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Business Ethics and Corporate Governance

• Introduction
• Importance and Need for Business Ethics
• The Indian Context
• Roots of Unethical Behaviour
• Some Unethical Issues
• Corporate Governance Ethics
• How Ethics Can Make Corporate Governance More Meaningful?

Introduction

The word “ethics” is derived from the Greek word “ethikos” meaning custom or character. It is the science of morals describing a set of rules of behaviour. Business ethics itself is an offshoot of applied ethics. The study of business ethics essentially deals with understanding what is right and morally good in business.

Ethics is a branch of philosophy and is considered a normative science because it is concerned with the norms of human conduct, as distinguished from formal sciences such as mathematics and logic, physical sciences such as chemistry and physics, and empirical sciences such as economics and psychology. As a science, ethics must follow the same rigours of logical reasoning as other sciences.

The principles of ethical reasoning are useful tools for sorting out the good and bad components within complex human interactions. For this reason, the study of ethics has been at the heart of intellectual thought since the time of early Greek philosophers, and its ongoing contribution to the advancement of knowledge and science makes ethics a relevant, if not vital, aspect of management theory.

 

What is Business Ethics?

Ethics is a conception of right and wrong behaviour, defining for us when our actions are moral and when immoral. Business ethics is the application of general ethical ideas to business behaviour. Ethical business behaviour is expected by public, prevents harm to society, improves profitability, fosters business relations and employee productivity, reduces criminal penalties, protects business against unscrupulous employees and competitors, protects employees from harmful actions by their employer, and allows people in business to act consistently with their personal ethical beliefs. Ethical problems occur in business for many reasons, including the selfishness of a few, competitive pressures on profits, the clash of personal values and business goals, and cross-cultural contradictions in global business operations. Similar ethical issues, such as bribery and corruption, are evident throughout the world, and many national governments and international agencies are actively attempting to minimise such actions through economic sanctions and international codes. Although laws and ethics are closely related, they are not the same; ethical principles tend to be broader than legal principles. Illegal behaviour by business and its employees imposes great costs on business itself and the society at large.

 

To be precise, “business ethics is the art and discipline of applying ethical principles to examine and solve complex moral dilemmas”.¹ Business ethics proves that business can be and have been ethical and still make profits. Till the last decade, business ethics was thought of as being a contradiction in terms. But things have changed, today more and more interest is being shown to the application of ethical practices in business dealings and the ethical implications of business. “Business ethics is that set of principles or reasons which should govern the conduct of business whether at the individual or collective level.”²

Ethical solutions to business problems may have more than one right answer or sometimes no right answer at all. Thus logical and ethical reasoning are tested in that particular business situation. “A business or company is considered to be ethical only if it tries to reach a trade-off between pursuing its economic objectives and its social obligations, i.e. between its obligations to the society where it exists and operates; its obligations to its people due to whom it can even think of pursuing economic goals; to its environment, from whom it takes so much without it demanding anything back in return; and the like.”³

Business ethics is based on the principle of integrity and fairness and concentrates on the benefits to the stakeholders, both internal and external. Stakeholder includes those individuals and groups without which the organisation does not have an existence. It includes shareholders, employees, customers, dealers, vendors, government and the society.

Evolution of Ethics Over the Years

If we trace the history of ethics in business, we would realise that ethics has emerged as a part of theological discussions prior to 1960. Catholic teachings through Papal Encyclicals emphasised the need for morality in business, such as workers’ rights and living wages as in Rerum Novarum of Pope Leo XIII. Some of the Protestant seminaries developed ethics as part of their curriculum. During the 1960s, we see the rise of social issues in business. During this period many business practices came under social scrutiny. President John F. Kennedy’s Consumer Bill of Rights reflected a new era of consumerism. Only during the 1970s we see business ethics as an emerging field. During this period professors, teaching business, began to write about business ethics and philosophers began to involve themselves in business ethics. Businessmen became more concerned with their public image and addressed ethics more directly. When we think from this background, we will be able to attach more importance to ethics in business.

Ethics Is More Than Just Collection of Values

Values are almost always over-simplified, which can rarely be applied uniformly. Values tend to be under-defined, situational by nature and subject to flawed human reasoning such that by themselves they cannot assure true ethical conduct. Consider the sought-after value of employee loyalty: should employees be loyal to co-workers, supervisors, customers, or investors? Since it may be impossible to be absolutely loyal to all the four simultaneously, in what order should these loyalties occur? Employers that demand employee loyalty rarely can answer this question completely.

Importance and Need for Business Ethics

Ethics is closely related to trust. Most of the people would agree on the fact that to develop trust, behaviour must be ethical. Ethical behaviour is a necessity to gain trust. Trust will be used as an indicator variable of ethics. Basically, trust is three-dimensional, that is, trust in supplier relationships, trust in employee relationships and trust in customer relationships. In such a situation, the entire stakeholders of the company are taken care of. If the company is able to maintain this trust-relationship with the internal as well as external stakeholders, then we can call that company as an ethical company.

 

Trust leads to predictability and efficiency of business. Ethics is all about developing trust and maintaining it fruitfully so that the firm flourishes profi tably and maintains good reputation. Lack of ethics would lead to unethical practices in organisations as well as in personal life. One wonders sometime why even educated, well-positioned managers or employees of some reputed companies act unethically. This is because of lack of ethics in their lives. We can point out to a number of examples of companies whose top managements are involved in unethical practices, to name a few, Enron, WorldCom, etc. Earlier it was said that—“business of business is business”— now there is a sudden change in the slogan. In the contemporary scenario where ethics has got due importance, the slogan has taken the form—“business of business is ethical business”.

There are a number of companies which have succeeded in profit-making and public esteem by following ethical practices in their realm of business. Some of such companies are: Boeing, Johnson and Johnson, Larson & Tubro, Wipro, Infosys, Tata Steel, and Ford. They have gained the trust of the public through ethical practices. In India, the House of Tatas, for instance, adheres to, and communicates key ethical standards in several ways. The Tata Code of Conduct affirms: “The Tata name represents more than a century of ethical conduct of business in a wide array of markets and commercial activities in India and abroad. As the owner of the Tata Mark, Tata Sons Ltd., wishes to strengthen the Tata brand by formulating the Tata Code of Conduct, enunciating the values which have governed and shall govern the conduct and activities of companies associating with or using the Tata name and of their employees.”⁴ Applying ethics in business makes good sense because it induces others to follow ethics in their behaviour. Ethics are important not only in business but, in all walks and aspects of life. The business of the society which lacks ethics is likely to fall sooner or later.

The Indian Context

With the onset of globalisation and the huge foreign institutional investment in India, the Indian corporates can no longer turn a blind eye to the needs of the hour. The writing on the wall for the erstwhile unethical corporates is clear—“clean up your acts or perish for want of investment”. It is inherently in the corporates’ own interest that they shape up to be better corporate citizens. The time has come for them to be more prudent in incorporating ethics into their systems. An ethical corporate can go a long way in serving the community around it directly and indirectly in a myriad ways. Furthermore, a corporate expects others in the line of business to be ethical in their dealings, or else the entire trust upon which business is conducted will be lost. Business cannot be conducted in an environment of mutual distrust and suspicion and hence it is in its own interest that a corporate conducts itself ethically.

Ethical business must be adhered to by the entire business community. Mere lip service to the cause would undermine the trust which is the very foundation on which business stands. Agreeing to be ethical and then reneging on the commitment would lead to inconsistency in the business environment. A trustworthy company that has over the years earned a good reputation and the goodwill of the people through its ethical conduct stands a much greater chance of attracting more business than the others. An ethical corporate not only attracts more business but also gains the respect of its employees, shareholders, creditors and the society at large.

Ethical business has only helped organisations to improve their brand equity and image. A good example would be Johnson and Johnson. The way it conducted itself in the wake of the Tylenol drug controversy was laudable. It had to withdraw massive stocks of drugs from various pharmacies and druggists and suffered huge loses running upto $100 million. The effort that went into recalling all the stocks from the retail outlets was mind-boggling. Ultimately, Johnson and Johnson came out triumphantly with its image enhanced even further when the public realised that it was not its fault. Johnson and Johnson was lavished with praises and the grateful public gave it an overwhelming support. The company regained its standing and also made up for its losses in a very short time. Nearer home, when it was pointed out to the late J. R. D. Tata that competitor companies were growing much faster than the House of Tatas, he answered that the Tatas believed only in growth that is based on ethics, equity and socially responsible behaviour. J. R. D. Tata once observed in an interview: “The prime influence in my career in Tatas was certainly that which was inspired by Jamsetji Tata. Jamsetji was a towering personality in every sense and above all, he was a man of vision. At a time when the British were skeptical about Indians setting up a steel plant, Jamsetji never had any doubts whatsoever. Even though there were several vicissitudes, TISCO emerged as the largest entity in the country. The same could be said about its entry into the power generation business and also hoteliering. I don’t think anyone was on par with Jamsetji as an industrial visionary. But that is not the sole reason why I have been an admirer of Jamsetji. The major reason was his sense of values, sterling values, which he imparted to the group. If someone were to ask me, what holds the Tata companies together, I would say it is our shared ideals and values as a corporate citizen which we have inherited from Jamsetji Tata.”⁵

Another Dimension: “Corporates in India Cannot Afford To Be Ethical”⁶

When questioned about unethical practices, many companies claim that the conditions in India are not conducive to allow them the luxury of being completely ethical. Thousands of underhand deals are struck everyday and go unreported. There is hardly a company which has not at sometime or the other been either involved or suspected of some foul play. Even companies that started off with intentions to do business in an ethical manner have had to compromise their principles due to the highly politicised and bureaucratic business environment in the country. Growing corruption, increasing disparity between people and rapidly reducing profit margins add to the woes of organisations that want to be ethical.

