Fallout from a corporate scandal: Enron Q & A

March 29, 2006

The 2001 implosion of Enron amid an avalanche of accounting failures, inflated profits and collapsed stock has been on public show since the fraud-and-conspiracy trial of the corporation's founder and former chairman, Kenneth Lay, and former chief executive, Jeffrey Skilling, began Jan. 30 in Houston.


Former Enron CFO Andrew Fastow, who has pleaded guilty to conspiracy and agreed to serve 10 years in prison in exchange for testifying against Lay and Skilling, has admitted stealing more than $40 million from the company. Fastow has testified that his former bosses conspired to hide losses and to inflate earnings so they could profit when outside investors paid more for Enron stock. Much of the trial has focused on the various executives' conflicting accounts of what happened.


Experts at the W. P. Carey School of Business have much advice to offer, since the collapse cost thousands of Enron employees their livelihoods and life savings. Taking part in a question-and-answer survey were Professors James Boatsman, accountancy; Albert Cannella, management; Robert Hoskisson, management; Marianne Jennings, legal and ethical studies; Angelo Kinicki, management; and Philip Reckers, accountancy. Also participating were W. P. Carey School Dean Robert Mittelstaedt and Associate Dean for MBA Programs Gerry Keim. The experts responded to any or all of the questions, depending on their areas of interest.



K@WPC: What has been the impact of the Enron collapse so far?


Boatsman: There are several important outcomes from the various accounting "scandals." One is an increase in SEC funding. The staff of the Division of Enforcement has essentially doubled. Another is a change in the accounting rules that would now eliminate the incentive to engage in at least some of the kinds of partnership arrangements Enron used to "manufacture" profits and keep debt off its balance sheet.


A third is a general escalation of attention to structured transactions. A structured transaction is one designed the way it is solely to produce a desired accounting portrayal. In a recent speech, the former SEC chief accountant announced that the policy will be to require restatements every time a structured transaction is detected. Past restatements have resulted in significant market price penalties. When the restatement is accompanied by an SEC enforcement action, the market price penalties have been particularly severe.


Cannella: Thus far, I would say that Sarbanes-Oxley is probably the most important impact. Its repercussions are still unfolding, but they will be wide-ranging. The biggest single impact of this legislation has been to make it much more expensive to be a public company.


Some of the changes are very simple, but have led to highly expensive remedies. For example, the requirement that the CEO and CFO certify that all financial statements are true and correct has led to a huge increase in the number of accountants on staff in companies and in the level of detail in internal data collection and analysis. CEOs are terrified that any errors made in accounting, whether their fault or not, will land them in jail. This is probably a bit overblown, but it has led to a lot of expense. Smaller firms are very likely to go private to avoid these very high costs. Firms that would have, in the past, been good candidates for IPOs are no longer good candidates -- it is just too expensive to be a public company.


One of the sayings I hear a lot, and while it isn't completely true it certainly has an element of truth, is that it costs General Motors about the same to be a public company as it costs Joe's Bagel Shack. Public sources of capital are shrinking except for the large corporations.


Jennings: Wow -- what hasn't Enron affected? Laws have changed -- Sarbanes-Oxley is the result.


And they have offered further proof of my important theory: Never trust the people you cheat with. They will throw you under the bus. They all have turned on Skilling and Lay, the folks who hired them, to save their own hides, and turned on each other to save themselves. There is no honor among thieves.


Enron debunked the highfalutin finance models -- that you could do all these transactions at high levels and not affect the retail level of investor. There has to be integrity throughout the market, or the impact is devastating.


Companies have changed their governance philosophies. Boards are stronger and board members are more likely to speak out. Accounting rules have changed -- FASB 125 doesn't exist now. The accounting profession lost the right to self-regulate -- its code of ethics and operations is now controlled by federal law and PCAOB (Public Company Accounting Oversight Board). Auditors cannot be consultants as well. Accounting firms have done quite well despite their role because of SOX 404 requirements on certification of internal controls.


Enron forced everyone to take a look at their own operations and financial reports and wonder whether they, too, were crossing lines, however incrementally.


