What are the Lessons of the Collapse of Enron for the Governance of the Corporation?

University Degree Business and Administrative studies

Student: 2003079040

Introduction

Enron was established in 1985 following the merge of Houston Natural Gas and InterNorth. In year 2000, Enron reported a remarkable growth of revenue of $ 100.8 billion, putting it at number seven in the Fortune 500 list of the country’s biggest companies. However, in October 2001, things were reversed with its report of $638 million third-quarter loss and $1.2 billion reduction in stock value. Following the revise of financial statements for past five years which accounted for $586 million in losses, in December, Enron filed for Chapter 11 bankruptcy, and became the US’s largest ever corporate collapse. Behind this world-shaking collapse is the fact of executives’ self-dealing, greed and the accountancy company’s default. Enron’s collapse recalls the debate of Anglo-Saxon corporate governance model, which supports deregulation, ‘shareholder value’ and opposition of public intervention. Now, the company has become a good example of why corporate governance should be rethought and enhanced. This essay tries to discuss some lessons of corporate governance from Enron. Firstly, we start with the factors causing problems in Enron. Then, we further discuss the root of its collapse and other ways to govern corporations.

Enron’s Failure in Corporate Governance

Directors In the Anglo-Saxon model, ‘the central mechanisms of corporate governance are the powers and responsibilities of directors, the requirement that directors report periodically to the shareholders, and the requirement that certain corporate actions receive explicit shareholder authorisation’ (Sternberg,1998:35). Therefore, under above principles, directors should be accountable to shareholders, but Enron failed in this fundamental element.

Firstly, it is regarded more accountable to separate the role of Chairman of the Board and CEO. The Chairman is ‘leader of the Board’; while the CEO is Head of the management. If the same person engages in both the positions, the power will be concentrated too much and the supervising capacity of the board to monitor the management will become weak. Unfortunately, in Enron, the Chairman and CEO is the same individual, Mr Kenneth Lay, who reoccupied the position CEO after a short appointment of Mr Jeff Skilling. Thus, Lay monitored his own management process. As a result, he was not independent of management and thus insufficiently accountable to shareholders.

Secondly, despite Chairman, in many corporations, directors are often ‘regarded – by themselves and by those who appoint them – as nothing more than senior sorts of managers’ (Sternberg, 1998: 63). When directors’ interests are different from their shareholders, the important function for directors to protect shareholders is more difficult under this arrangement of monitoring managements. Therefore there arises the ‘conflict of interest’ problem. One solution to this problem was suggested to have ‘non-executive or outside directors’. To some extent, non-executive directors may be more accountable in that they may challenge the action of management easier when separating from it. But there is still no immunisation to conflicts of interest: ‘the non-executives of one corporation are often executives of some other, and may be protective of the interests that all managements have in common’ (Sternberg, 1998:64). In the USA, most non-executive directors are appointed by the Chief Executive, rather than by shareholders. Another problem affecting the independence of directors is the ‘cross-directorship’. When the non-executive director of one corporation is at the same time the executive of another, considering the business relationship with the corporation, his will to check and correct the executive action may be limited. In the case of Enron, although its Board comprised of a majority of outside directors, their independence was challenged when ‘[s]ix of the 14 outside directors suffered from serious conflicts of interest. … [Moreover,] Mr Raymond Troubh, one of the directors, is a Director of 11 public companies’ (Gopinath, 2002:1).

In general, directors’ effectiveness and accountability for shareholder interests is considerably scarce in Enron. The way in which they are selected, nominated and remunerated restrained them sufficiently independent on the management which they were required to monitor. Thus it is easy to undermine shareholders’ interests.

Audit One of the important lessons from the Enron collapse is that no one in the ‘audit chain’ could alarm, disclose, and correct its weak financial status and bad business behaviour. The audit chain, including the audit committee of the board, the board, the outside auditor, the market specialists in stock, the stock exchanges, major creditors, and the credit rating agencies, etc., appears to have not had an enough incentive to find out and disclose the truth of the behaviour of Enron. Among them, Arthur Andersen, the outside auditors, who should be independent from the audited company, failed to report the accurate information because of a conflict of interest between the auditing and consulting activity for Enron. Enron was Arthur Andersen's second largest U.S. customer, paying $25 million in audit fees. But Andersen’s income from consulting businesses for Enron was twice of audit incomes.

