Analysis of Enron: The Smartest Guys in the Room

The PBS documentary Enron: The Smartest Guys in the Room reviews the business practices that led to the 2001 scandal. During the incident, shareholders learned that the company had inflated its stock through unethical accounting practices, and the economy lost billions of dollars when Enron stock prices collapsed and investors were left with stock that was significantly devalued. This case analysis reviews the legal and regulatory implications of the Enron scandal.

Facts

In the documentary Enron: The Smartest Guys in the Room, the history of Enron has reviewed as well as the business environment that contributed to the 2001 Enron scandal. Enron was a publically traded company that specialized in energy and commodities. According to the documentary, at the height of its success, Enron was the 7th largest corporation in the world and was valued at $7 billion. Further, the corporation was well connected politically and had established a close relationship with the Bush family through its political contributions. George H.W. Bush had helped the business obtain subsidies so that it could become a leader in the industry.

The film discusses Enron’s history of scandal. According to the documentary, CEO Ken Lay had enabled oil traders to engage in questionable practices in 1987 when they engaged in speculative practices in the oil trading business. Though attention had been brought to questionable practices by oil traders, including allegations that the traders had redirected profits to their own personal accounts, Lay merely encouraged the traders to continue bringing in high profits for the company. Further, he refrained to change operations after receiving revelations of the fraud.

The documentary also discusses the unethical practices that were introduced to Enron by CEO Jeffrey Skilling. As the document notes, Skilling elevated the speculative nature of Enron’s business model by introducing the idea of transferring the business into a stock market for natural gas. Further, Skilling introduced mark to market accounting, a practice that enabled accountants and record keepers to record potential future profits and account for them in financial statements. Second, under Skilling, the company introduced the practice of rank and yank, which developed a performance review system that routinely fired the bottom 15 percent of employees in the company. The impact of this system is that it made employees desperate to obtain profit at all costs, and it fostered a Darwinian environment that favored unethical behavior. Finally, the business engaged in the practice of pump and dump, a practice that involved driving up share prices by presenting inflated quarterly statements to investors so that executives could cash in on their options while share prices increased.

As a result of these unethical practices, fraud became rampant within the company. The price of Enron stocks became severely inflated because of unethical accounting practices encouraged under mark to market accounting. Further, employees under the rank and yank system were encouraged to obscure the results of their work and exaggerate their performance. Though Enron had invested in many projects that were losing money, this loss was not reflected by statements that were provided to investors. By 2000, the distortions to the value of Enron stock were revealed after a collapse to the market. Because many investors were drawn to Enron stock because of its perceived stability and performance, there was a ripple effect across the financial industry when Enron stock quickly devalued.

Issue

There are several ethical and legal issues that are presented in the documentary. First, the documentary highlights the issue of creating an ethical environment within the workplace. Many of the abuses that took place at Enron were encouraged by top executives. By utilizing high-pressure methods of assessment and promotion, the company encouraged its employees to place profits above ethical considerations. As a result, the company failed in its fiduciary duty to provide reliable information to shareholders.

Further, the documentary presents the issue of how businesses should comply with reporting requirements. While mark to market accounting might have been legal under certain circumstances, the practice contributed to an environment where the line between a legally acceptable practice and outright fraud were blurred. The legality of Enron’s accounting practices is an important consideration for this case.

Law

Statutes, including the Securities Act of 1933, are intended to ensure that investors receive timely and accurate information from publically traded companies. According to the philosophy that informs the Securities Act of 1933, the investor is entitled to material information that can help them determine the soundness of their investigation. Thus, the mark to market accounting practices conflicted with securities laws by deliberately altering material information that investors were entitled to under the law. Further, the acts of fraud engaged in by Enron were clearly illegal. The alteration of records to present losses as profit were in violation of securities regulations because they deliberately withheld pertinent information from investors that would have enabled them to properly assess the value of Enron stock.

Enron also stood in violation of federal laws on pension plans. As the documentary noted, employees were pressured to invest in a high percentage of Enron stock as part of their retirement portfolio. Following the crash of Enron stock, employees and individuals who had invested primarily in Enron stock lost their retirement accounts after the deflated stock values were adjusted to their true value. Federal pension laws attempt to prevent this scenario by requiring diversification and restricting the percentage of stock in a pension plan that can be invested in one type of security. By enabling employees to invest over 10 percent of their retirement plans to a single type of security.

Finally, while Enron faced a highly de-regulated environment that permitted many of its unethical activities, the company’s scandal led to increased regulation at the federal level. The 2002 Sarbanes-Oxley Act attempted to address many of the legal issues presented by the Enron scandal by requiring transparent accounting practices that prevented opportunities for fraud and deception to shareholders. Thus, the Enron scandal played a significant role in shaping the current regulatory environment.

Discussion

As the documentary demonstrates, securities and accounting laws cannot be relied upon to prevent every instance of unethical behavior and fraud. Though securities regulations preserved the right of investors to receive accurate information on the value of Enron stock, the company was able to engage in deceptive accounting practices the misled shareholders with little oversight. Additionally, the company was able to bypass federal pension laws by pressuring its employees to invest a significant percentage of their retirement savings into the inflated Enron stocks. Further, the market environment that rewarded companies for reporting high earnings, regardless of how questionable the figures, provided additional incentives for Enron executives to continue misreporting their earnings.

The primary reason that Enron was able to misreport its earnings for such a long period of time is that it enjoyed a fairly weak regulatory environment. As the documentary discussed, Enron executives utilized their political connections to press for weaker market regulations. Thus, the film presents the problematic nature of attempting to regulate businesses that have significant access to regulatory institutions. Though the Sarbanes-Oxley Act attempts to increase transparency by attempting to increase reporting requirements, the success of the measure will depend largely on the commitment to enforcement and the ability of regulatory officials to detect practices that might undermine federal securities laws.

Conclusion

Though federal legislation attempts to protect investors from receiving misleading information, the Enron scandal demonstrates the difficulty of monitoring ethical corporate accounting practices. Through utilizing controversial mark to market accounting practices, Enron was able to report expected future earnings as profit and significantly inflate the performance of the company. While federal regulations require businesses to provide all relevant information to shareholders, the Enron scandal demonstrates that motivated businesses can adopt accounting practices that bypass these legal requirements. Thus, stronger oversight is an important component of promoting ethical accounting practices among corporations.

Work Cited

Enron: The Smartest Guys in the Room. Dir. Alex Gibney. Perf. John Beard, Tim Belden, and Barbara Boxer. PBS, 2006. Film.