2
II. ENRON, AN EMBLEMATIC CASE OF DIVERGING INTERESTS BETWEEN
COMPANY’S EXECUTIVES AND ITS SHAREHOLDERS
In �theory�, shareholders are the only owners of a company, and the task of its
directors is merely to ensure that shareholders� interests are maximized. More
specifically, � The �duty� of directors is to run the company in a way which
maximises the long term return to the shareholders, and thus maximises the
company�s profit and cash flow� (Elliot, 2002, p. 789). Corporations� managers,
in contrast, tend to prefer a growth in turnover, which would justify an increase in
their own salary. Some studies have found that for 10% increase in company
turnover managers� compensation tend to increase on average of 20-30%
(Lambert and Larcker, 1986). Moreover, turnover growth implies an increase in
the overall size of the company, which enhance managers� prestige.
When a company grows, the media becomes very interested in it and the impact
on the general public is impressive. The CEOs of big, important companies �
which may not necessarily mean a profitable company- are far more well regarded
than the managers of small -tough profitable- companies, and they can
consequently ask for higher salaries.
On the contrary, when a company goes through a difficult period and its
performance decreases or simply when it shrinks in size, its managers are the first
to be blamed. It does not really matter whether there is a downturn in the overall
economy or in the firm�s industry, its managers will be always deemed to be the
main cause of poor results. For this reason, managers have a high incentive to hide
bad performance and accounting losses. Enron is an emblematic case of this
phenomenon: its corporate culture was to link tightly executive remuneration to
the good performance of the unit they were in charge of. The executives of Enron,
thus, fearing salary cuts and downgrading, falsified their accounts in different and
imaginative ways whenever they were not satisfied with them.
�In 1999 Enron�s managers and its board of directors decided to
create financing vehicles and specialized partnerships that seemingly
permitted, in some cases, off-balance-sheet financing. However, the
management team at Enron then engaged in some hanky-panky,
inasmuch as they did not disclose what the firm was really doing,
especially with respect to its liabilities� (Ketz, 2002, p. 5).
3
In other words, Enron�s managers created some Special Purpose Entities (SPEs),
which are a sort of subsidiary companies, and issued their shares in order to raise
capital. The money raised by the SPE was used to buy at incredibly high prices
Enron�s assets. This practice �legally� allowed Enron to transfer money from the
SPE to itself. At the same time, executives put Enron�s liabilities in those entities,
which were not consolidated in Enron�s financial statement, and thus allowed
Enron to �magically� remove part of its liabilities from its balance sheet.
Practically, Enron�s managers used SPE to both inflate their assets and hide their
debts.
Nevertheless, Enron is not the only case of corporate fraud, but simply a good
representative in a long line. Malpractice seems to be an �infectious phenomenon�
not even confined to the finance and accounts department. WorldCom�s sales staff,
in fact, were also inflating the sales figures, and on the 25
th
June the company
publicly admitted that it had falsely boosted profits by almost four billion dollars;
James Bingham, an assistant treasurer at Xerox, admitted that in an effort to push
sales of its Indian subsidiary, he had made �improper payments� over a period of
years to government officials; in the year 2000 payments amounted to
approximately $ 600,000- 700,000
2
.
All this happened because the corporate culture of those companies was to create
an illusion of value, and the people who played a role within them had to respect
the �rules of the game�. Corporate culture is what determines employees�
behaviour and company�s performance. Tom Tierney, a former managing partner
of Bain, says � A corporation�s culture is what determines how people behave
when they are not being watched�
3
.
2
Corporate culture. When something is rotten. The Economist (July 27
th
2002), pp.57-58.
3
Reforming corporate governance. In search of honesty. The Economist (August 17
th
2002), pp.49-50.
4
III. NEW FINANCIAL RULES TO PREVENT CORPORATE FRAUD
The accounting scandals of the last months led different financial regulators to set
new accounting rules, which complicate further the life of executive and
accountants worldwide. Surely, the rule which made the biggest sensation in the
financial world was the one set last summer by the Security of Exchange
Commission (SEC). By the 14
th
of August, America�s corporate chieftains had to
swear personally to the accuracy of their companies� accounts. The SEC decision
was taken in order to ensure that financial statements were fairly produced.
However, it did not exert any significant effect in the financial world: after all, the
financial statements were always meant to be fair, true and complete, and before
the decision of the SEC every Director already knew that lying is a fraudulent
practice. The SEC asked for the �promise� in the belief that it would boost
investor confidence, and thus would have produced positive effects on share
prices. The empirical evidence, however, showed that a simple swear was not
enough to boost investors� confidence and ��on the crucial question on the
impact [of the oath ] on the stock market, they found that, on average, announcing
that a firm had or, more strikingly, had not certified made no significant
difference on its share price�
4
. It highly likely that investors have lost so much
faith in CEOs that they consider their promises to be merely worthless words.
