BM2210
Date:
Instructor:
The Enron Scandal
Instruction: Read the scenario carefully and answer the following questions.
Enron was founded in 1985 by its chairman Kenneth Lay as a natural gas pipeline company. In the newly
deregulated gas industry, however, gas producers and buyers could now trade, and hedge gas supplies and Enron
quickly moved to exploit the new opportunities afforded by this development. Under the direction of Jeffrey
Skilling, then president of Enron's trading operations, Enron expanded into energy sectors in other countries,
developing an increasingly influential role as a trading house for the energy industry. Using this model, Enron
diversified into electricity, coal, paper, plastics, and metal, and then with the establishment of Enron Online, moved
into telecommunications bandwidth trading. By the late 1990s, Enron had secured a reputation for exceeding earnings
expectations -- Fortune Magazine selected Enron as "America's most innovative company" for six straight years
from 1996 to 2001.
In 1992, however, Skilling convinced federal regulators to permit Enron to use an accounting method known as "mark
to market." With mark-to-market accounting, the price or value of the security is recorded daily to calculate profits
and losses. Using this method, Enron could count projected earnings from long-term energy contracts as current
income. The money might not be collected for many years and could be used to inflate Enron's revenue figures by
manipulating projections for future revenue. The use of such "black box" accounting techniques was agreed to by
Enron's auditor, Arthur Anderson, but made it difficult for outsiders to see how Enron made money.
CFO Andrew Fastow also established a series of special-purpose entities to maintain the impression of sustained
profit growth. Large debts amounting to billions of dollars could now be concealed in Enron's financial arrangement
with the special purpose entities (SPEs). Enron's auditors were aware of the new provisions and agreed they were
probably legal. When Enron's share price began to fall in 2001, however, its capacity to hide its losses began to
diminish. In October 2001, Enron disclosed non-recurring charges of US$1.1 billion, a reduction in shareholder's
equity of US$1.2 billion, and a US$700 million loss, thereby revealing to the market the significance of the shadowy
SPE companies. Six weeks later, Enron, which had US$62 billion in assets, filed for bankruptcy. Arthur Anderson
would also collapse, and over 20,000 Enron employees (many of whom had invested in Enron stock) subsequently
lost their jobs.
By this time, Enron was acquiring an unsavory reputation not only for its accounting fraud but for the manner of its
business operations. Enron's operations at the center of the energy market caused a series of catastrophic power
shortages and blackouts in California in 2000/2001 that significantly harmed the state's economy. Rolling blackouts
began as Enron took advantage of the newly deregulated Californian energy market. Before May 2000, electricity
prices had averaged US$24-40 per megawatt-hour; frighteningly, the price surged to the price cap of US$750 per
megawatt-hour in June. Entire neighborhoods saw their power shut off for an hour to two hours at a time – at which
point their power turned back on, and another neighborhood went dark. Small businesses had to shut their doors
because they could not pay their bills. Schools had to send students home because their electricity shut off. Enron
took full advantage of the price hike, booking profits of some $200 million between May and August 2000. Enron
was accused of manipulating the energy market to its advantage, causing dramatic increases in the cost of power
until the Federal Energy Regulatory Commission was forced to intervene.
Questions (3 items x 10 points):
1. Discuss Enron's corporate governance from the perspective of agency theory.
2. Enron's chairman Kenneth Lay claimed that Enron was "laser-focused on shareholder value" and that no
one had been hurt more by Enron's collapse than him. What criticisms might be made of Enron's corporate
governance from a stewardship and stakeholder perspective?
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BM2210
3. If you are part of a company’s corporate governance, how would you solve potential problems, such as the
Enron scandal? What measures could be in place to prevent potential problems and bigger issues?
Rubric for Scoring:
CRITERIA PERFORMANCE INDICATORS POINTS
Content Provided content that is coherent to the question 7
Organization of Expressed the points in a clear and logical arrangement of ideas in the
3
Ideas paragraph
Total 10
Reference:
Charkham, J., & Simpson, A. (1999). Fair Shares: The future of shareholder power and responsibility.
Oxford University Press, Oxford.
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