The Corporation

And the rise of Corporate Governance

The Enron
Saga
About Enron

• Enron Corporation was an American energy, commodities, and services

company based in Houston, Texas.
• It was founded in 1985 by Kenneth Lay as the result of a merger between
Houston Natural Gas and InterNorth.
• Enron Corporation was one of the leading supplier of Natural Gas,
Communications , Pulp and Paper.
• Enron employed approximately 20,000 staff with claimed revenues of
nearly $101 billion during 2000.
• Fortune named Enron "America's Most Innovative Company" for six
consecutive years.
The Players

• KENNETH LAY:
Enron founder and former CEO. Lay took up the reins at Enron in 1986. Prior to Enron’s
collapse, he was credited with building Enron's success. Lay resigned as CEO in December
2000, and was replaced by Jeffrey Skilling. In August 2001, he resumed leadership after
Skilling resigned. Lay resigned again in January 2002. He drew on his $4 Million enron
credit line repeatedly and then repaid the company with the Enron shares after becoming
the focus of the anger of employees, stockholders and pension fund holders who lost
billions of dollars in this disaster.
• JEFFREY SKILLING:
Former Chief Executive, President and Chief Operating Officer. He joined Enron in 1990
from the consultancy firm McKinsey, where he had developed financial instruments to
trade gas contracts. He was also seen as a key architect of the company’s gas-trading
strategy. He resigned his post as Enron’s chief executive in August 2001 without a pay-off.
The Players

• ANDREW FASTOW:
Former Chief Financial Officer. He was fired in October 2001, when Enron
made losses amounting to $ 600 million. He was allegedly responsible for
engineering the off-balance sheet partnerships that allowed Enron to cover
its losses. He was also found by an internal Enron investigation to have
secretly made $30 million from managing one of these partnerships.
• DAVID DUNCAN:
Enron’s Chief Auditor at Andersen. His job was to check Enron’s accounts.
He is accused of ordering the shredding of thousands of Enron related
documents in an effort to hide them from the Securities and Exchange
Commission.
Mark-to-market Accounting
• One of Skilling's early contributions was to move Enron from a traditional
historical cost accounting method to a mark-to-market (MTM) accounting
method, for which the company got official SEC approval in 1992.
• MTM is a measure of the fair value of accounts that can change over time,
such as assets and liabilities.
• Mark-to-market aims to provide a realistic appraisal of an institution's or
company's current financial situation. It is a legitimate and widely-used
practice. However, in some cases it can be manipulated, since MTM is not
based on "actual" cost but on "fair value," which is harder to pin down.
Some believe MTM was the beginning of the end for Enron, as it
essentially started logging estimated profits as actual ones.
Whistle Blower

• SHERRON WATKINS:
Vice President of Corporate Development at the Enron Corporation. In June 2001, she
was given the task of finding some assets to sell off but it was very difficult for her.
She prepared a Memo regarding the various problems and placed it into the box but
this Memo was not taken into consideration. On August 22,Watkins handed CEO Lay a
seven page letter and told him that ENRON would implode in a wave of accounting
scandals. In August 2001, Watkins alerted then-Enron CEO Kenneth Lay of accounting
irregularities in financial reports. In February 2002,she revealed the various facts
regarding ENRON partnerships and finally resigned in November. But Watkins
Revealed all the facts only after Enron filed for bankruptcy. However, Watkins has
been criticized for not reporting the fraud to government authorities and not
speaking up publicly sooner about her concerns, as her memo did not reach the
public until five months after
The Shock

• By the summer of 2001, Enron was in a free fall. CEO Kenneth Lay had retired in
February, turning over the position to Jeffrey Skilling; that August, Skilling resigned
as CEO for "personal reasons."
• Around the same time, analysts began to downgrade their rating for Enron's stock,
and the stock descended to a 52-week low of $39.95.
• By Oct.16, the company reported its first quarterly loss and closed its "Raptor" SPV.
This action caught the attention of the SEC.
• A few days later, Enron changed pension plan administrators, essentially forbidding
employees from selling their shares, for at least 30 days. Shortly after, the SEC
announced it was investigating Enron and the SPVs created by Fastow. Fastow was
fired from the company that day.
The Shock

