The winning paper in this year’s Corporate Governance Paper Competition examines some of the common weaknesses that undermine board effectiveness, particularly those highlighted by the Enron case. In part two, to be published in next month’s CSj, the authors provide practical recommendations to ensure that your board avoids falling prey to the same mistakes.

Before its declaration of bankruptcy on 2 December 2001, Enron Corporation was one of the largest energy, commodities and service companies in the US with reported revenues of US$101 billion in 2000. Fortune magazine named Enron as the ‘most innovative company’ for six consecutive years, from 1996 to 2001. Ken Lay (Enron’s former Chairman and CEO) and Jeffrey Skilling (Enron’s former President, CEO and COO) received high praise in the media.

We now know of course that while the company was the idol of the market, and while the board was blithely approving the wise and responsible actions of top management, Enron was actually breaking every rule in the book. Many comparisons have been made between Enron’s fall and the sinking of the Titanic. Was the board, as Sherron Watkins (the former Enron vice-president who blew the whistle on the company) suggested, making sure the band was still playing while the ship was going down?

The Enron case is a dramatic demonstration of how some common weaknesses in boards can render them ineffective. These weaknesses, however, are symptomatic of a fundamental problem with the board culture. Were the directors only interested in adding an additional title to their business cards? In an article in Handbook of Frauds, Scams, and Swindles: Failures of Ethics in Leadership (CRC Press, 2008), Steven Solieri, Joan Hodowanitz and Andrew Felo describe the board culture in the Enron era as ‘see no evil, hear no evil, speak no evil and act no evil’ (「非禮勿視,非禮勿 聽,非禮勿言,非禮勿動。」). It seems that the Enron board fulfils the prophecy of influential author and management consultant Peter Drucker who warned in the 1950s that boards may become ‘a mere showcase, a place to inject distinguished names, without information, influence or desire for power’.

In this article we provide several recommendations to improve the effectiveness of 21st century corporate boards. Our recommendations emphasise the needs for modern corporate boards to increase board independence and board diversity, provide non-executive directors with better access to information and have a greater commitment to corporate social responsibility (CSR). In short, the culture of corporate boards in the 21st century will need to be changed in order to avoid the mistakes of the Enron board.

Board effectiveness – the challenges

As mentioned above, the Enron case highlights a number of common weaknesses that undermine board effectiveness – in particular a lack of independence, an abuse of information asymmetry and a lack of commitment to CSR.

1. Lack of independence

Independent directors, explains author and corporate governance expert Bob Tricker, ‘must have no relationship with any firm in upsteam or downsteam added-value chains, must not have previously been an employee of the company, nor be a nominee for a shareholder or any other supplier of finance to the company’ (Corporate Governance Principles, Policies, and Practices, Oxford University Press, 2012). The Enron board compromised its independence in a number of ways.

• Board members had interlinking directorships. Enron‘s board had 15 members many of whom were also members of other companies’ boards that were related to Enron’s suppliers and financial institutions so that they could easily manipulate transaction prices and costs.

• Board members served for a long period of time. More than 50% of the directors on the Enron board had served for more than 20 years. The directors had therefore become too close to management, leading to groupthink in decision-making and a lack of independence.

• Board members became too trusting. The CEO and chairman had close personal relationships with the other board members, who showed a great deal of respect and trust in their integrity and competence. As a result, board members did not criticise top management decisions.

• Board members had conflicts of interest. Directors, particularly independent non-executive directors, are supposed to act only in the interests of the shareholders of the company. Enron’s directors were more concerned with their own self-interest.

2. Information asymmetry

Information asymmetry arises where one party has more or better information than other parties. Often executive directors are party to much more information than their non-executive collegues on a board. However, board dysfunction quickly follows where the executive directors abuse this information advantage by denying important information to the board and to the general public. The Enron board demonstrates the consequences of this abuse of information asymmetry.

• Non-executive directors passively relied on disclosures made by executive directors. They treated top management as the one and only source of information about their companies’ operations and failed to question the veracity of what they were being told. For example, Enron’s non-executive directors approved the decision by the CFO to set up a private fund to transact with Enron without enquiring into the fund’s nature and the related parties involved.

• Executive directors effectively blocked important information from reaching the board. Enron’s CEO and chairman of the board did not disclose the accounting error made due to the losses from the Raptor hedging investment. They were also able to filter out important information on related party transactions and conflicts of interests.

• Executive directors provided misleading information to the board. Wendy Zellner points out in her BusinessWeek article ‘Hitting a wall in the Enron Case’ that the Enron board was continually lied to and misled by management.

3. Lack of commitment to CSR

A board of directors with a commitment to CSR would seek to ensure that the company not only complies with the law but also maintains high ethical standards in order to protect the environment, employees, minority shareholders and society as a whole. The Enron board allowed its obsession with maximising profit, as well as the company’s stock price and credit rating, to compromise basic ethical standards.

• The board failed to uphold ethical accounting practices. Directors unethically allowed many transactions to be kept ‘off the books’ with the aim of showing higher profit in the financial reports to maintain high credit ratings and attract more investors.

• The board condoned market manipulation. Enron created an artificial California energy crisis, claiming that there was a shortage of energy due to overusage in California. This enabled the company to manipulate the energy trade and boost its stock price.

Ken Chan Wai Kit and Sardonna Wong Ka Yi

Department of Accountancy City University of Hong Kong

In the second and final part of this article, to be published in next month’s journal, the authors make practical recommendations on how to increase board independence and board diversity, provide better access to information and improve ethical standards.

The Institute’s Corporate Governance Paper Competition is designed to promote awareness of corporate governance among local undergraduates. The competition is run in tandem with the Institute’s biennial Corporate Governance Conference. Authors of the competing papers also enter a presentation competition and the awardees of both competitions receive their certificates at the conference. More information and photos of this year’s award ceremony can be found in this month’s student news.