Académique Documents
Professionnel Documents
Culture Documents
By
MUHAMMAD JUNAID AKBAR SANDHU
Registration #: 121-FSL/LL.M (ITL)/F16
UNDER THE SUPERVISION OF
SIR USMAN NAWAZ
AT THE
Department Of Law
Faculty of Shariah & Law
INTERNATIONAL ISLAMIC UNIVERSITY ISLAMABAD
Session 2016
OUTLINE
I. Introduction.
II. Difference between Fraud and Corporate Fraud.
III. What was ENRON The Timeline.
Historical Background.
Key Management at ENRON.
ENRONS Operations.
IV. Rise & Fall of ENRON.
V. Factors behind the fall of ENRON.
VI. Investigations and Regulations.
VII. Who was responsible for the ENRONS fall?
VIII. The Sarbanes-Oxley Act (2002).
IX. Lesson learned from the ENRONS fall.
X. Proposed Reforms to Avoid Future Enronitis.
XI. What could be done to avoid such Enron-like crises in emerging markets such as Pakistan?
In Relation to the Exchange (PSX).
In Relation to the Regulator (ICMA).
In Relation to Auditing & Accounting Practices.
In Relation to Investors.
In Relation to Board of Directors & Management.
In Relation to Legal Practices.
XII. Conclusion.
XIII. References.
Introduction
As we know that, we are living in a corporate globe where everyone, right from the individuals or
corporations in their private capacities or countries in their public scopes, are indulge in the
financial activities to generate the maximum financial benefits for themselves or for the collective
welfare of their nations. In addition to it, to achieve the aforementioned objective, different
companies, either of national or international status, may go for merger to provide all-weather
services to their customers and products which are used on day to day basis to bring in the utmost
profits. But when these profit seekers indulge in such professional misconducts by which they
prefer the personal financial benefits over the collectiveness of benefits for the rest of the people
in an organization or by concealing an important information regarding the business from its
investors, then the ruination of that organization begins. Our this assignment work also intends to
document how the corporate malpractices destroy the huge profit earning organizations and bring
them to the ground as a result of White Collar Crimes in them. White Collar Crime, which was
coined by the sociologist Edwin Sutherland in 1939 as "a crime committed by a person of
respectability and high social status in the course of his occupation"1.
The Enron scandal is of alike nature, revealed in October 2001, eventually led to the bankruptcy
of the Enron Corporation, an American energy company based in Houston, Texas, and the
dissolution of Arthur Andersen, which was one of the five largest audit and accountancy
partnerships in the world. In addition to being the largest bankruptcy reorganization in American
history at that time, Enron undoubtedly is the biggest audit failure. It is ever the most famous
company in the world, but it also is one of companies which fell down too fast. In this assignment,
it is been analyzed the reasons for this event in detail including the management, conflict of interest
and accounting fraud. Meanwhile, it makes analysis the moral responsibility from individuals
angle and corporations angle.
1
https://en.wikipedia.org/wiki/White-collar_crime
Difference between Fraud and Corporate Fraud
Fraud:
Fraud, being one of the White Collar Crimes, is defined as an intentional deception made for
personal gain or to damage another individual. Under Contract Act 1872 in Pakistan, fraud2 means
and includes any of the following acts committed by a party to a contract, or with his connivance,
or by his agent, with intent to deceive another party thereto or his agent, or to induce him to enter
into the contract:-
(1) The suggestion, as a fact, of that which is not true, by one who does not believe it to be true;
(2) The active concealment of a fact by one having knowledge or belief of the fact;
(3) A promise made without any intention of performing it;
(4) Any other act fitted to deceive;
(5) Any such act or omission as the law specially declares to be fraudulent.
Explanation Mere silence as to facts likely to affect the willingness of a person to enter into a
contract is not fraud, unless the circumstances of the case are such that, regard being had to them,
it is the duty of the person keeping silence to speak, or unless his silence is, in itself, equivalent to
speech.
Corporate Fraud:
Apart from the fraud in general, corporate fraud is described as a fraud occurring within an
organization and involving deliberate dishonesty to deceive public, investors or lending
companies, usually resulting in financial gain to the criminals or organization3.
The correspondence between two aforementioned definitions is that they are the result of an
intentional deception by providing wrongful information to another person, by concealment of the
facts which should be disclosed to the other party or parties, deception to other party regarding the
performance of such act which is not intended to be carried out. But specifically, Corporate Fraud
is of limited scope which is regarding the corporate malpractices.