Indian companies face two types of corrupt practices: (i) political corruption in which money is paid for favours done, and (ii) administrative corruption. In the early days of Independence, companies had to grease the palms of bureaucrats to make them do things they were not supposed to do, but now corruption has graduated to such an extent that companies have to bribe bureaucrats to make them do things they are supposed to do. Examples of this sort of corruption include “gifts” to the Factory Inspector, Boiler Inspector, Pollution Control Board Inspectors, and assessors for customs, excise, income tax, sales tax and Octroi. It is the administrative corruption, which most companies find unavoidable most of the time.

 

A study on the ethical attitudes of Indian managers conducted by Arun Monappa (1977) reported that business executives listed three major obstacles to ethical behaviour, namely: (i) company policies, (ii) unethical industry climate and (iii) corruption in government. Company policies tend to be unethical due to socio-cultural environment, and get reinforced because of the sense of frustration and helplessness that comes from the prevalent and all pervading unethical environment.

With regard to the socio-cultural reasons underlying the tendency of Indian corporates to be unethical are, the low priority accorded to business ethics in newly formed democracies as it seems there are more urgent demands that have to be dealt with first (Rossouw, 1998): The imperatives of the day-to-day survival for businessmen and the law-makers to be unduly concerned about the ethical and moral implications of their actions. This situation has been sharpened by the opening up of the economy wherein Indian corporates find it increasingly difficult to compete in a dog-eats-dog kind of global markets. Another factor that has contributed to the lack of ethical ethos and behaviour is the country’s aspiration to build a strong and economically powerful nation in a short time.

The other factors affecting ethical dilemmas of corporates are: (i) socio-cultural factors such as the sense of hospitality (not inviting a business associate could be construed as impolite, and once invited, showering him with gifts is an accepted custom) and reciprocity (You gave me a license with which I make money, and there is nothing wrong in sharing a part of it with you); (ii) the psychological fear of losing jobs; (iii) lax government structures and regulations; (iv) sanctions and discriminations in society that can be offset with accumulation of wealth by fair or foul means; (v) uncertainties and fears about the future; (vi) strong family traditions and laws of inheritance in which parents want to leave substantial assets to their progeny; (vii) overall scarcity of resources and the difficulty of amassing wealth through normal and legitimate means; (viii) an inequitable and scorching tax system (almost an unbelievable 97.75 per cent in terms of both direct and indirect taxes at the highest bracket in the 60s and 70s of last century) which discourage hardworking and honest tax-payers and lead them to bribe tax-collectors; (ix) a belief that business and ethics are irreconcilable; and (x) a tendency to adopt an easy option when confronted with difficult ethical choices—“Well, if I can’t beat them, I may as well join them” becomes a natural choice.

Lea (1999) gives another explanation to the deviant ethical behaviour found among corproates in developing societies. Transition from subsistence culture to the commercial enterprise of capitalistic culture can result in a moral chaos in which behaviour falls short of ethical expectations. In traditional sub-cultures rituals govern life, these rituals are insufficient behavioural guides in capitalism, which increases individual autonomy and responsibility and generates surpluses and wealth. Rapid economic growth leads to the development of a distorted understanding of capitalism and growth, in which money power, survival and profitability at any cost are considered as the primary goals of any business. The manifestation of this idea is very apparent in India and, especially in the case of some famous “rags to riches” stories.

The need to adapt to the unethical environment is so strong that even large multinationals setting up facilities in India have been unable to avoid cutting corners. In their eagerness to capture the Indian market and beat the competition, many companies have grossly broken their stringent codes of conduct, which in the West would be unthinkable. This was apparent when a major portion of the top management of a leading FMCG multinational in India were removed on grounds of violation of the ethical code of conduct. However, there was no visible effort on the part of the company to own up or reverse some of the unethical actions performed by its erstwhile employees.

Roots of Unethical Behaviour

People often wonder why employees indulge in unethical practices such as lying, accepting bribery, coercion, conflicting interest, etc. There are certain factors that make the employees to think and act in unethical ways. Some of such influencing factors are: “pressure to balance work and family, poor communications, poor leadership, long working hours, heavy work load, lack of management support, pressure to meet sales or profit goals, little or no recognition of achievements, company politics, personal financial worries, and insufficient resources.”⁷ The statistical data given by Ethical Officers Association in 1997 shows how certain practices or factors contribute to unethical behaviour.⁸

 

 

 

From the above statistics it is very much evident that conflicting interests lead to most of the unethical practices.

Why Does Business Have Such a Negative Image?

Competitive pressures, individual greed, and differing cultural contexts generate ethical issues for organisational managers. Further, in almost every organisation some people will have the inclination to behave unethically (the ethical egoist)—necessitating systems to ensure that such behaviour is either stopped or detected (after unethical behaviour occurs), and remedied. Ethics (also called moral philosophy) involves systematising, defending, and recommending concepts of right and wrong behaviour.

Why Should Businesses Act Ethically?

There are a number of reasons given below as to why businesses should act ethically:

• Protect its own interest (prudence).
• Protect the interests of the business community.
• Keep its commitment to society to act ethically.
• Meet stakeholder expectations.
• Prevent harm to the general public.
• Build trust with key stakeholder groups.
• Protect themselves from abuse from unethical employees and competitors.
• Protect their own reputations.
• Protect their own employees.
• Create an environment in which workers can act in ways consistent with their values.

Moreover, if a corporation reneges on its agreement and expects others to keep theirs, it will be unfair. It will also be inconsistent on its part, if business agrees to a set of rules to govern behaviour and then to unilaterally violate those rules. Moreover, to agree to a condition where business and businessmen tend to break the rules and also they can get away with it is to undermine the environment necessary for running the business.

Additionally, an organisation has to be ethical in its behaviour because it has to exist in the competitive world. We can find a number of reasons for being ethical in behaviour, few of them are given below: Most people want to be ethical in their issues.

• Values give management credibility with its employees. Only perceived moral uprighteousness and social concern brings employee respect.
• Values help better decision-making.
• Hard decisions which have been studied from both an ethical and an economic angle are more difficult to make, but they will stand up against all odds, because the good of the employees, the public interest, and the company’s own long term interest and those of all stakeholders have all been taken into account.

Ethics within organisations is a must, as only then that can be conveyed through the activities they perform. Ethics should be initiated from the top management to the bottom of the hierarchy. “Ethical behaviour starts at the top. Before a company can expect to be viewed as ethical in the business community, ethical behaviour within its own walls to and by employees is a must, and top management dictates the mood. Ethical behaviour by the leaders of an organisation will inevitably set the tone for the rest of the company-values will remain consistent. Further, a well-communicated commitment to ethics sends a powerful message that ethical behaviour is considered to be a business imperative.⁹ If the company needs to make profit and to have a good reputation, it must act within the confines of ethics. The ethical communication within the organisation would be a healthy sign that the company is marching towards the right path. Internalisation of ethics by the employees is of very much importance. If an employee has properly internalised ethics, then the activities that he or his organisation caries out will have ethics in it.

Ethical Decision Making

Ethical decision making is a very tough prospect in this dog-eats-dog world. However, in the long run, all will have to fall in and play fair. The clock is already ticking for the unscrupulous corporates. In this age of liberalisation and globalisation, the old dirty games and unethical conduct will no longer be accepted and tolerated.

Norman Vincent Peale and Kenneth Blanchard in their book, “The Power of Ethical Management”, have prescribed some suggestions to conduct ethical business.

• Is the decision you are taking legal? If not legal, it is not ethical.
• Is the decision you are taking fair? In other words, it should be a win-win-equitable risk and reward.
• The Eleventh Commandment—”Thou shall not be ashamed when found”, meaning when you are hauled up over some seemingly unethical behaviour, if one’s conscience is clear, then there is nothing to be ashamed of.

How Corporates Observe Ethics in Their Organisations?

Organisations have started to implement ethical behaviour by publishing in-house codes of ethics which are to be strictly followed by all their associates. They have started to employ people with a reputation for high standards of ethical behaviour at the top levels. They have started to incorporate consideration of ethics into performance reviews. Corporations that wish to popularise good ethical conduct have started to reward ethical behaviour. Codes promulgated by corporations and regulatory bodies continue to multiply. Some MNCs like Nike, GM and IBM and Indian Companies like Infosys, ICICI, TISCO, ONGC, Indian Oil and several others want to be seen “socially responsible” and have issued codes governing all types of activities by their employees. SEBI, the capital market regulator, CII, Assocham, and such organisations representing corporates have issued codes of best practices and enjoin their members to observe them. These normative statements make it clear that corporate leaders anxious for business growth should not make plans without looking at the faces and lives of those oppressed by poverty and injustice. In fact, today managers and would-be entrepreneurs are groomed to be ethical and socially responsible even while being educated. The Indian Schools of Management (IIMs) and highly rated B-schools like the Xavier Labour Relations Institute (XLRI) and the Loyola Institute of Business Administration (LIBA) have core courses in their curriculum and give extensive and intensive instruction in business ethics, social responsibility and corporate governance. Many corporations conduct an ethics audit and, at the same time, they are continuously looking for more ways to be more ethical.

