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03/13/2012

Research Proposal - Re-evaluating the Shareholder and Management Jam: The Case of Enron A Case Study of the Enron Scandal Using Agency Theory


Re-evaluating the Shareholder and Management Jam: The Case of Enron

A Case Study of the Enron Scandal Using Agency Theory

 

Background and Overview

 

Over the past decade, institutional investors and other stakeholders have strongly criticized corporate boards of directors for failing to meet their perceived responsibility to monitor and control management decision making on behalf of shareholders (Wall Street Journal, 1995a, 1995b, 1996). Longstanding calls for board reform have emphasized specific changes in board structure thought to increase the board's ability to exercise control (Westphalia, 1998). Such changes include increasing the presence of outside or non-employee directors on the board, allocating board leadership to someone other than the chief executive officer (CEO), increasing demographic diversity on the board, and selecting directors who lack social or other ties to the CEO (Economist, 1994). Moreover, descriptive surveys suggest that more companies are considering changes in board structure that are assumed to increase the board's power to protect shareholder interests (Korn/Ferry, 1995).

This dominant perspective on CEO-board relationships essentially suggests that structural board independence increases the board's overall power in its relationship with the CEO (Westphalia, 1998). Many studies have simply equated structural independence with board power (e.g., Zahra and Pearce, 1989), while others have discussed how CEOs exploit structural bases of power to maintain ultimate control over the board. Conversely, recent empirical research has explored how structurally independent boards might limit top managers' ability to rely on such practices to maintain control. Abrahamson and Park (1994) provided some evidence that structurally independent boards limit the concealment of negative outcomes in letters to shareholders, and Westphalia and Zajac (1994) found that structural board independence reduced the adoption of "symbolic" incentive plans that appeared to align management's and shareholders' interests without actually putting CEO pay more at risk. Board independence is also thought to limit the CEO's ability to mandate passivity among directors and force renegade directors to resign (Lorsch and MacIver, 1989).

In recent years, scholarly and popular concern about corporate governance arrangements in large corporations has increased in intensity. Institutional investors and the popular business press have decried the apparent absence in many corporations of strong governance mechanisms that adequately promote managerial accountability to stockholders (e.g., Charan, 1993; Economist, 1994; Pozen, 1994). This concern has been reinforced by extensive academic research on the effectiveness of existing governance structures in protecting shareholders (Westhal and Zajac, 1998). Thus, while agency theory suggests that managerial incentives and boards of directors represent the primary mechanisms by which differences between managerial and shareholder interests are minimized (Jensen and Meckling, 1976; Fama and Jensen, 1983), a large body of empirical research suggests that neither mechanism is used sufficiently to represent shareholders. For example, research on executive compensation has led many observers to conclude that traditional management incentive practices are inadequate to reduce agency costs significantly (Finkelstein and Hambrick, 1988).

Large-scale empirical research on corporate boards suggests that boards have traditionally lacked the structural power needed to monitor effectively (e.g., Wade, O'Reilly, and Chandratat, 1990), and extensive qualitative evidence also indicates that boards have often been minimally involved in monitoring and controlling management decision making (e.g., Mace, 1971; Lorsch and MacIver, 1989).

This stream of research has bolstered claims by dissatisfied shareholders, and institutional investors in particular, that significant changes in governance structure are needed to enhance managerial accountability to shareholders.  This is particularly true when the Enron scandal broke out- prompting shareholders to guard their investments from their managers.

While prior research has tended to emphasize the overtly political nature of top executive behavior, Westphalia and Zajac (1994) and Zajac and Westphalia (1995) have recently introduced a symbolic management perspective on corporate governance (Wade, Porac, and Pollock, 1997). They suggest that top managers can satisfy external demands for increased accountability to shareholders while avoiding unwanted compensation risk and loss of autonomy by adopting but not implementing governance structures that address shareholder interests and by bolstering such actions with socially legitimate language. Their research focused on the antecedents of symbolic action, however, and thus did not examine either the targeted audience or the likely consequences of such alleged symbolic actions.

Compared to private companies, shareholders in public corporations have very limited rights compared to the "owners" found in other legal forms of organizing such as partnerships (Kang and Sorensen, 1999). Under the legal doctrine of limited liability, shareholders of public corporations do not bear the risk of facing legal claims against their personal assets. By contrast, partners not only risk their initial investment, but they also are personally liable for legal claims brought against the partnership. Therefore, shareholders' legal powers within the corporation should be viewed as highly limited in scope and very different from the broad legal powers given to "owners" of other organizational forms or other types of assets.