External regulatory bodies still have little power in ensuring that accounts are
fairly produced. Regardless of how hard regulators will work and of how many
corporate governance requirements they will set, managers will always find
loopholes in order to avoid saying what they do not want to be understood.
It can be argued, however, that if a way to cope with corporate fraud cannot be
found in external regulators, it can be found inside the firm.
Niccol� Machiavelli, in The Prince, stated that it is in the human nature to seek
one�s own benefit and profit even when it implies somebody else ruin. In the light
of this precious Renaissance teaching, why do we not link the interest of
shareholders and managers together? In doing so, managers could seek for their
own profit and at the same time increase that of shareholders. During the last few
years directors have tried to implement this strategy by giving managers share
4
Worthless promises?. The Economist (September 28
th
2002), p. 72.
5
options. However, it has not worked well and the principle reason why is that
managers want �real� shares and not �options� on shares.
Jack Dolmat-Connell (2002), Vice President of Clark/Bardes Consulting
conducted a research on how options and share premiums influence management
performance (Appendix 1). The research showed that a massive use of options for
executives, especially when combined with a low level of �real� ownership, is
associated with poor performance. On the contrary, shares seem to motivate more
managers. The top-performing companies of Connell�s model, in fact, tended to
have executives with high ratios of real stock ownership to their salary. Shares,
and not share-options are a very good motivator, especially for long term
performance. They make executives think twice before undertaking wild, risky
investments. As a proof of it, firms such as Enron and WorldCom, which
eventually went bankrupt, were allowing their executives an enormous amount of
options but very little actual ownership.
6
IV. CONCLUSIONS
The debate on corporate governance is still open and probably will never end.
Sometimes it seems like improvements in the regulatory system are reached, but
then a new corporate scandal occurs, and once more everyone loses faith in the
business world.
Corporate frauds will probably continue in perpetuity. However, recent findings
seem to show a new way to fight the problem. In harmony with Machiavelli�s
speculation, the new approach does not pretend to change the human nature,
which is intrinsically egoistic, but tries to take advantage of it. If it is true that
each person pursues only its own interests, everybody within a company should
have exactly the same interests so that they could move together towards
achieving the same goals.
APPENDIX 1
Stock ownership and stock options: a comparison of firms’ performance
Business Company Value of stock owned
divided by salary
Number of options
divided by stock owned
5-year shareholder
return
5-year performance
relative to peer groups
Storage EMC 12.1 4.4 336 98.3
Storage Tek 2.0 7.0 75 -71.9
Software Siebel 1,342.1 1.2 6,346 244.1
People Soft 8.5 9.2 350 38.1
Drugs Pfizer 39.5 2.1 302 61.2
Squibb 14.3 5.5 213 16.4
Banking Citigroup 348.8 0.8 352 90.6
Bank of America 20.9 3.7 149 -8.3
Computer Dell 3,863 0.1 2,931 917.0
Apple 33.6 1.0 mil 139 -20.0
Retail Target 55.1 1.8 625 136.3
Kmart 4.7 5.0 149 -99.1
Airlines Southwest 97.4 1.0 428 186.3
Delta 1.2 33.7 83 -33.9
From 1997 through 2001. One hundred = initial investment. Source: Clark/Bardes Consulting.
7
REFERENCES
Accounting Scandals and the SEC. Harvey Pitt fights back. The Economist (July
6
th
2002), pp. 73-74.
Corporate culture. When something is rotten. The Economist (July 27
th
2002),
pp.57-58.
Dolmat-Connell, J. Carrots and Sticks. Forbes (September 16
th
2002), p.42.
Elliot, B. and Elliot, J (2002) Financial Accounting and Reporting. 7
th
ed.
London: FT Prentice Hall
Ketz, E. Can we prevent future Enron?. The Journal of Corporate Accounting and
Finance (May/June 2002), pp.3-11.
Lambert, R. and Larcker, D. (1986). Executive Compensation, Corporate
Decision Making, and Shareholders Wealth: A Review of the Evidence.
Midland Corporate Financial Journal, Spring, pp. 64-71.
Reforming corporate governance. In search of honesty. The Economist (August
17
th
2002), pp.49-50.
Worthless promises?. The Economist (September 28
th
2002), p. 72.
READING BACKGROUND
Cadbury, A. Ethical Managers Make their Own Rules. Harvard Business Review
(Sept/Oct 1987).
Donaldson, J. (1992) Business Ethics: A European Casebook. London: Academic
Press.
Enron and stockmarket jitters. The good lay. The Economist ( February 2
nd
2002),
p. 66.
Enron, the twister hits. The Economist (January 19
th
2002), pp. 63-65.
Monks, R., and Minow, N. (2001) Corporate Governance. 2
nd
ed., Oxford:
Blackwell.
