Case study for Enron, Risk management

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    Management
  • Document type:
    Case Study
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    Masters
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RISK MANAGEMENT: CASE STUDY FOR ENRON 11

Risk Management: Case Study for Enron

The case “Enron: 21st Century Business – 19th Century Structure – Fact or Fiction”

Risk management: Case study for Enron

Abstract

Over the last two decades, the risk management has drawn a lot of public attention due to the apparent significance for economic wellbeing of companies. The recent collapse of Enron Corporation has exposed managers, particularly on their risk management practices or lack of it. Therefore, in this case study, the paper will analyze how Enron management failed in their risk management practices roles leading to collapse. The research will also find out how organization structure of Enron could have complicated risk management. In addition, the paper highlights various issues which could increase risks at Enron including poor expansion practices, increased innovation and poor corporate culture. This study used secondary data sources in gathering of information. In particular, the literature including journals, articles, books and websites were used to collect information. The case study found out that blind expansion, increased innovation and poor corporate culture complicated risk management practices leading to collapse of Enron Corporation. Therefore, the case study recommends that the companies needed to create of position of a risk manager and appropriate corporate culture which reduces incidences of financial and the reputational risks.

Contents

2Abstract

41.0 Introduction

52.0 Risk Theme Discussion

52.1 Poor expansion practices

62.2 Poor innovation practices

72.3 Corporate Culture practices

83.0 Recommendations

84.0 Conclusion

105.0 References

1.0 Introduction

The collapse of one of the major businesses like Enron Corporation became a subject of debate among investors, managers and academics in regards to risk management. Hull (2007, p. 4) claimed that, risk management has become an important activity every firm. Some scholars and investors think that the devastating losses of 2001 at Enron Corporations could have been prevented if effective risk management systems could have set before (Voinea & Anton, 2009, p.140). In most cases, the collapse of Enron was attributed to management failure starting with failure of risk management. The case “Enron: 21st Century Business – 19th Century Structure – Fact or Fiction” is an example of how the top managers failed to predict potential risks which the organization could have encountered with its new practices and even to develop suitable approaches to handle such risks. The company also expanded to other industries without identifying the risks associated with such moves. Enron had also embarked on innovation laced with personal interest which was very risky to the organization (Moncarz et al., 2006, p. 20). In some cases, Enron’s corporate culture has been blamed for failing to stop fraudulent actions of the manager which contributed to collapse (Fox, 2003, p. 96). Therefore, this case study will review various literatures to demonstrate how the poor expansion practices, corporate culture and innovation practices increased risks to Enron.

2.0 Risk Theme Discussion

2.1 Poor expansion practices

Expansion in the organization takes place in many forms, including increasing number of employees, expanding the number of outlets, increasing product portfolio or diversifying to other industries. Fox (2003, p. 38) claimed that for Enron, the company diversified into other sectors. Jeff Skillings who had been brought to be the head finance department recommended for the expansion into renewable energy sources, paper and pulp derivatives, trading in plastic and coal, internet and broadband services, trading in chemical, water and credit derivatives (Fox, 2003, p. 21). The rapid expansion by Enron Corporation demonstrated blind expansion by the management with an aim of the large scale of operation and maximization of profits. It is normally good for a company because it increases brand awareness as the company strengthens its position in the market and seeking more profits.

However, Dharan and Bufkins (2004, p.78) argued that it is often risky for a company to expand to numerous industries and seeking for many partnership at once in business industry which is now marred with uncertainty. In the event that this happens, the practice results into complex and decentralize corporate system, scattered capacity and resources, increased cost of operation making it hard to control the operations (Stulz, 2008, p. 60). Diversifying to many other industries makes the company to reduce its focus on core business. It also means the more funds are diverted to new projects, the more it could be overtaken by competition in its core business. Markham (2006, p. 46) claimed that at the time Enron was expanding into other sectors, the energy sector had just been deregulated hence the need for the company to review its strategies. The company overlooked the effect of deregulation, which are always severe.

Enron management did not have a standard risk management to identity risks that comes with deregulation. Moncarz et al. (2006) opined that while neoclassical economist often contend that deregulation promote efficiency, lower cost, induce innovation and lower prices, it also has several pitfalls. Deregulation creates a platform which increases the number of market players, manipulation of product supply and even prices, fleece of customers and evasion of scrutiny (Kolb & Overdahl, 2009, p.113). The situation can then lead to loss funds and uncounted resources, hence hurting the success that the company has managed to build over the years. The moment the company approved all these expansions, it was an indication of collapse. Enron Corporation had no proper risk management system, hence the management sometimes equated risk with the opportunity. Fox (2003, p.180) pointed out that Enron’s expansion plans were driven by short term mentality and quest for quick profits. The studies argue that expansion based on the two factors hardly last because when the quick gains are not made, the company may close the new venture leading to looses.