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In addition, the Enron audit committee also failed in overseeing the work of the auditors and inquiring the operation and management of the company independently. In the words of the Special Investigating Committee: ‘The Board assigned the Audit and Compliance Committee an expanded duty to review the transactions, but the Committee carried out the reviews only in a cursory way.’ The Chair of the Audit Committee was Mr Robert Jaedicke, who occupied this position for a long time from 1985. In contrast, normally, it is suggested to rotate this position every three or four years. Apart from Mr Jaedicke, the audit committee consisted of five persons, three of whom reside outside the USA. It is obvious that the working of an audit committee, which is an important committee because of its role in oversee accurate information disclosure and early bad signal warning, has been constrained because of its large portion of non-residents on the committee. For example, ‘one of the members, Mr Ronnie Chan, missed 75 per cent of the meetings in 2001’ (Gopinath, 2002: 2).

Remuneration The collapse of Enron harmed the numerous Enron employees, but directors gained a lot before its bankruptcy. Each company director received an annual fee of $50,000 as compensation; in addition, they also receive annual awards of stock and stock options. Lay got a $7 million bonus for the year 2000 and was granted options on 782,000 shares of stock, among which he exercised 2.29 million shares and obtained a gain on paper of $123 million. The same thing happed with Silling.

As Hutton said, now, American companies depend more upon ‘financial engineering’, such as futures, options and other financial derivatives, to ‘extract value’ than on ‘create value’ by persistent innovations and efficient resource utilities. ‘In the 1960s 44 cents in every post-tax dollar of profit was distributed as dividends; by the 1990s the proportion had nearly doubled to 85 cents’ (Hutton, 2002:133). The key reason for the increasing dividend distribution and consequent share price supporting is that CEOs’ remuneration is tightly linked with share prices via ‘stock option packages’: now about half of CEOs’ total earnings comes from stock options. As option schemes provide ‘a one-way bet’, it is possible to cause the divergence of interests between directors and shareholders. For example, if the share price is rising, directors holding stock options may exercise options with selling out shares heavily to gain proceeds, while shareholders will suffer the decreasing share price because of the huge selling in a short time, even overnight. Thus, even when a company is in danger its directors and CEO may still have high returns. In fact, apart from Enron, many companies suffered from weak share price while director and CEO remuneration was high: ‘between 1993 and 2000 the majority of companies headed by the ten highest-paid CEOs underperformed the stock market average over both one year and three years afterwards’(Hutton, 2002:135). Therefore, there is a growing concern of remuneration schemes, which, if designed uncarefully, may cause a significant ‘moral hazard’ of directors and managers to undermine the interests of shareholders and other stakeholders.

Information Sufficient and independent information is an important factor for a board and directors to perform their roles and duties properly. This is where Enron and also many other companies failed. Information independent from the management is seldom available. Board papers, on which directors rely for grasping corporate information, are normally provided by executives with ‘divergent departmental interests’. For executive directors, they may only have the information within their own managerial areas and often be informed insufficiently and/or distortedly about areas outside their management. For non-executives, they are more likely to lack sufficient and actual information from the company and its staffs. In addition, because they are not willing to bear any expenses personally in investigating company matters, it’s more difficult for them to know the genuine condition of the company. In the Enron situation, it is worthy to ask why directors, auditors, and shareholders did not get enough information about a lot of ‘murky deals’. According to the Special Investigating Committee report, ‘the board was denied important information that might have led it to action, but the Board also did not fully appreciate the significance of some of the specific information that came before it.’ For investors, their capacity to get efficient information is even more difficult in a corporate governance model like Enron: ‘executives determine the flow of information to directors, and directors determine the content and timing of information that is distributed to shareholders’ (Sternberg, 1998:68). Therefore, in Anglo-Saxon form corporate structure, the flow of information is difficult, either from the down to the top or from the corporate to shareholders.

Shareholders As mentioned before, the lack of information of corporate performance for shareholders seriously impede their ability to enhance their rights and accountability. But even there is corporate information available; there are also difficulties for shareholders acting on the information. ‘In the USA, communications amongst shareholders are subject to complex regulatory requirements; compliance is both difficult and expensive’ (Sternberg, 1998:68). Therefore, the dispersion of ownership for a corporation makes governance more difficult in practice. Even for institutional shareholders, it is also unpractical to expect them to improve corporate performances in that they are merely ‘intermediaries between corporation and ultimate owners’ of corporate stocks. In the USA, two of the largest classes of institutional investors, mutual funds and pension funds, are in fact barred from exercising the most basic kind of corporate governance. Moreover, for institutional investors, what influences their portfolio return is more likely the stock selection and asset allocation rather than improving corporate governance as, from which, the gain is much smaller and slower than from portfolio adjustment. Thus, when they are disappointed by the performance of particular corporate stocks, their reaction is to alter the composition of their portfolio. In general, in the sense of ‘dispersed and weakly organised’ shareholders, it is difficult for them to keep the corporations more accountable.

