Case Study: Enron

Background
Once the seventh largest company in America, Enron was formed in 1985 when
InterNorth acquired Houston Natural Gas. The company branched into many
non-energy-related fields over the next several years, including such areas as
Internet bandwidth, risk management, and weather derivatives (a type of
weather insurance for seasonal businesses). Although their core business
remained in the transmission and distribution of power, their phenomenal
growth was occurring through their other interests. Fortune Magazine selected
Enron as "America's most innovative company" for six straight years from 1996
to 2001. Then came the investigations into their complex network of off-shore
partnerships and accounting practices.

How the Fraud Happened

The Enron fraud case is extremely complex. Some say Enron's demise is rooted
in the fact that in 1992, Jeff Skilling, then president of Enron's trading
operations, convinced federal regulators to permit Enron to use an accounting
method known as "mark to market." This was a technique that was previously
only used by brokerage and trading companies. With mark to market
accounting, the price or value of a security is recorded on a daily basis to
calculate profits and losses. Using this method allowed Enron to count
projected earnings from long-term energy contracts as current income. This
was money that might not be collected for many years. It is thought that this
technique was used to inflate revenue numbers by manipulating projections for
future revenue.

Use of this technique (as well as some of Enron's other questionable practices)
made it difficult to see how Enron was really making money. The numbers were
on the books so the stock prices remained high, but Enron wasn't paying high
taxes. Robert Hermann, the company's general tax counsel at the time, was
told by Skilling that their accounting method allowed Enron to make money
and grow without bringing in a lot of taxable cash.

Enron had been buying any new venture that looked promising as a new profit
center. Their acquisitions were growing exponentially. Enron had also been
forming off balance sheet entities (LJM, LJM2, and others) to move debt off of
the balance sheet and transfer risk for their other business ventures. These
SPEs were also established to keep Enron's credit rating high, which was very
important in their fields of business. Because the executives believed Enron's
long-term stock values would remain high, they looked for ways to use the
company's stock to hedge its investments in these other entities. They did this
through a complex arrangement of special purpose entities they called the
Raptors. The Raptors were established to cover their losses if the stocks in their
start-up businesses fell.

When the telecom industry suffered its first downturn, Enron suffered as well.
Business analysts began trying to unravel the source of Enron's money. The
Raptors would collapse if Enron stock fell below a certain point, because they
were ultimately backed only by Enron stock. Accounting rules required an
independent investor in order for a hedge to work, but Enron used one of their
SPEs.

The deals were so complex that no one could really determine what was legal
and what wasn't. Eventually, the house of cards began falling. When Enron's
stock began to decline, the Raptors began to decline as well. On August 14,
2001, Enron's CEO, Jeff Skilling, resigned due to "family issues." This shocked
both the industry and Enron employees. Enron chairman Ken Lay stepped in
as CEO.

Enron: Discovering Fraud

On August 15, Sherron Watkins, an Enron VP, wrote an anonymous letter to
Ken Lay that suggested Skilling had left because of accounting improprieties
and other illegal actions. She questioned Enron's accounting methods and
specifically cited the Raptor transactions.

Later that same month, Chung Wu, a UBS PaineWebber broker in Houston,
sent an e-mail to 73 investment clients saying Enron was in trouble and
advising them to consider selling their shares.
Sherron Watkins then met with Ken Lay in person, adding more details to her
charges. She noted that the SPEs had been controlled by Enron's CFO, Fastow,
and that he and other Enron employees had made their money and left only
Enron at risk for the support of the Raptors. (The Raptor deals were written
such that Enron was required to support them with its own stock.) When
Enron's stock fell below a certain point, the Raptors' losses would begin to
appear on Enron's financial statements. On October 16, Enron announced a
third quarter loss of $618 million. During 2001, Enron's stock fell from $86 to
30 cents. On October 22, the SEC began an investigation into Enron's
accounting procedures and partnerships. In November, Enron officials
admitted to overstating company earnings by $57 million since 1997. Enron, or
"the crooked E," filed for bankruptcy in December of 2001.

Where Are They Now?

