You are on page 1of 20




1.1 Introduction 2
1.2 The Issue 3


2.1 Enron : A Background 4
2.2 Enron Scandal 5
2.3 Creative Accounting : The Special Purpose Entities (SPE’s) 6


3.1 Enron Board Of Directors 8
3.2 The Role Of Board Of Directors In Enron’s Collapse & Bankruptcy 9


4.1 From The Perspective Of Company Law In Malaysia 11
4.1.1 Duty To Acting Bona Fide 11
4.1.2 Duty To Act For Proper Purposes 12
4.1.3 Duty To Avoid Conflict Of Interest 13
4.1.4 Duty Of Care, Skill And Diligence 13
4.2 SPE’s In Malaysia 14


5.1 Conclusion 17
5.2 Recommendations 18




1.1 Introduction

Theoretically, the control of a company is divided between two bodies: the board of directors,
and the shareholders in general meeting. In practice, the amount of power exercised by the board
varies with the type of company. In small private companies, the directors and the shareholders
will normally be the same people, and thus there is no real division of power. In large public
companies, the board tends to exercise more of a supervisory role, and individual responsibility
and management tends to be delegated downward to individual professional executive directors
(such as a finance director or a marketing director) who deal with particular areas of the
company's affairs.

Another feature of boards of directors in large public companies is that the board tends to
have more de facto power. Between the practice of institutional shareholders (such as pension
funds and banks) granting proxies to the board to vote their shares at general meetings and the
large numbers of shareholders involved, the board can comprise a voting bloc that is difficult to
overcome. However, there have been moves recently to try to increase shareholder activism
amongst both institutional investors and individuals with small shareholdings.

It is worth noting that in most cases, serving on a board is not a career unto itself. Inside
directors are not usually paid for sitting on a board in its own right, but the duty is instead
considered part of their larger job description. Outside directors on a board likewise are
frequently unpaid for their services and sit on the board as a volunteer in addition to their other

1.2 The Issue

As a director of a company, the responsibilities are set out in the Company Law ("the Law").
Failure to fulfill the duties may lead to being sued or prosecuted. Enron case may explain some
of the major duties of directors and issues facing directors in running a company. This include
security fraud, bank fraud, money laundering, making false statement, misleading the public and
insider trading doing by the Enron former directors. This case will give a reality scenario about
what happen in real business now. It will also lead us to the main problem about the
responsibilities and duties of the directors from the perspective of Company Law in Malaysia.



2.1 Enron: A Background

Enron was born in July 1985 when Houston Natural Gas merged with Omaha-based Inter-North.
Enron was a power company selling electricity and gas. During the late 1990s, Enron grew
rapidly and moved into areas it believed fit its basic business plan: buy or develop an asset, such
as a pipeline or power plant, and then expand it by building a wholesale or retail business around
the asset. Like others in the sector it started small and grew rapidly by takeovers and mergers
raising money from banks and the share market. It was in the business of corporate competition
and market capitation rather than the business of supplying gas and power. As the energy
markets, and in particular the electrical power markets were deregulated, Enron’s business
expanded into brokering and trading electricity and other energy commodities.

The deregulation of these markets was a key Enron strategy as it invested time and
money in lobbying Congress and state legislatures for access to what traditionally had been
publicly provided utility markets. Some of Enron’s top executives became frequently named
corporate political patrons of the Republican Party. Enron needed the federal government to
allow it to sell energy and other commodities. According to the Center for Responsive Politics,
between 1989 and 2001, Enron contributed nearly $6 million to federal parties and candidates.

It was one of the first amongst energy companies to begin trading through the Internet,
offering a free service that attracted a vast amount of customers. But while Enron boasted about
the value of products that it bought and sold online - a mind-boggling $880bn in just two years -
the company remained silent about whether these trading operations were actually making any

money. At about this time, it is believed that Enron began to use sophisticated accounting
techniques to keep its share price high, raise investment against it own assets and stock and
maintain the impression of a highly successful company. Enron's 2000 annual report reported
global revenues of $100bn. Income had raised by 40% in three year.

