Arabia, Duchess Saudia T.

5BSA
Case Study: Enron
1. Statement of the Problem
How would Enron’s board of directors apply good corporate governance in Enron and promote a healthy
corporate culture by attaining company’s objectives through serving the interests of the company,
stakeholders/shareholders that is consistent with the rule of law?
2. Statement of Facts
Enron’s transformed from a regular national gas company into a financial trading. The company’s ambitions
were financed through manipulation of its accounts by setting up highly irregular special purpose entities, and utilizing
these to illegally conceal massive debts and other liabilities. This was all done with the complicity of its institutional
advisers- auditors Andersen, and lawyers Vinson and Elkins- and the secondary complicity of its team of consultants
and investment bankers. As a result of this declaration of deregulation, Enron executives: Enron chair Ken Lay, CEO
Jeffrey Skilling and CFO Andrew Fastow, were permitted to maintain agency over the earnings reports that were
released to investors and employees alike. Enron was founded in 1985, a natural gas pipeline company formed through
the acquisition of Houston Natural Gas (HNG). Ken Lay was the former CEO of HNG and became chairman in 1986.
In 1985 the firm’s business model evolved to focus on two related themes: the acquisition and operation of power
plants and electric distribution companies, and trading operations in which Enron created markets for trading gas and
electricity and financial securities based on those commodities.
Enron hired Jeffrey Skilling who has helped Enron develop its “Gas bank” idea. Under his leadership as CEO,
the company pioneered the use of risk management products and long term contracting structures in natural gas
industry. In 1999, trading operations had become Enron’s primary focus and the firm began systematically shedding
its physical assets following what it referred to as an “asset light” strategy. Enron formed a limited partnership with the
California Public Employees’ Retirement System (CalPERS) in 1993. This partnership was called the Joint Energy
Development Investment Limited Partnership (JEDI), with the purpose of investing in natural gas projects. Enron
earned profits from the partnership, but none of JEDI’s debt appeared on Enron’s balance sheet. In 1997, Enron
launched a new and larger limited partnership called JEDI II, to make Enron the sole investor in JEDI. But because
JEDI would no longer be independent, and its debt would have to appear on Enron’s balance sheet, CFO Fastow
proposed forming another new venture, Chewco Investments, to replace CalPERS as an independent investor. Rather
than find a truly independent investor for Chewco, Fastow decided that one of his subordinates could play the role of
independent investor in Chewco. Enron’s 2000 annual report stated global revenues of $100bn, suggesting that income
had sired by 40% in three years. In reality real revenue was far lower as company managers found that market-to-
market losses were having an increasingly adverse effect on net income. In 2000, the company ranked as the seventh
largest company on the Fortune 500 and the sixth largest energy company in the world. The company’s stock price
peaked at $90 buit suffered in the involvement in the energy crisis California. This led to CFO Fastow to design a
further scheme, Special Purpose Entities (SPE) transactions to buffer against future losses so it could keep its share
price high, raise investment against its own assets and stock and maintain the impression of a highly successful
company. Equally, the deals clearly violated GAAP SPE requirements: there was no substantive capital investment;
the equity level dropped below 3 percent of assets; the SPE was controlled by Enron’s CFO who could not possibly
have been an independent third party to the transactions.
On August 14, 2001, CEO Jeffrey Skilling resigned. After six weeks, Enron which had $62 billion in assets,
filed for bankruptcy. Enron international (EI) presented the heavy asset strategy of Enron which was headed by
Rebecca Mark. The reaction to Enron International (EI)’s price hike in India was massive protests, hunger strikes and
accusations of human rights violations Rebecca Mark’s skills and confidence in helping the company was undermined
by Skilling and his team which led to her resignation. Sherron Watkins found out about the SPEs and the approval of
Anderson in which she left the company after that. Anderson helped Enron in structuring its SPEs and acted as auditors
and consultants to the firm. The Enron board relied more on the advice and approval of Vinson and Elkin’s than on
Andersen’s. Enron’s banks have played roles as diverse as debtors, investors, guarantors and partners not only with
the company but with the SPE structures. JP Morgan Chase and Citigroup were fined over allegations that they had
committed fraud with Enron by lending money for the company’s wrongful conduct, and by duping and cheating
investors. JP Morgan Chase paid $135 million while Citigroup also paid for its role in misleading Dynegy over the State
of Enron’s financial health. Merrill Lynch settled $80 million over accusations it knowingly falsified accounts it had with
Enron in the SPEs. Within Enron, the responsibility of the collapse was attributed to Andrew Fastow and his finance
division. Enron allowed its CFO to run independent entities that were virtual hedges within Enron. Fastow exploited
this opportunity turning Enron into a vehicle to funnel money into his personal slush funds. Due to the actions of the
Enron executives, the Enron company went bankrupt and executives ended up getting sentences that matched the
spectacular nature of their frauds.
