Corporate Collapse: Enron Corporation - Case Study Example

Corporate Collapse: Enron Corporation Name: Course: Tutor: Date: Corporate Collapse: Enron Corporation Corporations are formed with a motive to generate profits. This objective can be attained only if corporations adhere to good corporate governance practices. Failure to do so might lead to redundancy and pressures to the firms to declare bankruptcy. This leads to massive job losses, and is a great harm to the community that relies on such corporations. Corporate collapse can also be attributed to difficult times experienced by corporations. Companies often encounter difficult times and how they ago about them determines whether they can survive or not. Some firms may undergo formal rescue procedures before regaining health while others may end up in liquidation. The fact that volumes of books and journal articles on corporate failure exist indicates that corporate collapse is not a new phenomenon. Collapse can occur due to many factors and may or may not be predicted. Hamilton and Micklethwait (2006) discussed in detail why firms fail. In their discussion, the authors identified six categories of the main causes of failure as (1) poor strategic decisions, (2) overexpansion and ill-judged acquisitions, (3) dominant CEOs, (4) greed, hubris and the desire for power, (5) failure of internal regulations at all levels from the top downwards, and (6) ineffectual or ineffective boards. This paper focuses in Enron, a giant firm in the United States, which collapsed due to a number of reasons that fall under some of the categories identified by Hamilton and Micklethwait (2006). The paper discusses in detail the particular cases that led to Enron’s collapse, with particular focus on failure in corporate governance. It begins with a prelude on the collapse. The collapse of Enron Enron Corporation was a giant firm that was once ranked among the top Fortune 500 Companies. It collapsed in 2001 due to a huge burden of debt that had been hidden through an intricate scheme of off-balance sheet transactions between partners as well as loss of investor confidence. So intricate were the details of the collapse as the company’s financial reports earlier indicated that it was making profits, in what Hamilton and Micklethwait (2006) term as “paper profits, cash losses” (p.33). The energy firm was thus forced to declare bankruptcy, causing it to lay off many of its employees, making them loss their retirement benefits that had been invested in form of Enron Stock. In addition, the company’s shareholders incurred a lot of losses as its stock price plummeted. The scandal surrounding the company led to a global loss of confidence in corporate integrity that still continues to affect the current market. Thus, there was need for stricter scrutiny of companies, through the enactment of legislation such as the Sarbanes-Oxley Act of 2002 (Ferrell, Fraedrich & Ferrell, 2006). The collapse of Enron needs no introduction - it is a giant corporation that went down in matter of weeks. But while it is important to focus on the factors that contributed the collapse, it is also worthwhile to evaluate the company’s entire story, as its collapse was preceded by a glamorous success. As noted by Fox (2003), “the fall of Enron would not be possible were it not for the preceding rise, and the company’s missteps – both intentional and unintentional - were not possible had it not enjoyed successes early on” (p. v). Going by the categories of factors mentioned by Hamilton and Micklethwait (2006) as highlighted above, it can be said that the collapse of Enron was due to nearly all of the six points. To begin with, the top management of the company, led by Kenneth Lay and Jeffrey Skilling believed that they could transform Enron, a pipeline operator, into a virtual company that traded a wide array of commodities. Thus, just before its collapse, Enron had transformed itself from an energy firm to a predominantly energy trading and financial company, dealing in derivatives as well as energy contacts and successfully running a gas pipeline as an additional investment (Solomon, 2007). See figure 1. Figure 1: Diagrammatic illustration of Enron’s diverse structure Source: Clarke, Dean & Oliver (2003), p. 260 The rapid expansion points out to an ambitious expansion scheme being spearheaded by dominant leaders. In order to fulfil their ambitions, the company’s leaders ensured that financial reports were “cooked” (Fox, 2003). There is no gainsaying the fact that Enron’s leaders made the wrong strategic decisions; and as noted by Zandstra, (2002), the collapse of Enron Corporation has brought attention to the roles played by chief executives and other members of top management of the modern corporation. In addition, a number of other players in corporate governance in the United States have a share of the blame. For instance the “cooking” of financial books and the related scandals is a matter that would have been appropriately dealt with by the relevant oversight authorities in the United States such as the Securities Exchange Commission with reference to accounting and auditing of firms. Along this line, Vinten (2002) points out that the collapse of Enron Corporation, in addition to signalling the biggest corporate bankruptcy in the United States, also throws up many questions regarding the effectiveness of modern accounting, auditing and general corporate governance practices. Also noteworthy is that fundamental elements of companies, such as the board, which did not play its role