Corporate Governance

Governance Failure at Enron

 CASE WRITE UP – Governance Failure at Enron
Prepared for:
Mona School of Business - Cohort 13

Course Name:

International Monetary and Economics and Finance

Course Code: SBFI6030

Lecturer: Dr. Lavern Mc Farlane

Prepared By:

620015509

620008830

620018965

620008853

02051303

January 13, 2011

Case questions

1. Which parts of the corporate governance system, internal and external, do you believe failed Enron
the most?

2. How do you think each of the individual stakeholders and components of corporate governance
system should have either prevented the problem at Enron or acted to resolve the problem before
they reached crisis proportion?

3. If all publicly-traded firms in the United States are operating within the same basic corporate
governance system as Enron, why would some people believe this was an isolated incident, and not an
example of many failures to come?
Corporate governance

The concept of corporate governance represents the collection of activities, rules, and professional guidelines that
make sure that the company is using its resources, strategies and directions in the best way possible, consistent with
its mission and stated goals.

The single most important objective of corporate governance in the Anglo-American markets is the optimization
overtime of the returns to shareholders. In order for companies to achieve maximization of returns to shareholder’s ,
good governance practices should focus the attention of the board of directors of the corporation on those objectives,
which ensure corporate growth and improvement in the value of the corporation’s equity. The board must ensure
that these objectives are also maintained and that timely and accurate disclosure is made on all matters regarding the
corporation, including the financial situation and performance of the company.

In response to the first question both the internal and the external corporate governance systems were factors which
contributed to Enron’s failure, but it may be argued that the internal system, primarily as it relate to the
responsibility of the board of directors and the management who are ultimately responsible, they are the agents
of the shareholder and therefore have a fiduciary responsibility to the shareholders to pursue value creation. The
board of directors in a company had the overall responsibility for the management and direction of its affairs. In this
regard, the directors should have exercised strategic oversight of business operations while directly monitoring,
measuring and rewarding management’s performance. The board should also have ensured the integrity of
accounting and financial reporting systems and oversee the process of accurate disclosure and communication.
Management on the other hand, not only had most of the knowledge of the business, but was also the creators and
directors of its strategic and operational direction. The board’s responsibilities inherently demanded the exercise of
judgment in an ethical manner. The board of directors had the responsibility to ensure that corporate behavior
conforms to best governance practices.

The external auditors and legal advisors

The auditor and legal advisers are responsible for providing an external professional opinion as to the fairness,
legality and accuracy of corporate financial statements. Companies, who decide to go public, in return for
investment, are required to have independent, third party validation of their financial report and progress. In doing
this they attempt to determine whether the firm’s financial records and practices follow generally accepted
accounting principles (GAPP). This is to make sure that management is not pulling the wool over the eyes of the
investors. Because of the importance of the external auditor, the external auditor must not only appear to be
independent, they must be seen as being independent. The central issue therefore is to ensure that there exist an
appropriate relationship between the auditor and the managers, whose financial statements they are auditing. Hence
a balance is required between working constructively with the company management and at the same time serving
the interest of the shareholders. Auditors have a fiduciary responsibility to make sure that the public and the
shareholders can be comfortable with the reports that are issued by the company management. The auditors are not
fraud investigators per se, but have a duty to inform management if they come upon anything that is suspicious. If
management does nothing to address the concerns then the auditors should withdraw their service. In Enron’s case
there was however conflict of interest as the Auditors also provided a large variety of consulting activities

Equity Markets

The Securities and Exchange Commission along did little firsthand investigation or conformation of reporting
diligence; they relied on the testimonials of other bodies like the Enron’s auditors and the auditors had conflict of
interest where the reporting of the Company’s performance is concern. The New York stock Exchange did no
independent first-hand verification and these practices allowed Enron to continue to mask their operation activities.
Their result was base on the information given as per financial reports.

