Academic journal article The American Journal of Economics and Sociology

Enron, Herding, and the Deterrent Effect of Disclosure of Improprieties

Academic journal article The American Journal of Economics and Sociology

Enron, Herding, and the Deterrent Effect of Disclosure of Improprieties

Article excerpt

The [visitors'] book [at a tourist destination] had a column for remarks. Reading down the list I saw, "Nice," "Real nice," "Very nice," "Nice." Such eloquence. I turned back to an earlier page. One visitor had misunderstood the intention of the remarks column and had written, "Visit." Every other visitor on that page and the facing page had written, "Visit," "Visit," "Revisit," "Visit" until someone had turned the page and they got back on the right track.

--Bill Bryson, The Lost Continent



THE FALL OF ENRON has understandably generated significant interest in the professional literature as well as in the popular press. The activities and events underlying Enron's collapse are manifold, but several stand out as particularly noteworthy. One is the use of special purpose entities (SPEs). Although SPEs often serve legitimate economic purposes and are still in use today, Enron used several of them to hide debt and to overstate equity and earnings. Accounting standards required that third parties own at least 3 percent of the assets in SPEs. This rule was violated. Enron also represented that the SPEs helped it to hedge downside risk. This turned out not to be the case, because the SPEs used Enron's stock and financial guarantees to carry out the hedges. While Arthur Andersen, Enron's outside auditor, initially raised objections, the accounting firm ultimately softened its position. Andrew Fastow, Enron's former CFO, became a partner in several SPEs and profited personally, which poses serious questions as to whether he breached his fiduciary duty to Enron stockholders. In late 2001, Enron was forced to restate its financials for 1997 through 2000 after consolidating the SPEs, resulting in a decline in earnings of approximately $600 million and an increase in debt of approximately the same amount. Equity fell by $1.2 billion (see Healy and Palepu 2003 for a fuller description).

A second procedure Enron used was mark-to-market accounting, in which a firm that signs a long-term contract can, under certain circumstances, recognize as current revenue the present value of the expected stream of future inflows and expense the present value of expected future

costs. While such a process is appropriate in some situations, Enron used mark-to-market accounting to book future revenues as current revenue even when serious questions existed as to whether the long-term revenues would in fact materialize.

As the price of Enron stock declined, some Enron executives exercised their stock options and sold their shares, in some cases out of public view through loan repayment plans, while at the same time encouraging employees to hold and even to buy the stock. Many employees who tried to sell the stock in their 401(k) plans were barred from doing so and lost not only their jobs but most or all of the asset value of their retirement plans.

What caused Enron to engage in the activities that ultimately resulted in its downfall, and what can be done to reduce the likelihood of future collapses? Opinions as to the causes of the downfall and possible remedies abound (see, for example, Healy and Palepu 2003).

Top executives at some firms, including Kenneth Lay and Jeffrey Skilling at Enron, receive a substantial portion of their compensation in the form of stock options. It has been argued that the activities Enron used were largely attempts to manipulate stock prices so as to enhance the value of these options. A wide range of proposals has been offered to reduce the incentive for top executives to engage in manipulation. Among these are proposals to substitute stock for stock options in executive compensation packages, proposals requiring those who receive and exercise stock options to hold the stock for an extended period of time, perhaps until after they leave the firm, and proposals to increase dividend payments on stocks, which is expected to reduce investor (and hence executive) interest in shortrun stock price swings and make investors who may rely more heavily on dividends as income become more interested in and vocal about corporate management. …

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