Question 1: What went wrong in ENRON, identify the factors, and actors/entities

involved.

Answer to question 1.

Background:
Enron was founded in 1985 by Kenneth Lay in the merger of two natural-gas-transmission
companies, Houston Natural Gas Corporation and InterNorth, Inc.; the merged company, HNG
InterNorth, was renamed Enron in 1986. After the U.S. Congress adopted a series of laws to
deregulate the sale of natural gas in the early 1990s, the company lost its exclusive right to
operate its pipelines. With the help of Jeffrey Skilling, who was initially a consultant and later
became the company’s chief operating officer, Enron transformed itself into a trader of energy
derivative contracts, acting as an intermediary between natural-gas producers and their
customers. The trades allowed the producers to mitigate the risk of energy-price fluctuations by
fixing the selling price of their products through a contract negotiated by Enron for a fee. Under
Skilling’s leadership, Enron soon dominated the market for natural-gas contracts, and the
company started to generate huge profits on its trades.

WHAT WAS HAPPENING IN ENRON (AN OVERVIEW)

Enron, like many other companies, used “special purpose entities” (SPEs) to access capital or
hedge risk. By using SPEs such as limited partnerships with outside parties, a company is
permitted to increase leverage and ROA without having to report debt on its balance sheet. The
company contributes hard assets and related debt to an SPE in exchange for an interest. The
SPE then borrows large sums of money from a financial institution to purchase assets or
conduct other business without the debt or assets showing up on the company’s financial
statements. The company can also sell leveraged assets to the SPE and book a profit.

WHAT WENT WRONG AT ENRON

The story of Enron Corporation depicts a company that reached dramatic heights only to face a
dizzying fall. The fated company's collapse affected thousands of employees and shook Wall
Street to its core. At Enron's peak, its shares were worth $90.75; just prior to declaring
bankruptcy on Dec. 2, 2001, they were trading at $0.26.1 To this day, many wonder how such a
powerful business, at the time one of the largest companies in the United States, disintegrated
almost overnight. Also difficult to fathom is how its leadership managed to fool regulators for so
long with fake holdings and off-the-books accounting.

Factors:
1. Intermediation and government failure was one of the major factors that led to the fall of
Enron. This problem was attributed to the activity of Arthur Anderson that assisted in
falsifying the auditing books.
2. Top management compensation was another factor leading to the fall of Enron. Enron
heavily compensates its top level management using stock options.
 3. Board of directors of Enron company failed to fulfill their fiduciary duties toward
shareholders because the top level executives were greedy and acted solely to protect
their personal interest.
4. The poor role of the audit committee was also attributed to the downfall of Enron
Corporation.
5. In the United States the accounting standards were both inflexible and mechanical.
Enron did not follow rules and regulation laid by FASB.

Actors/entities involved:
1. Directors: The contribution of Enron‟s directors to the Company's demise can be briefly
described as unfulfilled fiduciary duties. Generally, directors are wholly responsible for
governing and directing the company‟s affairs in the best interests of the company as a
whole and its shareholders.
2. Executive officers: The role played by executive officers in contributing to the Enron
fiasco is significant. The establishment and operation of SPEs was to best serve the self-
interests and satisfy the CFO and some other Enron employees, and ultimately lead
Enron to slide into bankruptcy. However, it is arguable that difficulties arising from the
SPEs could have been avoided if the CEO had acted in the interests of Enron’s
shareholders.
3. Whistleblowers: the culture of Enron was dishonest and unethical. Consequently, this
culture discouraged Enron’s whistle-blowers to come forward. Additionally, within this
context, it is not difficult to understand why some of Enron‟s employees came forward;
however, there was no action taken to follow this up. Besides the corporate culture, it is
also important to note that Enron‟s employees “blew to the wrong people‟, including the
CEO and the CFO, who were directly involved in such wrongdoings and acted in their
own interests. Accordingly, although Enron’s CEO did consult with the law firm Vinson &
Elkins, there was no follow-up action undertaken.
4. external auditor: In addition to Enron‟s internal corporate governance structure, Enron‟s
external auditor, Arthur Andersen, also played a key role in contributing to the Enron
fiasco. The role of the auditor, generally, is to provide reasonable assurance that audited
financial reporting is free from material misstatement, as well as truthfully and fairly
presented by management. In doing so, the external auditor is required to be impartial
and free from any financial interest in the audit client
5. Internal auditor: One of the most important mechanisms in internal corporate
governance is the internal audit. It is important to note that Enron’s internal auditors were
outsourced from Arthur Andersen for several years. The lack of a strong and capable
internal audit department also significantly contributed to Enron’s collapse because of
the high probability of undetected wrongdoing, unnoticed questionable transactions and
dealings, and earnings management.
Question 2: How you can link this fall of ENRON with the different foundational theories
of Corporate Governance.

