The internal control mechanisms were shorted by conflict of interest that benefitted managers at the expense of shareholders

Some of the internal factors which played a key role in growth, development and ultimately collapse of the company are:

1. Corporate Governance

Both auditors and analysts are external to the company but the board of directors is one such group which is internal to the company. The board has three broad roles:

i. Control, which is looking after functioning of the management and the corporation.ii. Service, where board of directors act as a bridge between corporation and external

shareholders.iii. Strategy, where the board gives a direction for the future of the corporation.

Among all the three roles, Control is the most basic and tradition function. A dispersed shareholders base trusts the board of directors to look after the corporation and ensure that the owners’ interests are protected. This is where the board of Enron failed.

Some issues related with the functioning of the board were:

a. Chairman and CEO.

Ideally it is a good practice to separate the roles of the chairman of the board and CEO of the enterprise. In case if the same individual occupies both of the role, then the principle argument that the board should supervise the management gets diluted.

Kenneth Lay was occupying both of the positions in Enron. For a brief period, when Skilling became the CEO, the roles were separated, and on his resignation, Lay again assumed both of the roles.

b. Audit Committee

The board of directors work through sub-committee and audit committee and independently inquire into the workings of the organization and bring any irregularities and lapses to the attention of the board. But as per Sharon Watkins, the internal ‘whistleblower’ Enron had no internal audit. It was outsourced to Arthur Anderson’s firm.

The board of the directors at Enron even suspended the ‘code of ethics’ so that the partnership between the company and the CFO, Andrew Fastoff could take place.

c. Independence and Conflict of Interest

The directors of the board should have no benefit from their position on the board except the remuneration from the position. They should not benefit from company’s actions and maintain their independence. Enron had many outside directors, but many of them had conflict of interest. Wendy Gramm granted exemption to Enron pertaining to regulatory oversight that comes with margin trading. She later joined Enron’s board.

The board was paid handsomely and held substantial amount of Enron’s stock too, which they later sold in market. This kind of transaction is directly in violation as they will be having material non-public information.

d. Dubious and aggressive accounting policies

The board authorized high risk accounting practices even when Andersen warned them. Enron had two major strategies:

i. Invest in energy, telecom etc. ii. become a major dealer in swaps

These two strategies are conflicting because the former requires substantial debt and later requires credit worthiness on part of the dealer.

In face of income volatility and hence prevent a prevent downgrade, they took to creative accounting methods which were cleared by the board of directors.

2. Corporate Culture and Greed.

Enron’s culture under Skilling became ‘rank or yank’ and the remuneration depended on only on the deals done and profits booked. No consideration was given to the practice of following due diligence. The ‘Friday Night Specials’ were the kind of deals that were being done at the last moments without due documentation. Incompetence in project management was a known fact internally to the company.

We can safely say that it was a not learning environment and the practice of asking questions and challenging the deals was discouraged.

In fact the culture was one of excessive privilege and abuse of power as we see that manager’s had to, one way or other cook up numbers. The top executives’ remuneration was very high, and from the case data we can see that the top 200 employees took away $1.3 billion in 2000 which was way higher than the $193 million in 1998.

3. In transparency and Information Asymmetry.

Transparency in market is a must because this is the only way of bridging the gap between investors and entrepreneurs. While Kenneth Lay believed in free market system vision, there was lack of transparency in Enrons reporting and media questions and guidance. The Notes to financial statements were not given clearly in case of SPE activities.

The company’s lack of transparency in the accounting of its liabilities and income eventually were the source of its failure. Shareholders’ didn’t have the complete picture regarding off the balance sheet obligations. Even Goldman Sachs bankers acknowledged that the transparency regarding Enron is low. Even Enron’s competitor, Dynergy withdrew its bid to acquire Enron after doing due diligence on its end

4. Auditor Role

The advice to float an SPE was given by Andersen firm to Enron, which later turned into some 3500 SPEs. Andersen failed to bring it to the notice of Enron’s Audit and Compliant committee reservations of Andersen’s partners regarding the deals as revealed in their memos. The creative accounting by Enron, was not checked by Andersen, thereby implying that their firm was in concurrence with the fraud.

In case of SPEs like Chewco, non-consolidation requirements of the independent equity investor holding at least 3% were violated. The debt financing from Barclays Bank was done via unsecured loan which was in reality guaranteed by Enron’s stock held by Enron itself. Thus the structure didn’t meet the requirements for non-consolidation of SPE and in aftermath of Sharon Watkins internal memo voicing her concerns, Andersen advised Enron to consolidate the entity.

The fact that Andersen firm had internally placed Enron as a high risk client with a habit of aggressive accounting still didn’t materialize to them discharging their responsibilities as an honest and transparent auditor for so many years until the Sharon Watkins ‘whistleblowing’ indicts there collusion with Enron’s management.