Corporate Corruption of the Enron and WorldCom Enterprises - Case Study Example

Introduction about Corporate corruption Corporate corruption has come into focus ever since the Enron and WorldCom enterprises went bust and the senior executives of the company jailed for fraud and unethical behavior. Though there have been several reasons put forth for the failure of Enron and WorldCom among others, the main reason is corruption among the executives and their unethical accounting practices that led to the downfall of these one time giants. It was inevitable corruption of public servants that, in part, made it important to privatize in developing countries. Advocates of privatization also lauded the private sectors ability to compete. But Im not sure these private sector advocates quite had in mind the abilities that American corporate capitalism has demonstrated so amply recently: corruption on an almost unfathomable scale. They put to shame those petty government bureaucrats who stole a few thousand dollars or even a few million. The numbers bandied about in the Enron, WorldCom and other scandals are in the billions, greater than the GNP of many countries. Conflict of interests Conflicts of interest will never be fully eliminated, either in the public or private sector. But by sensitizing ourselves to their presence, by increasing required disclosures - as the old saying goes, sunshine is the strongest antiseptic - by becoming aware of the incentives that are in place that can exacerbate these conflicts of interest, and by imposing regulations that limit their scope, we can do much to mitigate their consequences, both in the public and the private sector. In the wake of some of the biggest corporate scandals in history, the reputations of various lawyers, accountants, bankers and investment managers have recently taken some severe blows - a fatal one in the case of Arthur Andersen as a consequence of its links to Enron.) At best, many were guilty of putting immediate business concerns ahead of issues such as proper due diligence and the potential for conflicts of interest. Most of the corporate senior executives who have been accused of wrongdoing in recent years simply could not have succeeded for so long if they had not found major market fault-lines and opacity to exploit, and had either direct or implicit assistance from some of the key financial intermediaries and advisers. The principles With perfect information - an assumption made by traditional economics - these problems would never have occurred. With perfect information, shareholders would instantaneously have realized that the books were being cooked, and roundly punished the corporate officers. Instead, because of tax advantages and inappropriate accounting practices - which received support from the US treasury under both Republican and Democratic administrations - firms were encouraged to reward their executives handsomely with stock options. By this means, corporate officers could ensure that they were extremely well paid, without at the same time taking out anything from the corporations bottom line. It was almost too good to be true: while executives were receiving millions, no one seemed to be bearing the cost. The agent Incentives matter: but inappropriate incentives do not lead to wealth creation - they lead to the massive misallocation of resources, the consequences of which America is now suffering. Over inflated prices have led firms to over invest. More generally, when information is imperfect - as it always is - Adam Smiths invisible hand, by which the price system is supposed to guide the economy to efficient outcomes, may disappear. With the kinds of incentives that were in place in corporate America, there was a drive for the creation of the appearance of wealth, not for the creation of actual wealth. By the same token, auditing firms that make more money from consulting than from providing auditing services have a conflict of interest: they have (at least in the short run) an incentive to go easy on their clients or even, as consultants, to help their clients think of ways to improve the appearance of profits - "within" the rules. Analysts at investment banks that earn large fees from stock offerings may, as we have seen, have an incentive to tout the stocks, even when they have their doubts. And if they have a commercial bank division, they may have an incentive to maintain credit lines beyond the level which is prudent, simply because were they to cut them, they risk losing high potential future revenues from mergers and acquisitions and stock and bond issues. In most of these cases, some of the world’s biggest and most well-regarded investment banks, audit firms, and law practices were alleged to be not mere facilitators, but active participants in serious financial misconduct. "How could this happen in some of the worlds most efficient and transparent financial markets," asks the author. "And what does it say about the efficacy of corporate governance, market discipline and external regulation associated with key elements in the financial intermediation process in modern economies?" Principle incurs the cost/benefits of the performance Globalization also added complexity. The political liberalization of the 1990s allowed companies to operate in countries that were once forbidden territory. Information technology also greatly facilitated the co-ordination of geographically diversified operations, thus making it easier to become a multinational corporation. In less than a decade, Enron went from just doing business in the US to operating in 30 countries; Cisco Systems went from almost no international involvement to operating in 127 countries, which generate 65 per cent of its revenues. If rapid growth adds complexity, rapid international growth does so more intensely. Agent – ‘suppose to act in the best interest of the principal. Such large-scale fraud was also facilitated by the corrosive effect of these new business trends on the institutions created to protect shareholders. For more than a century, as salaried managers displaced owner-managers, a new category of practices and institutions emerged to safeguard the interests of owners who no longer ran the show. Boards of directors nominally independent from management, audit and compensation committees, external auditors, disclosure rules and stock market researchers were some of the tools used to ensure that top managers behavior was aligned to shareholders interests. Recent trends undermined the efficacy of all these institutions. Professor of International Management Ingo Walter considers a range of conflict of interest issues in wholesale and retail financial markets, and in financial services firms. He briefly discusses some of the most serious charges that have been made over the years regarding conflict of interest issues extending from the late, unlamented Robert Maxwell to the "conspiracy of fools" at Enron and the top guns at Parmalat. Conclusion and view Walter explains the differences between conflicts of interest encountered in wholesale inter-professional markets, on the one hand, and in activities involving retail clients on the other. His analysis reveals why their vulnerability to conflict exploitation varies dramatically, and why some of the most serious cases involve the intersection between these two domains. He also concludes that there is a near-inevitability that, recent transparency legislation in certain major markets notwithstanding, the broader the scope of activities of a financial firm: a) The greater the likelihood that the firm will encounter serious conflicts of interest; b) The higher will be the potential agency costs facing clients and shareholders, and c) The more difficult and costly will be any internal and external safeguards that may be necessary to prevent conflict exploitation. In such an environment, "subsequent adverse legal, regulatory and reputational consequences - along with the managerial and operational cost of complexity - can be considered "diseconomies of scope" that may negate some of the benefits of breadth for financial stability, revenue synergies and cost efficiency. Walter posits that, in general, "regulatory constraints and litigation are relatively blunt instruments" in dealing with financial-services-related conflicts of interest. However, disincentives for crossing important lines of demarcation that are rooted in market discipline can be "substantially more cost-effective and surgical than constraints based on external regulation." Moreover, "given the persistence of market inefficiencies and information asymmetries they can, in combination, have powerful deterrent effects on conflict of interest exploitation, and therefore on the chemistry of corporate governance in general". As an example of such market discipline proving effective, Walter cites the case of the worlds major credit rating agencies. Moody’s and Standard & Poors have between them roughly 80% of the global market for rating services in terms of revenues. Their reputations for competence, transparency, objectivity and impartiality have made giants in their market, and would be completely undone if these were ever lost. Walter concludes his analysis by considering how regulation and market based discipline to impede exploitation of conflicts of interests can intersect. In his view, market discipline is too often overlooked as an effective deterrent to exploitation of conflicts of interest in banking and financial markets. Properly structured, it can greatly reinforce regulatory sanctions, particularly involving firms that are considered "too big to fail" or when criminal conduct is involved. Read More