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ENRON Introduction Enron was the country’s largest trader and marketer for electric and natural gas energy. Its core business was buying energy at a negotiated price and later, selling the energy when prices increased. As an energy broker, Enron provided a service by allowing producers to negotiate a certain price while Enron took the risk that prices would fall below what it bought energy. Buyers of energy also benefited because Enron could ensure the supply of energy. In 2000 Enron was listed number five on the Fortune 500.
What happened to the company which was among the most admired for vision and quality thinking? Enron was the company that held virtual assets and not the real assets, such as power stations, which were capital incentive with low returns and ongoing debt. The decline in the market starting in 2000 uncovered the financial structure on which Enron was built, eventually forcing the company into bankruptcy. The main reason was the Special purpose entities. As per law a company can create SPE for a particular purpose.
The debt of the SPE is carried on the books of the creating company. However, it could be transferred to the SPE if an independent third party purchased a minimum of a 3 percent interest in the SPE. This financial structure became the favorite of Enron; it created more than 900 SPEs. During the 1990’s Enron set up special entities to transfer its debt off the balance sheet. Enron created businesses, sometimes joint ventures or partnerships. To capitalize these businesses Enron would find investors, sometimes; these were executives at Enron or friends.
Sometimes there was no “investment”. The real structure violated the SPE statutory requirements. Enron used its working relation with Merrill Lynch to buy an interest in one of its SPE. However in order to entice Merrill Lynch in to the transaction it promised to make a $250,000 payment to repay $7 million. These promises changed the position of Merrill Lynch from equity to debt. But Enron showed it as cash income and did not show that amount was really a loan to be repaid. Enron was not legally required to reflect any of its debt of the SPE (Bohlman, 2005).
World Com Introduction WorldCom, now named MCI, recently emerged from bankruptcy protection after reporting accounting irregularities of $11 billion. During the late 1990s there was formidable pressure on WorldCom to preserve historic levels of cash flow and EBIDTA (earnings before interest, depreciation, taxes, and amortization) while new telecommunications orders were in decline as well as continued pressure on existing price points. It was during this period that WorldCom began many of the fraudulent accounting practices.
The SEC Report (2003) on WorldCom identified fraudulent behavior in three main areas: the unauthorized movement of line costs to capital resulting in decreased expenses, the improper release of accruals reducing current expenses, and questionable revenue entries producing an increase to earnings. These accounting irregularities have resulted in many of WorldCom’s previous executives being prosecuted on securities’ charges. As part of emergence settlement, MCI paid the Securities and Exchange Commission (SEC) fines totaling $750 million and former bondholders received 36 cents on the dollar in stock in the new company (Scharff, 2005).
Legal & Ethical Issues Both the companies filed bankruptcy under chapter 11 and had similar accounting issues. This paper highlights the ethical issues faced by both the companies. Organizational dilemma Executives of the organizations faced a situation where the economic and financial performance of the business was in conflict with the organization’s social obligations. As it is known that legal standards sets the floor for ethical standards. The organizational issues are best identified by researching three main behavioral and cultural components which further caused these legal problems.
These three components are also known as building blocks for ethics in any organization but the reversal effect of these can be seen in these organizations. 1. Leadership: leaders or founders within an organization are not only responsible for building the climate and culture of the organization along with setting the mission, values, goals, and ethics of the organization but also selecting the group members responsible for making the organization a success. This finding appears to be true for these organizations as well.
The founders and leaders initiated much of the culture and pressure that emphasized making numbers above all and allowing the fraud to transpire resulting in legal issues. 2. Group Activities: Group synergy is when concurrence seeking becomes paramount in team decision-making. The characteristics of groupthink include a feeling of invulnerability, ability to rationalize events and decisions, moral superiority within the group, group pressure on dissenters, self-censorship within the group, and unanimity.
Groupthink may have contributed in the unethical behaviors as well as the length of time over which these frauds occurred. 3. External assistance: These companies began many fraudulent accounting practices. It is unclear if executives of these companies could have perpetrated this fraud without at least partial assistance from their external auditor Arthur Anderson and continued positive investment advice from financial analysts as well. Efficient Market Hypothesis
The above described situations challenge some of the core beliefs and practices that are the tools to convey investors the transparency in the operations and practices adopted by the organization such as the reliability of independent auditors, financial standards and full disclosure in protecting the integrity of financial reporting under securities law; the effectiveness of corporate governance in monitoring managerial performance. The flowing are the issues that confirm the lack in legal and ethical concerns of the organizations. . It questions the strength of the efficient market hypothesis, because stock price of these companies reached heights due to irrational reliance on its auditors’ compromised certification. The failure of markets to assess adequately the earning prospects of these organizations of which the board of directors took advantage by exercising their stock options and violating the insider trading act of 1988 causing legal and market failure. 2.