An agency relation is one where a "principal" delegates authority to an "agent" to perform some service for the principal. These relations may occur in a variety of social contexts involving the delegation of authority, including clients and service providers such as lawyers, citizens and politicians, political party members and party leaders, rulers and state officials, employers and employees, and stockholders and managers of corporations (Kiser 1998). Sociologists have recently used ideas regarding principal-agent relations to explore a wide range of social phenomena (Kiser 1998). Sociological research using agency theory approaches includes Adams' (1996) discussion of agency problems involved in colonial control, Kiser's (Kiser & Tong 1992, Kiser & Schneider 1994, Kiser 1994) work on the organizational structure of early modem tax administration, Gorski's (1993) analysis of the "disciplinary revolution" in Holland and Prussia, and Hamilton & Biggart's (1985) arguments about control in state g government bureaucracies. Similarly, current work in political science has also used agency theory approaches to explore state policy implementation (Kiewiet & McCubbins 1991).

Agency theorists suggest that the separation of ownership and control is often the best available organizational design, as the benefits of increased access to capital and professional management typically outweigh the costs associated with delegating control of business decisions to managers (Fama & Jensen 1983). However, in the absence of strong corporate governance systems, public corporations may suffer in performance when self-interested managers pursue their own interests rather than the interests of shareholders (Jensen 1989). Managers have opportunities for pursuing their own interests--in prestige, luxurious accommodations and modes of transportation, and high salaries--because they have been delegated rights through their contracts to control cash flows and information in their firms. Modern public corporations often are faced with considerable agency costs. It is expensive to gather information and assess managerial actions, and particular shareholders only gain a fraction of any pecuniary benefit s produced, proportional to the percentage of total equity they own (Shleifer & Vishny 1989). This creates collective action problems. Gains are available to all shareholders regardless of whether they have incurred the costs of monitoring, a problem that contributes to the separation of ownership and control (Berle & Means 1932). Because the costs of participating in corporate governance typically exceed the benefits, and because of the problem of free riding, dispersed shareholders are generally unlikely to participate in corporate governance.

Statement of the Problem

In the sociological and economic literature on organizations, the modern firm is usually seen as a large organization with four main groups of actors: shareholders, boards of directors, top executives and other managers, and workers (Kang and Sorensen, 1999). Shareholders are thought of as "owners"; they provide financial capital and in return receive a contractual promise of economic returns from the operations of the firm. Directors act as fiduciaries of the corporation who may approve certain strategy and investment decisions but whose main responsibility is to hire and fire top managers. Managers operate the firms; they make most business decisions and employ and supervise workers. Workers carry out the activities that create the firm's output.

This image of the modern firm accurately reflects the organization of many large public corporations that dominate the US economy (Kang and Sorensen, 1999). However, many other firms are organized in ways that merge two or more of these tasks: Owners may be both investing and managing, workers may be owners, managers may acquire large shares of ownership, and so forth. In entrepreneurial firms, one person fuses all four tasks: investing, monitoring, managing, and working. As a result, many firms, particularly large firms, are no longer owner-managed firms but corporations, sometimes with thousands of shareholders each of whom owns only a small fraction of the shares.

There are more than two types of ownership organization. Modern firms have a variety of ownership patterns, and exploring ownership type recognizes that large-block shareholders are not homogenous and that certain types of owners have a disproportionately large impact on corporate governance. Some very large firms are dominated by large-block shareholders who have a seat on the board of directors, some by shareholders who sustain their ownership blocks over time, and some by families owning large bocks of shares (Kang 1998).

Additional ownership types include top executives, employee stock ownership plans, buyers, suppliers, different types of institutional investors, leveraged buyouts, and venture capital. Top executive stock ownership has recently received considerable attention, as there is currently a trend toward compensating executives with stock options. However, little compelling evidence exists of the effects of these developments on firm performance (Loderer & Martin 1997, Bhagat & Black 1998).

Companies can see scandals unfold and think that it could never happen to them. But when seemingly reputable businesses run afoul of legal and ethical rules, one of two things has happened (Barefoot, 2002): (1) Employees have broken the rules intentionally and; (2) They have broken the rules without realizing it. The scandals of Enron, WorldCom, Global Crossing, Tyco, et al., have exposed a cesspool of fraud and corruption at the highest reaches of corporate power. Even prodigious corporate tool Tom DeLay now chirps about the need for more federal oversight (Reed, 2002).

At Enron, the alleged wrong-doing occurred at the very top of the company--the CEO and other senior executives stand accused of personally. At the heart of the Enron scandal is the allegation that the independent judgment of the firm's outside accountants, lawyers, consultants, and board was compromised.

