Chapter 5: The Abandonment of Business Codes of Ethics

Abstract

Avoidance of well established ethical business-codes currently continues as a prime societal problem. Examples of proper business codes of ethics, ones that are consistent with Kant’s (1996) categorical imperative, are reviewed, but these codes have a tendency to be ignored for reasons inherent to competitive firms. These inherent reasons are examined in the context of Arendt’s (Thinking and Moral Considerations, 1971; Responsibility and Judgment, 2003) theory of why ethical codes are abandoned. Svendsen’s Philosophy of Evil (2001) is shown to provide insights relevant for preserving these codes. In addition, the evidence from recent experimental psychology is shown to reinforce these devolution theories posed by Arendt and Svendsen.

Appendix: Enron as an Example

Enron presented one of the major accounting scandals of the early years of this century. Enron began as an energy company in 1985, but it largely grew to become an energy trading company, trading in futures and forward contracts.¹ By 2001, Enron was the world’s largest energy trading companies through holding 25 percent of all energy contracts. It claimed $40 billion in revenue in 1998, $60 billion in 2000, and $101 billion in 2000. Its stated goal was to grow revenue by 15 percent per year.

Enron’s ethical conflicts concerned five significant issues:

• 1. Its use of mark-to-market accounting practices, although perhaps conforming with FASB rules, were deceptive as to its real cash revenues.

• 2. It used numerous (about 3000 transactions) off-the-book special purpose entities (SPEs) such as limited partnerships and limited liability companies, that it ostensibly only partly owned, but in fact fully controlled, to remove liabilities off its balance sheet, although it still owed these obligations. There were almost 900 of these SPEs.

• 3. The SPEs were owned and controlled by officers of Enron, who personally benefitted from these subsidiaries although this involved conflicts of interest that violated Enron’s stated ethics code.

• 4. Enron sought to coerce its auditing company (Arthur Anderson and Co.) into not revealing its accounting manipulations.

• 5. When questions were raised about its accounting irregularities, and the conflicts of interests of executives with the SPEs, Enron sought to publicly humiliate its dissenters.

FASB Rule 125 allowed companies to sign contracts for future delivery of some good, and at a stated price, and to book this future income as current income (mark-to-market). If the price drops between the date of signing the contract and fulfillment date, the company can book this as a positive revenue even though it has yet to be actually received. According to mark-to-market, if the price increases, a loss should be booked. Enron merely entered positive revenues, and had its SPEs book its losing contracts. According to FASB 125, as long as the SPE owned at least 51 percent outside ownership, then Enron need not book this transaction on its own books. Most of these SPEs’ were registered as Cayman Island companies where the other owners were executives of Enron, either Chairman Kenneth Lay, or CEO Jeffrey Skillings or CFO Andrew Fastow. With limited liability in effect, these SPEs (881 in total by 2002) involved no personal losses for these executives.

This practice, since it was so large in effect, although within the letter of the FASB code, it clearly violated the spirit of accounting practice since the performance and health of Enron was hidden. This practice was deceptive to its core. This allowed Enron to book deceptive positive revenues so that performance objectives could be consistently met. Executive bonuses depended upon meeting these performance objectives of 15 percent growth per year in revenues.

Enron’s Code of Ethics addressed the issue of conflicts of interest in two sections. The first stated that, “An employee shall not conduct himself or herself in a manner which directly or indirectly would be detrimental to the best interests of the company or in a manner which would bring to the employee financial gain separately derived as a direct consequence of his or her employment with the company.” The code also continued to state, “….it follows that no full time officer or employee should: (c) Own an interest in or participate, directly or indirectly, in the profits of another entity which does business with or is a competitor of the company unless such ownership or participation has been previously disclosed in writing to the Chairman of the Board and Chief Executive Officer of Enron Corp., and such officer has determined that such interest or participation does not adversely affect the best interests of the Company.” The Board waived this policy for Andrew Fastow on three occasions.

In 1999, Arthur Anderson, Enron’s auditor, led by the Enron Account Executive David Duncan, initially questioned these SPE arrangements, calling them “form over substance transactions.” Pressure by Enron on its auditor, however, eliminated further questions about this practice.

Several analysts who questioned the accuracy of Enron’s reported accounting numbers were publicly attacked. For example, a reported for Fortune, Bethany McClean questioned Enron’s profits given its large off-balance-sheet transactions led to Ken Lay calling her editor to ask that she be removed from the story. During an analyst interview, Jeffrey Skillings called Ms. McClean an unrepeatable derogatory name. Also, when John Olson, and analyst for Merrill Lynch questioned advised his clients to avoid Enron due to their questionable earnings, he was fired. Enron was a client of Merrill Lynch. Internal employees were given the same treatment. When Sherron Watkins, was Vice President for Corporate Development questioned the off-the-books transactions, and consequential true debt load of Enron, Mr. Fastow accused her of wanting his job. She was fired. Other employees who questioned Enron executives were also fired and humiliated.

Enron’s stated policy was to eliminate underperforming employees. Of course, the executives decided the criteria for this performance. Approximately 20 percent were fired each year from 1998 through 2001. The culture of conformance was no doubt strengthened as a result.

In the end, Andrew Fastow stated in court, “Within the culture of corruption that Enron had, that valued financial reporting rather than economic value, I believed I was a hero.” Perhaps we can perceive Svendsen’s steps of devolution in the Enron story:

• 1. No doubt the off-balance-sheet transactions were minor at first, but they grew to be $25 billion out of the $38 billion in actual debt that Enron had in 2002. Violations of the spirit of accounting codes, and its own internal Code of Ethics were accepted by all including the Board, and escalated over 1999 through 2002.

• 2. Dissent was minor until the end when strong statements of regret were made. Dissenters were consistently humiliated until the end.

• 3. Leaders in this devolution saw themselves as heroic.