2.2 Enron Scandal

The Enron scandal was a financial scandal involving Enron and its accounting firm Arthur
Andersen, that was revealed in late 2001. Enron was the first of the great corporate collapses of
the 21st century. Like the others it blew up in a massive scandal of fraud and greed.

The real story is not about Enron. The real story is about structured finance and the giant
financial institutions who developed it, embraced it and used it as a vehicle for their own ends
without any regard for the social consequences. They set up and arranged the fraud. The real
story is also about the large number of credible financial giants who participated in Enron's
fraud. Without their active participation this fraud could not have occurred.

Structured finance was the credible sounding vehicle which the co-conspirators advising
Enron used to make what they were doing sound legitimate. Somewhere deep down they
obviously knew that what they were doing was wrong. This was never formally objectified and
recognized. It was officially seen as legitimate and the investment banks protested angrily when
they were accused of complicity in fraud.

The problem for Enron was that those who had invested had been promised and expected
to get more money from selling gas and electricity and this was not happening. Like the majority
of other companies in this position it sought to hide the truth from the public and borrow more
money to fill the hole.

A blatant fraud was concocted to create the illusion of real money, but those involved did
not see it as fraudulent. They were shielded by the legitimacy given to the arrangements by the

marketplace and by the complicity of Enron's partners, the banks and the accountants. They
designed and implemented the fraud on Enron's behalf.

Senior staff deluded themselves that things would improve and that those profits would
eventually come. They all knew that the value of the company lay in the price of its shares. This
is what they had borrowed against and the share price had to be kept up at all costs.

2.3 Creative Accounting: The Special Purpose Entities (SPE’s)

At the heart of Enron's demise was the creation of partnerships with shell companies, these shell
companies, run by Enron executives who profited richly from them, allowed Enron to keep
hundreds of millions of dollars in debt off its books. But once stock analysts and financial
journalists heard about these arrangements, investors began to lose confidence in the company's
finances. The results: a run on the stock, lowered credit ratings and insolvency.

How Enron used SPE’s for off balance sheet financing:

The above flow chart explains how Enron used the SPE’s taking most of its debt off balance

Merrill Lynch handled the sales pitch for one such vehicle, LJM2 Co-Investment.
According to claims and counter-claims filed in Delaware court hearings; many of the most
prominent names in world finance - including Citigroup, JP Morgan Chase, CIBC, Deutsche
Bank and Dresdner Bank - were still involved in the partnership, directly or indirectly, when
Enron filed for bankruptcy. Originally, it appears that initially Enron was using SPE's
appropriately by placing non energy related business into separate legal entities. What they did
wrong was that they apparently tried to manufacture earnings by manipulating the capital
structure of the SPEs; hide their losses; did not have independent outside partners that prevented
full disclosure and did not disclose the risks in their financial statements.

There should be no interlocking management: The managers of the off balance sheet
entity cannot be the same as the parent company in order to avoid conflicts of interest. The
ownership percentage of the off balance sheet entity should be higher than 3% and the outside
investors should not be controlled or affiliated with the parent: This was clearly not the case at
Enron. Enron, in order to circumvent the outside ownership rules funneled money through a
series of partnerships that appeared to be independent businesses, but which were controlled by
Enron management. The scope and importance of the off-balance sheet vehicles were not widely
known among investors in Enron stock, but they were no secret to many Wall Street firms. By
the end of 1999, according to company estimates, it had moved $27bn of its total $60bn in assets
off balance sheet.



3.1 Enron Board Of Directors

Whatever the final causes of Enron’s collapse, it appears that the Enron’s directors created a
business plan that failed. Many of its energy investments lost money and some of its trading
strategies produced questionable profits. As some of its investments began to fail, directors
apparently decided to use sales of investments to SPE’s as a means of showing continued
progress in earnings. In the special purpose entities, they have treated accounting standards as
rules to be evaded rather than as a means of assuring accurate disclosure. Its deliberate efforts to
prevent disclosure of credit risk and indebtedness through the special purpose entities at worst
may have violated SEC disclosure and fraud rules and at best amounted to a use of accounting
principles to hide the truth.