effectively prior to the downfall of Enron. In sum, the collapse of Enron Corporation was caused by a multiplicity of factors. It can be argued that the collapse was a result of accounting failure as investors and creditors were severely misled by false statements; but again, it is notable that there was a business failure that was obscured by accounting practices that strained the limits of credibility. Reviewing the above standpoint, Baker and Hayes (2005) contend in their paper that astute financial analysis would have revealed the instability of the business model adopted by Enron, thereby alerting creditors and shareholders to the lack of credit worthiness of the company. The authors also note that had there been an appropriate level of transparency in the financial reports, creditors and investors would have been provided with a more pragmatic view of the company’s position and its outcomes of operations, thus facilitating their capacity to assess the viability of the company and avoid the resultant bankruptcy losses. This thus points to lack of accountability and transparency in the governance of Enron. Aspects of poor governance and its implications at Enron The collapse of Enron was a case of making the wrong decision and protecting it so to mislead stakeholders about the consequences of the decision. The move taken by the management of Enron was meant to ensure that it became an innovative business-to business e-commerce based networked enterprise. However, in newer market-based activities, the company did not have an adequate base of experience to guide itself and it did not have the prerequisite counterpoints in place. In essence, Enron became a system without the necessary checks and balances (Chatzkel, 2007; Solomon, 2007). Effective corporate governance is a situation whereby the checks and balances imply that there are clearly defined roles and responsibilities for the board, corporate executives, the chairperson and the auditors. However, this was not the case at Enron as most of the activities of the company were dictated by the chairperson. Enron, like other companies that collapsed after it (such as WorldCom) was thus dominated by a few who ensured that their personal motives succeed, paying little attention to corporate laws. It is therefore inarguable that the implementation of the stricter Sarbanes Oxley Act of 2002 after Enron’s collapse served to bring the general company structure and function in order. Checks and balances to a firm can be maintained if the company aspires to do so. However, this is the area in which Enron failed. According to Chatzkel (2007), accountability goes with the “character of the firm” (p. 129). This is related to how the firm relates itself to its stakeholders and how it reflects its image to the market. A corporation creates an image of the firm to its stakeholders. This image or character is what forms the checks and balances on integrity, behaviour, and stewardship of the company. Nevertheless, there was a flaw in this process at Enron. When the company started operating with soft assets as it aspired to become a virtual marketer, it started ventures to move its return on interest from between six to eight percent to 18 percent. This was a good ambition, but it should be put in mind that the company did not have the robust values to achieve the target. Hence, what followed was “cooking” of financial reports to depict that the company was profitable when in reality it was running into losses. The leaders acted to deceive stakeholders on the real position of the firm. This is what Chatzkel (2007) calls bending “the moral spine of the company into something that erodes value in the long run” (p.130). The management of Enron also decided to employ methods that disguised the actual financial situation of the corporation. These methods included price book, net margin percentage, price earnings multiple, and return assets. The management also took into consideration the so-called risk management practices, which seemed to disguise highly volatile speculative derivative-based activities (Konstantin, 2005). Konstantin further argues that had Enron employed better earnings management practices, the problems that affected it would have been detected as early as 2000, a year before the eventual collapse. Nevertheless, the leaders’ vested interests motivated them to portray a different picture of the company to the various stakeholders and the public. An evaluation of the role of company auditors shows that something was amiss with auditors as had they been transparent in their practice, they would have offered a forewarning on the collapse of Enron, and at least some intervention would have helped salvage the company from the downfall. It is for this reason that the role of audit committees in ensuring the quality of corporate financial reporting came under considerable scrutiny due to high profile accounting scandals such as the one at Enron (Lin, Li & Yang, 2006). Audit committees have a number of functions, including recommending the particular persons or firms to be employed by the corporation as its independent auditors; consulting with the persons selected to be independent auditors with regard to the plan of audit; and reviewing, in consultation with the independent auditors, their audit report or proposed audit report (Braiotta, 2004). It can be said that had Enron adhered to these principles, the scandals involved in reporting of financial information would have been unravelled in good time to protect the company from collapse. Thus, it