Analysis Of The Causes Of Enron Scandal Using Different Theories
Enron Corporation, founded in 1985, was an American energy company based in Houston, Texas. Enron was the result of the merger between Houston Natural Gas Co. and InterNorth Inc. Enron was commended for its innovative business model and was awarded by Fortune magazine as “America’s Most Innovative Company” for 6 consecutive years. Enron was amongst the world’s leading natural gas, electricity, communications, pulp and paper companies before it bankrupted in December 2, 2001. Its annual revenues rose from $9 billion in 1995 to over $100 billion in 2000. The scandal led to the bankruptcy of Enron Corporations as well as the dissolution of one of the largest accounting and audit firm in the world, Arthur Andersen. Enron was the largest corporate bankruptcy in American history at the time with losses totalling around USD 66 billion. Firstly Choo’s (2008) framework and Bazerman & Tenbrunsel ethical blind spots would be applied at the preconditions stage, followed by Padilla et al - Toxic Triangle at the crisis stage. The following theories were chosen as it explains the causes that led to Enron’s collapse as well as to grasp a better understanding as to why this crisis has occurred in the first place and whether it can be prevented.
Enron’s crisis contained a lot of early warning signs that were ignored. The 3 causes that stop the signals from being processed are: Epistemic Blind spots, Risk Denial, and Structural Impediment. Organizations that overlook and ignore warning signals are potentially allowing problems to build up and escalate which could eventually lead to a full-blown crisis. This report will only focus on ethical and epistemic blind spots in particular. There were more than a dozen red flags that should have been investigated by Enron’s Board but those warning signs went unheeded due to blind spots. Epistemic blind spots are when warning signals are ignored as the “information does not fit on the organization’s current frame of reference” and information is selectively interpreted to fit our acceptance of the truth. Enron’s Board evaded the warnings that were appearing about the means by which the company was accounting for its assets and holdings on its financial statement as the board perceived that the disclosure was just a “normal part of conducting business”. Epistemic blind spots are when people come across information that contradicts their beliefs, they would rather ignore the information and question its reliability rather than contemplating change to their beliefs (Choo, 2006). The investigation found that the Board authorized numerous improper transactions even though they were aware and were given substantial information regarding Enron’s activities. When failures and existing losses started appearing in their company performance, instead of taking action to correct it, the company hid their losses to protect their reputations. Enron’s board of directors should have questioned on whether the performance of the company was “too-good-to-be-true” and paid greater attention to warning signals. Enron began to sell its assets to “unconsolidated affiliates” when it struggled to find willing investors. Unconsolidated affiliates were entities whose assets did not appear on Enron’s financial statements. Warning signals emerged about these methods but were dismissed by Enron’s board members as it was their shared belief that these methods were an essential part of conducting business at Enron. The Board was aware that Enron was planning to move underperforming assets and potential investment losses off its balance sheet. Red flags on Enron’s shortage of cash and profits should have alerted board members and yet, violations of accounting principles and rules went undetected.
Ethical Blind Spots
Ethical blind spot is the failure to notice others’ unethical behaviour. Enron’s board failed to notice top management’s corrupt behaviour as increasing share prices gave them little incentive to question the executives. The Board were less likely to condemn executives’ unethical behaviour when it was them who pressurized the executives to make stellar profits. Enron’s unethical misconduct and ethical shift happened gradually which makes it less noticeable by its board of directors. The board did not prevent the firm’s management from engaging in risky behaviour, and they failed to ensure the executives were doing business ethically and legally. The board claimed that they had been deceived and blinded by management as they were presented false numbers. The Board cannot be blamed for not acting on withheld information but they can be blamed for the lack of scrutiny on Enron’s transactions.