Regulators

Publicly traded firms in the United States and elsewhere are subject to the regulatory oversight of both governmental
organization and non-governmental organizations. In the United States, The Securities And Exchange Commission
(SEC) is a careful watchdog of the publicly traded equity market, both in the behavior of the companies themselves
in those markets and of the various investors participating in those markets. The SEC and other authorities like it
outside of the United States require a regular and orderly disclosure process of corporate performance in order that
all investors may evaluate the company’s investment value with adequate, accurate, and fairly distributed
information. This regulatory oversight is often focused on when and what information is released by the company,
and to whom. A publicly traded firm in the United States is also subject to the rules and regulations of the exchange
upon which they are traded (New York Stock Exchange, American Stock Exchange, and NASDAQ are the largest).
These organizations typically categorize as self regulatory in nature, construct and enforce standards of conduct for
both their members companies and themselves in the conduct of share trading. This is viewed as the external
governance system which had the second least impact on preventing the failure of Enron. The internal structures
have caused Enron to fail mostly, but there was not enough monitoring of the operation of the company by the
external bodies

Response question 2

Firstly the Board of Director and The Executive Management team appears to be one and the same and this is
evidently a road to disaster. This is so because there should be a distinct difference between the board and the
management in order for there to be transparency and integrity in reporting. It is a requirement of corporate
governance best practice that the board of directors be made up of executive directors and non-executive directors.
The executive directors that are full-time paid employees and the non- executive directors are independent of
management and are primarily responsible for the monitoring of management and senior officers of the company.
This should prevent any conflict of interest unless there is a direct collusion between them. Had Enron done things
in the right way, displaying ethical behavior in the way they operated, a lot of the fraud and irregularities could have
been avoided. It was simply greed on the part of management and the board that has led Enron and its shareholders
and other stakeholders to have encountered this crisis. Board members failed to question decisions and to scrutinize
financial statements. As a result the board failed in its duties to protect shareholders interest due to lack of due
diligence.

Auditors assess the internal controls of a client to determine the extent to which they can rely on a client’s
accounting system. Enron had too many internal control weaknesses. Two serious weaknesses were that the CFO
was exempted from a conflict of interest policy, and internal controls over special purpose entities (SPEs) were a
sham, existing in form but not in substance. Many financial officials lacked the background for their jobs, and
assets, notably foreign assets, were not physically secured. The tracking of daily cash was lax, debt maturities were
not scheduled, off balance sheet debt was ignored although the obligation remained, and company-wide risk was
disregarded. Internal controls were inadequate; contingent liabilities were not disclosed; and, Andersen ignored all
of these weaknesses. Arthur Anderson had both auditing and consulting businesses tied up with Enron with the
greater proportion of their business with Enron being non-audit activities. Perhaps it was perceived that a poor audit
or a qualify audit for Enron could result in a loss of consulting business. In this sense, Arthur Anderson could not
write needed qualified or adverse opinions for fear of losing millions of dollars of business. The way in which they
could have helped to prevent the problem and hence the crisis, is that firstly they as auditor should not have accepted
or offered non audit services to such proportions in excess of audit services or they should have avoided all together.
This is a requirement by the auditing standards and is reinforced by the Sarbanes-Oxley Act (SOX). Auditors should
have been guided by this act. “Auditors are expressly prohibited from carrying out a number of services including
internal audit, bookkeeping, system designs and implementation, appraisal or valuation services, actuarial services
management functions and human resources, investment management, legal and expert services. The auditing
standards also speak to the retention of working papers, it was cited in the Enron case that at senior member of the
audit team, David Duncan, a partner in the Houston office of Andersen, headed the Enron audit and allegedly
orchestrated a document shredding campaign. Audit firms should retain working papers for at least 7 years and have
quality control standards in place such as second partner review. As part of the audit they should have reviewed
internal control systems to ensure that they reflected the transactions of the client and provided reasonable assurance
that the transactions were recorded in a manner that permitted preparation of the financial statements in accordance
with generally accepted accounting principles (GAAP).