2
Section 17 of The Contract Act, 1872
3
http://www.revistanegotium.org.ve/pdf/18/art1.pdf
What was ENRON - The Timeline
Enron Corporation was an American energy, commodities, and Services Company based
in Houston, Texas. It was founded in 1985 as the result of a merger between Houston Natural Gas
and Inter North, both relatively small regional companies in the U.S. Before its bankruptcy on
December 2, 2001, Enron employed approximately 20,000 staff and was one of the world's
major electricity, natural gas, communications and pulp and paper companies, with claimed
revenues of nearly $101 billion during 20004.
4
http://archive.fortune.com/magazines/fortune/fortune500_archive/snapshots/2001/478.html
5
This Picture is Copyrighted material of Investopedia.
Key Management at ENRON
Kenneth Lay: Former Enron Chief Executive, Chairman and Board Member.
Lay took up the reins at Enron in 1986 after it was formed from the merger of two pipeline firms
in Texas and Nebraska. Prior to Enrons collapse, he was credited with building Enron's success.
Lay resigned as CEO in December 2000, and was replaced by Jeffrey Skilling. In August 2001, he
resumed leadership after Skilling resigned. Lay resigned again in January 2002 after becoming the
focus of the anger of employees, stockholders and pension fund holders who lost billions of dollars
in this disaster.
Jeffrey Skilling: Former Chief Executive, President and Chief Operating Officer.
Skilling joined Enron in 1990 from the consultancy firm McKinsey, where he had developed
financial instruments to trade gas contracts. Prior to becoming Chief Executive in February 2001,
Skilling was President and Chief Operating Officer of the firm. Skilling was also seen as a key
architect of the companys gas-trading strategy. Skilling resigned his post as Enrons chief
executive in August 2001 without a pay-off.
Andrew Fastow: Former Chief Financial Officer.
Fastow was fired in October 2001, when Enron made losses amounting to $ 600 million. Fastow
was allegedly responsible for engineering the off-balance sheet partnerships that allowed Enron to
cover its losses. Fastow was also found by an internal Enron investigation to have secretly made
$30 million from managing one of these partnerships.
Clifford Baxter: Former Chief Strategy Officer and Vice Chairman.
Baxter was known to have been one of the Enron executives, who had opposed its creative
accounting practices. Baxter retired from Enron in May 2001. Baxter committed suicide in January
2002.
ENRONS Operations
Enron had three main business units - Wholesale Services, Energy Services and Global
Services combing broadband and transportation services. It offered its services to thousands of
customers around the world.
The Wholesale Services unit was responsible for marketing a number of wholesale commodity
products, allowing industrial companies to manage commodity delivery and price risk.
Customers could arrange selling or buying commodities on terms that suited their needs (i.e.
long term, short term, fixed price, indexed price or other innovative variations).
Enrons Energy Services unit, the retail arm of Enron, offered companies a better way to
develop and execute their energy strategies. Enron was the largest provider of energy services
to commercial and industrial companies, with a total contract value amounting to $2.1 billion
in 2000.
Enrons Global Services unit included North American pipeline businesses of Enron
Transportation Services including Northern Natural Gas, Trans western Pipeline, Florida Gas
Transmission, Northern Border Partners, Portland General Electric and Enron Global Services.
On an international level it encompassed engineering businesses; Enron Wind; EOTT Energy
Corp; Azurix and Wessex Water. Enron Online was the world's largest e-commerce site for
global commodity transactions, which provided real-time transaction tools and information for
commodity transactions.
Rise & Fall of ENRON
Throughout the late 1990s, Enron was almost universally considered one of the country's most
innovative companies -- a new-economy maverick that forsook musty, old industries with their
cumbersome hard assets in favor of the freewheeling world of e-commerce. The company
continued to build power plants and operate gas lines, but it became better known for its unique
trading businesses. Besides buying and selling gas and electricity futures, it created whole new
markets for such oddball "commodities" as broadcast time for advertisers, weather futures, and
Internet bandwidth.
Enron was founded in 1985, and as one of the world's leading electricity, natural gas,
communications and pulp and paper companies before it bankrupted in late 2001, its annual
revenues rose from about $9 billion in 1995 to over $100 billion in 2000. At the end of 2001 it
was revealed that its reported financial condition was sustained substantially by
institutionalized, systematic, and creatively planned accounting fraud. According to Thomas
(2002), the drop of Enron's stock price from $90 per share in mid-2000 to less than $1 per share
at the end of 2001, caused shareholders to lose nearly $11 billion. And Enron revised its
financial statement for the previous five years and found that there was $586million in losses.
