The Rise and Fall of Enron
Case Prepared by
Dr. Sarah Stanwick, Auburn University, School of Accountancy
Dr. Peter Stanwick, Auburn University, Department of Management
No part of this case may be reproduced without the consent of the authors.
The authors gratefully acknowledge the receipt of a 2002-2003 Daniel F. Breeden
Endowment for Faculty Enhancement Grant.
The Rise of Enron
The origins of Enron started with the 1985 merger of the Houston Natural Gas company
with InterNorth. This merger was management’s first attempt to develop a national
pipeline system for natural gas. The following year, the former CEO of Houston Natural
Gas, Kenneth Lay, became the chairman and CEO of Enron. In 1989, Jeffrey Skilling
became an employee of Enron. In 1996, Skilling became the president and Chief
Operating Officer of Enron. By 2000, Enron had announced total revenues of $100
billion which was double the revenues of 1999. This huge increase was due to the
increasingly complex energy trading sector of the company. Based on market
capitalization, Enron became the world’s sixth largest energy company. In February
2001, Jeffrey Skilling became Enron’s new CEO and Kenneth Lay retained his title of
chairman. By August of 2001, Jeffrey Skilling abruptly resigned as CEO and Kenneth
Lay retained both titles again (Houston Chronicle, 2002). During his tenure at Enron,
Skilling made it clear to his employees that he wanted to focus solely on revenue and
profit margin increases and had no interest in examining Enron’s cash flows (Fowler,
2002). It was through both Lay and Skilling that Enron was transformed from an
established pipeline operator to a dominant energy trader (Fink, 2002).
In October 2001, Enron reported in their third quarter results that investment partnerships
that had been developed by Enron’s CFO had generated $35 million in revenue, The
CFO, Andrew Fastow, was fired by Enron and an official inquiry began at the Securities
and Exchange Commission pertaining to these transactions. By November, Enron
announced that it had to revise the company’s earnings for the previous four years and for
all three quarters of 2001, with an initial estimated adjustment of $600 million (Houston
Chronicle, 2002).
During the month of November, another energy company, Dynergy considers merging
with Enron but then walks away from the deal. Dynergy had initially offered up to $8.9
billion in stock for control of Enron. Around the same time, Kenneth Lay refused a
severance package of over $60 million. By November 30th, the House of Representatives
has established a panel to review the financial transactions at Enron (Wuensche, 2003).
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Causes of the Downfall at Enron
The performance of the employees was heavily concentrated towards bonuses and stock
options. One of Enron’s top goals was continuous increase in price, which had to been
based on continuously increasing levels of profitability. Rich Kinder, who was Enron’s
Chief operating officer from 1990 to 1996, reinforced this obsession with stock price.
Kinder left Enron in 1996 when he realized that he would not be able to become CEO
(Fowler, 2002).
The human resources department at Enron was told to hire strong outgoing ruthless
applicants. They had no problem hiring people from the top Ivy League Schools
(Ivanovich, 2002). Enron implemented a “rank and yank’ employee evaluation system
where employees ranked each other from 1 to 5 on their contribution toward the
company. Each division was required to rank 20 percent of their employees at the lowest
ranking. Employee were quick to rank others less favorable in order to increase their own
standings (Fowler, 2002).
This driven culture was established early at Enron. In 1987, Enron was accused of
manipulating oil-trading transactions in one of their New York offices. In addition, Enron
traders have been accused for years for generating false or incorrect transactions in order
to manipulate the volume levels. Kenneth Lay’s response to these accusations was not to
fire the traders but to continue to employee them. It is claimed that Lay stated that Enron
needed that “revenue” to continue their growth trends. However, Lay was forced to fire
the traders six months later when both Enron’s competitors and customers were
convinced that Enron was trying to manipulate the market (Fowler, 2002). Kenneth Lay
was also responsible for the development of Enron’s Code of Ethics. In the foreword of
the 62 page manual, Lay states "We want to be proud of Enron and to know that it enjoys
a reputation for fairness and honesty and that is respected. Gaining such respect is one
aim of our advertising and public relations activities, but no matter how effective they
may be, Enron’s reputation finally depends on its people, on you and me. Let’s keep that
reputation high” (Enron’s Code of Ethics, 2000).
.
When Enron partnered with an English power plant in the early 1990s, they recognized
$100 million in revenue as the plant was being built. They were able to do this by being
their own contractor. So, they were basically charging themselves for the contribution.
