Fraud Cases Involving Agency Conflicts

Fraud Cases Involving Agency Conflicts

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Fraud Cases Involving Agency Conflicts

Advancements in the financial markets led to the rise of agencies to represent the interests of investors. The investors in this case are principals and they hire agencies to act on their behalf. This sees to the entrustment of decision rights of the corporation to the agency managers to act in the interests of shareholders and other interested parties. Agency conflicts, also known as principal-agent problems are due to conflict of interest between the principal and the agent. Agency conflicts occur due to misrepresentation of the stockholders by the corporate managers from the agency. These problems occur when there is conflict of interest between the needs of the principal and the agent, mostly when the corporate managers look to their own needs first.

In economic theory, agency conflict revolves around the difficulty in motivating the agent to act on behalf of the principal, because these two parties have different interests and asymmetric information. It is therefore not a guarantee that the agent will work in the best interest of the principal, when the activities useful to the principal are costly to the agent. There have been a number of fraud cases involving agency conflicts in the financial markets in the United States of America. Some of the organizations involved include Enron, WorldCom, Boeing, and Goldman Sachs. This research paper focuses on the fraud case involving Enron Corporation, which was an energy company in the United States of America.

Enron Corporation, formed in 1985 through a merger between Houston Natural Gas Co. and InterNorth Inc., an Omaha-based organization, was an energy trader and supplier in the United States of America based in Houston, Texas. This merger was after the federal deregulation of natural gas pipelines. This deregulation led Enron Corporation to incur massive debt due to loss of exclusive rights to its pipelines. Enron was the seventh largest company in the USA in the 19th Century with about 21, 000 staff in more than 40 countries. The corporation started with trading in gas, then created a division called Enron Finance Corp, acquired an electric utility company Portland General Electric Corporation, created a division known as Enron Capital and Trade Resources, and its greatest development in the financial sector called Enron Online, an electronic commodities trading website. These developments were during the time that Enron was under the leadership of CEO Kenneth Lay and consultant Jeffrey Skilling. These advancements made Enron one of the energy giants and greatest and most admirable businesses in the stock market.

In the mid 1990’s Enron began to use various strategies to remain at the top in the financial markets, including market-to-market accounting. Increase in competition with the emergence and improvement by companies including Duke Energy, Dynegy, El Paso and Williams, led to erosion of profits for Enron Corporation. The fall of energy prices in the first quarter of 2001 and the start of economic recession in the world further led to reduced profits for Enron Corporation. This led the corporate managers in the corporation to develop various strategies to remain afloat. These strategies ended up in losses, fraud and fraud cases, and filing for bankruptcy by the company and the eventual collapse of Enron Corporation in 2001 after the retirement of CEO Kenneth Lay.

Those involved in the fraud case in Enron Corporation were the then CEO Enron Corporation Jeffrey Skilling, who formerly was a consultant for the corporation hired by the former CEO Kenneth Lay. Also involved in the fraud was Andrew Fastow, the Chief Financial Officer (CFO) for the corporation, who was involved in making key financial decisions. Another party involved in the fraud is Arthur Andersen LLP, whose audit and accountancy firm provided services to Enron Corporation. Andersen is alleged to have allocated a whole floor of auditors assigned to Enron Corporation all year round.

These three individuals through their various position in Enron Corporation committed the fraud. Skilling, once hired by CEO Lay, came up with innovations that drove Enron Corporation forward and made it the business giant it was. When Lay retired and Skilling took over, Skilling had to take action to salvage the falling company. He developed a staff of executives that exaggerated the profits and concealed debts from failed projects and deals. The publicly displayed figures by the corporation did not match the actual picture.

Under the leadership of Fastow, the CFO and other executives in the corporation, the board of directors and audit committee at Enron were misled on high risk and complicated accounting practices. Fastow lobbied credit rating agencies to increase the credit rating for Enron, and facilitating the complexity and sophistication of special purpose entities. He also promoted reduction of hard assets while increasing paper profits. This increased the return on assets (ROA) and reduced its debt-to-total-assets ratio, making it attractive to investors. This way, these individuals managed to conceal company losses.

The audit firm for Enron Corporation led by Arthur Andersen LLP, provided for manipulation of account loopholes, special purpose entities and financial reports for Enron Corporation. This way, the actual financial status of Enron Corporation remained concealed and the company remained afloat for some time. The audit committee for the corporation remained unaware of these happenings and company losses remained concealed. The stock prices for Enron stock went down, especially after skilling’s resignation, and later in 2001, Enron announced losses before it finally collapsed.

To stop such fraud relating to this conflict of interest, I would like to make recommendations including the installation and strict adherence to a system of current disclosures with quarterly and annual updates on real time basis. In addition to this, it is important to ensure the cooperation between the Securities and Exchange Commission (SEC) and registrants, encouraging public companies and their auditors to ask for advice on issues on disclosure. In addition, regulation of the accounting profession with strict penalties for those who go against the law in terms of accounting is important. Another important recommendation is the need to identify the most critical accounting principles by all public companies in their annual reports.

In conclusion, it is evident that fraud involving agency conflict is costly both to the principal and to the agent, but the principal suffers more losses. It is important that the principal pay attention to details in financial reports presented by their agency, in order to detect any foul play and quit before they incur losses and to raise alarm. Accounting principles are key to understanding financial markets, and in guarding investments. There is need to put in place strict rules and regulations to govern investments and the operations of agencies.

References

Emshwiller, J. R., & Smith, R. (2001). Behind Enron’s Fall, a Culture of Secrecy Which Cost the Firm Its Investors’ Trust. The Wall Street Journal.

McLean, B., & Elkind, P. (2013). The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron. Penguin Publishing Group.

Salter, M. S. (2008). Innovation Corrupted:The Origins and Legacy of Enron’s Collapse. Harvard University Press.

Thomas, C. W. (2002, March/April). The Rise and Fall of Enron. Today’s CPA.