Some Unethical Issues

As we discuss business ethics, it is necessary to address the ethical issues that are involved in business. Right from the Harshad Metha scam till the recent insider trading of L & T versus Reliance and even more recently Satyam Computers, we see unethical practices taking place even in reputed organisations. Researches and studies show that several ethical issues are faced by an organisation, they are: bribery, coercion, deception, theft, unfair discrimination insider trading, conflicts of interest, etc. Some of these are dealt in detail below.

Bribery

Bribery is a manipulative method where one buys the power or the influence of other person in order to satisfy his selfish need. Bribes create a conflict of interest between the person receiving bribe and his/her organisation. This conflict would result in unethical practices. When somebody is bribed for something his thinking and actions are oriented towards his personal goals. This direction towards personal goals always results in a mismatch between the interest of the organisation and of the individual. When there is a mismatch between the goals, naturally he cannot be loyal to the organisation, and in turn, he will indulge in unethical practices. Bribery undermines market efficiency and predictability, thus ultimately denying people their right to the minimal standard of living. “Bribery does more than destroy predictability; it undermines essential social and economic system.”¹⁰

 

For example, companies like Boeing and GE (General Electric) have well formed policies to deal with this issue. These policies of the company protect the employees from indulging in such practices. The statement of GE is worth mentioning, “No matter how high the stakes are, no matter how great the ‘stretch is’, GE will do business only by lawful and ethical means. When working with customers and suppliers in every aspect of our business, we will not compromise our commitment to integrity”.¹¹

Likewise, Boeing is categorical with regard to this issue: “It is the policy of The Boeing Company to deal with its suppliers and customers in a fair and impartial manner, business should be won or lost on the merits of the Boeing products and services. A business courtesy may never be offered under circumstances that might create the appearance of impropriety or cause embarrassment to Boeing or the recipient. An employee may never use personal funds or resources to do something that cannot be done with Boeing resources. Accounting for business courtesies must be in accordance with approved company procedures and practices.”¹² Nearer home, the Indian engineering giant, L & T makes its business policy clear thus: “All marketing personnel will adhere to the highest standards of personal and corporate integrity and thereby maintain and promote our reputation as an outstanding company with which to do business.”

Coercion

“Coercion is forcing a person to act in a manner that is against the person’s personal beliefs.”¹³ It is an external force or a man-made constraint created in circumstances asking the other to act against his free will. Authority of the person who demands certain activity plays an important role, that is, blackmailing or arm-twisting an individual in an organisation. This may be in the form of threat of blocking a promotion or the loss of a job. This sort of unethical practices in the organisation will lead to further unethical behaviour of an individual. For example, the Tylenol tampering case of Johnson and Johnson was done with an intention of damaging the image of the company and forcing it to incur heavy financial expenses in correcting the problem.

Insider Trading

This is one form of misuse of official position by an individual in the organisation. Here, the employee leaks out certain confidential data to outsiders or to other insiders, which in turn ruin the reputation of the company. Insider trading may lead to the bad performance of the company.

This is how it is done: If the employees trade the confidential matters, the competitor may intervene and make use of the opportunity. Inside traders often defend their actions by claiming that they don’t injure anyone. It may be true with nonpublic information but certain moral concerns arise because of this act. For example, the report of L & T versus Reliance (The Hindu, 23 November 2003) issue which was reported in the media shows that such practices are taking place in reputed companies and at the top management level.

Tax Evasion

There are major unethical practices towards tax evasion. Many large corporations hire the services of professional tax consultants to take advantage of loopholes in the law and evade taxes to the extent possible. The reason they attribute for such behaviour is the prevalent rate of corporate taxation, which is very high. In fact, this has generated a parallel economy in spite of government’s continuous endeavours to channellise this money towards legitimate purposes.

The well-known tax consultant, Dinesh Vyas, says that J. R. D. Tata never entered into a debate over tax avoidance, which was permissible, and “tax evasion,” which was illegal; his sole motto was “tax compliance.” On one occasion a senior executive of a Tata company tried to save on taxes. Before putting up the case, the chairman of the company took him to JRD and Vyas explained to JRD: “But sir, it is not illegal.” JRD asked, softly: “Not illegal, yes. But is it right?” Vyas says that during his decades of professional work, no one had ever asked him that question. Vyas later wrote in an article: JRD would have been the most ardent supporter of the view expressed by Lord Denning. “The avoidance of tax may be lawful, but it is not yet a virtue.”¹⁴

Conflicts of Interest

Even the most loyal employees can find that their interests collide with that of the organisation. Sometimes, this clash of goals and desires can take the serious form of conflicts of interest. In an organisation, conflict of interest arises when employees at any level behave with the private interests that are substantial enough to interfere with their job or duties. This conflicting interests in the individual and the decisions taken may act against the desire of the employer. Conflicts of interests are morally worrisome not only when an employee acts to the detriment of the organisation but also when the employee’s private interests are significant enough that they could easily tempt the employee to do so. Great men like J. R. D. Tata had been trying all their lives to reduce such conflicts of interest in the work place. JRDs’ strong point was his intense interest in people and his desire to make them happy. Towards the end of his life, he often said: “We don’t smile enough”. Once he told a friend about his dealings with his colleagues: “With each man I have my own way. I am one who will make full allowance for a man’s character and idiosyncrasies. You have to adapt yourself to their ways and deal accordingly to draw out the best in each man. At times it involves suppressing yourself. It is painful, but necessary. To be a leader you have got to lead human beings with affection.” It is a measure of his affection that even after some of them retired, he would write to them. He was always grateful and loyal. To him, ethics included gratitude, loyalty and affection. It came about because he thought not only of business, but also of people.¹⁵

 

In dealing with his workers he was particularly influenced by Jamshetji Tata, who at the height of capitalist exploitation in the 1980s and the 1990s gave his workers accident insurance and a pension fund, adequate ventilation at the workplace and other benefits. He wanted workers to have a say in their own welfare and safety, and he wanted their suggestions on the running of the company. A note that he wrote on personnel policy resulted in the founding of a personnel department. As a further consequence of that note came about two pioneering strokes by Tata Steel: a profit-sharing bonus and a joint consultative council. Tata Steel has enjoyed peace between management and labour for 70 years.¹⁶

Pollution

The unethical practice towards pollution affects society and population to a major extent. The high levels of pollution due to the indiscriminate and improper disposal of effluents by industries has rendered the world a highly unsafe place for progeny. In his last years, J. R. D. Tata was very conscious of the environment and industry’s part in spoiling it. He wrote in his Foreword to The Creation of Wealth in 1992: “I believe that the social responsibilities of our industrial enterprises should now extend even beyond serving people to the environment.” The J. R. D. Tata Centre for Ecotechonology at the M. S. Swaminathn Research Foundation was created in furtherance of his desire.¹⁷

Corporate Governance Ethics

Though the concept of corporate governance may sound a novelty in the Indian business context and may be linked to the era of liberalisation, it should not be ignored that the ancient Indian texts are the true originators of good business governance as one important sloka from the Rugveda says: “A businessman should benefit from business like a honey-bee which suckles honey from the flower without affecting its charm and beauty.”

As a public company, it is of critical importance that companies’ information reporting with the regulators be accurate and timely. The chief executive officer and the senior leadership of the finance department bear a special responsibility for prompting integrity throughout the organisation, with responsibilities to stakeholders both inside and outside of companies. In this context, it is appropriate to keep in mind the following seven cardinal principles of business, applicable at all levels, both national and international.

1. Act with honesty and integrity, avoiding actual or apparent conflict of interest in personal and professional relationships.
2. Provide information that is accurate, complete, objective, relevant, timely and understandable to ensure full, fair, accurate, timely, understandable disclosure in reports and documents that companies file with, or submit to, the regulators.
3. Comply with applicable laws, rules and regulations of federal, state, and local governments, and other appropriate public and private regulatory agencies in all material respects.
4. Act in good faith, responsibility, with due care, competence and diligence, without misrepresenting material facts or allowing one’ s independent judgement to be subordinated.
5. Respect the confidentiality of information acquired in the place of one’s work except when authorised or otherwise legally obligated to disclose. Confidential information required in the course of one’s work will not be used for personal advantage.
6. Share knowledge and maintain skills important and relevant to stakeholders’ needs. Proactively promote and be an example of ethical behaviour as a responsible partner among peers, in the work environment and the community.
7. Achieve responsible use of and control over all assets and resources employed or entrusted with.