In the wake of apparently dishonest practices by Enron Corp. executives, and apparent negligence by members of its board of directors, many are asking how people believed to be so smart could have lacked the moral courage to seek and tell the truth (Berlau, 2002). As there is after every financial scandal, a call is being made for more courses in "business ethics" in the leading universities. This pervasive view among faculty that successful businesses are by their very nature corrupt is itself corrupting to students in business-ethics classes, says Stephen Hicks, chairman of the philosophy department at Rockford College in Rockford, Ill (Berlau, 2002). Hicks says business-ethics professors need to stress that business is a creative endeavor, like art or music, in which integrity must play a central role (Berlau, 2002).

This proposed study seeks to investigate the financial scandal that faced Enron using the manager-shareholder power division using the Agency Theory. Enron shall be examined using MCKinsey’s 7 S in order to depict and illustrate the internal dynamics of Enron. The analysis of Enron’s internal environment shall be the basis of the Agency theory analysis. It is proposed in this study that the internal capability of Enron, the structure of Boards, the role of the manager, the role of the shareholders and the relationship between the board and the managers needs to be examined in order to avoid the Enron scandal. Thus, the Agency Theory shall be instrumental in proving or disproving this claim.

Research Objectives

This proposed study aims to illustrate the manager-shareholder relationship at Enron using McKinsey’s 7 S. The interplay of the internal dynamics depicted in Mc Kinsey’s framework shall be used as the basis of the analysis on the management-shareholder relationship using the agency theory. Moreover, it aims to evaluate and reexamine the manager-shareholder relationship and suggest the means of controlling large corporations such as that of Enron.

The proposed study shall make several contributions. This proposed study extends agency perspectives in organizational research by offering an interpretation of the agency problem using the biggest financial scandal made by Enron. While conventional economic perspectives focus on the cost reduction resulting from introducing substantive control mechanisms to resolve the conflicting interests of agents and principals, this proposal conceives the agency problem as one of reducing uncertainty about the alignment of managerial and shareholder interests through the introduction of symbolic rather than substantive control mechanisms.

Methodology

This study shall utilize the case study research method. An empirical investigation of a contemporary phenomenon within its real-life context is one situation in which case study methodology is applicable. Yin (1994) cautioned that case study designs are not variants of other research designs. Yin (1984) presented three conditions for the design of case studies: a) the type of research question posed, b) the extent of control an investigator has over actual behavioral events, and c) the degree of focus on contemporary events. In the Levy (1988) study and this study, there are several "what" questions. This type of research question justifies an exploratory study.

The guide for the case study report is often omitted from case study plans, since investigators view the reporting phase as being far in the future. Yin (1994) proposed that the report be planned at the start. Case studies do not have a widely accepted reporting format - hence the experience of the investigator is a key factor. Some researchers have used a journal format (Feagin, Orum, Sjoberg, 1991) which was suitable for their work, but not necessarily for other studies. The reason for the absence of a fixed reporting format is that each case study is unique. The data collection, research questions and indeed the unit of analysis cannot be placed into a fixed mold as in experimental research.

 

The research described in this document is based solely on qualitative research methods. This permits a flexible and iterative approach. During data gathering the choice and design of methods are constantly modified, based on ongoing analysis. This allows investigation of important new issues and questions as they arise, and allows the investigators to drop unproductive areas of research from the original research plan.

This study basically intends to the financial scandal that faced Enron using the manager-shareholder power division using the Agency Theory. The analysis shall lead to the conclusion on who should take control of the corporation- managers or shareholders. Furthermore, transparency and ethical responsibility among managers shall also be illustrated. 

Analysis

The primary source of data will come from published articles from business and business management journals, theses and related studies on agency theory and business management. For this research design, the researcher will gather data, collate published studies from different local and foreign universities and articles from law and business journals; and make a content analysis of the collected documentary and verbal material.  Afterwards, the researcher will summarize all the information, make a conclusion based on the statement of the problem. Moreover, a content analysis shall also be used in order to pinpoint the problems and the challenges agency theory.

            The output from these interviews, content analysis and observation shall be processed using McKinsey’s 7 S framework. Upon the determination of the internal dynamics of Enron, the agency theory shall be used to evaluate the management-shareholder relationship.

 

References

 

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Berlau, J. (2002). Is big business ethically bankrupt? a boom in business-ethics courses is likely in the wake of the Enron scandal, but critics say these classes need to focus on moral rather than political, correctness. Insight on the News, Vol. 18, March 18.

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