Legal Counsel: Vinson and Elkins poorly advised Enron, or at least did not foretell of the potential implosion of
Enron. Essentially, the law firm advised away Enron’s future interests. Vinson and Elkins responded that the
charges were serious, but that no action was needed because the accounting figures were acceptable. This raises an
interesting issue about the ethics of the legal profession issuing an opinion on accounting issues. During the
investigation, Vinson and Elkins consulted with Arthur Andersen. The fact that Vinson and Elkins would bring the
issue to Enron’s outside auditor raises serious ethical issues. Evidently the legal frame was totally corrupt and was
not about to lose its benefits by taking legal actions or even advising the managements of Enron to correct their
malicious way of conducting business, if this was not done. The legal counsel should have taken action by giving
advice to change or by withdrawing services as the legal mind for Enron. Instead they used the cover that the
financials were acceptable as they were cleared by the auditors.

Regulators may be defined as any form of interference with the operation of the free market. A gap existed between
the regulators for trading energy and what the company actually did. The regulation of Enron was non-existent.
Enron fell through the cracks of most U.S. regulatory bodies by industries. As a trader in the energy markets, the
Federal Energy Regulatory Commission (FERC) had some distant oversight responsibilities in regard to some of the
markets and trading which the company participated in. Hence it can be said that they made no intervention hence
the crisis, even though the crisis is not directly related to this aspect of the business

Equity Markets: The market did not police itself in the case of Enron. Debt Markets: Enron’s analysts were, in a
few cases, blinded by Enron’s latent successes in the mid to late 1990s, or working within investment banks which
were earning substantial investment banking fees related to the complex partnerships. Although a few analysts
continued to note that the company’s earnings seemed strangely large relative to the falling cash flows reported,
Enron’s management was generally successful in arguing their point. Again we see a lack of will to stand out and
make the difference, being the “white elephant in the room” and so the exasperation of the crisis at Enron.

Employees: Sharon Watkins became the most spectacular example of corporate whistle blowing when she exposed
former Enron chairman and CEO Kenneth Lay's very questionable accounting practices in 2002, which resulted in
thousands of employees losing their retirement and savings plans. A positive outcome of this situation has been the
passing of the Sarbanes-Oxley Act of 2002 which made sweeping reforms to corporate governance law, and
provided whistleblower protection to employees of public companies who disclose employer information who are
involved in fraud. The other employees at Enron who knew what was happening could have done the right thing ,
instead they colluding with senior management, because of fear of losing their jobs, but it would have prevented the
loss of millions of jobs and the billions of dollars of pensioners and other stakeholders funds. However, the act of
whistle blowing is often a David-and-Goliath battle still fraught with danger, sometimes life threatening.

Response question 3

Some would believe that this was an isolated incident because the executive leadership not only was unethical in its
business dealings but criminal in its operations, and they were able to convince their workers and business associates
to deceive and undermine the systems at play, actively practicing fraudulent transactions, meaning to disguise poor
performance and deceive the investors and the public at large. The reality is that prior to this incident there was
never a case of this magnitude, the perception held by most are that the governance systems then extend from the
corporate walls of companies to the electric barriers of the company’s regulators and the government itself, are full
proof. The belief is that it is a near impossible occurrence and any occurrence is the exception.

Although other companies fall into the same traps as Enron, these companies also have dishonest individuals
running the enterprise: criminal success at this level calls for collusion, the power to get individuals and
organizations to buy into your thinking, for example, Tyco with Dennis Kozlowski and WorldCom with Bernie
Ebbers. The overarching concern for profit above all else became greed on criminal proportions. As Eiteman et al
suggest, “This destructive short-term focus by both management investors has been correctly labeled impatient
capitalism” (p. 26).
The response by congress to Enron’s failures and those of other companies by passing SOX in 2002, now requires
for key elements, these are: CEO/CFO sign-off of financial statements, Audit/Compensation committees must be
independent, No loans may be given to corporate officers (Tyco had this issue), Proper controls to assess fraud must
be in place. Although SOX aimed to bring greater accountability to public corporations, it has been costly and not
well-accepted globally.

Conclusion

Lessons leant, do not cheat, there are a number of ethical ways to make money, know the basics of accounting ,
cultivate an open relationship with your accountant and auditor, establish a professional distance and give
employees ways to voice their objections, cultivate integrity and recognize that wrong decisions can be made and
corrected. Doing the wrong things is always so easy, tempting and attractive.