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1
  Corruption and Governance problems came to the
fore in the media and in the economics literature
after the Asian Financial Crisis of 1997, when
many banks, Third World corporations, and public
officials were found to be in cahoots, making
money that was often borrowed from foreign
countries, cooking up phony books, following
dubious business practices thus the term crony
capitalism was invented. Much of this was
associated with rising portfolio investment into
Asia from Japan, US, and EU which had gone bad.
2
The World Bank took on the role of corruption
police, theorizing on the need for good
Governance and institutions such as
Transparency International helped the World Bank
rank and study countries that were corrupt, where
capitalism would not work because of the lack of
ability to protect private property because of
cheating, malpractice, etc. They primarily
blamed the government and public sector  and
hoped that privatization would build an
entrepreneurial spirit
3
Joseph Stiglitz writes   Of late, there has been
much discussion of corruption in the public
sector of many developing countries. It was
inevitable corruption of public servants that, in
part, made it important to privatize in
developing countries. Advocates of privatization
also lauded the private sector's ability to
compete. But I'm not sure these private sector
advocates quite had in mind the abilities that
American corporate capitalism has demonstrated so
amply recently corruption on an almost
unfathomable scale. They put to shame those petty
government bureaucrats who stole a few thousand
dollars or even a few million. The numbers
bandied about in the Enron, WorldCom and other
scandals are in the billions, greater than the
GNP of many countries.
4
What exactly is the problem of corporate
corruption? Example of Enron  
5
Bankruptcy Declared when a company is unable to
pay creditors A corporation has to pay
bondholders first (as opposed to shareholders)
and therefore might declare bankruptcy when it
cannot pay bondholders. Chapter 11 bankruptcy
assets are not foreclosed, time is given to get
financial affairs back on track Chapter 13
bankruptcy assets are sold in an orderly fashion
so as to preserve as much value as possible for
stockholders (who are last in line) Bankruptcy
laws keep capitalism going smoothly as most
people want to preserve the company they have
lent to or have stake in
6
Some Bankruptcies from the past 3
years   K-Mart Competition from Target and
Wal-Mart destroyed K-Marts market as its
management and marketing practices fell
short   Global Crossing Borrowed billions of
dollars to string fiber-optic cables around the
world connecting Europe, North America and Asia
with broadband connections.   Chapter 11
bankruptcies were filed. K-Mart (assets 16
billion, debt 2 billion) Global Crossing
(assets 22 billion, debt 12 billion) The
assets were book value market value and
non-revenue generating. 
7
  Enron was a different story In the late 1990s
Enron was Listed as the 7th largest Global company
8
 What does Enron do? It trades energy, buying
from producers and selling to consumers
(utilities, industrial companies, etc.) Energy
such as oil, natural gas, electricity, gasoline,
etc. This market did very well in the 1990s
Enron operated in developing countries, former
Soviet economies, Middle East in places where
privatization of companies occurred, new owners
came in to produce energy, new energy sources
were found, etc. In 1993 Enron was involved in
corruption charges in Guatemala (power), India
(power), Argentina (Enron owns most of the
natural gas transportation lines natural gas
is the largest source of energy use), Brazil
(power).
9
In addition to detailing exactly who funded which
Enron projects, studies reveals that long before
Enron's tricks came to light in the US, the
company was infamous for even more egregious
practices in the developing world. Armed with
tax-payer financing from agencies like the
Overseas Private Investment Corporation (OPIC)
and the World Bank, Enron marched into developing
countries' energy sectors.
10
Enron has few competitors in the 1990s but other
firms entered the market Dynegy, Reliant
Energy, El Paso Energy, Duke Energy North
American, and others. Some Enron employers from
left for these companies. 
11
Enron reported more profits than it had, keeping
its stocks high, and giving its executives who
were paid in stock options large salaries.
  Example of a stock option A Call option is
the option to buy a stock If a call option
allows a holder of the option to buy a stock at
less than the market price of the option (strike
price of the option is less than market price),
then the owner of the option can exercise the
option and make a lot of money buy the stock at
the strike price and sell the option at the
market price). This is what Enron executives did.
And they inflated the market price of Enron
stocks to ensure they could do this.
12
How?   1) Enron was able to book its energy
trading contracts at the full contract price. It
would be like a stockbroker taking credit for the
full sales price when a customer sold stock,
instead of the commission that they earned on
selling the stock, which gave them a much
inflated earning figure.
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2) Enron created various subsidiaries which
borrowed heavily from banks and went into debt.
Enron entered into derivatives contracts with
these companies such that if their stock dropped,
Enron would report the profits of from the
derivative contracts if the stocks rose, Enron
would report profits because it was a subsidiary.
They also used watered stocks giving their
own stocks to their own subsidiaries in exchange
for notes receivable, thus inflating their
capital (SEC considers this illegal.
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3) Arthur Andersens lead accountant cooperated
with Enrons bookkeeping techniques.   4) Enrons
executives sold Enrons stocks while employees
were not allowed to sell theirs and employees
lost their money, savings, and retirement
funds.  
15
Why were Enron executives paid in stock
options?  Enrons executives were paid in stock
option to eliminate the principal-agent problem
inherent in capitalism why should the CEO take
good decisions as an agent of the stockholder
(the principal) if he/she does not get part of
the company profits? This could be fixed by
rewarding CEOs with stock options and giving them
part of the profit if the earnings of the company
did well. This backfired. 
16
Enron declared Chapter 11 bankruptcy. The Enron
debacle has set off various other corruption
debacles since
17

• Aftermath
• The number of companies restating their earnings
  went from 48 in 1996 to 230 in 2001.
• In 1996 there were 108 federal securities fraud
  class action suits. In 2001, there were 488.
• From November 2001 to November 2002, there were
  scandals or serious financial problems at Enron,
  Kmart, Global Crossing, WorldCom, Qwest,
  Adelphia, Xerox, and Tyco.
• At the peak of the wave of scandals, the stock
  market declined sharply as investors lost
  confidence. For example, the Standard Poor's
  500 Index lost almost 323 points from mid-March
  2002 to mid-July 2002.

18
In August 2002, the Brookings Institution issued
a report entitled "Cooking the Books The Cost to
the Economy", which estimated that corporate
corruption cost the U.S. economy 35 billion in
the first year. The estimate was based on the
analysis that the scandals caused about 60
percent of the 28 percent decline in the market
from March 19, 2002 until July 19, 2002. It
also caused pension funds to fall in value It
also impacted individual portfolios
19

• In July 2002, President Bush passed the
• SARBANES-OXLEY ACT Which
• Gives the SEC funding to investigate and penalize
• wrongdoing. Penalties have been increased
• 2) Establishes an Accounting Oversight Board to
  
• complement the work of the SEC
• Critics say that the Act has had little result so
  far
• And has increased costs because of compliance
• Requirements for most public companies.