• Also, the company restated earnings going back to 1997. Enron had losses of $591
million and had $628 million in debt by the end of 2000.
• The final blow was dealt when Dynegy (NYSE: DYN), a company that had previously
announced would merge with the Enron, backed out of the deal on Nov. 28. By Dec.
2, 2001, Enron had filed for bankruptcy.
• The company paid its creditors more than $21.7 billion from 2004-2011. Its last pay-
out was in May 2011.
Impact on Employees

• Thousands of employees lost their jobs as well as their retirement

savings with the company.
• The pension fund for the employees was obliterated.
• After bankruptcy, laid-off workers received $4500 severance payment,
no matter how many years they had worked for the company.
• Lower-level employees were prevented from selling their stock due to
restrictions and many subsequently lost their life savings.
• More than half of employees invested about $1.2billion in Enron stock.
Those shares were rendered worthless.
Impact on Shareholders

• Enron share holders received limited returns in law suits despite losing
billions.
• Eligible shareholders whose Enron holding became worthless when the
company crumbled in scandal received $7.2billion in settlements under a
distribution plan approved in federal court.
• Undermined the investors trust in the reliability of mandated corporate
filings.
• At Enron peak, its share was worth $90.75 but after the company
declared bankruptcy on December2,2001, it plummeted to $0.67 by
January 2002.
Criminal Charges

• Arthur Andersen was one of the first casualties of Enron's prolific demise. In
June 2002, the firm was found guilty of obstructing justice for shredding
Enron's financial documents to conceal them from the SEC. The conviction
was overturned later, on appeal; however, the firm was deeply disgraced by
the scandal, and dwindled into a holding company. A group of former
partners bought the name in 2014, creating a firm named Andersen Global.
• Several of Enron's execs were charged with a slew of charges, including
conspiracy, insider trading, and securities fraud. Enron's founder and former
CEO Kenneth Lay was convicted on six counts of fraud and conspiracy and
four counts of bank fraud. Prior to sentencing, though, he died of a heart
attack in Colorado.
Criminal Charges

• Enron's former star CFO Andrew Fastow plead guilty to two counts of wire
fraud and securities fraud for facilitating Enron's corrupt business practices.
He ultimately cut a deal for cooperating with federal authorities and served
more than five years in prison. He was released from prison in 2011.
• Ultimately, though, former Enron CEO Jeffrey Skilling received the harshest
sentence of anyone involved in the Enron scandal. In 2006, Skilling was
convicted of conspiracy, fraud, and insider trading. Skilling originally
received a 24-year sentence, but in 2013 it was reduced by 10 years. As a
part of the new deal, Skilling was required to give $42 million to the victims
of the Enron fraud and to cease challenging his conviction. Skilling remains
in prison and is scheduled for release on Feb. 21, 2028.
What went wrong?

• Lack of corporate governance & ethics, and the get-it-done business

pragmatism.
• Large discrepancies of attempting to match profits and cash, investors were
typically given false or misleading reports as it was difficult to estimate cost
and viability of contracts.
• Atmosphere of market euphoria and corporate arrogance.
• High risk deals that went sour.
• Deceptive reporting practices—lack of transparency in reporting financial
affairs.
• Excessive interest in maintaining stock prices.
 Corporate
Governance
Introduction

• Stage 1
• Company founded (owned and managed) by individual, his family, friends.
• Stage 2
• Company expands by issuing more equity and debt. New equity holders also get
voting rights as to who manages the company.
• Company founder must now choose between keeping control of the company or
allowing the company to be managed by professional managers.
• If they keep control there is a potential conflict between the founders and other
shareholders.
• If they pass management to professional managers there is a potential conflict
between owners and managers.
What is Corporate Governance?

• Corporate governance is about minimizing the loss of value that results

from the separation of ownership and control.
• It deals with the ways in which suppliers of finance to corporations
assure themselves of getting a return on their investment.
• While corporate governance has been a hot issue in recent years (Enron)
it is a problem that has been around for hundreds of years.
What is Corporate Governance?

