Noble laureate and economist Milton Friedman said in the 1970 that the Business of Business is Business and he elaborates in an article here.
He said that the sole responsibility of a business which is run by corporate executives acting as agents on the behalf of the principal- shareholders, is to maximize profits and hence, increase shareholders’ wealth.
Should a business really be amoral, decoupled with any responsibility apart from working under the basic requirements as might be mandated under law?
Let’s look at one of history’s major corporate scandals and more that followed where corporate executives fudged their balance sheets and duped the investors and public at large:
Enron was an energy company formed out of a merged of two natural gas companies: Houston Natural Gas Corporation and InterNorth, Inc, in the 1980s.
Series of events that led to the scam:
- In the 1990s when the US market of energy supply became deregulated, Enron lost its monopoly status.
- To compete in a newly competitive environment, Enron business was transformed into a trading of energy derivative contract. This essentially means that Enron could act as an intermediary between natural gas producers and their customers, fixing the prices and allowing the two parties mitigate risk against random price fluctuations.
- Enron was able to gain a competitive advantage with the trading business and generated huge amounts of profits.
- To serve the shareholders’ interests, Enron aggressively pursued trading and exploit margins. The bullish market of the 1990s, encouraged Enron to create more markets for trade — electricity, paper, steel and more.
- Enron online was launched to enable high speed trading.
- During the dotcom bubble however and in the midst of competition from other trading companies, Enron’s profits declined!!
Crisis at Enron and remedial measures
- Shareholders got the cold feet. And to sate them, executives relied heavily on an accounting practice called ‘Mark-to-Market”. Under this practice a company can provides a market matched fair value of their assets and liabilities in their balance sheets and not the value at which it was brought — the true value. A legitimate practice, however, prone to heavy manipulation. Enron began to add unrealized future gains from its trading deals to its valuation.
- To continue pleasing its investors and creditors, it also hid its problematic debt from them by way of off-balance sheet special purpose entities (SPE). The tool was used as a way for Enron transfer its troubled assets to those SPEs in exchange for cash. Enron’s stock was used an a hedge against those assets.
Enron, kept its loss-making assets off the balance sheet and thereby hide its accounting reality.
Time to take out the dirty laundry
- By 2001, many analysts dug into the financial statements and began questioning Enron’s dubious practices.
- Enron’s stock prices fell free.
- As word got around, Enron’s stock price fell from 90$ in mid 2001 to 1$ by November 2001. Enron was soon declared bankrupt.
- Shareholders lost $74 billion
Enron Scandal created a wave of new regulations and a call for a more ethical business conduct.
More scams followed:
- Worldcom Scam: a telecommunications company, world com cooked up its accounts by capitalizing its expenses and inflating its profits by leaps and bounds
- Satyam Scandal-India’s Enron: Another case of fudging numbers to paint rosy books of accounts far from reality.
In all these cases and more that followed, the metric used to misguide millions were the profits, ironically, that which maximizes shareholder wealth.
What if the metric of success had been something else? What if the business of business was not judged purely on ‘business’ but something more wholesome? Such as:
- How many of your employees have you helped to become close to their true potential?
- How have you regenerated nature, from which resources are constantly plundered?
The consistent appearance of such scandals reminds humanity about the flaws in our current ways of engaging in the means of sustenance.
The blog is the part of series ‘Lessons in Sustainability’ and comprises of class discussions and key insights from readings, at IIML. The next one is going to be a combined blog on:
> the significance of language in perceiving nature’s gifts and,
> Richard Thaler’s Experiments to Nudge and the 20:70:10 Rule
Sources and Credits:
- BSEM Elective class discussions led by Prof Sushil
- Investopedia and Britannica pages on the scandals mentioned in the blog