According to the consolidated class action complaint filed in the Enron Corporation
Securities Litigation, during a three year period prior to Enron’s collapse, twenty eight officers
and directors of Enron sold almost 21 million shares of Enron’s common stock for more than
$1.1 billion. Kenneth L. Lay, Chairman of the Board and Chief Executive Officer (CEO) sold
over 4 million shares for approximately $185 million, Jeffrey K. Skilling, the President and
Chief Operating Officer and later CEO sold 1.3 million shares for more than $70 million, and
Andrew S. Fastow, the Chief Financial Officer, sold 687 thousand shares for more than $33
million. These officers apparently had ample motivation to try to keep Enron stock prices high so
that they could sell stock received through the Company’s stock options program at enormous

According to the report of the Enron Board of Directors Special Investigative Committee,
when the Board approved the special purpose entities, many Board members did not understand
“the economic rationale, the consequences, and the risks of those transactions.” In agreeing that
the special purpose entities could be managed by Enron’s CFO, Andrew Fastow, the Board
waived its conflict interest rules. It established a system for monitoring these conflicts by Board
committees, but the Board apparently did not ask enough questions about the extent and nature
of the possible conflict transactions and the committees apparently failed in their monitoring

The Enron’s directors probably could have anticipated the legal problems they and the
company would face, and yet they continued to hide the problems. They seems to have been so
intent on pursuing its chosen strategies and hiding negative results that it failed to recognize that
lack of adequate disclosure will eventually have ruinous consequences.

Unfortunately, Enron’s directors behaved in ways typical of failing companies. They

apparently believed that disclosure of its troubles would have a negative effect on its ability to do
business. Directors of failing companies are not likely to sound warnings of their death throes,
and in that sense, Enron’s directors were not different from other directors.

3.2 The Role Of Board Of Directors In Enron’s Collapse & Bankruptcy

Based upon the evidence over one million pages of subpoenaed documents, interviews of
thirteen Enron Board members, and the Subcommittee hearing on May 7, 2002, the U.S. Senate
Permanent Subcommittee on Investigations makes the following findings with respect to the role
of the Enron Board of Directors in Enron’s collapse and bankruptcy.

1) Fiduciary Failure. The Enron Board of Directors failed to safeguard Enron shareholders
and contributed to the collapse of the seventh largest public company in the United
States, by allowing Enron to engage in high risk accounting, inappropriate conflict of
interest transactions, extensive undisclosed off-the-books activities, and excessive
executive compensation. The Board witnessed numerous indications of questionable

practices by Enron management over several years, but chose to ignore them to the
detriment of Enron shareholders, employees and business associates.

2) High Risk Accounting. The Enron Board of Directors knowingly allowed Enron to
engage in high risk accounting practices.

3) Inappropriate Conflicts of Interest. Despite clear conflicts of interest, the Enron Board
of Directors approved an unprecedented arrangement allowing Enron’s Chief Financial
Officer to establish and operate the LJM private equity funds which transacted business
with Enron and profited at Enron’s expense. The Board exercised inadequate oversight of
LJM transaction and compensation controls and failed to protect Enron shareholders from
unfair dealing.

4) Extensive Undisclosed Off-The-Books Activity. The Enron Board of Directors

knowingly allowed Enron to conduct billions of dollars in off-the-books activity to make
its financial condition appear better than it was and failed to ensure adequate public
disclosure of material off-the-books liabilities that contributed to Enron’s collapse.

5) Excessive Compensation. The Enron Board of Directors approved excessive

compensation for company executives, failed to monitor the cumulative cash drain
caused by Enron’s 2000 annual bonus and performance unit plans, and failed to monitor
or halt abuse by Board Chairman and Chief Executive Officer Kenneth Lay of a
company-financed, multi-million dollar, personal credit line.

6) Lack of Independence. The independence of the Enron Board of Directors was

compromised by financial ties between the company and certain Board members. The
Board also failed to ensure the independence of the company’s auditor, allowing
Andersen to provide internal audit and consulting services while serving as Enron’s
outside auditor.



4.1 From The Perspective Of Company Law In Malaysia

Because directors exercise control and management over the company, but companies are run for
the benefit of the shareholders, the law imposes strict duties on directors in relation to the
exercise of their duties. The duties imposed upon directors are fiduciary duties, similar in nature
to those that the law imposes on those in similar positions of trust: agents and trustees.