Keim: Enron has further enhanced the negative view of corporations and big business in the United States, and that's a serious problem because it could cause a government response that is not well thought out and that is costly.


Kinicki: The impact has been widespread. Probably one of the biggest involves the new requirements regarding financial reporting associated with the Sarbanes-Oxley Act. This act requires organizations to spend considerable time and effort to stay within the guidelines of the act.


Another impact pertains to lessons associated with culture and leadership. From a cultural perspective, the Enron case shows how the creation of an entrepreneurial culture can lead to disastrous results when management does not put ethical boundaries around its entrepreneurial goals.


Enron also is good signal about the inappropriateness of acting unethically because executives are being prosecuted and going to jail. This sends a strong message to other executives about the consequences associated with lying and breaking the law.


Mittelstaedt: Obviously the most damaging impact has been to employees, shareholders and others personally affected by Enron's collapse, but we should not ignore what this has done to public confidence in business and business executives.


The indirect fallout via Sarbanes-Oxley has had good and bad effects. The positive result has been that the very painful Section 404 compliance has caused corporations to examine and tighten up their controls. The negative side of this is that the cost has been and will continue to be huge. There is benefit in that most companies have found ways to improve their controls, but there's a real question about the cost-benefit ratio.


Reckers: Of course some things may not be attributed to Enron exclusively. A lot of allegedly unethical activity surrounded financial disasters at a number of firms in and around the same time frame.


Major items resulting were Sarbanes-Oxley reform legislation, which: massively increased attention to corporate internal controls (Section 404); mandated enhanced corporate board independence, expertise and responsibility/liability; stripped the American Institute of Certified Public Accountants of audit standard-setting authority and created a new entity -- the Public Company Accounting Oversight Board; prohibition and/or limited non-audit services for audit clients; and new regulatory reforms for brokerage industry.



K@WPC: Is one of the lessons of the Enron trial that it is vital to keep records of executive interaction?


Boatsman: If I were employed in an accounting capacity by a public company, I would certainly spend a lot of time documenting any conversation with a superior in which there was the slightest suggestion to use accounting as a vehicle to meet an EPS forecast or avoid a credit downgrade.


Cannella: I really don't know. ... Executives are in charge, and can use all sorts of levers to their advantage. I would also add that it is important not to let a few bad apples spoil the entire barrel, which I think has been and is happening. Good oversight is the key, but it is hard at the top echelons of public companies, because the executives are so powerful and have control over so much information.


Jennings: You had best have witnesses for these transactions. ... When things go wrong, everyone points fingers at everyone else. Success has many parents. Failures have none.


Kinicki: For some people this may be a lesson. Personally, I'd rather say that the lesson is that executives don't need to keep records of all their interactions if they are adhering to government regulations, behaving ethically, and not breaking the law.


Hoskisson: It's not just the record-keeping requirements that are problematic and costly. The big question in my mind is the nature of strategic decisions that will be made if corporate governance moves toward over-governance such that top managers become risk-averse with regard to major strategic and entrepreneurial decisions.


If the governance devices implemented by owners and the board reduce potential fraud and provide better transparency, then more intense systems may improve performance. But such a measure only reduces the downside risk. On the other hand, if intense governance shifts too much risk to managers and makes them more risk-averse in regard to taking important strategic risks that will advance performance, then the upside potential of risky decisions is lost. The potential gain lost may be more than the potential downside risk which is reduced.


Mittelstaedt: It is naive to believe that any of us remember every interaction we have in the workplace, but it would be disastrous if any of us felt we needed to keep records of every interaction. That's the kind of paranoia and arrogance that got Richard Nixon in trouble. If we spend time documenting interactions we're likely to reduce productivity and competitiveness. Make good decisions, learn from mistakes, and if you are asked or ordered to do something illegal or unethical or something horrible happens, start writing, but don't waste time on it before then or you'll confuse your priorities.


