Information asymmetry in principal-agent relationships

Lessons learned from Enron

Term Paper , 2006 , 33 Pages , Grade: B

Business economics - Business Management, Corporate Governance

This paper investigates the principal-agent problems within the collapse of Enron and why safeguarding activities did not lead to positive results. Having set the framework of principal-agent relationship in general, the focus will be put on Enron. In order to reduce the complexity two specifc cases will be extracted from overall case of Enron. Different potential safeguarding activities will be crafted. Finnally, it will be stated, that separating the implementation of safeguarding activities can be lead to the desired results.

Table of Contents

EXECUTIVE SUMMARY

TABLE OF CONTENTS

LIST OF FIGURES

1 INTRODUCTION

2 SCOPE OF WORK

3 PRINCIPAL-AGENT RELATIONSHIPS
3.1 Theoretical framework
3.2 Characteristics of actors
3.3 Agency problems
3.3.1 Moral Hazard
3.3.1.1 Hidden information
3.3.1.2 Hidden actions
3.3.2 Hold up
3.3.3 Adverse selection
3.4 Methods of Resolution

4 MAPPING TO THE ENRON AFFAIR
4.1 History of the Enron’s situation
4.2 Key actors
4.2.1 Kenneth Lay
4.2.2 Jeffrey Skilling
4.2.3 Andrew Fastow
4.3 Examplary principal-agent relationships within Enron
4.3.1 Case 1: Special Purpose Entities
4.3.2 Case 2: 401(k) Savings Plan

5 BALANCING THE METHODS OF RESOLUTION WITHIN ENRON
5.1 Case 1: Special Purpose Entities
5.2 Case 2: 401 (k) Savings Plan

6 CONCLUSION

BIBLIOGRAPHY

ITM-CHECKLISTE

List of Figures

Figure 1: Methodology

Figure 2: Graphical representation of special purpose entities relationship

Figure 3: Relationship between management, employees and stockoptions

Executive Summary

This paper investigates the principal-agent problems within the collapse of Enron and why safeguarding activities did not lead to positive results. Having set the framework of princi- pal-agent relationship in general, the focus will be put on Enron. In order to reduce the complexity two specific cases will be extracted from overall case of Enron. It will be shown how agents used their power to manipulate possible safeguarding activities. By designing safeguarding activities for the principal, the agent can be sure that he will be able to exploit the relationship in the future. Finally, it will be stated, that separating the implementation of safeguarding activities can be lead to the desired results. But to give up the safeguarding activities completely to the agent will not be an option to reduce information asymmetry within principal-agent relationships.

1 Introduction

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 evalu- ate 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.

illustration not visible in this excerpt

Figure 1: Methodology

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 re- garding 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, princi- pal 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 market- actor has all relevant information at any time he needs. Therefore market mechanism is defined as allocation instrument without costs. It synchronizes individual plans by custom- ers and individual plans by firms perfectly. Inter-subjective relationships will not be con- templated. 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.

Regarding the perfectionism of markets, two essential assumptions can be made: Actors are able to sign complete contracts and are able to prevail these contracts. A complete contract includes every prospective influence and is able to compensate any possibilities. Beside, the assumption is made, that all parties have information symmetry at any time regarding all possible contingencies.

Taking everything into consideration, equilibrium of markets in neoclassical economy implies fully perfect contracts and symmetrically distributed information at no costs.⁵

In reality it is impossible to predict any contingencies and to organise them within con- tracts. Moreover, contract establishment and conclusion as well as information procure- ment is not free of costs. Coase showed that relevant information is not provided by the market without costs.⁶ Coase asked the question why there are firms, when market mechanism work freely without costs. The existence of transaction costs was his answer.⁷

The use of market mechanism consequently leads to costs: searching costs or e.g. nego- tiating costs. These coordination costs can be minimized by vertically integrating special activities into firm’s organisation.⁸ Activities that have been demanded on markets with high transaction costs can be demanded within the firm’s organisation with less transaction costs.

As real contracts are always incomplete and relevant information can only be anticipated sequentially, it is quite important which contractual party owns decision- or property rights and what safeguarding measures should be implemented in unpredictable situations.⁹

3.2 Characteristics of actors

Problems within principal-agent relationships are fundamental to incomplete contracts.¹⁰ Jensen/ Meckling define “an agency relationship as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent.”¹¹ It is assumed that both parties expect rational acting but have different risk awareness.¹² Hav- ing incomplete contracts, parties have incentives to depart from these contracts either in expected performance or in expected quality.¹³ This opportunistic behaviour will be sup- ported by the fact that information can not be provided without costs to any party in the same way. Information asymmetry between contract parties comes into existence. Having contracted, the information is assumed as asymmetric due to the fact, that the principal is not able to observe the agent at any time or the agent observed anything, the principal did not.¹⁴ In general, one party gains more information than the other party. For the party, having less information, it is difficult - or sometimes impossible - to turn the information asymmetry into information symmetry.

