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BISA School Meeting, Autumn 2012
Prof. Stefania Servalli
1
BUSINESS ETHICS AND CORPORATE GOVERNANCE
Corporate Governance weaknesses and failures
BISA School Meeting, Autumn 2012
AimThis lecture considers ways in whichcorporate governance weaknesses havecontributed to corporate failure.
Enron as case study.Watch this film “The smartest guys inthe room"http://watchdocumentaries.com/enron-the-smartest-guys-in-the-room/
BISA School Meeting, Autumn 2012
CG and Corporate FailureThe Collapse of Enron
Enron:• Energy company based in Houston• Created by Kenneth Lay in 1985
• CEO was Jeffrey Skilling
BISA School Meeting, Autumn 2012
The Collapse of Enron
Category of Disaster:• 1999 sales reached $40.1 billion• 2000 revenues reached over $100 billion• 2001 February company’s stock market value
was $60 billion
BISA School Meeting, Autumn 2012
The Collapse of EnronEnron:• In 16 years: from a small company to the world’s largest energy trading company
In 2001 they changed the words over the main door in Houston from
The world’s leading energy companyto
The world’s leading company
BISA School Meeting, Autumn 2012
The Collapse of EnronEnron:• Handling risk management derivatives• Weather derivatives were invented by Enron (1997)
“Weather derivatives had aninauspicious start: the firsttrade was done by Enron in1997. The instruments wereinitially used by American energycompanies to hedge against theeffect that unseasonaltemperatures could have on gassales.”
4th February 2012
BISA School Meeting, Autumn 2012
The Collapse of EnronEnron:• Online platform was adopted for trading
(Enrononline) with a great success (1999)
From an energy company
to a financial and energy trading company
BISA School Meeting, Autumn 2012
• August 2001• Jeffrey Skilling (CEO) left the company
• October 2001• Enron’s shares fell by 19%
• November 2001• S&P downgraded Enron’s debt to junk bond
status
BISA School Meeting, Autumn 2012
But …
• December 2001• Enron filed for bankruptcy
• January 2002• Kenneth Lay resigned
BISA School Meeting, Autumn 2012
• January 2002
• Arthur Andersen fired partner in charge of Enron’s audit, David Duncan, for ordering disposal of documents
• March 2002
• Berardino resigned as chief executive of Andersen
• October 2002
• Andrew Fastow, former finance director of Enron, charged with: money laundering, wire and mail fraud, conspiracy to inflate profits to enrich himself
BISA School Meeting, Autumn 2012
Enron’s devious accounting
• Recorded profits from a joint venture with Blockbuster Video that never materialize
• One ‘special purpose’ vehicle, Chewco, created by Enron to offload liabilities for off-balance-sheet financing purposes
Accounting fraud!
BISA School Meeting, Autumn 2012
Reasons of disaster?
• Exaggerated focus on EPS (its main aim as declared in 2000 financial report)
Considering CG Theory, what’s the risk?
Short-termism and temptation to cheat!
BISA School Meeting, Autumn 2012
Short-termism and cheating!
• Too heavily relaying on non recurring items(sales of assets)
• Manipulation of numbers to increaseearnings
• Removing debt from balance sheet bysetting up of a series of off-balance sheetentities
Fraudulent and unethical management!
BISA School Meeting, Autumn 2012
Fraudulent and unethical management!
• In addition …Top executive sold over 1 billion $of Enron shares to other investors
… Insider trading!Information asymmetry
Agency problems
BISA School Meeting, Autumn 2012
And what about internal and external auditors?
Internal auditor:• IA was a weak function.
Why? • Chairman of IA Committee Wendy Gramm was the wife
of Senator Philip Gramm who received huge politicaldonations from Enron;
• Lord Wakeham of the IA Committee had a consultancycontract
Conflict of interests, not independent!
BISA School Meeting, Autumn 2012
External auditor:
• Strong conflict of interest:25$million audit + 27$million for consultancy
• Familiarity with top executives
• Overlooked effects on the financialreporting of some operations
• Shredded the documents of the audit
BISA School Meeting, Autumn 2012
The Enron Trial• January 2006 Trials of top ex-directors began• Federal investigators were convinced top
directors:• responsible for use of creative accounting to
conceal debt and massage reported profits
• 25th May 2006 Lay and Skilling wereconvicted on fraud charges– Lay found guilty on all six charges of fraud and
conspiracy– Skilling found guilty on 19 charges of fraud,
conspiracy, insider trading and making falsestatements
BISA School Meeting, Autumn 2012
The Enron Trial
Kenneth Lay:Died before the final sentence
Jeffrey Skilling: conviction of 14 years
BISA School Meeting, Autumn 2012
Effects on Accounting Profession
Carnegie, G.D. & Napier C.J. (2010),Traditional accountants and businessprofessionals: Portraying the accountingprofession after Enron, Accounting,Organizations and Society, Volume 35,Issue 3, pp. 360-376.