• Good corporate governance practices involve:

• The corporate governance framework should protect
SHAREHOLDERS RIGHTS.
• The corporate governance framework should ensure the EQUITABLE
TREATMENT OF ALL SHAREHOLDERS.
• STAKEHOLDERS should be INVOLVED in corporate governance.
• DISCLOSURE AND TRANSPARENCY is critical.
• The BOARD OF DIRECTORS should be MONITORED and held
ACCOUNTABLE for what guidance it gives.

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Board of Directors

 The board of directors is responsible for overseeing

management and representing shareholders’ interests.
 Majority of the countries have single-tiered boards, headed
by a Chairman of the Board. The CEO and other executives
usually also sit on the board.
 Some other countries (Germany, Indonesia) have two-tiered
boards. The roles and composition of the two boards can
differ.

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 Boards should be an appropriate size –
not too big not too small.

Depending on the size of the company

Board within the range of 5-15 is normal.

Size If the board is too small, there is a lack of

monitoring.

If the board is too big, there are problems

reaching a consensus for decision making.
 Boards should have a majority/high proportion of
outside/independent directors.

Board Outside/independent directors should have no personal

interest in the company and therefore are more effective
Independence monitors.

But it is also a good idea to have some company insiders

(CEO, executives) on the board to provide the board with
a better understanding of the company’s operations.
Chairman/CEO Positions
 The Chairman of the Board is responsible for overseeing the board of
Directors.
 The CEO is responsible for the day-to-day running of the company.
 In family-controlled companies it is common for the same person or
relatives to hold both of these positions. But this concentrates power
and reduces monitoring.
 Therefore, the positions of Chairman and CEO should be separated.
Board Committees
 The board of directors can delegate certain duties to board committees
– this can provide increased monitoring on specific issues.
 Audit committee – responsible for internal audit function and
appointment of external auditor.
 Remuneration committee – responsible for setting appropriate
compensation for directors and executives.
 Nomination committee – responsible for finding appropriate directors
and executives.
Executive Compensation
 Compensation of top executives can be used to tie the interests of the
executives to those of shareholders.
 Variable performance packages are preferred:
 If they perform well, they are rewarded.
 If they perform poorly, they are not rewarded or fired.
 Alignment of interests is usually achieved through:
 Stock ownership
 Stock options
Ownership Structure
 Where companies are usually owned by widely-dispersed shareholders
and controlled by professional managers; no single party is in control of
the company.
 However, in some nations around the world, ownership is usually
concentrated in the hands of family groups or government entities.
This means that one group is in control of the company and there is
very little you can do (other than sell) if you don’t like what they’re
doing.
Ownership Structure
 The identity of the controlling owner can also have corporate
governance implications.
 Family-controlled strive to gain effective control of the company with
their ownership. The market recognizes this & the risk attached is
reflected in the share price.
 Government-owned and widely-held companies are more likely to
follow the rules.
Ownership Structure
 The presence of a non-management related blockholder of shares can
increase monitoring of the firm.
 A blockholder usually holds at least 5% of the outstanding shares,
therefore has a significant interest in the future performance of the
company.
 Blockholders can be governments, financial institutions, individuals or
other companies.
External Auditors
 Stock exchange listing requirements usually make it mandatory for
companies to employ an external auditor to audit their financial
statements (and internal controls).
 External auditor should be independent of management, but ….
 Tenure of auditor
 Tenure of audit partner
Monitoring by Debt holders
 Debt holders provide capital to the company usually with conditions:
 Debt covenants
 Secured on assets

 Therefore debt holders actively monitor management to ensure that

companies are meeting debt conditions and that they won’t default.
Analysts
 Securities analysts are professionals
employed by investment banks / brokers /
asset managers to monitor companies and
provide stock recommendations (buy/sell),
earnings forecasts, long-term growth
forecasts, target prices etc.
 Provides an extra level of monitoring for
investors.

