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What light, if any, does the downfall of businesses such as Enron, Northern Rock,
HBoS and Bradford and Bingley, cast on the relationships between shareholders
and management of corporations?
“When a company called Enron…ascends to the number seven spot on the Fortune 500
and then collapses in weeks into a smoking ruin, its stock worth pennies, its CEO, a
confidante of presidents, more or less evaporated, there must be lessons in there
somewhere.” – Daniel Henninger, Wall Street Journal.
Enron Corporation filed for bankruptcy on July 22, 2002. The price of Enron stock had
sank from its peak of $105 to just cents when it was delisted by the NASDAQ, resulting
in employees and retirement accounts across America losing hundreds of millions of
dollars. Through unrecorded transactions with Special Purpose Entities (SPEs) and
“creative accounting techniques” (Arthur Anderson also went under after it was
convicted for Obstruction of Justice in the auditing services it provided to Enron) Enron
both concealed masses of debt and collateralized that debt into Enron stock.
The collapse provoked many questions about the nature of corporate governance in
America but to both understand how a company such as Enron could come to collapse,
and to learn anything from this, and similar events we need to understand the principal
agent problem.
Munzig (2003) highlights how the principles of Adam Smith do not apply when it comes
to the world of corporate finance. The invisible hand cannot allocate resources in the
market mechanism when a firm does business under the separation of ownership and
management, which explains why intervention is needed in the form of a board. The
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problem associated with this separation of ownership and management is known as the
principal agent problem.
Shareholders (the principal) provide liquidity for managers they appoint (the agent) to
generate capital to run a firm. In exchange the shareholders want steady return on their
investment in the form of increased equity in their shares. However there is no guarantee
that this return will be made or even that the full value of their investment will be
returned, as it is not necessarily in the interests of a CEO or management.
Therein lay a problem. Shareholders want a conservatively run corporation that will pay
a steady dividend and provide a long term increase in their equity. CEOs and
management often receive higher bonuses through raking great risk that generates huge
short term profits – risk that often leads to the decline of the corporation in the long run
as illustrated by the subprime crises we have seen unfold recently.
This conflict of interests is essentially what led to the collapse of Enron Corporation.
The board allowed Andrew Fastow, CFO of Enron, to pursue unrecorded transactions
involving the SPEs mentioned earlier, concealing the debt of an unprofitable company
and transferring it to the share price. Kenneth Lay, the former CEO of Enron, claimed
ignorance but both pocketed handsome bonuses and pay offs at the expense of the
company. Furthermore, the company’s attempt to align the interests of shareholders and
employees also contributed to its downfall. Stock options were given to employees,
meaning that employees could lend or pledge their company stock at a certain price in
the future provided the price had risen by a given amount by that time. Traders had
every incentive to push up the price of the company’s stock to increase their income,
even if the increase in share price was to the long term disadvantage of shareholders.
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Artificial blackouts were staged in California to simulate a power crisis to push up the
price of the energy that Enron traded.
Businesses such as Northern Rock and Bradford & Bingley also help to illustrate the
dangerous nature of relationships between shareholders in management in many publicly
limited companies.
The break up and nationalization of Bradford & Bingley means that every building
society floated on the stock market in the demutualization craze of the past 20 years has
either collapsed or been sold to a conventional bank. When a building society is
“mutual” it is owned by its members and therefore run on a non-profit basis with profits
being reinvested to benefit the members. However demutualization created the principal
agent problem with the conflict of interest between shareholders and management I
discussed earlier. For a mutual organization, it is in the best interest of the management
to run the firm conservatively to generate a steady, reliable return for all the members.
However for newly mutualised building societies, it was in the best interest of the
management to pursue high profits through taking great risk.
Northern Rock Ordinary Share Price
GBP
Daily closing price, £s per share
13
13
12
12
11
11
10
10
9
9
8
8
7
7
6
6
5
5
4
4
3
3
2
2
1
1
0
0
97
98
99
00
01
02
03
04
05
06
07
08
Source: Reuters EcoWin
By pursuing high profits in the but-to-let market, as well as granting sub-prime loans etc.
B&B and Northern Rock generated massive levels of profit, and asset prices were rising
so everything was dandy. However when asset prices started to fall, the businesses
suffered heavy losses. In the case of B&B, the business was about to face demand from
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investors for the return of billions of pounds it didn’t have after credit rating agencies
were downgrading the rating of its covered bonds i.e. repackaged mortgages. CEOs still
pocketed hefty bonuses, but as for shareholders and their steady return on their
investment: B&B fell from £4 to 70p in a year.
Shareholders appoint management to provide a steady increase in their equity, but as we
have seen, the conflict of interests between the two does not always result in maximum
utility for the shareholders, who often suffer in the drive for unsustainable profits and big
bonuses for management. Furthermore, attempts to align the interests of shareholders
and employees can often actually increase the conflict of interests, as was the case with
Enron and its share options. Another colossal mistake was the demutualization of the
UK’s building societies.
A lesson to be learnt is that interests of shareholders and management need to be more
closely aligned in the right way. An interesting and fairly radical idea to ponder is the
provision of stock options for managers that allow them to lend or pledge stock as
collateral but only a few years after they have left the company. This could encourage
sustainable growth and profits and therefore a more conservative approach to running a
company that would provide a steady increase in shareholder equity and eventually,
bonuses for CEOs provided this sustainable growth was achieved.
Sources
Bonsignore, T. Was the fad for demutualisation to blame for the mess we are in now? 13
June, 2008. www.citywire.co.uk/Personal/-/diversions/the-moneyblog/content.aspx?ID=305640
Frank, B. The Principal-Agent Problem, Sub-Prim e Mortgages and Risk. 26 September,
2008. www.eclectecon.net/2008/09/the-principal-a.html
Kay, J. The Truth About Markets. Penguin Books, 2004.
Munzig, P. G. Enron and the Economics of Corporate Governance. Department of
Economics, Stanford University. June 2003.
Peston, R. B&B to be nationalised. 27 September, 2008.
www.bbc.co.uk/blogs/thereporters/robertpeston/2008/09/bb_to_be_nationalised.html