Organizational Design 615PFP scheme depends on a trade-off between fostering the desired incentives
and insuring the agent against undue monetary risks.^28 This task is easier in
principle than in practice.ENRON, WORLDCOM, TYCO, AND LEHMAN What do the spectacular failures
of some of our largest corporations say about the organizational design of the
modern firm? Of course, business failure in itself does not necessarily imply orga-
nizational failure. Even with the most able management and the most efficient
organization, business carries numerous risks. Consumer tastes change; input
availability and price can fluctuate dramatically; new ideas can create new mar-
kets and destroy others; natural disasters can alter fortunes. Nevertheless, faulty
organizational design and poor decision making can have devastating effects.
Prior to its collapse in December 2001, Enron earned over $100 billion in
revenues and had 20,000 employees. It had pioneered online energy trading and
had moved into other areas such as broadband communications. However, to
hide its exposure to risk, Enron illegally moved many of its risky activities to affil-
iated companies, often run by Enron personnel. This removed the activities from
Enron’s books but did not remove the risk from the corporation. Because its busi-
nesses required huge amounts of credit, and thus a good credit rating, Enron pur-
sued these off-the-books strategies in order to retain access to capital at reasonable
borrowing rates. Other questionable accounting practices inflated the value of
Enron’s assets. In late 2001, some of these assets began to perform poorly. This,
in turn, exposed the company’s hidden fragile capital structure, and the firm’s
credit rating fell. Investors began selling its stock, and Enron collapsed.
By 1997, WorldCom, Inc., through internal growth and its acquisition of
MCI, had become the second-largest long-distance provider in the country.
After the collapse of Enron, investors at WorldCom, Inc. became suspicious of
accounting irregularities and filed a class-action suit that ultimately exposed
one of the biggest fraudulent accounting schemes of all time. Accounting fraud
also undid Tyco International, a conglomerate that produced a wide variety of
products. Tyco’s chief executive officer, chief financial officer, and general
counsel stole hundreds of millions of dollars from the company through fraud-
ulent accounting and illegal stock transactions.
These and other cases represent the principal-agent problem run amuck.
The participants in these schemes were able to remove transactions from the view
of their principals, the investing public. Without proper monitoring, the partici-
pants could then act in their own interests to the detriment of their principals.
The government policy response to these scandals has focused on increased
monitoring and penalties. In 2002, Congress passed the Sarbanes-Oxley Act,
which raised firm reporting requirements and increased fines and jail time for
violations. For example, the act mandates that the chief executive officer and the(^28) For a lucid analysis of this trade-off, see John McMillan, Games, Strategies, and Managers(New
York, Oxford University Press, 1996), Chapter 9.
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