Reckers: Certainly loans to employees/management or contractual relations with companies in which a member of management or their families are major owners is problematic -- Enron is one example of alleged abuse here. SPE's (special purpose entities) were another area of abuse. Domestic and international standards of accounting have been reformed in this area since.


But, this is hardly a new issue. Potentially, most relevant here is that in recent years boards of directors have taken on very passive roles, meeting seldom, often with board membership packed with members of management (CEO being chairman of the board) and/or members without financial expertise (former generals, priests and ministers). Reforms address board membership. Certainly the onus and liability of corporate boards has ascended greatly to monitor the actions of management from a skeptical perspective and keep in touch with internal and external auditors.



K@WPC: How extensive do company record-keeping requirements have to be to prevent questionable activity?


Cannella: Again, even extensive record-keeping won't prevent questionable activity. At the hierarchical levels we're talking about, there is all sorts of "butt cover" available. A given action may represent one of a dozen or so intentions or sequences of activity, but it is awfully hard to tell without insider information. Good oversight is hard.


Jennings: My experience and research tell me that the written memo or e-mail that is contemporaneous with the transaction is always a slam-dunk in terms of proof. That's what Fastow had with his little memo (his handwritten three-page memo, which Fastow testified documented improper deals), with the problem being that he didn't find it until (later) and it looked suspicious. Journal entries can be very convincing proof because they are written at the time of events and carry great weight because their significance is not understood at the time they were written.


Mittelstaedt: Good controls aren't optional in any business and there are rules set by various agencies and best practices observed by CPAs and accounting firms. Good controls do not put any greater burden on one company over another except that, as a company grows, computerization becomes ever more important and that changes the nature of the controls, security and auditing. In the long run, the firm with better controls has a good probability of doing better than firms in similar businesses.


Reckers: You can never insure that questionable activity cannot occur. What you can do is install internal controls that should greatly reduce its likelihood ... and monitor those controls to see that they are operational.


Most of the big scandals have involved members of top management overriding internal controls and engaging in untoward conduct. They were able to do this often because the internal controls were weak to begin with and secondly nobody was watching the internal control structure closely. This has drastically changed post-SOX.


Extensive new internal controls are being instituted (which need to be there) and extensively monitored as mandated as to adequacy and whether the controls are actually being adhered to. Corporate management (who doesn't want any restrictions on their latitude) obviously opposed these reforms from day one, but Congress was in the mood for reform. Now, management is trying to gut much of the substance of the reform provision by crying that the cost of reforms is too high. The costs are high, but the cost of a lack of controls was and is also high (Enron and others).



K@WPC: But won't all this watching of each other hinder trust, open exchange and creativity, and hurt profits?


Boatsman: I don't think so. If senior management is aware that conversions with subordinates regarding accounting manipulations are being documented, it's less likely that those conversations will take place. If that's a deterioration of trust, it doesn't strike me as a harmful one.


Short-term profits might be hurt if there is less accounting manipulation, but that's unlikely to be the case in the long run. For the most part, manipulating accounting numbers can't change profits over multiple periods. Suppose, for example, that I hold inventory that's suffered a decline in value. Rather than write it down, I arrange to sell it to you at an inflated price and recognize current profit. But to get you to buy the inventory, we enter into a secret side agreement in which I promise to make you whole at some future date. When that date arrives, I'll have to pony up. At that point, there's almost nowhere to hide, and the prior profit overstatement will be unwound.


Cannella: To me, that isn't a critical problem. Hindering trust is probably OK if you don't trust the person anyway and don't feel like you need to trust him or her. Do keep in mind that the theoretical foundations of agency theory -- the most widely used theory to explain the existence of public corporations -- is that managers can't be trusted, period. There are other sources of influence, however, like the ability to sell the stock, that can keep them honest.


By the way, there is a great quote from Adam Smith (1776) about this. It is about joint stock companies, which parallel today's public companies. Here is the quote: "The directors of such [joint-stock] companies, however, being the managers rather of other people's money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master's honor, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company."