One the one hand, opportunistic behaviour occurs before contracting (ex ante). On the other hand divergences may occur after the contract is established (ex post). Having es- tablished the contract, the agent can diverge from the fixed contract, if it is not possible to be observed directly by the principal. This is called moral hazard.¹⁵ Beside, other agency problems may occur.

Within the relevant literature there are two approaches regarding the principal-agent the- ory. The normative approach of the principal-agent theory is related to the usual micro- economic. Problems regarding the individual utility function are into focus and tried to solve mathematically. Beside, there is the positive approach of the principal-agent theory, which is related to contracts and organizations. This approach has the focus in empirical orientation.¹⁶

3.3 Agency problems

Agency problems are the consequence of different objectives as well as different status of information between principal and agent. The classification of agency problems is made regarding the different time periods; information is given within the relationship.¹⁷

3.3.1 Moral Hazard

3.3.1.1 Hidden information

If the agent owns more information than the principal before the contract is fixed or even before activities start, the agent holds “hidden information”.¹⁸ Due to this hidden informa- tion the principal’s risk occurs that the agent used the information to gain individual profit rather than to obtain principal’s interests ex post. Unequal information provides the agent important added value. Before the contracted activities are done, the unequal imperfect information provides the agent the possibility to exploit the situation to his own benefit.¹⁹

3.3.1.2 Hidden actions

Another problem of principal-agent relationships is described by the hidden actions. During the time period of contract fulfilment and closure of the principal-agent relationship information asymmetry is still present. The principal does not have precise information about the agent’s performance fulfilment as well as his acting options. Due to the wide range of possible options the agent is able to choose different instruments to achieve the objectives. These instruments can not be observed by the principal at no costs. The principal is just simply able to observe the final results ex post. Although the final result can be assessed by the principal backward indication regarding the agent’s effort is not possible. The result might be traced back to other circumstances.²⁰ The agent has environmental information the principal is not able to participate.²¹

3.3.2 Hold up

The risk of hold up problems occurs due to specific investments by the principal. Establishment of specific investments can be exploited by the agent after conclusion of the contract. The individual risk awareness by the principal is called hidden intentions. The principal has no solid information about the agent’s intention. Compared to hidden actions, these hidden intentions will be evident for the principal in the course of the principal-agent relationship ex post.²² The main factor of the hold up problem occurs due to the specific investment by the principal. The information asymmetry is decisive for these kinds of problems.

3.3.3 Adverse selection

Another risk of principal-agent relationship is the possibility of the principal choosing the false agent. The adverse selection is based upon information asymmetry after the closure of contract. The principal is not able to observe any characteristics of the agent. Important characteristics stay hidden (hidden characteristics). Due to private information, the agent is now able to exploit the relationship opportunistically. The principal may suffer from actions, which are not in his interest. The problem of adverse selection may prevent relationships or may lead to the collapse of whole markets.²³

3.4 Methods of Resolution

To avoid agency problems there are different mechanisms and approaches, which might prevent the risk of exploiting the relationship. The first approach is the incentive structure tuned to the benefit of the agent. The principal is able to set the agent’s objectives to his own interests. An efficient incentive structure includes the agent’s participation of the achieved results.²⁴ The more the contractual agreement is based upon the agent’s participation of the adduced performance, the more the incentive for the agent to achieve the agreed performance. Performance-orientated contracts are used to bind the objectives by the principal and agent.²⁵ Conflicts within the objective structure can be neglected.²⁶ The principal also has the advantage that his demand of information regarding the agent decreases, because just the allocation of the results has to be decided. The agency costs will decrease and the risk of moral hazards will be reduced.²⁷

Another mechanism to discipline the agent is direct behaviour control. This control is based upon a special behaviour, which is contractual agreed. Any abuse or violation of these rules will be negative sanctioned.²⁸ The advantage of direct behaviour control is that the behaviour has to be observed constantly. However, the principal can not ensure the monitoring at any time. Beside, permanently observation does not lead to a positive incentive regarding the agent.²⁹ Furthermore, behaviour control has to be financed by the principal. Therefore behaviour control is no real option to discipline the agent.³⁰

To avoid further agency problems the principal has the possibility to refer to another in- strument to discipline the agent. This instrument is the improvement of information sys- tems. With the help of qualified information systems the principal is able to increase his information about the agent’s activities. The more information the principal has, the more takes the agent takes all principal’s interests into consideration. By increasing the trans- parency of agent’s acting options, the actions of exploiting are decreased. Measures re- garding the information systems may be accounting standards, benchmarking or cost ac- counting. The agency costs to implement information systems are high.³¹

Beside these mechanisms to safeguard agency relationships, there are further methods to harmonise the objectives of the principal and the agent. In order to avoid adverse selection two methods can be used to adjust the pre-contract information asymmetry (which is a cause of contractual imperfection): screening and signalling.³² Screening is initiated by the principal to separate different types of agents ex ante. Examples for screening are differ- entiated contractual offers, which are designed for a specific group of agents, tests or spe- cial selection processes. Signalling activities arise from the agent. With the use of certifi- cates, guarantees or seals of approval the agent tries to decline the pre-contract informa- tion asymmetry.³³

The acquisition of specific investment can be used to eliminate the risk of hold ups.³⁴ An- other option to minimize the risk of hold ups is to acquire the property right of a hostage.