Answer:

Agency theory and Enron:

In Enron's case, the existence of the "agency problem" within its board of directors is partly to
blame for the company's mismanagement and apparent unethical behavior. The agency
problem states that because top managers are typically not owners of a company, they can't be
trusted to act in the best interest of those who do own the company -- the shareholders. "Boards
of directors were seen as a solution to the agency problem because they have a legal
responsibility to protect and serve the shareholders. But what the Enron case illustrates is that
the agency problem also exists within a company's board of directors, Boards, too, have
incentives not to act in the best interest of shareholders. The agency problem at Enron and
other companies often is created because the CEO also serves as chairman of the company's
board of directors. "When the chairman is the CEO, then the nature of information that goes to
the board is often distorted. The Enron case should prompt a lot of re-thinking about the role of
the board of directors and whether it's better or worse for a board to own shares of a company.
"The general feeling has been that board members should own shares if they are to represent
the shareholders. But what we're learning from Enron is that when board members own shares,
there's a disincentive to ask the really tough questions for fear that those questions will drive
down the stock prices.

Stakeholder Theory:

Stakeholder – Employees :

Enron lured new employees with attractive signing bonuses and the promise of earning annual
bonuses of as much as 100% of their salaries and they were encouraged to move around the
organization freely to positions where they felt they could add value and generate additional
revenue. Enron relied on Biannual feedback system biannual based on 360-degree reviews of
employees from peers, customers, and supervisors.

Stakeholder – Community Around :

CEO, Kenneth L Lay was among strongest advocates for deregulation of prices of the energy
market, so he involved Enron and allies into lobbying and campaign activities in 24 states
across the US, later they extended to Great Britain and India. Enron played a major contribution
in deregulating energy markets in those states. Enron invested $450 million in the Dabhol
project, Mumbai. This project was troublesome as the terms offered were unfavoured by neither
locals Indian States nor the national government. In other words Enron invested for their
personal profit as India was emerging deregulated.

Stakeholder – Government & Politics :

Enron had close personal connections with high ranking government officials. The contribution
in presidential campaigns of George W. Bush and George H.W. Bush was remarkable. Enron
was supported firmly by the government as the relationship was maintained strongly between
them. Kenneth Lay was a prominent member of Vice President Cheney‘s task force in
development of a National Energy Policy; he also served as co-chairman of Bush‘s Economic
Summit in Houston in 1990, and headed Houston‘s host committee for the Republican National
Convention. He was also an occasional golf partner of President Clinton.

Stakeholder – Board of Directors / Owners :

The board entrusted responsibility to an Audit Committee for overseeing the internal and
external auditors and the financial reporting process, and responsibility to a Compensation
Committee for evaluating the CEO‘s performance and setting CEO compensation. Despite
debts and expenses, the board allegedly managed to draw compensation and bonuses to the
members and senior officers. The issue of unregulated outside income of senior officers was
never taken care of, there was lack of information about funding. Board created SPEs to hedge
stocks and to report back, but later on stock prices fell from $60 to $40 and Enron had to invest
$35 million to keep support of those SPEs. Just eight months after becoming CEO Jeffrey
Skilling resigned and stated family reasons for the resignation which led to 50% stock-price
decline from its high of $90 in September 2000. In the period of 1999-2000 a series of board
members resigned.

Stakeholder – Auditors

During the 1980s and 1990s the auditing industry increased in competency so they began
changes that prompted audit firms to mechanically apply consistent accounting and auditing
standards, and to develop standardized audit procedures to lower costs and reduce their
liability. Moreover Enron was also aggressively diversifying into higher-growth, and was
interested in higher-margin consulting services. Arthur Andersen used to be Enron‘s external
auditor since 1985. Enron outsourced many of its internal audit functions to Andersen. About 40
Enron employees shifted to Andersen‘s payroll. Internal documents which were later destroyed
had evidence that Enron was engaging in high- risk accounting and hence later on they even
classified Enron in the maximum risk category. They never even took any steps to highlight
these risks and never reported them to the board.