Benefits from Managing Ethics in Workplace

(a) Attention to business ethics has substantially improved society: Establishment of anti-trust laws, unions, and other regulatory bodies has contributed to the development of the society. There was a time when discriminations and exploitation of employees were high, the fight for equality and fairness at workplace ended up in establishing certain laws which benefited the society.

(b) Ethical practice has contributed towards high productivity and strong team work: Organisations being a collection of individuals, the values reflected will be different from that of the organisation. Constant check and dialogue will ensure that the employee aligns himself or herself to the values of the organisation which will in turn result in better co-operation and increased productivity.

(c) Changing situations require ethical education: During turbulent times, where chaos becomes the order of the day, one must have clear ethical guidelines to take right decisions. Ethical training will be of great help in those situations.

(d) Ethical practices create strong public image: Organisations with strong ethical practices will possess a strong image among the public. This image would lead to strong and continued loyalty. Conscious implementation of ethics in organisations becomes the cornerstone for the success and image of the organisation. It is because of this ethical perception, that the employees of TISCO and the general public protested in 1977 when the then Minister for Industries in the Janata Government, attempted to nationalise the company.

(e) Strong ethical practices act as insurance: Strong ethical practices of the organisation are an added advantage for the future function of the business. In the long run, it would benefit if the organisation is equipped to withstand the competition.

Characteristics of an Ethical Organisation

Mark Pastin in his work, The Hard Problems of Management: Gaining the Ethical Edge provides the following characteristics of ethical organisations:

1. They are at ease interacting with diverse internal and external stakeholder groups. The ground rules of these firms make the good of these stakeholder groups part of the organisation’s own good.
2. They are obsessed with fairness. Their ground rules emphasise that the other persons’ interests count as much as their own.
3. Responsibility is individual rather than collective, with individuals assuming personal responsibility for actions of the organisation. These organisations’ ground rules mandate that individuals are responsible to themselves.
4. They see their activities in terms of purpose. This purpose is a way of operating that members of the organisation highly value. And purpose ties the organisation to its environment.
5. There will be clear communications in ethical organisations. Minimised bureaucracy and control paves way for sound ethical practices.

Recognising Ethical Organisations

There are certain principles by which we will be able to identify the ethical organisation.

(a) On the basis of corporate excellence: Corporate excellence mainly centre on the corporate culture. Values and practice of such values constitute the corporate culture. Values of the organisation give a clear direction to the employees. Values are found in the mission statement of the organisations. Often they remain as a principle and never put into practice. Only the practised value cerates the organisation culture. When values act in tune with the goals of the organisation, we call it as the corporate culture of that organisation. Often we see conflicting interests between the value and the organisations’ goal. An organisation must eradicate such impediments to be identified as an ethical organisation.

(b) In reference to the stakeholders: Meeting the needs of the stakeholders by the activities of the managers determine whether the organisation is ethical or not. The top management represents the stakeholders and every decision taken must satisfy the needs of the stakeholder. The management in taking decisions must see that the stakeholders enjoy the maximum benefit of that decision. For example, Marico, the makers of Parachute Oil, discovered a harmless tint in the oil from one of its production lines. The company withdrew the batch from the market, shut down the production line, but kept the workers on payroll and involved them in the investigation of the cause. Shortly, the workers located the cause, rectified it and resumed production.

(c) In relation to corporate governance: Managers are only stewards of the owners of the assets of the company. Thus they are accountable for the use of the assets to the owners. If they perform well in the prescribed manner, then there would not be much question of corporate governance. Such behaviour of the top managers would generate ethical practices or at least would encourage ethical practices in the organisation. If only the top management is paid as per their performance, this approach would work.

How Ethics Can Make Corporate Governance More Meaningful?

1. Corporate governance is meant to run companies ethically in a manner such that all stakeholders—creditors, distributors, customers, employees, the society at large and governments—are dealt in a fair manner.
2. Good corporate governance should look at all stakeholders and not just shareholders alone. Otherwise, a chemical company, for example, can maximise the profit of shareholders, but completely violate all environment laws and make it impossible for the people around the area to lead a normal life. Ship-breaking in Valinokkam, near Arantangi in Tamil Nadu, leather tanneries in South Arcot and hosiery units in Tirupur, have brought about too much of environmental degradation that has unleashed untold miseries to people in and around their locations.
3. Corporate governance is not something which regulators have to impose on a management, it should come from within. There is no point in making statutory provisions for enforcing ethical conduct.
4. There is a lot of provisions in the Companies Act, for example, in dealing with the following issues: (i) disclosing the interest of directors in contracts in which they are interested; (ii) abstaining from exercising voting rights in matters they are interested; and (iii) statutory protection to auditors who are supposed to go into the details of the financial management of the company and report the same to the shareholders of the company. But most of these may be observed in the letter, but not in spirit. Members of the board and top management should ensure that these are followed both in the letter and spirit.
5. There is a number of grey areas where the law is silent or where regulatory framework is weak, which are manipulated by unscrupulous persons like Ketan Parikh and Harshad Mehta. In the US, for instance, the courts recognise that new forms of fraud may arise, which may not be covered technically under any existing law and cannot be interpreted as violating any of the existing laws. For example, a clever conman can try to sell a piece of the blue sky. In order to check such crooks, there is the concept of the “blue sky” law. However, such wide-ranging process are not available to courts in developing countries.
6. The Securities and Exchange Board of India (SEBI) has jurisdiction only in cases of limited and listed companies and are concerned only with their protection. What about the shareholders and others of other unlisted Limited companies?
7. The Serious Fraud Investigation Office (SIFO) in the Department of Corporate Affairs (DCA) has been investigating several “Vanishing Companies”. By 2003, SEBI has identified 229 as “vanishing companies”—which tapped the capital market, collected more than Rs. 800 crores from the public and subsequently became untraceable. However, thousands of investors have lost their hard-earned money and no agency has come to their rescue so far.

• Bribery
• Business ethics
• Changing situations
• Collection of values
• Conflict of interests
• Corporate excellence
• Corruption
• Decision-making
• Ethical education
• Ethical organisations
• Ethical practices
• Ethics in organisations
• Ethics within organisation
• Evolution of ethics
• High productivity
• Insider trading
• Negative image
• Pollution
• Stakeholders
• Strong public image
• Strong team work
• Tax evasion
• Unethical behaviour
• Unethical issues

1. How would you define business ethics? Trace the evolution of business ethics over the years.
2. Discuss the importance and relevance of ethics while conducting business.
3. Do you find a contradiction between running profitable business and following ethical practices? Substantiate your answer with suitable examples from the Indian business scenario.
4. Critically comment on the statement: “Corporates in India cannot afford to be ethical”.
5. Why do businesses have a negative image? Explain the reasons behind the unethical behaviour of business organisations.
6. Discuss how ethics can make corporate governance more meaningful. Give suitable examples.

• Cowton, Christopher and Roger Crisp, Business Ethics: Perspective on the Practice Theory, p. 9.
• Drinan, Robert F. S. J., former US Congressman and Professor at George Town University Law Center during the Tenth J. R. D. Tata Oration of Ethics in Business at XLRI, Jamshedpur on 21 December 2000. The topic of the oration was “Globalization and Corporate Ethics”.
• Fritzsche, David J. Business Ethics: A Global and Managerial Perspective, Singapore The McGraw-Hill companies, Inc. (1997), p. 12.
• Mulla, Zubin “Corporates in India cannot Afford to be Ethical”, Management and Labour Studies, Vol. 28, No. (1 February 2003.)
• Raj, Rituparna (1999), A Study in Business Ethics; Bombay: Himalaya Publishing House, p. 3.
• Weiss, Joseph W. (1988), Business Ethics: A Stakeholder and Issues Management Approach, Orlando: Harcourt Brace College Publishers, p. 7.

 

 

Case Study

The Enron Fiasco: Does End Justify the Means?

(This case is based on reports in the print and electronic media. The case is meant for academic purpose only. The writer has no intention to sully the reputations of corporates or executives involved.)

Enron Presented a Contrasting Scenario

Between 1996 and 2001, Enron was considered the darling of American industry and of investors. By December 2000, the company reported $15 billion in assets, $100 billion in revenues and 25,000 employees worldwide. Enron was one of America’s fastest growing companies. Its double-digit revenue growth in the late 1990s became triple-digit growth with the launching of EnronOnline in late 1999. The energy major’s revenue growth was accompanied by profit growth. In 2000, for instance, Enron shares’ returned around 90 per cent, when most technology stocks lost value. Enron was widely acclaimed as a model of an “old economy” company transforming itself as a powerhouse of the technological, fast-tracked “new-economy” company.

All these achievements catapulted Enron to the status of a true market darling. The company was considered a role model for others to emulate, and McKinsey, the world-renowned consulting firm had been citing Enron frequently as an example of how innovative companies could outperform their more traditional rivals. Enron won Fortune magazine’s “America’s Most Innovative Company” award among the magazine’s list of Most Admired Companies in a row of 6 years between 1996 and 2001. The energy giant became the world’s largest marketer of natural gas and the first to introduce online trading. Fortune also rated Enron 24^th on its list of “Best Companies to Work For”, 29^th on “America’ s Fastest Growing Companies”, 2nd on “Reputation of Employee Talent” and 1st even ahead of General Electric—on “Reputation of Quality Management.”

