Term Paper: Enron: The Smartest Guys

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Enron: The Smartest Guys in the Room


The Smartest Guys in the Room

An Analysis of Insider Trading and the Related Costs to Society

Ken Lay (Reecius)

Insider trading occurs when someone has been granted, whether intentionally or unintentionally, knowledge of a company's financial situation before the same information has been shared with the public and then acts on this information for personal gain. For example, if Joe works for a corporation's accounting department and knows that his company is going to post an unexpected loss next quarter and then informs his brother about the loss who consequentially sells his stock the next day. Joe's brother would have saved lots of money by selling his stock before the market got the see the company's quarterly filings rather than waiting to the information was released. When a person or individual has secretive information that the public does not have and uses this for personal gain then this can be considered a form of insider trading.

There are many other forms of insider trading as well. The key concept within the idea of insider trading is that the individual has some kind of valuable information that the public does not have. Therefore, this creates a sense of unfairness in financial markets. Most investors make their predictions of companies' performances legitimately by examining the company's financial releases as well as other items such as press releases and media coverage. Basically, anyone that makes a profit on information that wasn't released to the public can be held liable for insider trading. This creates an unfair advantage for the market and is treated as a crime. There have been many high profile insider trading cases that perpetuated through the media in the last decade. This analysis will consider the role that insider trading plays in society as well as examine the movie "Enron: The Smartest Guys in the Room" and the events that unfolded in the Enron scandal.

Insider Trading

In 1934 the U.S. Congress enacted the Securities and Exchange Commission (SEC) to protect investors who wished to purchase stocks on the public stock market. The government realized that some investors who had an unfair advantage to company knowledge; especially when trading they are trading their own company's shares. For example, a company's CEO or member of the board of directors may have information regarding the company's strategy or competitive situation that the public does not have access to. Therefore, if these individuals use this information to make personal stock trades then this gives them an unfair advantage against the rest of the market. The design of the market is such that it is supposed to be fair in order for it to maintain its integrity.

What might surprise many individuals is that insider trading is virtually every day with full knowledge by the U.S. Securities and Exchange Commission. The SEC does allow some levels of insider trading and many employees are provided opportunities to purchase their own company's stock as part of their compensation plan. However, there is a fine line that corporate insiders must walk when trading shares of their own company's stock. Violations to the regulations would include such instances as purchasing large amounts of shares just before their company posts good financial results that would increase the stock price. Allegations of insider trading can have serious implications for the publics' perception of the integrity of the system.

One of the most publicized cases of insider trading in recent news can be illustrated by the SAC Capital Advisors series of cases. There were decades of whispers that SAC, Stephen Cohen's Capital Fund, was engaged in regular insider trading deals. The SEC accused Cohen of illegally obtaining information, through himself or members of his firm, and using this information to profit. SAC Capital Advisors was charged in federal court in Manhattan in an indictment with wire fraud and four counts of securities fraud; prosecutors allege the crimes were carried out from 1999 through at least 2010[footnoteRef:1]. Other cases also arose from the initial investigations. One recent case involves a former SAC Capital Advisors trader, Matthew Martoma, who is being tried for trading companies such as Elan Corp and Wyeth in 2008[footnoteRef:2]. [1: (Rexrode and Gordon)] [2: (Raymond)]


Despite more recent cases breaking the records in terms of fines, the Enron case was probably the most publicized case of corporate malfeasance in the last decade. The Enron scandal was a financial scandal involving Enron Corporation and its accounting firm Arthur Andersen made headlines in late 2001. Enron Corporation was an American energy, commodities and services company based in Houston, Texas and in 2001, it filed for bankruptcy; however before its December 2, 2001, bankruptcy filing, Enron employed approximately 20,000 staff and it was one of the world's leading electricity, natural gas, communications and pulp and paper companies, with claimed revenues of nearly $101 billion in 2000[footnoteRef:3]. [3: (SAS)]

Enron broke a plethora of laws that go far beyond insider trading. For example, many of Enron's recorded assets and profits were inflated, or even fraudulent and nonexistent; debts and losses were put into entities formed "offshore" that were not included in the firm's financial statements, and other sophisticated and hidden financial transactions between Enron and related companies were used to take unprofitable entities off the company's books[footnoteRef:4]. The company used a systematic approach to improve the way that their financial situation could be perceived by the market and individual investors. [4: (Folger)]

By "cooking" the books, the company was able to artificially drive up the price of their stock to record levels. Once the stock price had reached new heights, some of the executives to used insider information of their own company and its fraudulent practices to trade millions of dollars' worth of Enron stocks to their benefit. Many of the top executives at Enron were fully aware of the illegal accounting practices that the company was using. Not only were they compliant in these practices but they also sold off their stock before the information became public. However, during this time the public knew nothing about the offshore accounts or what was going on behind the scenes.

As the scandal was revealed, Enron shares dropped from over $90 to less than $.50 and later Enron filed for bankruptcy on December 2, 2001[footnoteRef:5]. Furthermore, the insider trading was not limited to just the top executives like most insider trading schemes, even secretaries got in on the action. The former corporate secretary of Enron, Paula Rieker, pleaded guilty to insider trading in Federal District Court in Houston and agreed to cooperate with the government's investigation of the company[footnoteRef:6]. Ms. Rieker pleaded guilty to selling 18,380 Enron shares in July 2001 after she learned that the company's broadband services division was "experiencing significant problems" and would have to report a $102 million loss for the quarter, according to court papers; a perfect example of insider trading that was from an executive secretary. [5: (Public Citizen)] [6: (LA Times)]

Ethical and Social Issues

International corporations like Enron usually have multiple groups of stakeholders on many different levels and in much different geographies. The company's stakeholders included their global investors, many of whom had their entire retirement policies with, customers, employees, suppliers, as well as the local community. Corporations such as Enron are tasked with balancing the interests of all their stakeholders the best they can. In Enron's case, the scales were tipped towards the greediness of the upper management and these behaviors were allowed to persist because of lack of oversight.

Obviously the executive management team violated the conflict of interests on several different occasions. They put their private interests, including personal gain as well as their reputations, before those that they were being paid by to represent. CFO Andrew Fastow created financial partnership to hide Enron debt, from which he allegedly collected $30 million in management fees[footnoteRef:7]. The action obviously made Enron financial look better, but at the same time deceived the entire set of stakeholders as to Enron's real position in the market. [7: (Saporito)]

Ever since cases such as Enron and the other scandals that followed, the media is quick to focus their blame on a "few bad apples." Yet it is hard to believe that such scandals involving billions of dollars can be summed up so easily. Behavioral economist, leading author, and professor at MIT, Dan Ariely relates his interpretation of the systemic situations that could illustrate the underpinnings of a flawed system in a talk entitled "Why we think it's OK to cheat and steal (sometimes)[footnoteRef:8]" (Toyko, 2009). Airely has identified several situations that increase the likelihood of individuals to lie and cheat which could easily be applied to the corporate world. [8: (Toyko)]

One such situation arises in a simulation when money is replaced by an alternative object, such as a gold token which makes people more likely to cheat because the consequences are more abstract. For example, moving numbers around in accounts may not seem as bad as the… [END OF PREVIEW]

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