In addition, there is a democratic deficit for shareholders to control corporate direction through general meetings and corporate elections. Firstly, shareholders’ power is limited as directors have the power in setting the general meeting’s agenda and proposing the solution to problems. For example, in Enron and many companies, shareholders have been limited the power to control the payment to directors in the light that a director’s remuneration package can not be opposed by shareholders unless his/her appointment to the board is opposed. Secondly, according to the jurisdiction, some restriction on conditions, under which shareholders’ proposal can be considered by the board, are not benefit for dispersed and divergent shareholders. For example, ‘in the USA, companies need only consider resolutions when their holders own a minimum of 1 per cent of the securities entitled to vote on the proposition, and must have been held for at least one year’ (Sternberg, 1998:61). In addition, the content and extent in corporate governance shareholders can influence is also limited by the Board: ‘they cannot be about “the conduct for the ordinary business operations” of the company or about company elections, nor can they bind the board, even when passed unanimously’ (Charkham, 1994:220).

Influence of ‘Big Money’ in Politics Another noticeable problem from the collapse of Enron is the relationship between companies and governmental politicians. According to Centre for Responsive Politics, the money contribution of Enron in politics is huge:

‘Enron and its affiliates gave more than $2 million in soft money contributions to Democrats (30%) and Republicans (70%) during the 1999-2000 election cycle. Over the past decade, Enron has given roughly $5 million to federal candidates. In fact, 71 Senators and 186 House members have reported taking contributions from Enron over the last decade’.

As receiving more and more contributions of large donations from Enron, politicians requited more and more to their donors. A good example is the special treatment on Capitol Hill Enron got, resulting in millions of dollars to politicians. Enron also received special exemptions from federal regulations, e.g. ‘Commodity Futures Modernization Act’ of 2000, which allowed it to undertake questionable and possible illegal activities.

The same thing has also happened with audit firms. In 2000, Arthur Levitt, Chairman of Securities and Exchange Commission (SEC), has foreseen the potential for outside auditors to compromise their independent position because of well-paid consulting contracts they got from the same firms they audit. He proposed separating the consulting business and auditing business to different accounting firms. However, this proposal was not realised because ‘at least 13 senators and 25 representatives, from both parties, wrote to the SEC to oppose the rule and protect the auditors' conflict of interest’ (Harshbarger, 2002: 2). Behind the failure of this proposal is the huge political contribution, more than $27 million, from the ‘Big five’ to federal candidates and the Democratic and Republican parties in the past ten years.

In summary, from the above discuss of Enron’s failure in corporate governance, we can say that the overall lesson of Enron is that the market is not perfect and cannot always work well enough to guide the corporate behaviour. In this sense, the incentive behind bad behaviours of Lay and other directors and managers is created by the market to pursue the short term share value. In the whole chain of company players, each individual has the potential to default and lack the incentive to avoid the bad outcomes in that the interest of these individuals is to maxmise the shareholder value, rather than improve the collectivity.

Alternatives in Corporate Governance

From above analysis of governance problems from Enron and a lot of other companies, we can say that the root, causing the collapse of Enron and the potential danger to many companies, employees, and investors, is the structure and model governing corporations. In this section, we dig lessons from Enron further and compare some alternative governance solution.

Corporate Governance Structure

Enron, like most US corporations, took a governance structure with ‘command and control’ hierarchies. The structure can be figured as below:

Shareholders

Board of directors (shareholders and advisory panel)

Chairperson (managing director*)

Officers (president or chief executive officer [managing director*])

Divisions (middle management)

Line staff

* In the US, a managing director can be either the chairperson or the president/CEO.

(Figure from: Clark and Demirag (2002) Enron: The Failure of Corporate Governance pp.9 Figure2)

In such a top-down corporation with a ‘single unitary board’, as discussed in the second section, there are many potential problems in its accountability to shareholders. According to Turnbull, these problems can be concluded as ‘the tendency of centralized power to corrupt; the difficulty of managing complexity; and the suppression of “natural”- human – checks and balances’ (Turnbull, 2002 :2). If the minority of shareholders control the majority of the shares and consequently the corporation and its managers, this centralised power will lead to corruptions of people and corporation behaviours, lacks of independent and efficient information, and difficulties in guiding managements especially in big corporations. The hierarchical structure of the corporation is the main reason why Enron’s directors and advanced officers could default, operate illegally, and gain the huge wealth without any obstacle and early warn system.

Shareholder Model V.S. Stakeholder Model

According to the shareholder model, the priority goal of the firm is to maximise the profit and thus the shareholder value. In return, the shareholder value, or market value becomes the criteria by which the corporate performance can be judged. In this model, directors and managers are required to run the company in shareholders’ interests. But the underlying problem of corporate governance arises from the ‘principal-agent’ relationship in the light of the separation of firm owners and managers. Therefore the conflict of interests between dispersed shareholders and strong managers threatens the profit maximising objective, the shareholder interests and corporate growths.