An important side note to this transaction was that it gave a taste to top managers how
they could be compensated through Enron’s bonus system. Enron had developed a bonus
system in which the bonus was paid when the contract was signed instead of when the
contract was completed. This upfront bonus system encouraged managers to sign any
deal regardless of the viability of the contract. Top managers were paid up to 3 percent of
the total value of the deal, which encouraged the managers to sign as many large scale
deals as possible. In addition, managers then tried to inflate the total value of the deal to
increase their bonus levels. The level of inflation became so rampant that Enron Energy
Services, one of the divisions of Enron, had to cancel their bonus systems since they
could not afford to pay the bonus based on inflated values.
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Enron also implemented a “mark to market” approach to accounting. This approach
allowed Enron to recognize as current revenue the total lifetime value of a deal. As one
former employee stated “It was a moral hazard being able to record your profits
immediately…It created many temptations” (Fowler, 2002).
There was also lack of control in top management. The CEO and Chairman interchanged
roles and responsibilities. The top financial officers were rewarded for continually
producing better results. The Board of Directors performed only a rubber stamp duty in
reviewing the actions of top management. Although Kenneth Lay was also actively
involved in the decision making at Enron, Jeffrey Skilling is the top manager who
demanded performance at all costs. Skilling was known for his creative approach to
solving problems. While this could be considered a positive attribute for any executive,
Skilling went beyond the legal and ethical boundaries to ensure the upward movement of
Enron. One former Enron dealer is quoted as saying “It was all about taking profits now
and worrying about the details later….The Enron system was just ripe for corruption”
(Fowler, 2002).
The final straw for Enron was the disclosure of the off-balance partnerships between
Enron and the Chief Financial Officer. These partnership came to light when Jeffrey
Skilling stepped down as CEO in August 2001. Reporters from the Wall Street Journal
started to investigate the SEC filings of Enron to see why Mr. Skilling would leave his
dream job. As a result, the reports found a number complex transactions involving
partnerships named LJM1 and LJM2 where Mr. Skilling was able to capture hundreds of
millions of dollars from his relationship with Enron (Smith and Emshwiller, 2003).
By the end of 2002, Enron had imploded under the huge number of illegal and unethical
transactions. Both Mr. Lay and Mr. Skilling have left the company. The employees of
Enron have lost their retirement savings when the stock price fell to pennies a share.
Enron had to file for bankruptcy protection due to the huge outstanding debt from their
operations. The hard lessons that have been learned from Enron are shown in Table 1. It
took the passage by Congress of the Sarbanes-Oxley Act of 2002 before investors started
to restore their faith in the conduct of large corporations in the United States.
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Table 1
Ten Lessons Learned from Enron
(Source: USA Today, February 19, 2002)
1. You can’t trust analysts.
2. Watch for red flags.
3. ‘Independence’ is an illusion.
4. Directors may be clueless.
5. Many firms tweak numbers.
6. Beware of special partnerships.
7. Diversity, diversify.
8. Wealth can be fleeting.
9. Don’t expect miracles.
10. Regulators are weaklings.
Questions for consideration:
1. Who is to blame for the fall of Enron?
2. How should ethics be developed for Enron after its bankruptcy?
3. How can the company ensure this will not happen again?
Resources to consult:
July 2000. Enron’s Code of Ethics.
January 17, 2002. Enron Timetable. Houston Chronicle. www.HoustonChronicle.com.
February 1, 2002. Beyond Enron: The Fate of Andrew Fastow and Company Casts a
Harsh Light on Off-balance-sheet Financing. Ronald Fink. CFO Magazine.
www.cfo.com.
February 19, 2002. 10 Lessons for Investors from Enron’s Fall. Gary Strauss. USA
Today, page 1A.
October 20, 2002. The Pride and the Fall of Enron. Tom Fowler. Houston Chronicle.
www.HoustonChronicle.com.
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October 21, 2002. Everybody knows Enron’s Name. David Ivanovich. Houston
Chronicle. www.HoustonChronicle.com.
August 7, 2003. The Pride and the Fall. Robert Wuensche. Houston Chronicle.
www.HoustonChronicle.com.
August 8, 2003. ’24 Days’: Behind Enron’s Demise. Rebecca Smith and John R.
Emshwiller. The Wall Street Journal. www.wsj.com.
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