Come December 2001, heavens have fallen on the investors of Enron. Enron, till then perceived as one of the world’s largest electricity and natural gas traders, filed for Chapter 11 bankruptcy protection. Only in September 26 that year the Company’s Chairman and CEO, Kenneth Lay assured loyal employees of Enron: “The third quarter is looking great” and persuaded them to buy the company’ s stocks. Just 3 weeks after this false assurance with a view to persuading them to buy stocks that he and his co-executives would sell before announcing the results on October 16, Enron reported a $618 million third-quarter loss and disclosed a $1.2 billion reduction in shareholders’ equity. When Enron collapsed, most of its employees were devastated as they lost their retirement and other savings tied up in Enron shares. In addition to their losing their jobs, they also faced financial ruin. By contrast, Lay made $205 million in stock-option profits in the previous 4 years.

The exasperating swiftness with which things happened stunned the market. Billions of dollars worth of shares and bonds were literally wiped out of one of the New Economy’ s most admired companies that has brought about one of the largest bankruptcies in the US history. What brought about Enron’s collapse? “Multiple theories abounded, and they all had one core idea in common: the roots of the collapse spread both deep and wide through the company’ s history” (Bert Spector).

Enron’s History

Enron came into being in July 1985 as a result of the merger of Houston Natural Gas with InterNorth, a natural gas company based in Omaha, Nebraska. With energy having been deregulated in the late 1970s in the United States, there was ample scope for bigger entities to consolidate new natural gas discoveries to enjoy economies of scale and to benefit from free market prices. Gas was conveyed through pipelines and was traded in centres as per the demand that existed. The above-said merger integrated several pipeline systems owned by these companies to create an interstate natural gas pipeline system. The merged entity owned the largest natural gas pipeline system in the US with around 37,000 miles stretching from the border of Canada to Mexico and from the Arizona-California border to Florida, apart from considerable oil and gas exploration and production interests. Apart from natural gas, Enron also traded electricity since 1994. The company appointed a laissez-faire oriented energy economist who became the Under Secretary of the US Interior Department, Kenneth Lay, as the Chairman and CEO in 1986. Lay had been working as the CEO of Houstan Natural Gas, after his stint in Washington, and was mainly instrumental in bringing about the merger.

Having considerable degree of natural gas pipeline system in the country, Enron aimed to “become the premier natural gas pipeline in North America.” Between 1985 and 1990, the company purchased gas from producers and sold it to local distributors while shipping it through the company’s pipeline. However, though this gas distribution business brought in considerable revenue to the company, it was only less than $5 billion in 1985, which was far less compared to what Enron made in 2000, at $100 billion. The growth in 1980s in the natural gas business was stymied as it was under regulation “that, affected the rates, accounts, records, the addition of facilities, the abandonment of services and facilities, the extension of services in some cases, in addition to other matters” (Karen Bong), which occured in any industry that was being regulated by public authorities.

Energy Deregulation Fuels Enron’s Growth

As a result of constant efforts of businessmen in the energy sector and strong advocacy of laissez-faire economists to open up the sector to competition, the natural gas industry that had been a “regulated monopoly” since 1900s underwent deregulation in the 1990s, that allowed the market to determine energy prices. It was believed that in a competitive market environment, competition would force companies in the energy sector to operate more efficiently in the long run than the so-called regulated monopolies of the past. This, it was argued, would result in lowering the end price of energy to the ultimate consumers. Deregulation further developed in the 1990s under the watchful eye of the Federal Energy Regulatory Commission (FERC) set up in 1977 as part of President Jimmy Carter’s response to the energy crisis of 1970s. The FERC, through one of its orders—Order 636—enacted in 1996, ensured the creation of a reseller market for transportation and storage capacity, enabling the marketing of unused or underutilised pipeline capacity. Following the FERC’s Order 636, pipeline companies started efforts at consolidation to meet the intense competition and ensure economies of scale. In 2001, there were 14 corporations that included Enron, which accounted for more than 85 per cent of interstate natural gas pipeline capacity in the USA.

Along with natural gas supply deregulation, electricity deregulation also went apace during the 1990s. “The electricity and natural gas industries began to converge as companies with strong ties to the electric power industry acquired natural gas pipelines as natural gas explorers and producers divested themselves of pipeline assets. Natural gas was increasingly used to fuel electricity generation” (Karen Bong). Enron who was into the business of natural gas and electricity became a wholesale supplier of these two energy products along with exploration and production, transportation and distribution, retail energy services, etc. While the growth in all these services was moderate, Enron’s revenues from its Wholesale Energy Operations and Services registered a growth of more than 1,200 per cent. The company registered a revenue growth of more than $87 billion between 1995 and 2000 in this sector of its business.

Establishment of GasBank

In the second half of the 1980s, there arose a period of price instability in gas prices due to the operation of market forces. Under a deregulated regime, producers and distributors of natural gas required some means of managing the risk arising from serious market fluctuations in prices. To take advantage of the new environment and to cash on the opportunities that were thrown open, Kenneth Lay hired in 1989 Jeffrey Skilling, an MBA from Harvard, who was then the partner in charge of energy practice with the international consultant, McKinsey in Houston, to be the head of Finance at Enron. Skilling was responsible for the establishment of GasBank, a mechanism for providing funds to small producers of gas with a view to enabling them “to invest more in exploration and development and at the same time, provide Enron with reliable sources of natural gas to feed its pipeline system”. Through GasBank, Enron created a market for natural gas commodities that established future prices on long-term supply contracts through the trading of these forward commitments. Through GasBank, Enron became a wholesale trader and marketer of natural gas and electricity both in the US and the United Kingdom.

Enron Becomes a Global Player

In the meanwhile, Enron, with a view to becoming a global player, spread its wings far and wide, under the dynamic leadership of Rebecca Mark, who was placed in charge of international power and pipeline development on her joining Enron. Enron signed the much-controversial contract for the $3 billion Dabhol power project in Maharashtra in 1992. Enron also purchased power plants in Brazil and Bolivia. It also invested substantially in a 4000 mile Argentina pipeline system that supplied two-third of the that country’s gas. Rebecca Mark moved on a global expansion spree with a missionary zeal and built more and more such hard assets. Enron wanted to make its presence felt in Europe, South America and Russia. Azurix, Enron’s subsidiary, which worked on its water-related assets and activities, bought the United Kingdom’s Wessex Water for $1.9 billion to develop and operate water and wastewater assets including distribution systems, treatment facilities and related infrastructures. Azurix pursued such projects in Europe, Asia and Latin America. By 1995, Rebecca Mark had constructed or acquired five plants in the United States and was on her way to buying or building 15 more in Europe, Asia (India and China), South America and the Middle East. It may not be out of context here to mention an incident. Kenneth Lay had arranged to hang a banner in Enron’s Corpoate lobby with the legend: “The world’s leading energy company.” Skilling got it replaced with a new banner: “The world’s leading company.” Such was the euphoria Enron’s executives had with regard to the company’s future.

Enron’s Unconventional Methods of Adding New Businesses

Just as Enron spread its wings overseas, the company also diversified its businesses into areas other than its core competencies. Executives were encouraged by Lay and Skilling to be innovative entrepreneurs. To make them more committed and involved, Enron offered “phantom equity” to the teams that organised start-up businesses. Once the business began to be profitable, the phantom equity could be swapped for real Enron shares. Once the businesses were firmly established, these were made independent, selecting their own infrastructure, and often, pulling out employees from Enron’s other units.

Enron Online Story

It is in this manner that GasBank and online trading of energy products were innovated by company executives. One of Enron’s employees, for instance, drove an initiative to set up EnronOnline, an entirely new concept that was put to commercial use successfully. Louise Kitchen, based on her previous experience with Internet trading, began to work on an ad hoc basis, putting together an informal team of commercial, legal and technical personnel drawn from various Enron units. When the team grew to 250 persons, John Sheriff, Louise’s boss approached Skilling in November 1999 for sanction to make it a separate business unit. Once skilling approved it, rather hesitantly, EnronOnline was ready to do business in less than a year. Company executives exulted saying that online trading was revolutionary for the company, not only because of its new technology, but more because of the impact it had on its traders. “Since EnronOnline has reduced our transaction time to less than a second, our guys have to manage their businesses by the second—not by the day as in the past”. (Economist quoting McCornel. Economist. com, June 28, 2001). Such unconventional methods of promoting entrepreneurial innovations had contributed in no small measure to the initial success of Enron in completely new areas of business.

