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The case study of Enron’s scandal

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  • The case study of Enron’s scandal
    ——from the corporate governance perspective

    1 Executive Summary

    This paper aims to analyze the scandal of Enron Corporation, which has left a huge influence in the development of economy in the world. At first Enron was a fast-advancing company, which made a great achievement in many aspects and drew a lot of attention. However, the scandal broke out in 2001 and Enron fell all the way down to bankruptcy, which reached a record of the largest assets going bankrupt in the history of America. This case study will take a glance at the whole event and put forward an analysis on the basis of corporate governance.

    2 Introduction

    Enron Corporation was founded in 1930, headquartered in Houston, USA. It was the largest integrated natural gas and electricity companies all over the world, ranked 6 in the “Fortune” Global 500 in 2000. Enron Corporation was a hit at that time. (Gordon, 2002)
    In October 2001, Enron Corporation announced it was decreasing in the after-tax net income by 544 million dollars and in its shareholders’ equity by 1.2 billion dollars. Later on November 8th, Enron announced that it was restating the previously reported net income from 1997 to 2000 due to accounting errors. Under Chapter 11 of the United States Bankruptcy Code, Enron Corporation filed for bankruptcy on December 2nd, 2001. Because of the assets of 63.4 billion dollars, it became the largest American corporate bankruptcy. Of course, this event caused a great shock in the security market. (Bratton, 2002)

    3 Analysis of the Case

    In this part, the corporate governance structure of Enron Corporation will be analyzed and asked what was wrong. The financial cheating behaviors of Enron were mainly as follows: establishing complex corporate organization system (more than 3,000 affiliates); taking on large amounts of debt by affiliate enterprises but not put it in the consolidated statements to conceal debts; providing financial guarantees for the debt by shares. These frauds aimed to keep the share’s prices in expectation and get huge gains by stock options. They were put into practice for the imperfection of the corporate governance.
    The Board of Directors was lack of independence. The Board had established the Nomination Committee, the Audit Committee and the Remuneration Committee. 15 of the 17 members of the board of directors were independent directors, and 7 directors of the Audit Committee were all independent directors. However, independent directors failed to implement effective supervision of senior managers, because they were not truly independent in fact. Enron entered into consulting services contracts with 14 independent directors, and contributed to the non-profit organizations where independent directors worked as well. The Board of Directors was influenced or even control by managers actually. (Gillan, and Martin, 2007)
    Board of directors is an organization which is set up to monitor the affairs in the company. (Molz, 1988) It represents the rights and interests of all the shareholders. Minority shareholders are lack of ability and incentive to monitor management for the asymmetry of information. On the other hand, major shareholders have the ability to control the company through effective measurements, but the rights and abilities are easily abused. (Farrar, 2008) In the case of Enron, the board of directors did not perform their functions and even cover up the scandal. Consequently, a large number of people became victims, including shareholders and employees. It shows that how it is important for the board of directors to keep independent and perform their duties.
    The separation of ownership and control was too large. The stakeholders’ participation in corporate governance was not enough. In the case of Enron, a large amount of stakeholders went through big losses. Because of the diffuse ownership, the major shareholders of Enron were mainly institutional investors. However, according to the Securities and Exchange Act in United States, institutional investors can not directly control the company. Hence, the ability of controlling from shareholders was extremely limited in corporate governance.
    The separation of ownership and control is caused by the principal-agent theory. The theory is defined by Jensen and Meckling (1976) as “a contract under which the principals engage the agents to perform services on their behalf which includes delegating some decision-making authority to the agents”. However, the contract cannot exhaust all the distribution of rights, responsibilities and benefits, which also was called incomplete contract. (Gillan, and Martin, 2007) Because of the incompletion and uncertainty, two problems would arise: adverse selection and moral hazard. This is just what happened in the case of Enron Corporation.
    The management incentive mechanism was abused. Stock options were utilized as one of the incentives of management in Enron Corporation. However, for the fact that Remuneration Committee was affected or controlled by the management, the stock-based compensation plans were abused. Options became the main motivation for managers to practice financial frauds.
    Incentive contracts are the primary mechanism to make sure the management acts in accordance with the interests of shareholders. Stock options, management holdings and other rewards linked to operating performance are common in the incentive mechanism. However, incentive contracts cannot solve all the problems, especially in the case that management controls board of directors or management lacks of drive to accomplish the missions. (Raheja, 2006) In the case of Enron Corporation, the managers took advantage of the stock options to earn profits for themselves, producing great damages to the company. The incentive mechanism should be utilized properly.
    Auditing lacked of independence as well. As the auditor of Enron Corporation, Arthur Andersen also provided consulting services, and consulting services fee was much higher than the audit fees. This made a serious damage to the independence of the audit. In addition, the Audit Committee was composed of independent directors, but the selection of the auditor was actually determined by the managers, which could not guarantee the independence and credibility of auditors.

    4 Conclusion and Recommendation

    Looking back the case of Enron Corporation, some essential problems are put forward by the unethical and immoral behaviors. Corporate governance should protect the rights and interests of shareholders. Besides, board also should be independent and perform key functions, such as monitoring the process of companies’ advancement. Last but not the least, the rights of managers and executives should to be supervised responsibly. The lessons of Enron had better be learned.



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