3. Guide Questions
3.1) Causes of corporate governance failure of Enron are: (1) The lack of truthfulness (Disclosure, accountability
and transparency) by management about the health of the company with the complicity of its institutional
advisers- auditors Andersen and lawyers V&K, Mckinsey & Co. and investment bankers. Andrew Fastow, the
Chief Financial Officer, and other executives also misled the board of directors and the audit committee about the
accounting practices adopted. In addition, the external auditors, Arthur Andersen, at the time one of the five largest
auditing and accounting practices in the world, approved of Enron’s accounting practices. The Enron board relied more
on the advice and approval of V &E, than on Andersen’s. When they investigated the conflicts of interest Fastow had
in Enron, V&E did not bring a stronger, more objective and more critical voice to the disclosure process. JP Morgan
and Citigroup committed fraud by lending money for the company’s wrongful conduct. Special Purpose Entities (SPE)’s
was the scheme designed by CFO to buffer against future losses and maintain the impression of a highly successful
company. Using the Enron’s stock as collateral, the SPE, which was headed by the CFO, Fastow, borrowed large
sums of money. And this money was used to balance Enron’s overvalued contracts. Thus, the SPE enable the Enron
to convert loans and assets burdened with debt obligations into income. To solve the lack of truthfulness by
managements, the company must Develop a Value Reporting framework- provides a comprehensive view of the critical
value-relevant information, and how it can be presented in a cohesive and logical way. The aggregate view is
maintained as following: (1) Market forces- the dynamic environment is analyzed and its impact is studied on customer
needs, (2) Goals and objectives, corporate structure design is aligned with the desired set of procedures, (3) Value
enhancement - The value added should be assessed at various interfaces of the supply chain .It should also aim at
equalising wealth along the value chain and (4) Performance assessment – It should help the management in delivering
the financial numbers quarterly . It should generate cash and the required returns for its investors. Penalize employees
or officers for such acts could include stripping the employee of his position or his compensation, such as reducing
annual bonuses, and even pensions. (2) Conflict of interest and lack of independent oversight of management
by Enron’s board. Andersen helped Enron in structuring its SPEs. Andersen found itself in a conflict of interest, having
not only been the company’s external auditors from the inception but also rendering consulting services to Enron. There
is also conflict of interest in the Fastow’s roles as CFO of Enron and equity holder of the SPEs. No director appears to
have questioned the wrongdoings of CFO because CEO Lay permitted him to do so. To solve this is for Enron to create
a compliance plan. This includes ensuring all employees are aware of acts and situations that i) are improper; ii) might
give an appearance of impropriety; or iii) might impair their good judgment when acting on behalf of the company. This
should include procedures enabling employees to report these conflicts, and a subsequent review process to determine
whether the conflict requires intervention or can exist. without detriment to the company. Adherence to such a plan
enables a company to ensure regulatory compliance while providing employees with the knowledge that their
relationships do not conflict with their duties to the company. Each company should have a clear and recognized
regulations for the directors and staff regarding the prevention of conflicts of interests.(3) Market-to-market
accounting. This technique was used to report profits in some Enron businesses. When its energy services unit signed
a power-supply contract with a company, it would structure the deal to bring it under those accounting rules. It would
then project electricity and natural gas prices for the full term of the deal, which could last as long as 10 years, according
to former Enron officials. To solve this, the company should use the full cost accounting method. In this method, all
costs incurred in pursuit of that activity should first be capitalized and then written off over the course of a full operating
cycle.