4.1.1 Duty To Acting Bona Fide

s. 132(1) which requires a director to act for proper purposes and in good faith. Directors must
act honestly and bona fide ("in good faith"). A director must act honestly at all times towards the
company. This is a statutory obligation. The test is a subjective on - the directors must act in
"good faith” in what they consider - not what the court may consider - is in the interests of the
company..." However, the directors may still be held to have failed in this duty where they fail to
direct their minds to the question of whether in fact a transaction was in the best interests of the

Difficult questions can arise when treating the company too much in the abstract. For
example, it may be for the benefit of a corporate group as a whole for a company to guarantee
the debts of a "sister" company, even though there is no ostensible "benefit" to the company
giving the guarantee. Similarly, conceptually at least, there is no benefit to a company in

returning profits to shareholders by way of dividend. However, the more pragmatic approach
illustrated in the Australian case of Mills v Mills (1938) 60 CLR 150 normally prevails:

"directors are not required by the law to live in an unreal region of detached altruism and to act
in the vague mood of ideal abstraction from obvious facts which must be present to the mind of
any honest and intelligent man when he exercises his powers as a director."

The majority of cases of dishonesty involve fraud, theft or other misuse of the company's
property. The Courts have sent dishonest directors to prison and imposed very heavy fines.
Acting honestly means more than just avoiding outright dishonesty. If the directors take a
decision knowing that it cannot be in the overall best interests of the company, they will not be
acting honestly even if they did not intend to defraud anyone.

4.1.2 Duty To Act For Proper Purposes

s. 132(1) of the Companies Act 1965 - Directors must exercise their powers for a proper purpose.
While in many instances an improper purpose is readily evident, such as a director looking to
feather his or her own nest or divert an investment opportunity to a relative, such breaches
usually involve a breach of the director's duty to act in good faith. Greater difficulties arise where
the director, while acting in good faith, is serving a purpose that is not regarded by the law as
The seminal authority in relation to what amounts to a proper purpose is the Privy
Council decision of Howard Smith Ltd v Ampol Ltd (1974) AC 832. The case concerned the
power of the directors to issue new shares. It was alleged that the directors had issued a large
number of new shares purely to deprive a particular shareholder of his voting majority. An
argument that the power to issue shares could only be properly exercised to raise new capital was
rejected as too narrow, and it was held that it would be a proper exercise of the director's powers
to issue shares to a larger company to ensure the financial stability of the company, or as part of
an agreement to exploit mineral rights owned by the company. If so, the mere fact that an
incidental result (even if it was a desired consequence) was that a shareholder lost his majority,
or a takeover bid was defeated, this would not itself make the share issue improper. But if the

sole purpose was to destroy a voting majority, or block a takeover bid, that would be an improper

4.1.3 Duty To Avoid Conflict Of Interest

The Companies Act 1965 requires directors interested in a contract with the company to disclose
their interests pursuant to s. 131, regulates substantial property transaction in ss. 132E, 132F,
132G and loans to directors and connected persons in ss. 133 and 133A respectively. Thus, the
prohibition in the provisions applies not only to directors, but also to persons connected with
directors and in the case of s. 132G, to shareholders.

As fiduciaries, the directors may not put themselves in a position where their interests
and duties conflict with the duties that they owe to the company. The law takes the view that
good faith must not only be done, but must be manifestly seen to be done, and zealously patrols
the conduct of directors in this regard; and will not allow directors to escape liability by asserting
that his decision was in fact well founded.

Traditionally, the law has divided conflicts of duty and interest into three sub-categories.

1) Transaction with the company

2) Use of corporate property, opportunity or information
3) Competing with the company

4.1.4 Duty Of Care, Skill And Diligence

s. 132(1A) was inserted which directors should at all times employ a reasonable degree of skill,
care and diligence in the exercise of their powers and the discharge of their duties. This is made
subject to a new business judgment rule in s. 132(1B), reliance on information provided by
others in s. 132(1C), and reliance on the actions of delegatee in s. 132 (1F). Traditionally, the
level of care and skill which has to be demonstrated by a director has been framed largely with
reference to the non-executive director. In Re City Equitable Fire Insurance Co (1925) Ch 407, it
was expressed in purely subjective terms, where the court held that:

"a director need not exhibit in the performance of his duties a greater degree of skill than may
reasonably be expected from a person of his knowledge and experience."