 But, analysts' incentives/conflicts of

interest mean that not all their output is
trustworthy.
Takeover Market
 The merger and acquisition (M&A) market stands as a ‘court of last
resort’ for assets that are not being utilized to their full potential.
 If management are underperforming there is a good chance that this
will be noticed by the market and other players will want to take
control of the company.
 There are active takeover markets in Australia, US, UK, New Zealand,
but few other countries.
Legal Systems
 Each country’s legal system has built in a certain degree of investor
protection. However, there is a wide variation in protection and
enforcement of these rules around the world.
 Common law countries provide highest protection and French civil law
countries provide the least protection.
 Low investor protection seems to result in concentrated ownership and
underdeveloped equity markets.
Recent Regulations
 In response to the Enron crisis in the US, the Sarbanes Oxley Act was
passed in 2002. This has significantly increased governance practices
and the personal liability of directors in the US.
 Most other nations have issued Corporate Governance Best Practice
Guidelines to assist companies in improving their governance.
Convergence?
 Originally there were market-based, family-based, bank-based,
government-affiliated systems.
 In recent years, most nations have started to promote US and UK best
practice corporate governance guidelines. But not all companies are
adopting these measures.
 There is evidence that many family-controlled companies are refusing
to improve their corporate governance practices.
Measuring Corporate Governance

 Understanding what good corporate governance is about is quite easy.

However, it is difficult to measure whether companies are really
committed to good governance.
 All we can do is measure if they have certain corporate governance
mechanisms in place – we don’t know if they are effective or not!
 Organizations such as Standard and Poors and Credit Lyonnais
Securities Asia have started providing corporate governance ratings in
recent years.

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Benefits of Good Governance

 Researchers have shown that companies with good corporate

governance practices are valued more highly and run more
effectively.

 So the benefits of good governance include:

 Higher share price
 Lower cost of funds
 Greater international following

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What you need to remember…
 When investing it is worthwhile keeping in mind whether a company
has committed to good corporate governance or not. You can use the
corporate governance ratings as a guide.
 Corporate governance becomes most important during stock market
crashes and bad economic times.
 But it is not a perfect science. Managers will always find a way to
circumvent monitoring to achieve their own goals!
Satyam Scam
• The Satyam Computer Services scandal was a corporate scandal affecting India-based
company Satyam Computer Services in 2009, in which chairman Ramalinga Raju
confessed that the company's accounts had been falsified.
• The Satyam scandal was a Rs 7,000-crore corporate scandal in which chairman
Ramalinga Raju confessed that the company’s accounts had been falsified. On January
7, 2009, Ramalinga Raju sent off an email to Sebi and stock exchanges, wherein he
admitted and confessed to inflating the cash and bank balances of the company.
• Weeks before the scam began to unravel with his famous statement that he was riding
a tiger and did not know how to get off without being eaten, Raju had said in an
interview that Satyam, the then fourth-largest IT company, had a cash balance of Rs
4,000 crore and could leverage it further to raise another Rs 15,000-20,000 crore.
Satyam Scam

• The Satyam saga eventually turned out to be a case of financial misstatements to the tune of
approximately Rs 12,320 crore, as per Sebi’s probe then. Citibank froze all its 30 accounts in
2009.

• Raju also manipulated the books by non-inclusion of certain receipts and payments, resulting
in an overall misstatement to the tune of Rs 12,318 crore, shows an analysis of findings of
Sebi’s probe.
• As many as 7,561 fake bills which were even detected in the company’s internal audit reports
and were furnished by one single executive.
• Merely through these fake invoices, the company’s revenue got over-stated by Rs 4,783 crore
over a period of 5-6 years. The probe itself continued for almost six years and found that
fictitious invoices were created to show fake debtors on the Satyam books to the tune of up
to Rs 500 crore.
Satyam Scam
• After the fraud came to the light, the government had ordered an
auction for sale of the company in the interest of investors and over
50,000 employees of Satyam Computers.
• It was acquired by Tech Mahindra, and was then renamed as Mahindra
Satyam, and was eventually merged into the parent company.
Thank you!