Broadband Story

Enron’s venture into broadband was not a planned affair and developed in the pattern of its other business units. In 1997, Enron had acquired Portland General Electric, an Oregon electricity generator and distributor that owned 1500 miles of fibre-optic cable along its transmission rights of way. Enron, through its new subsidiary, Enron Broadband Services (EBS), making use of its own substantial rights of way, started to build its network, with a view to selling capacity to heavy data users, such as Internet providers and telecom companies on long-term contracts, which could then be “marked to market” and to trade bandwidth in a manner similar to gas or electricity adding 4000 miles in 1998 and a further 7000 the following year. The business was developed at a breakneck speed without even a market feasibility study and Enron started competing with established and product-specific companies such as WorldCom and Global Crossing for customers in a market, which had huge over-capacity. Even more bothersome was the fact that technological improvements were exponentially increasing the amount of data that could be carried by existing cables. With considerably increased overheads, EBS lost $60 million on revenues of $415 million in 2000. The anticipated volumes of traffic did not materialise, which caused great problems, as the only way to generate profits from cable is to get data flowing through it. With high degree of existing capacity and intense competition from more established players it proved impossible to attract enough subscribers to make it pay. But, this did not preclude Enron from booking a “mark-to-market” profit on EBS business based on its predictions of the project’s future cash flows.

The novel way Enron created new businesses has been succinctly explained by Brian Cruver, an ex-employee of Enron, in his book Anatomy of Greed: The Unshredded Truth from an Enron Insider. “Enron’s business was essentially creating new commodity markets. Take their weather derivative division as an example—some businesses are particularly vulnerable to the weather, such as tourism and snow plowing. A bumper year for snow might make the snow plow business rich and can spell doom for the local tourist businesses if it keeps customers away. Enron would sell a kind of “weather insurance” to businesses, for which they pay their premium and then, if the weather turned unfavourable, their policy would compensate the loss. Enron dominated the new markets it created—essentially selling a weather policy to both the snowplow and the tourist business—thus ensuring it would achieve some profit no matter what the weather conditions.”

Problems of Enron’s Unconventional Business Model

Enron’s unconventional business model—the way a business was conceived and funded, the haphazard manner in which it was being operated, the lack of proper market feasibility studies, the unrealistic mode of pricing and making provision for adding to Enron’s profits from the so-called new business when there was no such profits—brought in too many administrative and financial problems for a public limited company such as Enron.

(a) nability to follow a viable price strategy: The problems with Enron’s business models were many. Cruver has pointed out a few such problems in his book cited above. One such problem was that Enron had no idea how to price business items that did not yet exist, or how to price items in a rapidly-changing regulatory environment such as California’s energy market in 2000. Thus, their growth was not built on successes from the past but by booking the largest deals it could. This meant that they became the darlings of Wall Street after booking enormous deals, such as a 15 year deal to supply the San Francisco Giant’s stadium with power, despite that, after 2 years, it became obvious their price was well below the cost incurred by Enron. These unprofitable ventures were subsequently spun-off into shell companies to hide the loss. The profit for the entire 15 year deal had already been booked on their balance sheet.

(b) verstated profits: The other problem with their business model was that even when they did make a profit, it was significantly overstated. In the example of the snow plows and tourists, it was obvious that on any given winter, Enron was liable for paying one of those businesses. But when the deals were closed with each individual business, the estimated profit for the entire transaction was booked. The booked profit had an inherent and in-built liability.

(c) Circumventing anti-trust laws: The illogical nature of its business model showed another problem with Enron—it needed to both be able to commoditise new markets and be the biggest player. That meant using political influence to control the flow of potential competitors and circumvent antitrust laws when necessary. Though this was where Enron truly excelled, it collapsed later because of the unsustainability of such market manipulations.

(d) Lack of risk management: Compounding all these problems was Enron’s lack of genuine risk management. Cruver explains in shocking detail how the risk management group was dramatically under-staffed and actively subverted by management and Arthur Andersen. The now defunct accounting firm used its name to help pressure Enron’s internal controls to quickly approve new deals.

Cruver’s book amply illustrated that complex business models, even once flawed to the core, can survive for a long time if enough people are duped into it. In addition, once duped, stakeholders tend to resist all evidence to the contrary. Literally, Enron’s business strategy relied on brainwashing its employees, investors and regulators. The inexorable economic laws of demand and supply were made inoperable for this behemoth. In the aptly put words of Santiago Zorzopulos: “Enron, which had its Core Values enshrined all over the company, including the parking garage, also illustrates the spectacular failure of American business ethics, and its advocating community. The insistence on epiphenomenal features of good conduct, such as codes and nice little training programs, disguise the incredible weakness of it not having formulated a genuine performance criteria.”

The Gathering Storm

In February 2001, Lay appointed Jeff Skilling as the CEO, while he remained Chairman of Enron. Meanwhile, Enron’s investment in the broadband business, and its not-so-successful overseas operations severely strained Enron’s liquidity position. It was widely held both within Enron and without that Rebecca Mark has overstretched Enron’s capability leading to the company’s financial difficulties.

Enron financed its growth partly with debt which accounted for more than $13 billion in 2001. But the company, with a view to protecting its credit rating, had to limit its debt and went for additional financing of its ever-climbing requirement for funds through Special Purpose Entities (SPEs).¹ It was reported that Enron had more than 3000 of them in which organisations such as Citigroup, Merril Lynch, JP Morgan Chase, Credit Suisse, First Boston, the MacArthur Foundation were some of the well-known investors. Enron sold ingeniously energy contracts and assets to some of these unsuspecting SPEs, sometimes at prices far above fair market value. “These transactions enabled Enron to move the sold assets off its balance sheet and to show income from the sales on its income statement. While the money Enron received for the sale of its assets obtained by SPEs’ borrowing against the transferred assets, the money from these loans was counted as debt on the SPEs’ books, but was recorded as income on Enron’s books” (Karen Bong).

In the creation of these SPEs, Andrew Fastow, Enron’s Chief Financial Officer, played a key role. He created and was running in the year 2000 four partnerships known as the Raptors, which were approved by Enron’s Board mainly with a view to hedging Enron’s market risk in its portfolio of volatile technology stocks. To finance these SPEs, Enron gave shares in exchange for notes receivable from them, which amounted to Enron selling its shares to itself and being compensated for them by issuing an IOU to itself! This dubious exercise in case of Raptors alone resulted in the shareholders’ equity on Enron’s balance sheet being inflated by $1 billion and Enron’s notes receivable being inflated by $1 billion. The net result was this: Enron’s SPEs helped the company to keep debt off its balance sheet, thus protecting Enron’s credit rating. The SPEs also kept losses off Enron’s income statement, thus helping it to show higher profit than it really earned.

Role of Arthur Andersen in the Enron Collapse

For a reputed and well-established audit firm, the role played by Arthur Andersen was not only passive but also shameful for which it paid a heavy price of getting totally disbanded. Arthur Andersen was both the internal and external auditor of Enron. It also provided several non-audit services to the energy giant. Enron was one of the most important clients to the audit firm and had been its clients since its inception. Enron paid Andersen rather lavishly for the services rendered to it. In 2000, it was reported that Andersen received payments from Enron to the tune of $ 51 billion, $25 million for auditing and $26 million for consulting services. Naturally, for such a hefty compensation paid to the audit firm, Enron extracted its pound of flesh. It made the auditors accomplices in the crime of manipulating and doctoring its accounts. Andersen’s audit partners like David Duncan and his team were more than willing to compromise the firm’s reputation for honesty, integrity and steadfastness in its unexceptional execution of the audit work, which its founder, Arthur Andersen and his successors followed for a major part of 79 years of its existence. There were many reasons for this downfall of Andersen for compromising its values with clients like Enron. Excessive greed of partners who were a legion in the firm, deteriorating standing of auditors vis-à-vis the firm’s consulting professionals who earned more for less work which made them follow aggressive accounting in tune with what was dictated by difficult clients like Enron, unprofessionally close relationships that existed between auditors and their clients, inappropriate accounting standards that were not updated to meet the challenges of mega corporations which took liberty with accounts to achieve their ends and the over all deteriorating standards of moral behaviour of those who were at the helm of affairs in corporates.

Once nemesis caught up with both Enron and Andersen when the third quarter of 2001 results were announced, and the audit firm’s playing second fiddle to the likes of Jeff Skilling and John Fastow were being probed by Wall Street Journal and analysts, David Duncan and his team started shredding massively Enron-related documents, anticipating an SECs probe. It is part of history that Arthur Andersen was convicted by lower and Appellate Courts for obstruction of justice. Though the US Supreme Court overturned the conviction in May 2005 on appeal by Andersen, it was only a posthumous relief for the firm as all of its clients had deserted it, all of its offices were closed and most of its staff had found employment elsewhere. Andersen paid a huge price for its inability to protect the lofty ideals of its founder and for playing second fiddle to unreliable and difficult clients like Enron.

The Positive Side of Enron

Though in hindsight most observers blame Enron for its failure to observe ethical practices leading to its collapse, Enron’s case if analysed objectively one would realise that there were many things that Enron did led to condemnation, there were many things they did, which would place them as innovators and trend-setters in a sort of free in market energy that was just evolving.

(a) Enron’s business strategy was legitimate: Though at hindsight one is more than tempted to paint Enron with a black brush, there were many positive sides to Enron which cannot be lost sight off. Enron’s failure arose not because of a poor business model but due to several fortuitous circumstances. The collapse of Enron Corporation has been often explained in terms of accounting fraud and greed. Not everything that Enron did, however, was wrong or fraudulent. Fraud contributed to the timing of Enron’s failure but was not the root cause of that failure. In analysing Enron, it is critically important to distinguish what Enron did wrong from what it did right. In the words of Christopher Culp and Steve H. Hanker: “Enron’s basic business strategy, known as “asset lite,” was legitimate and quite beneficial for the marketplace and consumers. By combining a small investment in a capital-intensive industry, such as energy with a derivatives-trading operation and a market-making overlay for that market, Enron was able to transform itself from a small, regional energy market operator into one of America’s largest companies.”