3.2) To make corporate boards supervise companies better, the board of directors should recognize and publish the
respective roles and responsibilities of board and management. The Corporate governance framework should clearly
articulate their roles. The board would be effective if there is independent leadership. The chair should be separate
from the CFO because they have fundamentally different and often conflicting responsibilities. This is to avoid conflict
of interest which may lead to unethical practices. Boards should embrace diversity, considering gender, age, culture,
sexual orientation, ethnicity while also having sufficient mix of relevant skills and industry experience, to make the
board most effective. Directors must monitor and evaluate management’s performance vigorously. They must
participate in key decisions and offer advice and judge management decisions and they must promote ethical and
responsible decision making therefore the directors should be a good example of a person with ethics and discuss the
penalties to the employees who perform unethical practices in the company. The board should create an audit
committee to monitor the integrity of the financial reports of the company, remunerations committee to set the right
compensation or remuneration for the board and executives, and risk committee to manage the potential threats or
risks that may occur in the company any time.
3.3) To make accounting more transparent and auditing more effective, the board should compose an audit committee
to oversee the integrity and disclosure of financial reports of the company and to ensure that the audit process is
objective, an audit committee should be an “independent” body. This frees them to make unbiased judgments about
internal financial procedures and the performance. Without an effective chair, an audit committee is unlikely to be
effective. There should exist a comprehensive position description for the audit committee chair which may be used as
basis for recruitment, succession planning, assessment and remuneration. Then, making sure that the audit committee
chair is comfortable with the process, conduct a comprehensive assessment of the chair’s effectiveness, e.g.,
considering the position description and the competencies and skills the chair is expected to bring providing feedback
and reporting, taking timely, corrective action as required, and reporting on the nature of the review process in sufficient
detail to shareholders in all appropriate public documents so as to demonstrate its effectiveness. There should be a
risk management system to enhance the review process that the audit committee undertakes, i.e., it should drive the
internal audit plan, external audit process, insurance negotiations and other business processes, e.g., identifying key
risks and compliance obligations where independent assurance is needed. Transparency in financial statement means
the statement should be easily understood/ clear or user friendly and everything should properly be disclosed.
3.4) The extensive development of corporate regulation since Enron is likely to prevent further large corporate failures.
Enron will be the morality play of the new economy. It will teach executives and the American public or other large
corporations the most important ethics lessons. All corporations want to be successful, just like Enron. But Enron
achieved success with malfeasance which although billed the company to be the seventh largest company in America,
led the company to bankruptcy and imprisonment of Lay, Skilling, Fastow and Anderson. There should be a healthy
corporate culture in the company. When there existed failures and losses in their company performance, what Enron
did was covering up their losses in order to protect their reputation instead of trying to do something to make it correct.
The “to-good-to-be-true” should be paid more attention by directors of board in a company. Because corporations
wouldn’t want to end up like Enron, they would prevent actions Enron did. On July 30, 2002. A new law was passed by
the U.S Sarbanes-Oxley Act- the Public Companies Accounting Oversight Board (PCAOB) to oversee the auditing
profession. Corporations shall make no mistake, they have a difficult task ahead of them as they consider regulatory
reform — a task made all the more difficult since it’s being done without the benefit of the kind of public anger that
immediately follows a scandal. This time, the PCAOB has anticipated a likely cause of future scandals and is
considering closing the door before it’s too late.
3.5) Shareholder primacy is a theory in corporate governance holding that shareholder interests should be assigned
first priority relative to all other corporate stakeholders. Enron did not practice this because the company did not focus
on the shareholders’ interests but their own personal interests by hiding the real debts by using SPEs to attract more
investors to invest and creditors to give loans, to spend on their own personal things. Stakeholder engagement was
not given attention in Enron. The irony in the Enron case is that the executives would have been better off or still
employed and not under criminal investigation, had they remembered the interest of other stakeholders. Stakeholder
engagement implies a willingness to listen; to discuss issues of interest to stakeholders of the organization; and,
critically, the organization has to be prepared to consider changing what it aims to achieve and how it operates, as a
result of stakeholder engagement. Examples are employees Sheron Watkins and Rebecca Mark who weren’t given
importance of their ideas; Rebecca’s suggestion in Enron’s water business that would help the company obtain more
profits and the issue with Watkins regarding the unethical activities done by the executives that would harm the
company. Managing for stakeholders involves attention to more than simply maximizing shareholder wealth attending
to the interests and well-being of those who can assist or hinder the achievement of the organization's objectives. Other
stakeholders like Andersen, V&K, JP Morgan Chase and Citigroup were bribed and they were engaged in the fraudulent
activities done by the executives in which they helped.