BM2210

Name: Date:
Section: 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.

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Enron's corporate governance, as seen through the lens of agency theory, had serious shortcomings.
Agency theory focuses on the relationship between the company's management (the agents) and its
shareholders (the principals), addressing potential conflicts of interest. In the case of Enron, there
was a notable misalignment of interests between the company's executives and its shareholders. The
executives, with Kenneth Lay and Jeffrey Skilling at the helm, pursued strategies that prioritized
their personal financial gain. They used accounting methods like "mark to market" to inflate the
company's apparent performance and conceal its financial issues. This focus on short-term gains and
the manipulation of financial data gave rise to a significant agency problem, deviating from the
shareholders' interests in long-term value and transparency. Furthermore, the creation of special-
purpose entities by CFO Andrew Fastow, with the approval of Enron's auditors, only worsened the
agency problem by allowing the executives to hide substantial debts and losses. In the end, the lack
of oversight and ethical responsibility in Enron's corporate governance structure resulted in its
catastrophic collapse, inflicting significant harm on shareholders and the wider economy.

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?

Critics of Enron's corporate governance, from both a stewardship and stakeholder perspective,
would argue that the company's actions demonstrated a clear disregard for the interests and well-
being of its stakeholders, including employees, shareholders, and the public. Enron's leadership,
including chairman Kenneth Lay, promoted a culture that prioritized short-term financial gains
and manipulated accounting practices to inflate the company's revenue figures, thereby misleading
shareholders and investors. This corporate culture was characterized by a focus on maximizing
shareholder value at the expense of ethical and responsible business practices.

Enron's use of "mark to market" accounting and the establishment of special-purpose entities
(SPEs) allowed the company to hide its massive debts and present a false image of sustained profit
growth, ultimately leading to the loss of jobs and savings for thousands of employees and
shareholders. Furthermore, Enron's actions in the energy market, such as causing power shortages
and manipulating electricity prices, had severe consequences for the general public and the
economy of California. This demonstrated a lack of stewardship and corporate responsibility in
ensuring the well-being of the communities in which the company operated.

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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?

To address potential issues like the Enron scandal and improve corporate governance, we should
take several important steps. First, prioritize transparency and accountability. Companies should
offer stakeholders clear, accurate, and easily understandable financial information. We should also
have reputable firms conduct independent audits to ensure the accuracy of financial reports.
Second, it's crucial to establish a separation of powers and responsibilities within the organization
to avoid centralizing authority, as we saw in the case of Enron. This means having a strong,
independent board of directors that can question management decisions. Third, we need to set up a
strong code of ethics and a compliance program that promotes ethical behavior. We should also
have mechanisms in place for employees to report any misconduct through whistleblowing.
Fourth, we must strengthen regulatory oversight and enforcement to ensure that corporate entities
adhere to accounting and financial reporting standards. Finally, creating a culture of ethics and
integrity from the top is vital. We need to emphasize that ethical behavior is not just about
compliance; it's a fundamental value of the organization.

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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