Enron contributed to the creation of the natural gas derivatives market, and, for a while, it was the sole market maker, entering into price risk management contracts with all other market participants. Its physical market presence as a wholesale merchant of natural gas and electricity, placed Enron in an ideal position to discover and convey to the market relevant knowledge of energy markets and to make those markets more efficient. When Enron applied that same strategy in other markets in which it had no comparative informational advantage or deviated from the asset-lite strategy, it had to incur significant costs to create the physical market presence required to rectify its relative lack of market information. The absence of a financial market overlay in several of those markets further prevented Enron from recovering its costs. It was at that point that Enron abused accounting and disclosure policies to hide debt and cover up the fact that its business model did not work in those other areas. The two learned professors further commented: “For its innovations, Enron should be commended; for their alleged illegal activities, Enron’s managers should be prosecuted to the full extent of the law. But under no circumstance should Enron’s failure be used as an excuse to enact policies and regulations aimed at eliminating risk taking and economic failure, because unless a firm takes the risk of failure, it will never earn the premium of success. As was demonstrated in the case of Enron, markets—not politicians—are the best judges of success and failure.”

(b) Employee development: Enron’s top executives believed strongly in building human assets. Skilling, for instance, believed that intelligent, flexible, performance-oriented employees would provide Enron with a competitive advantage, especially when compared to asset-heavy traditional companies. To retain talents Enron compensated executives generously. Lay and Skilling realised that if they had to compete with investing and consulting firms for talent, they would have to offer competitive compensation packages. High salaries were matched with lavish perks. The company had devised what they termed as “Performance Unit Plan” under which executives were paid one-time bonus if a series of stock price targets were met. Top executives received huge payments based on a calculated combination of dividends and enhancement in stock prices. Andrew Fastow, Enron’s CFO received bonus cheques amounting to more than $3.5 million between January and 7 February 2001. Likewise, CEO Jeff Skilling received $7.5 million, while Chairman Lay received $10.6 million. It is not as if excessive payments were the privileges of only top executives. It was reported that a 27 year old energy trader earned an astronomical $8 million bonus on reported profits of $7.50 million in natural gas contracts.

(c) Culture of pride and a deep sense of belonging: The corporate culture at Enron instilled in employees a tremendous sense of confidence and pride in themselves and a deep sense of involvement in the organisation in which they were a part of. They sincerely believed that if you were an Enron employee “You thought you were better. You were smarter than everyone else.” This confidence, though often was considered as arrogance and brashness by outsiders, propelled employees to be totally involved and committed to the organisation and helped them scale peaks of achievement hitherto unattained by their counterparts elsewhere.

The Ultimate Collapse

The events leading to the ultimate collapse of Enron, the mammoth energy conveyor of the world, occurred in quick succession. Jeffrey Skilling, the then CEO, unexpectedly put in his papers on 14 August 2001. Expectedly, this triggered a precipitous fall in stock prices. As stock prices plunged, Enron faced huge losses. Sherron Watkins, Enron Vice President wrote a memo to Lay, expressing her concern that Enron would “implode in a wave of accounting scandals.” Lay reassured her and other employees that all was well with Enron. At the same time he contacted David Duncan, the Andersen partner in Enron, who concluded that there was nothing to worry about, after a month-long investigation. On October 16, Enron released its third quarter results showing losses amounting to more than $2 billion. Lay removed CFO, Fastow to quell the upheaval in the market. But the announcement of SEC on October 22 of an impending investigation was the last straw. Enron went through a series of hiccups and losses after mounting losses. With more than $37 billion losses, stock price plummeting to less than a dollar, the access to capital markets totally closed, there was no light seen at the end of the tunnel. Enron filed for Chapter 11 bankruptcy on 2 December 2001.

Enron’s Growth Rooted in Unethical Practices

Some analysts have underlined the fact that there were several positive aspects in the manner Enron conceived and conducted its business. But several other analysts point out that Enron executives indulged in several activities which could not be justified, both legally and ethically. The company’s malpractices easily outnumbered its morally and legally acceptable practices.

(a) Enron’ haughty culture: It was said that Enron executives and employees regarded themselves as an elite. Enron’s culture was to have tremendous pride that led people to believe that “They could handle increasingly exotic risk without danger.” There was an overwhelming pressure to do more and better. The company’s highly paid army of MBA’s specialised in Finance and encouraged by the CFO, Jeffrey Skilling, sought highly innovative but dubious ways of translating any business deal into a mathematical formula that could then be traded or sold on to Special Purpose Entities (SPE) set up for that purpose. By December 2001, Enron had more than 3000 subsidiaries and unco-nsolidated associates including 400 registered in the Cayman Islands.

(b) Heavy donations to political parties to curry business favours: Enron and its Chairman, Kenneth Lay, had been generous contributors to political campaigns of both Republicans and Democrats, giving them a reported $2 million. To achieve his goal of the energy markets deregulation from being public utilities so that Enron could cash in on the unregulated market, Lay became heavily involved in state-level political campaigns and spent about $2 million of Enron’s money on 700 candidates in 28 states. This did have the desired effect. By 2000, 24 states moved towards energy deregulation in which Califoornia took the lead. Enron officials sought and obtained the support of former President Bill Clinton and Vice-President Al Gore for the Kyoto treaty, because it would generate immense profits for the company’s trendy energy-saving products, though it was subsequently vetoed by President Bush. The company had also close ties with the Bush administration. It was Enron that was at the centre of the energy deregulation scheme that accelerated the electricity crisis in California costing consumers and the State billions of dollars in excess payments. The company and its top executives used every clout they could gather to bring about energy deregulation that brought them enormous profits and enabled them to become the world’s largest supplier of energy. Brian Cruver, an Enron employee, has documented how Enron received more than $1 billion in subsidised loans from the US government. Incidentally, Enron, which virtually became an energy company, was filed with the Securities and Exchange Commission as an investment bank, when it commenced its operations.

(c) Influencing public policies for their own benefit: Enron had a corporate culture that encouraged its staff to influence public policy-makers on the deregulation or privatisation of the US (and of the world) energy sector. For instance, the State of California went into energy deregulation in a by-partisan manner that substituted “public monopolies” for “private monopolies.” In 1997, before the energy market in California was deregulated, the California Public Utilities Commission unanimously ruled to move ahead to throw open the State’s $20 billion electricity market to competition, which in their opinion, would make California the first State to join a world-wide movement to deregulate utilities. Experts and politicians alike joined the bandwagon, which led to deregulation along the laissez-faire model established in the United Kingdom. “Competition should bring down prices and foster a host of new services along with dozens of potential new suppliers” was a resounding chorus of approval. In this whole scheme of things, Enron played a decisive role to influence public policies. When the power utility was deregulated, a representative of Enron exclaimed in a fortuitous manner “We think the Commission took a bold step. This hasn’t been done anywhere else in the country.”

However, deregulation in the absence of adequate public infrastructure and proper policies in place brought about an energy crisis in 2000. California’s flawed deregulation scheme created an energy nightmare, sent electricity prices soaring and led to rolling blackouts. The price for electricity went from an $30 per megawatt to over $1,000 in some cases, averaging about $300 per megawatt, until the governor imposed consumer price caps. The results were that the energy suppliers and marketers sucked $40 billion in excess profit out of California over a two-year period and also forced the state into power-buying business. In 2000 and the first half of 2001, Enron among other market force suppliers, reaped enormous profits from California’s deregulated energy market. Records show that the prices paid for power over this period of time were hundreds of percent higher than normal or historical prices during a similar period.

With the political clout they acquired through hefty political contributions, Enron tried to influence public policies, either covertly or overtly, especially in the areas of business they were operating. On 17 April 2001, for example, Kenneth Lay made eight recommendations regarding federal energy policy to Vice President Cheney who headed The Energy Task Force. One of his recommendations hinged on Enron’s continued opposition to price caps. When the White House released the final report of its energy task force, seven out of Enron’s eight recommendations had been fully adopted by the report. It was also reported later that Enron’s staff and senior officers, as well as members of its board had tried to influence the White House during the Clinton administration too and systematically pursued its self interest in states such as California that were then considering deregulation.

(d) Hypocricy pervaded the corridors of Enron: There was a lot of hypocricy in Enron and wide differences in the manner in which they promulgated policies and the way in which they were implemented. There was dichotomy between percepts and practices in Enron. Kenneth Lay was insistent that all staffers should follow faithfully four core values: Communication, respect, integrity and excellence. Banners were put-up in the Company’s Corporate lobby proclaiming those values. “I was always in the forefront of trying to make sure that our people did in fact live and honour those values. Integrity and character are incredibly important to me” asserted Lay. But, in actual practice, Enron observed these values only in breach. They hardly communicated the truth of the state of affairs in the company to their shareholders, there was no respect for people who valued truth and it was apparent that integrity was a very rare commodity—from the manner they used Arthur Andersen to commit accounting frauds. Lay himself whom his employees adored as a father figure and placed their complete trust in him—betrayed them when he painted a rosy picture about the company’s performance before its collapse and was instrumental for many of their financial ruin.