It is unwise for directors to simply agree to proposals put forward by other directors without
obtaining some information about the effect of the proposals on the company's business.

4.2 SPE’s In Malaysia

To promote Malaysia as a preferred choice for Islamic capital markets and a centre for sourcing
of funds, the Government has accorded tax incentives in relation to the issuance of Islamic
financial instruments. The Special Purpose Vehicle (SPV) set for the purpose of Islamic
financing is exempted from income tax. The company that established the SPV is also given a
deduction on the cost of issuance of the Islamic bonds incurred by the SPV. Current tax
exemption on interest income received by non-residents from financial institutions established
under the Banking and Financial Institutions Act 1989 has now been expanded to include profits
income received by non-residents from financial institutions established under the Islamic
Banking Act 1983.

A major concern for banks to be involved in microfinance is how to manage their risk
inherent in financing activities involving the poor and small entrepreneurs. The issue of risk is
paramount especially in banking business that requires efficient and effective mechanisms and
instruments in managing asset and liability on banks’ balance sheet to ensure their viability and

One of the possible alternatives for banks to get involved in microfinance is through a
SPE or popularly known as SPV. An SPV is a legal entity created by a firm (known as the
sponsor or originator) to undertake some specific purpose or restricted activity spelt out by the
sponsoring firm (Gorton and Souleles, 2005). The SPV may be a subsidiary of the sponsoring
firm or it may be an independent SPV, which is not consolidated with the sponsoring firm for
tax, accounting or legal purposes. The latter has an added feature of being a bankruptcy-remote

The legal form for an SPV may be a limited partnership, a limited liability company, a
trust, or a corporation (Gorton and Souleles, 2005). In case of Malaysia, SPV normally takes the
legal form of a trust and governed by Trustee Act. SPV is a trust set up to fulfill specific
purposes. In this regards, it can perform specific microfinance activities to benefit certain
beneficiaries. The trustee will be appointed by the sponsoring bank to oversee the operations and
activities outlined in the trust deed. More importantly, the designated funds channeled by the
bank as a form of trust should be used only for the prescribed objectives.

An essential feature of an SPV, which makes it promising as a vehicle to offer

microfinance is its bankruptcy-remote in nature. This implies that should the sponsoring firm or
Islamic bank enter a bankruptcy procedure, the firm’s creditors cannot seize the assets of the
SPV. To ensure the SPV as bankruptcy-remote as possible, its activities can be restricted. For
instance, it can be restricted from issuing debt beyond a stated limit (Gorton and Souleles, 2005;
Standard and Poor, 2002). The shares are customarily being held by a charitable trust established
for that purpose. The trust will be the sole shareholder in the SPV. There must also be no
provision in the constitutional documents of the SPV giving the sponsoring bank a right to
control the affairs of the SPV.

Standard and Poor (2002) provides the following list of characteristics for a bankruptcy-remote
1) Restrictions on objects, powers and purposes
2) Limitations on ability to incur indebtedness
3) Restrictions or prohibitions on merger, consolidation, dissolution, liquidation, winding
up, asset sales, transfers of equity interests, and amendments to the organizational
documents relating to ‘‘separateness’’
4) Incorporation of separateness covenants restricting dealings with parents and affiliates
5) ‘‘Non-petition’’ language (i.e. a covenant not to file the SPV into involuntary
6) Security interests over assets; and
7) An independent director (or functional equivalent) whose consent is required for

8) The filing of a voluntary bankruptcy petition.

Nowadays Islamic banks may establish an SPV by allocating certain amount of funds for
microfinance purposes. The Articles of Association of the SPV will limit its business activities to
a particular activity of the deal, such as the microfinance. The SPV must be fully bankruptcy
remote so that the Islamic bank is fully protected from the failure of the SPV and hence
maintaining its viability and sustainability in banking business. This means, for instance, that it
cannot be a subsidiary of the Islamic bank. The transfer of funds must be on a ‘‘full sale’’ basis
for accountancy and regulatory purposes. There must not be any possibility of the SPV being
consolidated with the selling bank. The benefits to the bank will be lost if the accounts of the
SPV are consolidated with those of the selling bank.