Enron's CFO, Andrew Fastow, was behind the complex network of partnerships
and many other questionable practices. He was charged with 78 counts of
fraud, conspiracy, and money laundering. Fastow accepted a plea agreement in
January 2004. After pleading guilty to two counts of conspiracy, he was given a
10-year prison sentence and ordered to pay $23.8 million in exchange for
testifying against other Enron executives.

Jeff Skilling and Ken Lay were both indicted in 2004 for their roles in the fraud.
According to the Enron Web site, "Enron is in the midst of liquidating its
remaining operations and distributing its assets to its creditors. "

On May 25, 2006, a jury in a Houston, Texas federal court found both Skilling
and Lay guilty. Jeff Skilling was convicted of 19 counts of conspiracy, fraud,
insider trading and making false statements. Ken Lay was convicted of six
counts of conspiracy and fraud. In a separate trial, Lay was also found guilty
on four counts of bank fraud.

Kenneth Lay died of a heart attack on July 5, 2006, and a federal judge ruled
that his conviction was void because he died before he had a chance to appeal.
On October 23, 2006, Skilling was sentenced to 24 years in prison.

Case Study: WorldCom

WorldCom took the telecom industry by storm when it began a frenzy of
acquisitions in the 1990s. The low margins that the industry was accustomed
to weren't enough for Bernie Ebbers, CEO of WorldCom. From 1995 until 2000,
WorldCom purchased over sixty other telecom firms. In 1997 it bought MCI for
$37 billion. WorldCom moved into Internet and data communications, handling
50 percent of all United States Internet traffic and 50 percent of all e-mails
worldwide. By 2001, WorldCom owned one-third of all data cables in the United
States. In addition, they were the second-largest long distance carrier in 1998
and 2002.

How the Fraud Happened

So what happened? In 1999, revenue growth slowed and the stock price began
falling. WorldCom's expenses as a percentage of its total revenue increased
because the growth rate of its earnings dropped. This also meant WorldCom's
earnings might not meet Wall Street analysts' expectations. In an effort to
increase revenue, WorldCom reduced the amount of money it held in reserve (to
cover liabilities for the companies it had acquired) by $2.8 billion and moved
this money into the revenue line of its financial statements.
That wasn't enough to boost the earnings that Ebbers wanted. In 2000,
WorldCom began classifying operating expenses as long-term capital
investments. Hiding these expenses in this way gave them another $3.85
billion. These newly classified assets were expenses that WorldCom paid to
lease phone network lines from other companies to access their networks. They
also added a journal entry for $500 million in computer expenses, but
supporting documents for the expenses were never found.
These changes turned WorldCom's losses into profits to the tune of $1.38
billion in 2001. It also made WorldCom's assets appear more valuable.

How it Was Discovered

After tips were sent to the internal audit team and accounting irregularities
were spotted in MCI's books, the SEC requested that WorldCom provide more
information. The SEC was suspicious because while WorldCom was making so
much profit, AT&T (another telecom giant) was losing money. An internal audit
turned up the billions WorldCom had announced as capital expenditures as
well as the $500 million in undocumented computer expenses. There was also
another $2 billion in questionable entries. WorldCom's audit committee was
asked for documents supporting capital expenditures, but it could not produce
them. The controller admitted to the internal auditors that they weren't
following accounting standards. WorldCom then admitted to inflating its profits
by $3.8 billion over the previous five quarters. A little over a month after the
internal audit began, WorldCom filed for bankruptcy.

Where Are They Now?

When it emerged from bankruptcy in 2004, WorldCom was renamed MCI.
Former CEO Bernie Ebbers and former CFO Scott Sullivan were charged with
fraud and violating securities laws. Ebbers was found guilty on all counts in
March 2005 and sentenced to 25 years in prison, but is free on appeal.
Sullivan pleaded guilty and took the stand against Ebbers in exchange for a
more lenient sentence of five years.

Case Study: Tyco

Tyco Background
Tyco International has operations in over 100 countries and claims to be the
world's largest maker and servicer of electrical and electronic components; the
largest designer and maker of undersea telecommunications systems; the
larger maker of fire protection systems and electronic security services; the
largest maker of specialty valves; and a major player in the disposable medical
products, plastics, and adhesives markets. Since 1986, Tyco has claimed over
40 major acquisitions as well as many minor acquisitions.