Moreover, another drawback of this model to solve governing corporations is that it ignores the reality that ‘the competitiveness and ultimate success of a corporation is the result of teamwork that embodies contributions from a range of different resource providers including investors, employees, creditors, suppliers, distributors, and customers’ (Mahar and Andersson, 1999 :7). Therefore, shareholders are not the only investors in companies; there are above various stakeholders of the firm who affect the corporate performance. In this sense, many people argue that corporate governance framework needs a wider consideration which includes a wide constituency of stakeholders. (Turnbull, 2002; Mahar and Andersson, 1997; Kay, 1997; etc.) Compared with the shareholder model, the stakeholder model requires more responsibilities than increasing market value from companies in employment, trading relations with suppliers and purchasers, financial performance, and even the environment and society. This broader view of the firm supports that corporation should take more social responsibilities and manage in more public interests, which have been neglected in the shareholder model in which ‘companies are driven wholly by price signals and the desire to maximise profits. … Loyalty, trust, the organisation’s social capabilities and the capacity to learn over time count for nothing’ (Hutton, 2002:134,135).

According to the shortcomings of the hieratical corporate governance structure and the shareholder model, Turnbull suggested an alternative way to govern corporations – network governance though which a ‘self-governing network’ involving ‘compound boards’ and stakeholder participation. According to the successful experiences from the Mondragon Corporation Cooperative (MCC), Keiretsu, and Visa International, this method has advantages in getting ‘decenrtralised and independent information’, ‘democractical decision-makings’, and ‘check and balances’ power restriction in corporate governance (Turnbull, 2002). Firstly, a ‘compound board’, which includes ‘supervisory board’, ‘executive board’, ‘social council’, and ‘watchdog’ board, divides and decentralizes powers and improves independent human relationships. Secondly, an inclusive stakeholder network provides a broader dimension of corporate governance, resulting in improving corporate social responsibilities.

Conclusion

Enron, once one of the world’s largest companies, whose collapse evokes the consideration of good corporate governance. The lessons from Enron involve all but every level of governance from directors to auditors to shareholders and government. Therefore, we argue that corporate governance should involve a wide dimention of relationships among a company’s board, managers, shareholders, and other stakeholders. In this sense, a new method, network governance, has been suggested as an alternative to the traditional ‘command and control’ hierarchical structure and shareholder model which have many potential dangers. In general, the debate about good corporate governance is continuing. Overall there arise more concerns about shareholders’ rights and other stakeholders’ interests, the corporate structure, and the responsibility of the board to the company, shareholders and stakeholders. As highlighted in the OECD’s Principles of Corporate Governance, the corporate governance reform should comprise of four principles – ‘equitable treatment’, ‘responsibility’, ‘transparency’ and ‘accountability’ (Witherell, 2000:4).

Bibliography

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Kay, J. (1997) ‘A Stakeholding Society – What does It Mean for Business?’ Scottish Journal of Political Economy, Vol.44, Iss.4, 1997, pp.425-443

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Prentice, D. and Holland, P. (1994) Contemporary Issues in Corporate Governance, Clarendon Press: Oxford

Sternberg, E. (1998) Corporate Governance: Accountability in the Marketplace, Institute of Economic Affairs: London

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See Fox, L. (2003) Enron: The Rise and Fall, Jon Wiley & Sons, Inc. pp.221

ibid.

See Harshbarger, S. (2002) Unaccountable all over in Enron (p.1)

ibid.

quoted in Gopinath (2002) Corporate governance failure at Enron (p.1)

Harshbarger, S. (2002) Unaccountable all over in Enron

ibid.

see Fox, L. (2003) Enron: The Rise and Fall, Jonh Wiley & Sons, Inc. (pp.222)

ibid.

see Hutton (2002) The World We’re in (PP.133)

quoted in Gopinath (2002) Corporate Governance Failure at Enron (p.1)

see Sternberg (1998) Corporate Governance: Accountability in the Marketplace (pp.71)

Sternberg (1998) Corporate Governance: Accountability in the Marketplace

from: Common Cause News: www: commoncause.org

see Cruver (2002) Anatomy of Greed: The Unshredded Truth from an Enron Insider

from: Common Cause News: www: commoncause.org

see Common Cause News: www.commoncause.org

More detail of these cases see: Turnbull (2002) A New Way to Govern: Organisations and Society after Enron (pp.18-26)

See OECD (1999) Principles of Corporate Governance (www. Oecd.org)

What are the Lessons of the Collapse of Enron for the Governance of the Corporation?

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