Enron fall to bankruptcy on December 2, 2001.
One of the lessons of the Internet boom is that it's often difficult for analysts to understand and
evaluate new kinds of businesses. And executives like Mr. Skilling, who once swore at an
analyst during a conference call for asking a pointed question about Enron's balance sheet,
don't do much to foster the kind of open inquiry that could lead to better information.
But the Enron debacle is also emblematic of another problem that has become all too evident
in the last few years: Wall Street's loss of objectivity. Investment banks make far more money
from underwriting or merger deals than they do from broker fees. Analysts at these firms often
face conflicting loyalties. They can be put in the position of having to worry as much about
whether a chief executive might find a report offensive as whether an investor might find it
helpful.
Factors behind the fall of ENRON6
I. Truthfulness
The lack of truthfulness by management about the health of the company, according to Kirk
Hanson, the executive director of the Markkula Center for Applied Ethics. The senior executives
believed Enron had to be the best at everything it did and that they had to protect their reputations
and their compensation as the most successful executives in the U.S. The duty that is owed is one
of good faith and full disclosure. There is no evidence that when Enrons CEO told the employees
that the stock would probably rise that he also disclosed that he was selling stock. Moreover, the
employees would not have learned of the stock sale within days or weeks, as is ordinarily the case.
Only the investigation surrounding Enrons bankruptcy enabled shareholders to learn of the CEO
stock sell-off before February 14, 2002 which is when the sell-off would otherwise have been
disclosed. Why the delay? The stock was sold to the company to repay money that the CEO owed
Enronand the sale of company stock qualifies as an exception under the ordinary director and
officer disclosure requirement. It does not have to be reported until 45 days after the end of the
companys fiscal year. (The Conference Board, Inc., 845)
II. Interest
It has been suggested that conflicts of interest and a lack of independent oversight of management
by Enron's board contributed to the firm's collapse. Moreover, some have suggested that Enron's
compensation policies engendered a myopic focus on earnings growth and stock price. In addition,
recent regulatory changes have focused on enhancing the accounting for SPEs and strengthening
internal accounting and control systems. We review these issues, beginning with Enron's board.
(Gillan SL, Martin JD, 2007)
The conflict of interest between the two roles played by Arthur Andersen, as auditor but also as
consultant to Enron. While investigations continue, Enron has sought to salvage its business by
spinning off various assets. It has filed for Chapter 11 bankruptcy, allowing it to reorganize while
protected from creditors. Former chief executive and chairman Kenneth Lay has resigned, and
restructuring expert Stephen Cooper has been brought in as interim chief executive. Enron's core
business, the energy trading arm, has been tied up in a complex deal with UBS Warburg. The bank
has not paid for the trading unit, but will share some of the profits with Enron.
III. Enron and the reputation of Arthur Andersen
The revelation of accounting irregularities at Enron in the third quarter of 2001 caused regulators
and the media to focus extensive attention on Andersen. The magnitude of the alleged accounting
errors, combined with Andersen's role as Enron's auditor and the widespread media attention,
provide a seemingly powerful setting to explore the impact of auditor reputation on client market
prices around an audit failure. CP investigates the share price reaction of Andersen's clients to
various information events that could lead investors to revise their beliefs regarding Andersen's
reputation. (Nelson KK, Price RA, Rountree BR, 2008)
6
http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.663.9418&rep=rep1&type=pdf
Perhaps most damaging to Andersen's reputation was their admission on January 10, 2002 that
employees of the firm had destroyed documents and correspondence related to the Enron
engagement. For a sample of S&P 1500 firms, CP reports that in the 3-day window following the
shredding announcement (0, +2), Andersen clients experienced a significant 2.03% market
reaction, and this reaction was significantly more negative than for Big 4 clients. Andersen's
Houston office clients, where Enron was headquartered, experienced an even stronger negative
market reaction than Andersen's non-Houston clients.2 Overall, CP concludes the shredding
announcement had a significant impact on the perceived quality of Andersen's audits, and that the
resulting loss of reputation had a negative effect on the market values of the firm's other clients.
In this study, we report new findings that shed light on whether this event study evidence is
consistent with an auditor reputation effect. In so doing, we do not suggest that auditor reputation
does not matter. As discussed above, there is ample evidence that reputation is important to
auditors and their clients. Rather, our purpose is to determine whether client returns around
Andersen's shredding announcement and related events can be considered evidence of a reputation
effect, or whether the results are confounded by other effects.