How the Fraud Happened

According to the Tyco Fraud Information Center, an internal investigation
concluded that there were accounting errors, but that there was no systematic
fraud problem at Tyco. So, what did happen? Tyco's former CEO Dennis
Koslowski, former CFO Mark Swartz, and former General Counsel Mark
Belnick were accused of giving themselves interest-free or very low interest
loans (sometimes disguised as bonuses) that were never approved by the Tyco
board or repaid. Some of these "loans" were part of a "Key Employee Loan"
program the company offered. They were also accused of selling their company
stock without telling investors, which is a requirement under SEC rules.
Koslowski, Swartz, and Belnick stole $600 million dollars from Tyco
International through their unapproved bonuses, loans, and extravagant
"company" spending. Rumors of a $6,000 shower curtain, $2,000 trash can,
and a $2 million dollar birthday party for Koslowski's wife in Italy are just a few
examples of the misuse of company funds. As many as 40 Tyco executives took
loans that were later "forgiven" as part of Tyco's loan-forgiveness program,
although it was said that many did not know they were doing anything wrong.
Hush money was also paid to those the company feared would "rat out"
Kozlowski.

Essentially, they concealed their illegal actions by keeping them out of the
accounting books and away from the eyes of shareholders and board members.
How it Was Discovered
In 1999 the SEC began an investigation after an analyst reported questionable
accounting practices. This investigation took place from 1999 to 2000 and
centered on accounting practices for the company's many acquisitions,
including a practice known as "spring-loading." In "spring-loading," the preacquisition earnings of an acquired company are underreported, giving the
merged company the appearance of an earnings boost afterwards. The
investigation ended with the SEC deciding to take no action.
In January 2002, the accuracy of Tyco's bookkeeping and accounting again
came under question after a tip drew attention to a $20 million payment made
to Tyco director Frank Walsh, Jr. That payment was later explained as a finder's

fee for the Tyco acquisition of CIT. In June 2002, Kozlowski was being
investigated for tax evasion because he failed to pay sales tax on $13 million in
artwork that he had purchased in New York with company funds. At the same
time, Kozlowski resigned from Tyco "for personal reasons" and was replaced by
John Fort. By September of 2002, all three (Kozlowski, Swartz, and Belnick)
were gone and charges were filed against them for failure to disclose
information on their multimillion dollar loans to shareholders.
The SEC asked Kozlowski, Swartz, and Belnick to restore the funds that they
took from Tyco in the form of undisclosed loans and compensations.
Where Are They Now?
Kozlowski and Swartz were found guilty in 2005 of taking bonuses worth more
than $120 million without the approval of Tyco's directors, abusing an
employee loan program, and misrepresenting the company's financial condition
to investors to boost the stock price, while selling $575 million in stock. Both
are serving 8 1/3-to-25-year prison sentences. Belnick paid a $100,000 civil
penalty for his role. Since replacing its Board Members and several executives,
Tyco International has remained strong.
The difference in the Tyco case and some of the others is that it is more related
to greed than accounting fraud.

The case of Tycos corporate scandal of 2002 focuses on the problem of unethical
business practice and related issues. Tyco was a large organization that grew through
numerous acquisitions. Tycos case shows that the problem was the unethical business
practices of a number of its top ranking officers, especially CEO Kozlowski. Kozlowski
was involved in numerous financial transactions that were not included in the financial
reports of the company. Kozlowski was also involved in unethical transactions with other
Tyco officers and lower ranking employees to cover up for Kozlowskis illegal financial
transactions. Kozlowski even got outsiders involved in the problem when his second
wife received money diverted from the firm. Court proceedings proved that Kozlowski
stole millions of dollars from Tyco, and that his illegal financial transactions were
extensive. Kozlowski and other officers from Tyco were imprisoned. Tyco declined as
investors lost confidence in the company.

This article analyzes the major ethics issues in the Tyco corporate scandal of
2002, CEO Kozlowskis motivation to avoid sales taxes on art purchases, the
relevance of the concept of commingling assets, and the role of the board of
directors in monitoring adjustments in Tycos programs.

