Term Paper, 2006, 33 Pages
Fachhochschule für Ökonomie und Management Hamburg
Master of Business Administration (MBA)
Information asymmetry in principal-agent relationships
Lessons learned from Enron
Andre Wiedenhofer, Markus H. Krahnke
Table of Contents
1 Introduction ... 6
2 Scope of work ... 7
3 Principal-agent relationships ... 8
3.1 Theoretical framework ... 8
3.2 Characteristics of actors ... 9
3.3 Agency problems ... 10
3.3.1 Moral Hazard ... 10
18.104.22.168 Hidden information ... 10
22.214.171.124 Hidden actions ... 11
3.3.2 Hold up ... 11
3.3.3 Adverse selection ... 12
3.4 Methods of Resolution ... 12
4 Mapping to the Enron Affair ... 14
4.1 History of the Enron’s situation ... 14
4.2 Key actors ... 18
4.2.1 Kenneth Lay ... 18
4.2.2 Jeffrey Skilling ... 18
4.2.3 Andrew Fastow ... 18
4.3 Examplary principal-agent relationships within Enron ... 19
4.3.1 Case 1: Special Purpose Entities ... 19
4.3.2 Case 2: 401(k) Savings Plan ... 22
5 Balancing the methods od resolution within Enron ... 24
5.1 Case 1: Special Purpose Entities ... 24
5.2 Case 2: 401 (k) Savings Plan ... 27
6 Conclusion ... 28
Bibliography ... 30
ITM-Checkliste ... 32
Nowadays the situation in the economy is characterized by fusions, M&A or cooperations within the business environment. More and more takeovers and overestimations occur, which lead to a collapse within exchange rates. As there is no appropriate value to evaluate the firm, firms have to focus on shareholder value that is calculated on the market.1
Regarding the shareholder value, firms have to change their objectives and their instruments to achieve a higher shareholder value on the market. All characteristics of the firm have to be adjusted to the shareholder value: increasing globalization2, short productlifecycles, planning with negative cash-flow, high dynamic3 on the capital market as well as entrepreneurial flexibility.
It could be recognized that firms try to achieve the objectives regarding the enhancement of the shareholder value with questionable instruments. In the last years, many evidences have been documented the prevalence of entrepreneurial behaviour that does not serve the interests of firm’s shareholders (Worldcom and Vivendi Universal for the most recent examples).
Managers try to maximize their own utility but fail to make decisions that maximize shareholder value. Laws and rules do not seem adequate instruments to stop fraud. The fundamental question is how to design the relationship between the shareholder and the managers to assure investors that they get a return on their invested capital. Instruments provided by the principal-agent theory are commonly viewed as a possible approach to reduce the gap of information asymmetry between principal and agent.
2 Scope of Work
The primary objective of this assignment is to demonstrate occurred principal-agent problems within the collapse of Enron. The secondary objective is to discuss possible safeguarding activities on the case of Enron and their impact on principal-agent relationships.
Figure 1 shows the methodology of the assignment.
Figure 1: Methodology (only available in download-version)
Firstly, the theoretical framework regarding the principal-agent theory will be set. It will be shown that information asymmetry is the cause for the relationship between two parties, described by the principal-agent theory. Different parties will be given different instruments to compensate information asymmetry and safeguard the current relationship regarding their own interests. The principal-agent theory provides instruments that help to identify explanations and problems of the participating actors. These instruments will be briefly shown.
Having set the theoretical framework of principal-agent theory, these instruments will be mapped to a specific situation in economic business. The practical example of Enron comes into focus: the different instruments of the principal-agent theory will be shown regarding its effectiveness. In order to reduce the complexity within the case of Enron, two specific cases and their individual principal-agent relationships will be presented. It will be questioned what instruments have been used, and what were the major problems, principal and agent had to face?
Afterwards the used instruments will be discussed in a wider range. The used instruments will be balanced generally whether they have an added value regarding the objectives of all participating actors of regarding the specific case of Enron. Positive and negative side effects will be shown.
Finally, the conclusion summarizes the achieved results and answers the question what lessons could be learned regarding the use of principal-agent theory instruments specifically and in general. The conclusion will also give further recommendations how to safeguard principal-agent relationship within a highly complex environment.
3 Principal-agent Relationships
3.1 Theoretical framework
Neoclassical economy describes scarcity of goods regarding its coordination of different interests on markets.4 Regarding the neoclassical economy, the coordination on markets is bounded to fully perfect markets. Perfectionism of markets means that every marketactor has all relevant information at any time he needs. Therefore market mechanism is defined as allocation instrument without costs. It synchronizes individual plans by customers and individual plans by firms perfectly. Inter-subjective relationships will not be contemplated. The focus of neoclassical economy is aligned to person-good relationships. Therefore, the price is the significant instrument to coordinate all activities on neoclassical markets. Price provides the necessary information to market actors regarding scarcity of goods. Due to these assumptions, problems between market-actors are not possible.
1 Rappaport notices that it has become fashionable to blame the pursuit of shareholder value for the ills besetting corporate America. Cp. Rappaport (2006), p. 66.
2 Regarding globalization of information-, labour- and consumer market cp. Welfens/ Addison/ Audretsch (2000). Refering to the increasing growth of globalization new market entrants and new competitors play an important role. On the one hand globalization can be refered to economic liberalization in Eastern Europe as well as Asia. On the other hand Welfens et al. see the development of telecommunication as key impulse of globalization. Cp. Welfens/ Addison/ Audretsch (2000), p. 105.
3 Klimecki/ Gmür (1997), p. 206 see rising entrepreneurial risks as a consequence of increasing environmental dynamic.
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