IV. An important factor: accounting fraud (using mark to market and SPE as tools)
IV.I. Mark to market:
As a public company, Enron was subject to external sources of governance including market
pressures, oversight by government regulators, and oversight by private entities including auditors,
equity analysts, and credit rating agencies. In this section we recap the key external governance
mechanisms, with emphasis on the role of external auditors. This method requires that once a long-
term contract was signed, the amount of which the asset theoretically will sell on the future market
is reported on the current financial statement.
In order to keep appeasing the investors to create a consistent profiting situation in the company,
Enron traders were pressured to forecast high future cash flows and low discount rate on the long-
term contract with Enron. The difference between the calculated net present value and the
originally paid value was regarded as the profit of Enron. In fact, the net present value reported by
Enron might not happen during the future years of the long-term contract.
There is no doubt that the projection of the long-term income is overly optimistic and inflated.
IV.II. SPESpecial Purpose Entity:
Accounting rule allow a company to exclude a SPE from its own financial statements if an
independent party has control of the SPE, and if this independent party owns at least 3 percent of
the SPE.
Enron need to find a way to hide the debt since high debt levels would lower the investment grade
and trigger banks to recall money.
Using the Enrons stock as collateral, the SPE, which was headed by the CFO, Fastow, borrowed
large sums of money. And this money was used to balance Enrons overvalued contracts. Thus,
the SPE enable the Enron to convert loans and assets burdened with debt obligations into income.
In addition, the taking over by the SPE made Enron transferred more stock to SPE. However, the
debt and assets purchased by the SPE, which was actually burdened with large amount of debts,
were not reported on Enrons financial report. The shareholders were then misled that debt was
not increasing and the revenue was even increasing.
1. Capital Market Regulatory Authorities: In theory, such a scandal should never have
taken place. The US financial markets are supposed to be the best regulated in the world,
with the Securities and Exchange Commission (SEC) enforcing strict rules on disclosure
to protect investors, besides the presence of private agencies that monitor companies. The
SECs main role is to ensure that investors have accurate information about companies and
that companies do not deceive investors or manipulate the market price of their shares. The
SEC has strong investigation powers and can fine companies for violations or failing to
cooperate. Although, the SECs investigation into Enron started in October 2001 based on
allegations regarding the mismanagement, mistreatment of shareholders and potential
fraud, the SEC was accused of failing to notice earlier irregularities in Enrons accounts
and failed to scrutinize the companys reports in detail since 1997. The SEC has defended
its actions by stating that Enrons accounts were impenetrable to regulators, since its core
business, energy trading, was only lightly regulated by another set of government agencies,
which exempted it from many reporting requirements. Moreover, the Commodity Futures
Trading Commission (CFTC), the regulator of futures and derivatives markets was
supposed to regulate Enron. Originally most futures trading were related to physical
commodities like the price of wheat or pigs, but in recent years, much of the trading has
been in financial commodities like exchange rates. Enron pioneered the trading of energy
contracts for the supply of gas and electricity, which became the centerpiece of its business.
The main problem is that CFTC believed in light-touch regulation. In 1993, the CFTC
exempted such energy trades from its regulatory overview, a ruling that was confirmed in
the 2000 Commodity Futures Modernization Act. The chair of the CFTC at the time was
Wendy Gramm, the wife of prominent Texas Republican Senator Phil Gramm. She later
joined the board of Enron! 16 Another regulatory body that oversees the energy market is
the Federal Energy Regulatory Commission (FERC), which was established to oversee the
US domestic energy markets in 1977 and is part of the US Department of Energy. The
FERCs main duty is to ensure that fair prices are paid for the transmission of gas, oil and
electricity across state boundaries, a job that gained importance as the deregulation of
energy markets gathered pace. However, the FERC exempted trading in electricity
contracts from its reporting requirements after lobbying from Enron in the 1990s. It also
failed to closely examine reports filed by Enron. Its current chairman is Pat Wood, a close
associate of President Bush. Wood was the chief energy regulator for the state of Texas
before taking up his current post. Press reports suggest that Enron boss Lay suggested his
appointment to the Bush administration. The Financial Accounting Standards Board
(FASB) is currently reviewing industry standards to check their applicability and whether
changes or amendments are required to avoid future corporate collapses like Enrons.
