Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan D1: What has the Enron case showed about the problems of corporate control? Presenters: Cary Cheung Christie Cheung Rita Chung Ryan Chan Date: Sept 30, 2002 Managerial Economics – Professor Howard DAVIES

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Outline Introduction to Corporate Control Background of Enron Corporation The Story of Bankruptcy Reasons for Bankruptcy Problems of Corporate Control Reforms Conclusion

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Nominal Corporate Structure Senior Manager Board of Director Company Staff Shareholders Audit Committee Auditor Executive Directors Non-Executive Directors

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Ownership VS Control? Shareholders Senior Manager  Senior managers seek for max profit? Looking for significant discretion? Is there any Control mechanism?

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Importance of Corporate Control Market Corporate Control is the market for voting shares, which give ultimate control value of a firm ’ s stock = value of the stream of future profits  Market Corporate Control should prevent managers from being lazy or pursuing objectives other than maximizing the organization ’ s profit Important and powerful mechanisms

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Rise and Fall of an Energy Giant Let’s see Enron case…

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Shareholders Structure Types Family-Controlled Single Shareholder hold >20% e.g Cheung Kong Holding Ltd.  managed by major shareholders Management-Controlled No Single shareholder hold >20% e.g. Enron  managed by professional managers Other shareholders:  Institutions  Corporations  Pension funds  Charities foundations  Small individual investors

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Background of Enron Corporation (1) Houston-based energy trading and distribution company Famous for advocacy of energy deregulation In just 15 years, climb to be 7 th largest company in US (Fortune 500, 2000), with 21,000 staff 16 th largest in the world In 2000, stock has crested at $90 a share Market capitalization: $80 billion Revenue $139 billion

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Background of Enron Corporation (2) Arthur Andersen acts as accountant and consultant Board of director –14 members, only 2 insiders –Most of the directors owned stock Employee stock ownership and retirement planning –Incentive purpose –Enhance company profit

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Enron’s Bankruptcy (1) Enron announced a large loss in its quarter statement 3rd qtr loss of >$600 million (surprised Wall Street) Stock price fall from the mid-$30s to the low- $20s (triggered a crisis of confidence in the company) Overstated its profits by ~16% Jul Oct Nov Dec ……… Bankruptcy 2001 < Year 2001 Prosperous business performance…..

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Enron’s Bankruptcy (2) Major reason of bankruptcy? A substantial fraction of Enron’s reported profits over a 4 year period ( ) had been the result of accounting manipulations --- investigation by special committee of the Enron board Reported profit  Actual profit

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Reason For Bankruptcy (1) Accounting gimmickry: –Unable to spot bad accounting practices and company’s overstatement of profits Conflict of auditor: –The multiple conflicting roles of auditor –Automatic renewal of auditing contracts  Affecting the independence of auditor Accounting and staff policy failure –Although a professor of accounting and a dean for monitoring the company, but they all fail in their profession –Disastrous loss in employees’ retirement fund, but the ex-CEO has cashed his own stock much earlier? Source: Enron Posts Surprise 3rd Quarter Loss After Investment, Asset Write-Downs, Wall St. J, Oct 17, 2001

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Reason For Bankruptcy (2) Political confusion: –Ironical relationship between governmental monitoring parties and political parties Source: /

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Reason For Bankruptcy (3) Managerialism –Managers tend to build up their own empires and scarify the profits/benefits of the organization Conflict of the board –Enron’s board of directors fail to control and oversee the management –The board had been benefited in various relationship with the company  Lack of independence of the board Source: Professor of international business and strategic management at Suffolk University, Boston, US

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan What’s Wrong with it? How can they be fixed?

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Problems of Corporate Control (1) Stock Option Scheme CEOs, Managers and employees are given STOCK OPTIONS as their compensation package Their aim is to get a maximum reporting profit so as to boost the stock price of the company

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Problems of Corporate Control (2) Board members and corporate partnerships were not independent Allowing private partnerships (set up by employee) to be valid Enron investment Board members could be benefited in various relationship Control and Management Overlapping

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Problems of Corporate Control (3) CFO badly perform his role The financial report was very complicated to be understood A special team of reviewing the reports fails to perform their role Failure in Financial management

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Problems of Corporate Control (4) O ver 50% of Enron’s employee retirement schemes’ asset are invested in Enron’s share All employee have a common goal to boost the stock price of the company Employee Retirement Schemes

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Reform (1) Monitoring The selection of Qualified CEO to monitor the work of senior staff An independent committee of external board of directors to work with the company’s auditors Auditors should not be allowed to perform other services that may compromise their independence Management’s compensation should be a flat rate

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Reform (2) Corporate governance regulation Government and Stock Exchanges should tighten regulations and rules to avoid any insider- trading Limitation of percentage of assets of retirement funds which can be invested in their own company.

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Reform (3) A good Financial reporting system The financial report should not be too complicated (like Enron) It is dangerous that the report was only understood by only one or two people Reports should be made to a “easy-to- read” and easy to be understood by shareholders

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Conclusion Enron challenges some of the core beliefs and practices that have underpinned the academic analysis of corporate law and governance we rely on assumptions of the efficacy of corporate governance/control in monitoring managerial performance

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan THANK YOU END of D1 Group’s Presentation

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan Appendix 1.Execution of nominal corporate control 2.Enron’s Governance Structure

Enron Corporate Control Presented by: Cary Cheung, Christie Cheung, Rita Chung, Ryan Chan How is the Corporate control executed? Non-Executive directors –independent view to strategy performance, resources and standards of conduct Executive directors –business decision makers Shareholders –voting rights –layoff/appoint any Board of Director who is beneficial to the company such that the future profit will reflect on stock price Audit Committee –consists of non-ex director and Financial Director (without voting rights) –assurance of independence between Director and Auditors

Enron’s Governance Structure Board Ken Lay: Chair; Co-chair ZZZ Audit, Compensation Cees. Management Lay, Skilling: CEO Fastow, CFO; Koppers Causey, CAO; Buy, CRO Watkins; Kaminsky; McMahon Company Policies Code of Conduct Internal Audit ? Whistleblowers ? Auditor Arthur Andersen Outside Law Firm Consultant: Arthur Andersen Missing Suspended Compliance Guidance Finan. Reports SPEs © L. Brooks