2.2 Poor innovation practices

Innovation has also been proven to fuel risks at the organization especially when they are not well thought (Stone, 2010, p. 26). Enron Corporation introduced numerous innovations to increase profits and to make a name within the US business environment. The company spotted an opportunity and shifted to unregulated market to add to its existing regulated natural gas industry (Fox 2003, p. 164). The company created Gas bank in 1989 which created a platform where gas manufactures and the whole buyers could buy gas and evade price risk too. In addition, Bryce (2008, p. 63) posited that in quest of attracting investor to form a regular profiting practice in the firm, Enron investors were compelled to project high cash flows in the future and lower discount rates on their long-term agreement with the company. The company also created own accounting practice where it would include projected income from new ventures in their accounting books even the money was not yet earned or received (Rosen, 2003, p.1575). The practice is risky because if the company makes a loss, it would be very difficult to convince shareholders. It means the company would give false information on financial performance when the projected profit turn out to be losses. Enron innovation saw it introduce special purpose entities to fabricate and hide loses (Moncarz 2006, p. 24). In this perspective, the company had identified risk but instead of getting the approaches to reduce them, they choose to hide presence of risk. Use of SPE enabled Enron to report the return on the assets, but without reporting the debt on the company’s balance sheet (Moncarz et al 2006, p. 24). Research found out that there are numerous controversial special purpose entities that were innovated majorly to defy accounting standards but to hoodwink with financial reporting. Chewco, Raptor, LJM1 and LJM2 are some of SPEs that Andrew Fastow formulated which were intended to hide debt. LJM1 was personally managed by Fastow; a practice which posed conflict of interest (Fox 2003, p. 194).

2.3 Corporate Culture practices

Research shows that corporate culture normally plays a big part in organization performance (Tipgos & Keefe, 2005, p. 46). The case presents a poor corporate culture which played part in Enron’s collapse. Fox (2003, p. 180) pointed out that Enron Corporation had what experts could describe as a bad corporate culture which had the feature of competition, individualism, selfishness, sabotage and jealousy. Such practices led to poor performing groups with no collaboration. Since the company had a competitive hiring, the staff showed open jealousy and sabotage. The top management also inculcated a culture of greed and dishonesty. Andrew Fastow and Jeff Skillings with the knowledge about finance devised ways they defrauded the company and enrich themselves (Healy & Krishna 2003, p.15). The practices also involve cover ups which ensured other managers did not realize the financial losses posted by Enron.

3.0 Recommendations

Hiring a risk manager would have been the first step for Enron Corporation if they were to avoid involving is risky strategies. Risk managers would have advised the company on potential risks to company’s existence and profitability (Hull, 2007, p.17). Risk manager helps the firm in identifying and assessing risks, planning and deciding on how to reduce, prevent or even transfer risks. Kolb and Overdahl (2009, p. 69) stated that hiring risk manager also ensure that risks are managed in the organization, including employees, reputation, customers, assets and stakeholders’ interests. Experienced risk manager would have stopped blind expansion and poor innovation at Enron hence saving the company finances and brand reputation.

This research recommends creating an appropriate corporate governance as a measure of fostering a positive corporate culture. The practice can be encouraged by setting ethical codes by the top leadership which every member of the organization is to abide to (Tipgos & Keefe, 2005, p. 48). Ethical codes provide direction to what the company wants are what is not wanted and in this way teamwork, integrity and hiring competent people can be nurtured to become part of the organizational culture.

4.0 Conclusion

The research has identified various risk issues which Enron Corporation could have dealt with through and effective risk management systems. Some of the issues include blind expansion, poor innovation practice and poor corporate culture. In its innovation practices, the company adopted the use of derivatives and SPEs, which made the company to appear to be performing positively. When the management realized their strategies were not working, they resorted to giving false financial information until the company collapsed. The case study has also realized the company had a poor corporate culture full of competition among employees, individualism, and love for money, sabotage and selfishness. The corporation made staffs to work towards enriching themselves while neglecting the risk which comes with it. The case of Enron and its collapse is a wake call to a company which thinks of quick expansion to other sectors, companies with several innovative ideas and firms which have poor corporate culture. It’s a means that companies must first think if risk management systems before they endorse any project or innovation exercise in future. The case study also concludes that companies must foster an effective corporate culture if they want to manage risks especially the reputational risk.

5.0 References

Bryce, R. (2008). Pipe Dreams: Greed, Ego, and the Death of Enron. PublicAffairs.

Dharan, B.G., & Bufkins, W.R. (2004). Enron: Corporate Fiascos and Their Implications.

Foundation Press.

Fox, L. (2003). Enron the Rise and Fall. New Jersey: John Wiley & Sons.

Healy, P.M., &Krishna G.P. (2003). The Fall of Enron. Journal of Economic Perspectives 17 (2),

Hull, J.C. (2007). Risk Management and Financial Institutions. New Jersey: Pearson Education.

Kolb, R., & Overdahl, J. A. (2009). Financial Derivatives: Pricing and Risk Management.

Hoboken, New Jersey: John Wiley & Sons.

Markham, J. W. (2006). A Financial History of Modern U.S. Corporate Scandals from Enron to

Reform. Routledge.

Moncarz, E.S, Moncarz, R., Cabello, A. & Moncarz, B. (2006). The Rise and Collapse of Enron:

Financial Innovation, Errors and Losses, 17-37. Retrieved 5th August 2016 http://www.ejournal.unam.mx/rca/218/RCA21802.pdf

Rosen, R. (2003). Risk Management and Corporate Governance: The Case of Enron.

Connecticut Law Review, 35 (1157), 1175-1186.

Stone, J. (2010). Innovation — a business risk that can be managed and mitigated. Keeping Good

Companies, 62(1), 25-30.

Stulz, R. (2008). Risk Management Failures: What Are They and When Do They Happen?

Journal of Applied Corporate Finance, 20(4), 58-67.

Tipgos, M., & Keefe, T. (2005). A comprehensive structure of corporate governance in post-

Enron corporate America. The CPA Journal, 74(12), 46–51.

Voinea, G., & Anton, S.G. (2009). Lessons from the Current Financial Crisis. A Risk

Management Approach. Review of Economic and Business Studies, 3, 139-147.