Motivated blindness is when people overlooked others’ unethical actions when it is against their own best interests to notice. Enron’s board of directors, Arthur Andersen, and credit rating agencies had access to relevant data and should have detected and acted on Enron’s unethical behaviour. Andersen’s motivational blindness led them to not noticing Enron’s flawed accounting practices as Andersen was motivated to retain Enron as a profitable client. The conflict of interest Andersen faced prevented them from making impartial verdicts about Enron as they possessed a psychological tendency to turn a blind eye on the bad data. Analysts saw the warning signs in the public fillings but they had no incentive to expose Enron as it was in their best interest to protect their relationship with profitable clients such as Enron. Sherron Watkins is the former Vice President of Enron Corporation and was famously known as the whistleblower who warned then-CEO Kenneth Lay of accounting irregularities within the company and the impending financial doom in the fall of 2001. The financial world changed when Watkins blew the whistle. Watkins was brave enough to step forward as she feared that Enron would “implode in a wave of accounting scandals”. By mid-2001, Watkins came across evidence of massive fraud which prompted her to investigate in which she noticed “off-balance-sheet financial structure” (Raptors) and losses worth hundreds of millions of dollars. Watkins initially wrote to Ken Lay questioning accounting methods and Raptor transactions. Watkins advised Lay to come clean to investors, restate its financials, and to admit to its problems as she believed that it was their only chance to survive. She told Lay to hire outside law and accounting firms apart from those working with Enron to investigate her concerns but Enron failed to use independent investigators which led to her claims being dismissed. The accounting irregularities that Watkins had discovered were “the tip of the iceberg” and her warnings came too late to save Enron which eventually led to its bankruptcy a few months after her warnings. The point when Enron’s crisis produces the greatest damage is its bankruptcy on December 2, 2001. The crisis escalated from August 2001 to December 2001 and causes for the crisis was due to the destructive culture brought upon by the unethical conduct of their senior officials within the company.
Enron’s collapse was a result of unethical leadership such as the distortion of information, engagement in unlawful act, and the abuse of power. Followers are equally responsible for Enron’s moral misdemeanour. The concept of the toxic triangle explains why companies end up with scandal. If all three factors (destructive leadership, susceptible followers, and environmental factors) are present, it will lead to a scandal.
Enron’s demise was due to the escalation of moral decline in Enron. Kenneth Lay and Jeff Skilling were seen as remarkable leaders with charismatic leadership style as proven by Enron’s label as a “blue chip” stock investment. However, Enron’s leaders became self-centred, greedy and arrogant after numerous successes. They were not content with their successes and their thirst for power grew which eventually led to Enron’s unsustainable expansion and diversification projects. Lay and Skilling were continuously pushing the boundaries and had high expectations for their employees to add value even if it violated the rules. Lay’s Enron was an outcome of destructive leadership due to its close association of leaders with “acute personalized needs for power”. Unethical leaders like Andrew Fastow and Jeffrey Skilling use their power for personal gain and self-promotion. The destructive leadership practice permitted leaders to manipulate accounts and deceive government regulatory bodies. Enron’s reward scheme established a “win-at-all” costs focus. Enron’s top management was heavily rewarded with stock options which incentive executives to maintain high stock price at any cost. Lay and Skilling supported disloyal leadership behaviour through “extravagant bonus” and encouraged blatant financial metrics misrepresentation to heighten short-term profits. Enron’s senior executives held the belief that the company had to be the “best at everything” and are willing to do anything to protect their reputations. Watkins described Fastow as “vindictive” and Skilling as “intimidating”. Fastow requested Watkins to lie to an Enron’s partner regarding an investment.
Susceptible followers are recognized as providing opportunities for leaders to commit sinful activities. Leaders alone are not able to bring destructive repercussions. Lay and Skilling cultivated a competitive, elitist environment by only hiring top aggressive and ambitious graduates who were willing to maximize short-term profits by circumventing the rules. Watkins felt like Enron’s employees were somewhat like “cult followers”. Enron’s followers were divided into two groups: Colluders and Conformers. Ambitious colluders are easily recruited when there are opportunities to profit. Opportunistic ambitious individuals thrived at Enron due to their “individualistic and aggressive efforts” to achieve profits. Colluders see an opportunity to promote themselves and attain their personal gains by following destructive leaders. Colluders share similar world-view ideas and bad values as toxic leaders which makes them willing to participate and support the leader’s plan. Enron’s employees are ambitious and seek personal gain through their association with the leader. Employees “Machiavellian tendencies” and hunger for status led to their willingness to engage in fraudulent actions. It became apparent that many Enron employees had aided senior executives in implementing corrupt and unlawful business schemes. Deceitful tendencies were encouraged by management and it was the norm for employees to overlook imprudent dealings and unethical conduct. Unhealthy competition between co-workers existed and they would rather “stab each other in the back than help one another”. Conformers accepted destructive leaders as a way to save themselves. They are primarily driven by fear due to extreme pressure to produce fast results else they would be terminated if they fail to do so. Enron’s aggressive environment inherently provided employees with an incentive to commit fraud to ensure their survival in the company. Questions about the business dealings of the company or the raising of concerns were punishable and very few dared to raise objections.