It undermines the corporate governance mechanism; the monitoring board’s capacity to analyze the integrity of financial disclosure which was not in tandem with the increasing reliance on stock price performance and also the board was unable to justify the mode of measuring and rewarding managerial performance. 3. It questions the utility of stock options in aligning managerial and shareholder interests and the value of employee ownership as an incentive device.
Mainly the existence of tradeoffs in the use of stock options in executive compensation because of the potential objective of creating the risk-preferring management team. 4. It shows the poor fit between stock-based employee compensation and retirement planning. Reasons for Failure The reasons for failure are combinations of two things: first organizational influence, which influences the ways individuals work to accomplish the organizational goals.
These also include the shared values that we call group culture, the rules and policies that group develops to govern their interaction with each other and the rest of the world. These organizations were more inclined towards raising the stock of the company through speculation rather than improving the basic operations that are core to achieve success in the market. Second is systemic influence such as environmental forces for example the regulatory system that drives groups or individuals to achieve the success within these regulatory boundaries.
These include the laws and the regulations that provide the framework in which people act and the culture that shapes the values and perceptions of people and groups. The obvious systematic causes of the Enron and World Com scandal are loop holes in legal and regulatory structure. First, current laws and SEC regulations allow firms like Arthur Andersen to provide consulting services to a company and then turn around and provide the audited report about the financial results of these consulting activities. Second, a private company like Enron hires and pays its own auditors.
This is a conflict of interest built into the legal system because the auditor has an incentive not to issue an unfavorable report on the company because auditor is not only getting paid for the services but also has risk of losing the client to its competitors. Third, most large companies like Enron are allowed to manage their own employee pension funds. Again, this is a conflict of interest built into our legal system because the company has an incentive to use these funds in ways that advantage the company even when they may disadvantage employees. Recommendation
Following considerations in the legal and ethical standards should be made in order to overcome the situations stated above. 1. In order to avoid the above situations it is important for an organization to establish an independent ethics committee. The main benefit is that the committee will be the stepping stone to generate the awareness among the employees. The role of this committee is not only of presence but also to train employees to avoid situations where in they fail to perform there fiduciary duty knowingly or unknowingly and sometimes under the pressure to save the job.
The same committee will also help employees in getting the whistle blower status on the legal and ethical issues. The main reason for coupling the committee’s role with whistle blower is to build employee moral in order to come forward in these issues by taking away fear and pressure. 2. The new regulatory system of auditing needs to be established. The concept of this system will be that an independent government body will appoint auditors for the organization in such a way that these auditors will act as the extended arm of this regulatory body.
The auditor will be paid by the regulatory body and the same is deducted from the organization as standard deduction. This type of arrangement will have numerous benefits through utilitarian theory of ethics. First auditors will have business from regulatory body rather than from companies, so they can perform there fiduciary duties without fear of loosing the business and this will avoid the conflict of interest. Second, organization need not to hire their own auditors and whatever they pay the auditors will now be paid to this regulatory body as standard deduction towards audit charges.
Third this will enhance the control mechanism as the regulatory body can hire auditors from the audit companies on hourly basis and can put them on projects as their agents so that there will be a rotation of the auditors and no team of auditors from same organization. 3. The board member should be aware of their duty to control the activities of their directors. It is the moral duty of the board to know what financial arrangements and complex variables go in the balance sheets.
Although it is very difficult to control each and every activity of the directors without their knowledge it is very important for the board members to collect the important financial reports and have understanding of the complex financial engineering activities so as to avoid deception becoming part of financial engineering. 4. Organizations need somebody outside the company, constantly asking good questions in order to avoid ethical situations. Another important duty for board members is to have understanding of director’s activities to avoid conflict of interest.
The main area of concern is investigating reports of ethical misconduct by directors. These investigations can be serious affairs requiring thoroughness and tact. Even if initial incidents appear to be frivolous, investigations can uncover serious ethical lapses. The board can have external investigators under corporate governance program to investigate all reports and conduct of directors. References Bohlman, H. M. (2005). The Legal Ethical and International Environment of Business. Thomson South Western . Scharff, M. (2005). WorldCom: A Failure of Moral and Ethical Values. Journal of Applied Management and Entrepreneurship .