(e) Dubious and aggressive accounting practices: Enron had both instructed and led its accounting firm Arthur Andersen into dubious financial transactions which ultimately caused the collapse of Enron as also Anderson as an independent firm, especially in its core business of accounting. Arthur Andersen, which had more than 100 executives and auditors devoted to Enron were misled by David Duncan, the lead audit partner who ordered the rapid destruction of Enron documents after learning that the SEC was looking into Enron’s iffy numbers. The unprofessional relationship that was nurtured between Enron and the likes of David Duncan was such that any auditor who found fault or even suggested change in the manner Enron accounts were written was sacked. Though there were serious doubts among Andersen employees about the accounting practices of some of Enron’s off-balance sheet activities, they were overruled by Duncan who seemed to be more loyal to Enron than their own employees. In fact, Andersen got an auditor Carl Bass removed from the engagement after Enron complained that he was being deliberately obstructive.

(f) Enron’s uncharitable and unethical employee policies: Enron had adopted a policy of “Hire and Fire” in which loyal employees who could not perform as per the company’s dubious yardsticks were fired while those indulging in unethical practices were able to make a fast buck. For instance, CEO Skilling had introduced a rigorous employee performance assessment process under which the bottom 10 per cent in performance was dismissed. This created a heavy pressure on executives to meet targets. Remuneration was linked to the deals done and profits booked in the previous quarter. This pressure was particularly acute at the quarter end and gave rise to the expression “Friday Night Specials.” These were deals put together at the last moment, which were often poorly conceived and inadequately documented, despite the efforts of 200 or so in-house lawyers that Enron employed. The emphasis was on doing deals and not necessarily bothered about how they were to be implemented or managed in the future. Even internally, its was recognised that project management was not a core competence in Enron.

(g) Poor project implementation: In a short period, Enron showed to the industrial world, too many projects all at one time. However, many of them were poorly conceived and theoretical. Its failure revealed that many such projects could not fructify or could not be funded by Enron’s coffers which were being drained due to many such ill-conceived projects.

The Fall-out of the Enron Crisis

(a) A pension double standard: Enron’s retirement plan was heavily invested in its own stock. Executives cashed out over a billion dollars, while ordinary employees were locked in. Even when the company’s performance was extremely poor causing huge losses, Kenneth Lay and other executives painted a rosy picture to employees and prompted them to invest in Enrons stocks. As a result, almost all the company’s employees were ruined financially.

(b) Bogus accounting: Since the great depression, the one form of regulation that even Wall Street had supported was the regulation of stock trades and corporate accounting. Enron’s entire game was to make its business plan so complex that neither investors nor regulators nor even its own auditors could penetrate it. While its core energy business made money (at the expense of consumers), it had speculative off-the-books subsidiaries. These borrowed heavily to make risky investments and eventually took the whole company down.

(c) The business press: Enron’s breathless cheerleaders included not only its own insiders and stock touts but also a business press that pronounced Enron the epitome of the new economy. The financial press of America which is credited to have a number of investigative journalists were extolling the fantastic success of Enron and had no clue as to what was happening inside the company until one day the Wall Street Journal brought to the open the large number of irregularities at Enron.

(d) Deregulation hiccups: Enron’s collapse impeaches the conceit that a market economy can be efficiently self-policing. Enron fleeced consumers by manipulating prices of electricity and gas; it fleeced investors and its own employees. Enron signalled a whole new era of re-regulation-of everything from electricity to pensions to accounting standards.

(e) The spin-off effect on the capital market: Another outcome from the Enron debacle is most significant. Enron had forced the US financial markets into chaos and the need for drastic reforms that most certainly would not have occurred had the company continued on. The reforms eventually have become international; focusses on standard accounting practices and has impacted the audit functions of all accounting firms.

Nemesis Catches Up with the Culprits

The ongoing investigations of SEC, Federal authorities and other administrators of the government followed Enrons various frauds, malpractices and violations of law. By 2004, many of them ended up in prison.

On 13 January 2004, former Enron chief financial officer Andrew Fastow and his wife Lea Fastow pleaded guilty to charges related to accounting fraud. On 23 January 2004, former Enron chief accountant surrendered to authorities to face federal criminal charges that he served as an “architect” of a wide-ranging scheme to manipulate the company’s earnings and improperly boost its stock price. On 20 February 2004, Jeffrey K. Skilling, Enron’s former CEO, surrendered to authorities to face nearly three dozen fraud, conspiracy and insider trading charges related to the company’s collapse. On 6 May 2004, Lea Fastow was sentenced to 1 year in prison. On 8 July 2004, Kenneth L. Lay surrendered to federal agents, pleading not guilty to criminal charges. The government framed 11 criminal charges against Lay of conspiracy, fraud and making false statements. On 15 July 2004, a Federal judge approved Enron bankruptcy plan, under which it would sell most of its prized assets to repay creditors about 20 cents on the dollar in cash and stock. On 22 July 2004, Federal regulators ordered Enron to repay $32.5 million in energy-trading profits made before and during the West Coast electricity crisis in 2004. On 30 July 2004, Kenneth D. Rice, former chief executive of Enron Internet broadband unit, pleaded guilty to securities fraud and agreed to cooperate with prosecutors. On 21 September 2004, the first criminal trial involving former Enron executives opened with prosecutors charging that the defendants conspired with Wall Street bankers to carry out a sham transaction. A jury convicted a former Enron executive and four ex-Merrill Lynch officials in the first criminal prosecution arising from the accounting fraud that led to the energy a trader’s collapse. The 6-week trial in Houston Federal court stemmed from Enron’s 1999 sale to Merrill of a $7 million stake in three energy-generating barges. Prosecutors said that the deal was a disguised loan because Enron promised to pay Merrill the money back and that the energy trader committed fraud when it booked the loan as a $12 million profit so it could meet earnings estimates. The trial was “a milestone in bringing both an Enron executive and Merrill Lynch executives who aided and abetted the fraud at Enron to justice,” Assistant US Attorney General Christopher A. Wray said in a statement. Prosecutors said Merrill executives helped Enron “cook its books” when in December 1999 the investment bank paid $7 million for a stake in the three energy-generating barges moored off the Nigerian coast. Enron secretly promised to buy back Merrill’s investment, with interest, 6 months after the sale, making the deal a loan under accounting rules and Enron’s subsequent booking of a profit fraudulently. Enron used the profit to meet earnings estimates, while Merrill agreed to the deal to curry favour with Enron and gain investment-banking business. Five executives of Merrill were convicted of conspiracy, wire fraud and making false statements.

Impact of Enron’s Failure

The Enron collapse triggered a chain reaction. Enron left behind $15 billion of debts, its shares became worthless, and 25,000 workers around the world lost their jobs. Many banks were exposed to the firm, from lending money and trading with it. JP Morgan admitted to $900 million of exposure, and Citigroup to nearly $800 million. Former high-ranking Merrill Lynch bankers have been charged with fraud in connection with Enron transactions. Arthur Andersen, who failed to audit the Enron books correctly, collapsed. Enron’s collapse in conjunction with the failure of several hitherto popular and famous corporations severely shook investors’ confidence, while most people became cynical about accounts of corporates even when audited by big audit firms.

However, the Enron’s collapse and the Arthur Andersen fiasco resulted in some positive outcomes too. A number of corrective measures were initiated worldwide to correct corporate frauds. Many corporate governance and accounting reforms have been enacted in the US in the wake of the collapse, followed by such reforms worldwide. The Sarbanes-Oxley Act brought in stiff penalties for violations of US securities laws. CEOs and CFOs of companies required to restate their results due to “material non-compliance” will have to repay bonuses and any profits from share sales over the previous 12 months. Other new rules prohibit loans from public companies to their directors, Audit firms are prohibited to provide non-audit services to firms they audit. Chief executives of every public American company will have to certify in writing that their results comply fully with the rules and fairly present the group’s financial condition; failure to do so or false certification will invite huge fines and imprisonment.

1. How was Enron, considered once the darling of American industry, turned into a company that caused terrible damage to the investments by investors?
2. Trace Enron’s growth as a powerhouse of the technological, fast-tracked “new economy” company.
3. Explain Enron’s unconventional methods of adding new businesses to its portfolio. How did the company branch into areas that were not its core competency business?
4. What role did Arthur Andersen play in bringing about the ultimate collapse of Enron?
5. Would you agree with the view that Enron’s growth was rooted in unethical practices? Substantiate your answer.

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• Enron Scandal May Be Worldwide Fiasco, http://www.americanfreepress.net01_27_01_scandalperson_candal.ht
• Hamilton, Stewart (2003), “The Enron Collapse”, International Institute for Management Development, Switzerland.
• Laurel Brubaker Calkins, Bloomberg News, “Enron Fraud Trial Ends in 5 Convictions” (Washingtonpost. com).
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• Timeline of Enron’s Collapse (Washintonpost.com).