Culture set by its destructive leadership played a major part in Enron’s downfall. Annual performance review committee, known as the “harshest employee-ranking system” in the US, fires the bottom 15% of employees. Associates are required to grade their peers which generated a great deal of hostility and distrust among employees. The bottom 5% got “publicly shamed” during annual reviews (Sims & Brinkmann, 2003). Arthur Andersen applied lax standards to Enron’s audits due to a “vested interest “over significant consulting fees paid by Enron. Anderson’s attitude evidently led to management taking advantage of the absence of checks and balances. Enron’s top management was provided a conducive environment to commit fraud. A few former executives were charged with offences and sentenced to jail post-Enron. The aftermath of the Enron’s scandal led the public to question the sufficiency of U. S. disclosure practices and the integrity of the independent audit process. Increased oversight and regulation have been legislated to help prevent corporate scandals of Enron’s level. The lessons learnt from Enron scandal was that the decisions made by executives can influence a company’s profitability and reputation. There was a need for ethical disciplines within organizations, and substantial reforms in the US accounting and corporate governance. The scandal resulted in the creation of new regulations and legislation that were designed to increase the accuracy of financial reporting for publicly held companies. U. S. Senator Paul Sarbanes and U. S. Representative Michael Oxley passed the Sarbanes-Oxley Act in 2002 with the intention of protecting investors by imposing harsh consequences for “destroying, altering, or fabricating financial records”. The corporate accountability law requires organisation to put measures in place to prevent fraud and ensures management is held personally responsible to certify truthful financial report else, they would “face up to 20 years in jail”. Sarbanes Oxley process was costly but it resulted in the rise of corporate governance standard. Sarbanes-Oxley stringent rules have led to a decline in accounting frauds. The Financial Accounting Standards Board implemented new compliance measures to significantly raise the levels of its ethical conduct. These new methods are vital to detect and close loopholes that were commonly used by companies to evade accountability. Enron’s fraud changed the perceptions of and attitude towards whistleblowers. Watkins futile efforts to stop the fraud resulted in the creation of the 2010 Dodd-Frank Reform Act. The aim is to protect whistleblowers and reward them with a share of any penalties recovered due to their information. After a decade, law enforcement decided to incentivise and protect whistleblowers as a way to fight financial fraud. Major changes are implemented regulatory as a direct result of Enron’s downfall. The 3 major effective governance changes are:
- Strengthening of internal control systems,
- increased board independence, and
- Provision of non-audit services by external auditors are restricted.
Enron’s downfall was a result of the internal and external corporate governance system that failed to control Enron’s management. External monitors were “slow to react” to the firm’s warning signs and Enron’s board internal oversight was lacking. A new disciplinary board is formed to provide greater transparency and to administer “annual quality monitoring process” for large firms. Instance of non-compliance would be referred to the disciplinary board and the new organisation would have increased authority to “monitor compliance with SEC practice standards”. The AICPA will not restrict limits on offering certain non-audit services to audit clients of public companies. Audit standards have been amended to detect fraud, and new measures have been implemented for discouraging fraud such as increased “internal control procedures” for boards, management, and audit committees. It has also declared its support for greater extensive changes in its self-regulatory structure. Additional reforms such as an enhanced financial reporting model would need to be enacted to prevent and avoid another accounting Enron scandal from occurring in the future.
In sum, Enron’s collapse was an accumulation of a breakdown in Enron’s internal controls and board governance, inattentive regulatory agencies, investment banks misrepresentation of Enron’s true financial condition, lack of ethical discipline, and the failure of credit rating agencies to whistle blow. The main cause of the collapse was the organization culture. Choo’s (2008) epistemic blind spot framework combined with Bazerman and Tenbrunsel (2011) ethical blind spots theory explained that blind spots were the reason why Enron ignored warning signs. Watkins as a whistleblower was the trigger as Enron went into a crisis shortly after her warning. The crisis stage incorporated Padilla et al (2007) toxic triangle theory to help explain how destructive leadership is made possible through a combination of leaders, followers, and conducive environment. Lastly, the Post-crisis section highlighted regulatory changes and the implementation of new laws such as Sarbanes-Oxley following Enron’s scandal. All in all, Enron’s crisis was preventable had the management be more truthful about the health of the company, the board paid greater attention to management activities, and a change in leadership and corporate culture.