may be true that the company’s top management, including directors, were part of the ploy to protect the misdeeds that led to the massive losses. Conflict of interest is a common problem in the audit profession. In many cases, independent appointment of company auditors by company’s shareholders is replaced by subjective appointment by company bosses, in which case the auditor is too loyal to the company’s senior management. Further, according to Solomon (2007), there is a likelihood of cosy relationships developing between auditors and senior management when the two parties work together for a long time, meaning that the auditors may be influenced to cloud the audit process, as was the case of Enron. Addressing the flaws in the management of Enron, Marwa and Zairi (2008) point out that Enron’s error “was reflected in its management hubris that was tacitly encouraged by board members, regulators and politicians and stock analysts. The authors also mention that many of the highlighted parties had financial ties with the company and therefore looked away as the warning lights flashed. Such arrogance by the concerned parties was meant to protect their vested interests in the company at the expense of its success. Marwa and Zairi (2008) also quote Finkelstein (2004) who emphasizes that corporate failure can be linked to three shortcomings. The first point is when the chief executive officer is arrogant and proud of it (as was the case at Enron). Such CEOs believe that their companies can do whatever comes into their mind because of the companies’ position in the market place. Second is that CEOs tend to make the same decision repeatedly, even when those decisions no longer seem appropriate. Here it is noteworthy that if the Enron leaders had made consultations about the consequence of their strategy they would have got a corrective path and thus avoided the collapse. The third cause of corporate failure as noted by Finkelstein (2004) (as quoted by Marwa and Zairi (2008)) is that CEOs tend to elevate public relations over a strategic decision. This was the case at Enron as the leaders produced figures to show that the company was in a profitable position when in real sense it was on downward trend. A summary of the issues surrounding the collapse of Enron is illustrated in figure 2. Figure 2: Issues surrounding the collapse or Enron Source: Adapted from Clarke (2004), p. 1861 The current discussion shows how intricate the information regarding a corporation’s collapse can be. The case of Enron depicts that failure in corporate governance and corporate collapse can happen even in the strongest company provided the loopholes to facilitate the same exist. It shows how investors, employees and creditors can be lured into trusting a company for its creditworthiness, when in reality it is on the verge of collapse. The fact that various corporate players could be blinded by the image that company leaders presented disregards the economic and finance theory as economic agents are supposed to be rational. Conclusion In conclusion, the discussion has revealed that corporate failure can occur to corporations regardless of their size. In any case, large corporations are more susceptible to failure because of the intricate nature of processes used to evaluate their performance (which are likely to be manipulated by those with ulterior motives). The collapse of Enron has been attributed to many factors, but poor strategic decisions; dominant leadership; greed, hubris and the desire for power; and failure of internal regulations at all levels from the top downwards are some of the factors that have been noted to have contributed most to the position. It has been noted that the company’s top management had business expansion motives meant to satisfy their own interests, and thus ensured that the company audit process was flawed to disguise the real financial position. References Baker, C. R. & Hayes, R. (2005). “The Enron fallout: Was Enron an accounting failure?” Managerial Finance. 31(9): 5-28. Braiotta, L. (2004). The Audit Committee Handbook (4th edition). New York: John Wiley and Sons. Clarke, F. L., Dean, G. W. & Oliver, V. (2003). Corporate Collapse: Accounting, Regulatory and Ethical Failure (2nd edition). Cambridge: Cambridge University Press. Clarke, T. (2004). Theories of Corporate Governance: The Philosophical Foundations of Corporate Governance. New York: Routledge. Ferrell, O. C., Fraedrich, J. & Ferrell, L. (2006). Business Ethics: Ethical Decision Making and Cases (7th edition). Cengage Learning, New York. Fox, L. (2003). Enron: The Rise and Fall. New York: John Wiley and Sons. Hamilton, S. & Micklethwait, A. (2006). Greed and Corporate Failure: The Lessons from Recent Disasters. New York: Palgrave Macmillan. Kastantin, J.T. (2005). “Beyond earnings management: Using ratios to predict Enron's collapse.” Managerial Finance. 31(9): 35-51. Lin, J.W., Li, J. F. & Yang, J. S. (2006). “The effect of audit committee performance on earnings quality” Managerial Auditing Journal. 21(9): 921-933. Marwa, S. & Zairi, M. (2008). “An exploratory study of the reasons for the collapse of contemporary companies and their link with the concept of quality.” Management Decision. 46(9): 1342-1370. Solomon, J. (2007). Corporate Governance and Accountability (2nd edition). New York: John Wiley and Sons. Vinten, G. (2002). "The corporate governance lessons of Enron", Corporate Governance. 2(4): 4 – 9. Zandstra, G. (2002). "Enron, board governance and moral failings", Corporate Governance, 2(2): 16 – 19. Read More