Smith, G. Enron�s Lesson: Rebuild Internal Auditing Now!. The journal of
corporate Accounting & Finance (May/June 2002), pp.13-15.
Wiggins, J. Rules set for big change. Financial Times (7 October 2002).
8
FINANCIAL DEVELOPMENT AND ECONOMIC PERFORMANCE
I. INTRODUCTION
During the past there decades it was a widespread opinion among economists that
the development of the financial system had a positive influence on economic
growth. During the eighties and early nineties, this view was further reinforced by
the fact that the developing countries who had deregulated their financial system
experienced impressively high growth rates. In the middle nineties, it was still
argued that financial development was unquestionably the most important cause
of economic growth, and that discussion on the issue was not even worthwhile
(Miller, 1990).
In the last decade, however, some economists started to challenge this widespread
view. King and Levine (1993) argued that the previous literature had given too
much importance to financial development as a determinant of economic growth.
This change in opinion among economists was mostly due to the financial crises
of most developing countries, which followed their financial liberalization.
Demetriades and Hussein (1996), through time-series studies on DCs, provided
the statistical evidence that financial development does not always contribute to
economic growth, especially in the long-run.
The purpose of this paper is to evaluate the conditions under which financial
development is likely to boost economic growth, and when, on the contrary, it is
likely to produce economic instability and financial crises. More precisely, it will
argue that a well regulated financial system is essential if long-term economic
growth is to be reached, and that financial liberalization in economically unstable
countries is likely to bring more harm than good.
9
II. THE RECENT EXPERIENCE OF STOCK MARKET EXPANSION IN DEVELOPING
COUNTRIES
Due to massive financial liberalization, the market capitalization in developing
countries (DCs) has increased dramatically over the past twenty years. The ratio
of market capitalization to GDP has increased in Chile from 13.2% to 78% and in
Thailand from 3.8% to 55.8% in a ten-year period (Feldman and Kumar, 1994).
This sharp growth in market capitalization is peculiar to new DCs, in contrast to
the development of the more �established� countries. Europe and USA, in fact,
had a far slower increase in market capitalization even during periods of rapid
economic growth. It took 85 years for the market capitalization ratio of the United
States to pass from 7% to 71%, while most DCs reached the same results in a
decade. Nevertheless, the sharp development of the stock market in DCs has
caused some problems, which led to the severe financial crises of the nineties. It
can be argued that DCs were not yet mature for such a quick liberalization in their
financial system. The process of financial liberalization in those countries was
too fast and it did not allow the creation of an adequate regulatory framework.
Moreover, it must be noticed that the main cash inflows in the stock market of
DCs came mostly from developed countries, whose investors were not able to
evaluate the prices of the shares traded in those countries, since they did not have
a past record of share performance. External investors could therefore rely much
more on the shares traded in their own countries than those of DCs�, and it
implied that stock price fluctuations in DCs were far wider than those in
developed countries.
10
III. STOCK MARKET VOLATILITY AND ECONOMIC PERFORMANCE
Stock market volatility is probably the main cause of the financial crises in DCs,
since it has a destabilizing effect on the overall economic environment:
™ It tends to increase the real interest rate.
™ It produces wide exchange rate fluctuations.
™ It is likely to create asset prices �bubbles�.
™ It harms the banking system.
Increase in Real Interest Rate. High degree of market volatility frightens risk-
adverse savers and investors: they become extremely reluctant to lending and
investing. This leads to an increase in the real interest rate, and thus an increase
of the cost of capital for businesses.
Exchange Rate Fluctuations. High share price fluctuations lead investors to buy
enormous amounts of shares when share prices are increasing, and to sell
enormous amounts when share prices are decreasing. Since cash inflows in the
stock market of DCs come mostly from foreign investors, a massive inflow and
outflow of foreign currencies implies wide exchange rate fluctuation. Moreover,
DCs have generally a high degree of debt with foreign countries and thus, when
their local currency weakens, interest repayments to those foreign countries
become extremely costly, sometimes unaffordable. This can lead to severe
financial crises (e.g. Mexico 1994), which would generally involve long periods
of economic regression.
Asset Prices Bubbles. Wide share fluctuations often bring share prices at very
high levels, which do not reflect their real value. Hence, the assets of the
corporations that invest their resources in the stock market may be overestimated.
Unquestionably, the banking industry, which is the industry with the largest
percentage of assets invested in the stock market, is the most affected by share
price fluctuations. Banks may therefore have inflated assets during high share
price periods, .
Harm to the Banking System. Conversely, market volatility also brings share price
to very low levels, and when this happens bank�s assets shrink. Hence, the asset
quality in the banks balance sheet deteriorates as a consequence of market
volatility. This phenomenon weakens the overall banking system and brings
macroeconomic instability.
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