BISA School Meeting, Autumn 2012
Effects on Accounting ProfessionAbstract
Society’s perception of the legitimacy of the accounting profession and itsmembers is grounded in the verbal and visual images of accountants thatare projected not only by accountants themselves but also by the media.The paper uses the critical literature on stereotypes to examine how bookswritten for a general readership on Enron and other recent corporatefailures portray accountants and accounting, and the implications theirauthors draw for corporate governance and the survival of the financialsystem. The paper explores how commentators have analyzed the changingactivities of accountants (including the rise of consulting) and havecontrasted the personalities of “founding fathers” of the US accountingprofession with their early 21st-century successors. The paper concludesthat changing stereotypes of accountants are evidence of “negativesignals of movement” for accounting as a profession.
BISA School Meeting, Autumn 2012
Themes identified by Carnegie & Napier
• The character of accountants
• Honesty, integrity and trust
• The shredding of integrity
BISA School Meeting, Autumn 2012
The character of accountants
• Old stereotypes:– Bean-counter, boring technocrat with green
eyeshades– Honesty, integrity, competence
• New images:– Youth and aggressiveness, backslapping
BISA School Meeting, Autumn 2012
• Specific contrast:– Carl Bass (Andersen technical
partner) “by-the-book, resolutely cheerless”
– David Duncan (Andersen engagement partner) “party boy”, “sharply handsome”
The character of accountants
BISA School Meeting, Autumn 2012
Honesty, integrity and trust• Integrity as key characteristic of accountants in the
past• Accountants (Auditors) of 1990s not persons of
integrity?– “In the end, it was all about the bucks. . . . The four
cornerstones of success at Andersen – peoplemanagement, quality, thought leadership and financialperformance – were referred to colloquially as ‘threepebbles and a boulder’. The boulder was financialperformance. The rest, it seemed, was a joke.” [Toffler]
PeeblePeople mgmt
QualityThought Leadership
BoulderFinancial Performance
BISA School Meeting, Autumn 2012
The shredding of integrity
• Shredding of integrity as a powerful image:– “The Enron story shifted from a reasonably contained accounting scandal to a full-blown,
all-American morality play . . . reduced to a few simple elements that anyone couldunderstand, i.e., greedy executives live large while duping loyal employees and unwittingshareholders.” [Swartz, 2003]
[Swartz, M. (2003). Power failure: The rise and fall of Enron. London: Aurum Press]
• Auditors: Serving the public interest vs pleasing the client
• ‘‘Enron prompted Congress to wonder if accountant werecorrupt. WorldCom prompted Congress to wonder ifaccountants were incompetent” Brewster (2003, p.283)
[Brewster, N. (2003). Unaccountable: How the accounting profession forfeited a public trust. Hoboken: John Wiley]
BISA School Meeting, Autumn 2012
CG problems in Enron
• Excutive and non-excutive:– Unfettered power in the hand of the chief
executive– Non-executive directors ineffective– Poor moral character of directors, willing
to fraud– Lack of understanding of risk and
derivatives used
BISA School Meeting, Autumn 2012
• Management:Enron Trader:
“All the money you guys stole from the poor grandmothers?”
***
Enron Trader:
“You just steal money from California to the tune of a million bucks or two a day”
Enron Trader:
“Can we rephrase that?”
Audacity, Ambition, Arrogance
CG problems in Enron
BISA School Meeting, Autumn 2012
CG problems in Enron
• Internal Auditor:
– Absence of a strong and competent IA:• Conflict of interests
• Not independent
Unethical activities should have beendetected by not independent people
BISA School Meeting, Autumn 2012
CG problems in Enron
• External Auditor:
– Conflict of interests: audit + consultancyservices
– Familiarity
– Destruction of documents
Opinion on financial reports should haveexpressed by people with conflict ofinterests
BISA School Meeting, Autumn 2012
After Enron• 2002 Sarbanes-Oxley Act
Regulated approach to CG problems
Other countries principle approach (UK)
But, remember …
• No matter how many mechanisms are in place to ensure that companies are run in an accountable manner, people at the top can act unethically
CG checks and balances can detect unethical behaviour not cure them
BISA School Meeting, Autumn 2012
Concluding
https://www.youtube.com/watch?v=vtpDFTm-fOA
What is it?
The segment at the end of the Enron commercials
Did they ask why?
BISA School Meeting, Autumn 2012
Learning outcomesexplain the contribution of CG weaknesses to
corporate failure
discuss different CG aspect involved in Enron collapse
References• Solomon (2013),Corporate Governance and Accountability, Chapter 2.
• Carnegie, G.D. & Napier C.J. (2010), Traditional accountants and business professionals: Portraying the accounting profession after Enron, Accounting, Organizations and Society, Volume 35, Issue 3, pp. 360-376.