The basic procedures of microfinance through SPV are straightforward and summarized as
follows :
1) The Islamic bank mobilizes various sources of funds with specific microfinance
2) The Islamic bank creates a bankruptcy-remote SPV.
3) The bank allocates certain amount of funds and pass it to the SPV.
4) The funds are channeled to various clients depending on needs and demands. For
example, zakah funds may only be allocated to poor clients for consumption purposes
and capacity building initiatives, while other type of funds can be used to finance their
productive economic activities.



5.1 Conclusion

Enron’s Directors protest that they cannot be held accountable for misconduct that was concealed
from them. But much that was wrong with Enron was known to the Board, from high risk
accounting practices and inappropriate conflict of interest transactions, to extensive undisclosed
off the-books activity and excessive executive compensation.

At the hearing, the Subcommittee identified more than a dozen red flags that should have
caused the Enron Board to ask hard questions, examine Enron policies, and consider changing
course. Those red flags were not heeded. In too many instances, by going along with
questionable practices and relying on management and auditor representations, the Enron Board
failed to provide the prudent oversight and checks and balances that its fiduciary obligations
required and a company like Enron needed. By failing to provide sufficient oversight and
restraint to stop management excess, the Enron Board contributed to the company’s collapse and
bears a share of the responsibility for it.

The behavior by Enron’s directors in following a high risk business plan and attempting
to cover up the failure of that plan through accounting tricks offers an important lesson for
corporate shareholders. That lesson is that management conduct must be monitored. We know
that many responsible directors will understand that a culture of honesty and disclosure
ultimately will benefit their businesses. Nevertheless, one must devise a system for monitoring

managerial conduct that will protect the corporation and its shareholders from improper
managerial behavior.
5.2 Recommendations

By strengthen the internal corporate governance will offer a means to achieve an important goal,
the meaningful and efficient monitoring of corporate management by an independent, well
informed, will motivated group of non-management directors. These directors must have the
means and opportunity to perform the monitoring function, and they must also have the will and
determination to conduct the monitoring properly, even if in so doing they may disagree with
management and force changes in management conduct.

The following is a recommendation to strengthen the internal corporate governance :

1) The Board of Directors should include a substantial majority of independent directors

who should meet in executive session outside the presence of senior management. (Use
of the word “substantial” apparently suggests that independent directors should be more
than a majority of the board.)

2) A corporate governance committee should be responsible for identifying and contacting

potential independent directors, and should ultimately approve nominations in executive
sessions outside the presence of senior management.

3) The audit committee should consist entirely of independent directors, and should have
authority to hire and fire auditors and the ability to hire separate legal and accounting

4) The compensation committee should consist entirely of independent directors, should

have authority to “recommend or take action” regarding executive compensation, and
should be able to engage independent legal advisers and executive compensation

5) The corporate governance committee should recommend a corporate code of ethics and
should establish a “mechanism for communication to independent directors of
information about material violations of law and breaches of duty to the corporation.”

6) A committee of independent directors should approve all material transactions with a

director or executive officer.

7) The board should establish procedures for holding routine meetings between board
committees and the corporate officers, including the general counsel, chief internal
auditor, and the chief compliance officer.

The final decision maker regarding the conduct of the corporation should be the independent
board of directors. The policy of the corporation should be determined by the board, and the
CEO should understand that his or her actions will be scrutinized in detail by the board through
its various committees and acting as a whole. The CEO should not be the “Imperial CEO”, but
should recognize that disclosure to and cooperation with board in the exercise of its monitoring
functions is essential. This change in effective power within the corporation will only occur if the
independent directors have the will to accomplish their monitoring task.

On the whole, it could be said that the updating of the Companies Act was a move in the
right direction. It has streamlined the duties of directors by codifying the common law duties of
directors, updated the rules on substantial property transactions, and where possible attempted to
streamline the provisions of the Companies Act with those of the Bursa Malaysia’s Listing


Company Law Act 1965,8599,193520,00.html