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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 environ- mental dynamic.

⁴ Cp. Cezanne/ Mayer (1998), p. 1345.

⁵ Cp. Jost (2001), p. 89.

⁶ Cp. Coase (1937).

⁷ Cp. Jost (2001), p. 90.

⁸ Jensen/ Meckling describe the firm as a “black box” which operates as to meet the relevant marginal conditions with respects to input and output. Cp. Jensen/ Meckling (1973), p. 306.

⁹ Hart notices that “in a world where it was costless to think about, plan for, and write down provisions for future events, parties engaged in trade would write a “comprehensive” contract which specifies precisely what each of their obligations is in every conceivable state of the world.” Cp. Hart (1990), p. 140.

¹⁰ Cp. Kieser (2002), p. 209. Jensen/ Meckling emphasize, that “the agent will not always act in the best interests of the principal”. Jensen/ Meckling (1973), p. 308.

¹¹ Cp. Jensen/ Meckling (1973), p. 308.

¹² In general, it is assumed that the principal is risk neutral and the agent dislikes risks. Cp. Kieser (2002), p. 211.

¹³ Cp. Jost (2001), p. 90.

¹⁴ Cp. Richter/ Furubotn (1999), p. 174.

¹⁵ Cp. Akerlof (1970); Jost (2001), p. 91.

¹⁶ Cp. Richter/ Furubotn (1999), p. 177.

¹⁷ Cp. Kieser (2001), p. 213.

¹⁸ Cp. Kieser (2001), p. 213; Richter/ Furubotn (1999), p. 174.

¹⁹ Kieser recognizes that this hidden information often occurs while awarding contracts to consultancies. This hidden information allows the consultant a higher bargaining power while deceiving self presenta- tion. Kieser (2001), p. 213.

²⁰ Cp. Kieser (2001), p. 213.

²¹ Cp. Ripperger (2003), p. 66. If the principals has contracted more then one agent, the problem regarding the agency relationship increases intensely. As far as the performance will be achieved within a team, in- terdependend problems occur. Cp. Kieser (2001), p. 223. Furubotn/ Richter also notice that more agents lead to more problems, due to the productivity function, which cannot be separated. Cp. Furubotn/ Rich- ter (1999), p. 291.

²² Cp. Ripperger (2003), p. 67.

²³ Cp. Ripperger (2003), p. 65. Akerlof describes the market of insurances as an example for adverse se- lection. But he also takes the example of the market for lemons which supersede the “better goods”. The result was that the market collapsed. Akerlof called this the “lemons problem”. Cp. Akerlof (1970), p. 492. Also Furubotn/ Richter describe problems of the principal-agent relationship within the insurance indus- try. Cp. Furubotn/ Richter (1999), p. 175.

²⁴ Richter/ Furubotn point out that it is difficult to define and measure relevant performance indicators. Cp. Richter/ Furubotn (1999), p. 216. Mainly there are no unique correlations between performance indica- tors and managers’ activities. This allocation of performance indicators is also a problem within the lower and middle-management.

²⁵ Hart notices that putting workers or managers on an incentive scheme does not automatically make them owners of the firm. Cp. Hart (1990), p. 143.

²⁶ Complex incentive structure should include a diversity of dimensions: profits, firm’s value, market share or the achievement of project’s objectives. Cp. Furubotn/ Richter (1999), p. 217.

²⁷ Cp. Kieser (2001), p. 214.

²⁸ Cp. Kieser (2001), p. 215.

²⁹ Cp. Kieser (2001), p. 215.

³⁰ Furubotn/ Richter show the possibility to implement a supervisory board within firms to control the man- agement. This board has the task to control the management regarding the owners’ interests. But Fu- rubotn/ Richter also notice that problems within agency relationships can not be eliminated by imple- menting supervisory boards. However, the agency problems may be reduced. Cp. Richter/ Furubotn (1999), p. 217.

³¹ Cp. Kieser (2001), p. 215.

³² Cp. Ripperger (2003), p. 65.

³³ Cp. Ripperger (2003), p. 65.

³⁴ Cp. Hart (1990). Transaction costs economy recommends to vertically integrate transaction with high specifity.

• College: University of Applied Sciences Essen (IOM)
• Course: Human Resource Management (MBA)
• Grade: B
• Authors: Andre Wiedenhofer (Author), Markus H. Krahnke (Author)
• Publication Year: 2006
• Pages: 33
• Catalog Number: V76339
• ISBN (eBook): 9783638799690
• Language: English
• Tags: Information, Human, Resource, Management