Major Ethics Issues in Tycos Case

Tycos case shows that ethics issues can occur in different parts of an organization.
Even outsiders or third parties could get involved in these ethics issues. The major
ethics issues in Tycos case were as follows:
1.
Unethical Leadership
2.
Unethical business practice of subordinates
3.
Unethical auditing practice on Tycos business
Tycos Unethical Leadership. The unethical business practice of leaders was
observed in Kozlowski. Kozlowski was the main actor in the financial troubles and legal
battles in this case. Kozlowski was the main recipient of the money stolen from Tyco. In
addition, he was the main influential person who persuaded other top-ranking Tyco
officers and lower ranking employees to get involved and to keep silent to cover up for
Kozlowskis illegal activities. This case shows that extensive involvement of Kozlowski
and other leaders in unethical and illegal activity brought Tyco down.
Unethical Business Practice of Subordinates. The complications in Tycos
case involved people other than Kozlowski. Kozlowski recruited the support of other
high-ranking officers in the organization. He also convinced some lower ranking
employees to keep their silence in exchange for financial benefits. Also, Kozlowski
convinced one of the board members to keep silent about the illegal financial
transactions on the mansion Tyco paid for the benefit of Kozlowski and his wife. In
exchange, the board member received financial benefits.
Unethical Auditing Practice. The auditing firm PricewaterhouseCoopers
responsible for checking the financial reports of Tyco failed to identify Kozlowskis illegal
financial transactions. As a result, Kozlowskis unethical business practice continued
and became extensive. These practices became more difficult to stop because of
absent constraining influence from the auditing firm.

Kozlowskis Motivation for Avoiding Sales Taxes on

Art Purchases
Kozlowskis motivation for trying to avoid sales tax on his art purchases were (1) his
materialistic desires, and (2) his avoidance of raising a red flag on his illegal activities at
Tyco.
Kozlowskis materialistic desires pointed to greed for financial or material gains. These
desires led him to commit illegal financial transactions at Tyco. This case shows that
Kozlowski had a history of tax evasion that goes even years before investigations
started. Thus, he has a history of prioritizing materialistic gains over ethical conduct.
Also, Kozlowski tried to avoid paying sales taxes for his art purchases because doing so
would raise red flags for authorities. Sales taxes create formal records of financial
transactions. In Tycos case, the sales taxes amounted to millions because the
purchased art items were expensive. It would have been easier for authorities to detect
Kozlowskis illegal financial transactions because it was unusual for Tyco officers like
Kozlowski to make such big purchases in a small amount of time.

Commingling of Assets in Tycos Case

The concept of commingling of assets in Tycos case refers to the adoption of the view
that the assets of an employee are similar to the assets of the company. Commingling
of assets occurred when Kozlowski considered the assets of Tyco as his own personal
assets. The case shows that Kozlowski used Tycos funds to pay for his personal
expenses. He used Tycos money to pay for his second wifes birthday party. He also
used Tycos money to cover the costs of properties he purchased. He used the
companys money to purchase household items and art pieces for his personal use.
Tycos case shows that commingling of assets made it easy for Kozlowski to use the
companys assets for personal needs. The company had programs that enabled
Kozlowski to unethically use assets for personal needs. Kozlowskis use of Tycos
money was not just mere stealing of funds. It was also an exploitation of the weakness
of the financial loopholes in the firm at the time of his leadership.

Board of Directors and Adjustments in Tycos

Programs
It would have been possible for the board of directors to see the adjustments taking
place in programs at Tyco. This would have been so if the board of directors had
appropriate mindsets and activity. Tycos programs were a weakness in the
organization. These programs provided benefits to officers and other employees. The
financial programs were opportunities for Kozlowskis illegal financial transactions and
unethical business practices.
The board of directors should have examined these programs to evaluate their
appropriateness. The directors should have identified the programs weaknesses and
loopholes, which Kozlowski and other officers exploited for their own personal benefit
for years. Thus, the ineffectiveness of the board of directors in examining Tycos
programs enabled Kozlowskis unethical business practices.