value technique. In many cases, the viability of
these contracts and their future costs were difficult to judge.
50
Authors such as Hamilton and Micklethwait (2006: 36) argue that irregularities
at Enron started after the departure of its former COO Richard Kinder, an
executive dedicated to more traditional businesses and to the operational matters of
the company’s projects. Kinder left the company in November 1996 after being
passed over for the CEO job.
51
Weather derivatives are financial instruments that can be used as part of a risk
management strategy to reduce risks associated with adverse weather conditions.
In comparison with other derivatives, the underlying asset (e.g., rain, temperature)
344 Homo Oeconomicus 30(3)
56
The New York Times, February 16th 2002. Enron’s many strands; ex-chairman’s
finances; Lay sold shares for $100 million.
57
Senate Hearing 107-773: Hearing before the Committee on Commerce, Science,
and Transportation of the United States Senate. February 12th, 2002. Available at:
http://www.gpo.gov/fdsys/pkg/CHRG-107shrg82951/html/CHRG-
107shrg82951.htm
58
Tonge et al. (2003, appendix 1).
59
Sources: The New York Times, June 6th 2002. Summations In Andersen's
Criminal Trial. http://openjurist.org/374/f3d/281/united-states-v-arthur-andersen-
llp
60
The Wall Street Journal, October 17th 2001. Enron jolt: Investments, assets
generate big loss LJM.
61
http://www.cbsnews.com/8301-100_162-502198.html
346 Homo Oeconomicus 30(3)
• After its bankruptcy in late 2001, the players involved with Enron
suffered the following consequences:
• Executives: Andrew Fastow made a deal with the U.S. justice pleading
guilty of fraud and agreeing to incriminate his superiors. He was
sentenced to ten years in prison and pay $ 24 million. In 2006, his
sentence was revised and reduced to six years. The Abbreviation for Chief
Accounting Officer (CAO) Richard Causey also pleaded guilty, receiving
a sentence of seven years in prison in 2005. Jeffrey Skilling and
Kenneth Lay continued to plead innocence and went into trial. In May
2006, they were found guilty on almost all allegations. Skilling was
sentenced to 24 years in prison and a fine of $ 45million in October
2006. Lay did not receive his final sentence, dying from a heart attack at
his country residence in July 2006.
• Independent directors: Enron’s former independent directors faced very
different consequences than of its executives. Although seven have been
prosecuted for insider trading and ten directors have agreed to pay $13
million from their pockets in a deal with prosecutors, none have been
criminally prosecuted for fraud. Many of them continue to serve on
boards of large companies, with some simply omitting from their
resumes any mention about their term on Enron’s board.
• Audit: Arthur Andersen was charged with obstruction of justice,
initially being convicted in June 2002. Two months later, the company
62
Healy and Palepu (2003: 4) and
http://www.sec.gov/Archives/edgar/data/1024401/000095012901504218/h92492e
10-q.txt
63
http://www.gpo.gov/fdsys/pkg/CPRT-107SPRT80604/html/CPRT-
107SPRT80604.htm
64
Technically, the company filed for “Chapter 11” bankruptcy protection, a
famous chapter of the U.S. bankruptcy code that allows the company's
reorganization. Since Enron has not resumed operations, this is considered the de
facto date of its bankruptcy.
Di Miceli da Silveira: The Enron Scandal a Decade Later:… 347
(an empty entity at the time due to the exit of customers and
employees), paid $60 million to settle the case, then going bankrupt. In
May 2005, the U.S. Supreme Court reversed the initial decision of the
justice after understand that the destruction of Enron documents was
made in accordance with Andersen’s document retention policy. In
2007, the bankrupt estate of the company agreed to pay $72 million to
investors who had sued it in 2001.
• Investment banks: many investment banks with active participation in
the structuring of SPEs agreed to reach billionaires deals to finish the
various lawsuits filed by investors and prosecutors. By the end of 2009,
Enron investors were able to recover about $7.2 billion from several
investment banks such as JP Morgan, Citigroup, Merrill Lynch, Chase
and CSFB. The biggest disbursements were made by Canadian Imperial
Bank of Commerce ($2.4 billion), JP Morgan Chase ($2.2 billion) and
Citigroup ($2 billion). The investment banks also agreed with internal
reforms in their areas of research and investment analysis. In earlier
2012, some cases were still pending.
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