I. Individuals Angle:
As corporate acts originate in the choices and actions of human individuals, it is these
individuals who must be seen as the primary bearers of moral duties and moral
responsibility. The then chairman of the board, Kenneth Lay, and CEO, Jeffrey Skilling,
to allowed the then CFO, Andrew Fastow, to build private cooperate institution secretly
and then transferred the property illegally. The CFO, Andrew Fastow, violated his
professional ethics and took the crime of malfeasance. When the superior, the chairman of
the board of Kenneth Lay and CEO Jeffrey Skilling, ordered conspiratorial employees to
carry out an act that both of them knowing is wrong, these employees are also morally
responsible for the act. The courts will determine the facts but regardless of the legal
outcome, Enron senior management gets a failing grade on truth and disclosure. The
purpose of ethics is to enable recognition of how a particular situation will be perceived.
At a certain level, it hardly matters what the courts decide. Enron is bankruptwhich is
what happened to the company and its officers before a single day in court. But no company
engaging in similar practices can derive encouragement for any suits that might be
terminated in Enrons favor. The damage to company reputation through a negative
perception of corporate ethics has already been done. Arthur Andersen violated its industry
specifications as a famous certified public accountant7.
The acts of a corporation's managers are attributed to the corporation so long as the
managers act within their authority. However, the shareholders of Enron didn't know and
realize this matter from the superficial high stock price. Therefore, the whole corporation
was not of responsibility for this scandal. Actually, if the board and other shareholders paid
more attention to those decisions made by the chief, CEO, CFO and those relevant staffs,
ENRON can avoid this result8.
7
http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.663.9418&rep=rep1&type=pdf
8
http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.663.9418&rep=rep1&type=pdf
The Sarbanes-Oxley Act (2002)
The Sarbanes-Oxley Act of 2002 (SOX) is an act passed by U.S. Congress in 2002 to protect
investors from the possibility of fraudulent accounting activities by corporations. The SOX Act
mandated strict reforms to improve financial disclosures from corporations and prevent
accounting fraud. The SOX Act was created in response to accounting malpractice in the early
2000s, when public scandals such as Enron Corporation, Tyco International plc,
and WorldCom shook investor confidence in financial statements and demanded an overhaul of
regulatory standards9. Following are the sections which are chosen from the aforementioned act
regarding the concerned topic under our topics discussion:
Section 101: The board's members will serve on a full-time basis. No member may, concurrent
with service on the board, share in any of the profits of, or receives payments from, a public
accounting firm.
Section 103: The board must adopt an audit standard to implement the internal control review
required by section 404 (b). This standard must require the auditor evaluate whether the internal
control structure and procedures include records that accurately and fairly reflect the transactions
of the issuer, provide reasonable assurance that the transactions are recorded in a manner that will
permit the preparation of financial statements in accordance with GAAP, and a description of any
material weaknesses in the internal controls.
Section 102 (a): Mandatory Registration Clause
Section 104: The SEC may order a special inspection of any firm at any time.
Section 107 (d): The board must notify the SEC of pending investigations involving potential
violations of the securities laws, and coordinate its investigation with the SEC division of
enforcement as necessary to protect an ongoing SEC investigation.
Section 206: The CEO, Controller, CFO, Accounting Officer or person in an equivalent position
cannot have been employed by the company's audit firm during the one-year period preceding the
audit.
Section 302: Corporate Responsibility for Financial Reports-The CEO and CFO of each issuer
shall prepare a statement to accompany the audit report to certify the appropriateness of the
financial statements and disclosures contained in the periodic report and that those financial
statements and disclosures fairly present in all material aspects, the operations and financial
condition of the issuer.
Section 401 (a): Each annual and quarterly financial report.....shall disclose all material off-
balance sheet transactions and other relationships with unconsolidated entities that may have a
material current or future effect on the financial condition of the issuer.
9
http://www.investopedia.com/terms/s/sarbanesoxleyact.asp
Title VIII: Corporate and Criminal Fraud Accountability. It is a felony to knowingly destroy or
create documents to impede, obstruct or influence any existing or contemplated federal
investigation. Auditors are required to maintain all audits or review work papers for five years.
Section 1105: The SEC may prohibit a person from serving as an officer or director of a public
company if the person has committed securities fraud.
I. Great care and due diligence should be undertaken in the listing of foreign companies
on Pakistan Stock Market (PSX) to avoid having Enrons. PSX should not suffice if a
foreign company is listed on a developed and well-regulated stock exchange, rather it
must conduct due diligence analysis of prospective issuers prior to their listing.
II. Importance of educating investors about the importance of disclosure of listed
companies and how to be able to read financial statements of listed companies.
III. Regulations should be enforced to ensure timely and full disclosure of information from
issuers.
IV. Imposing penalties on listed companies that are engaged in fraud or misguide its
investors.