Jennings: I hope the effect is just the opposite. I tell people that they should assume that 100 percent of what they say in a meeting, what they intend, and what they do will become public knowledge and subject to full examination. The hope is that with this disclosure thought hanging over them that they will think carefully through their conduct and decisions. The days of 'This doesn't leave the room' or 'This meeting never happened' are over. My hope is that the focus can return to strategy, creativity and problem-solving instead of trying to find a way to manipulate our way out of a crisis.


Keim: Trust is diminished, and trust is an asset that can cut the cost of doing business with an organization.


Kinicki: Of course it will. How open is someone going to be in a meeting if a manager starts the meeting by stating that it will be tape recorded? Not very. This lack of being open will constrain creativity and innovation, which ultimately can impact financial results.


Reckers: The perspective of the Congress and regulators is not a focus on trust (which may not always be deserved -- we have enough examples of this) but on protecting the public. A country's economy may operate on a central planning approach (Russia, China, nearly all communist countries and many dictatorships) or on a free-markets basis. The U.S. follows the latter. A free-market system simply does not work without investor confidence in publicly available corporate financial statements.


If confidence wanes, investments will not occur and the efficiency of the system degrades sharply. Thus, the focus is on investor protection from unscrupulous management, via creating of safeguards (internal controls) and watchdogs (boards of directors, auditors). Much of our problem today stems from incentive compensation schemes so uniquely American historically. The incentive programs placed great temptations in front of upper management, and their greed took over.


There was the candy store, and nobody was minding the store. The U.S. relies on an efficient capital market to allocate scarce national resources. This is not a trivial matter. The nation must act to protect that capital-market integrity. It is irresponsible to just smile and act like nothing happened or will happen again without change. Without change, history tells us that mistakes repeat. Arguments that changes recently instituted will inhibit creativity are, in my opinion, garbage. There are still massive economic incentives to be ethically creative. Unethical creativity is not a good!



K@WPC: What other types of corporate governance procedures and/or mechanisms can an organization enact to prevent improper behavior?


Cannella: I really think that the key here is in the recovery of trust in the public accounting firms. This is where the huge failure came about anyway. No investor worth his or her salt "trusts" managers in a general sense. There is simply too much conflict of interest in that setting.


However, most investors (and academic researchers) trusted public accounting firms until the Enron thing hit. Here, the public accounting firms worked hand in glove with the executives to defraud investors. Honestly, I believe that the founders of these public accounting firms were turning in their graves about this. Public accounting firms used to stand for principles, and stand very strongly for them. Today, they seem like cheap sellouts.


This is where the confidence is needed. If I can't trust the public accountants, there is no way I can count on the financial statements that they certify. Again, rebuilding confidence in public accounting firms will be key to regaining confidence in public corporations.


Remember, too, that the SEC's regulation is based on a very simple rule: The SEC can't protect a fool from himself, but can protect a fool from fraudulent behavior. Put differently, as long as public companies don't lie to investors, the fact that they lose money can't be used against them. Full disclosure is the SEC's rule -- withholding important information from investors in order to keep them investing is fraud, and will be prosecuted. Having a stupid strategy that any moron should be able to see through isn't fraud, (as long as you are clear about what the strategy is, and don't lie about it) and won't be prosecuted.


Jennings: The easy parts have been done -- the codes of ethics, the ethics training, the anonymous reporting systems. The hard part now is the culture.


Culture is the character of the company, and that is formulated by conduct, decisions, and, to a large extent, how employees are treated. For example, if employees who cross ethical and perhaps, legal lines are rewarded, then the signal is to do what it takes to succeed. If there is discipline for crossing these lines, employees get the message.


Recent research shows that the most important factor in influencing what employees do and do not do is the example of their supervisors and other leaders in the company. Managers should assume they are parents who must set a good example.


These two areas of shortcomings are the biggest problems. In some company surveys, taken as recently as this year, 80 percent of employees say they have seen an unethical or legal problem in the past year while only 20 percent of managers say they have seen an unethical or legal problem. Fifty to 60 percent of employees who have seen an ethical or legal issue will say nothing for two main reasons: They believe nothing will be done anyway or they fear retaliation. Those two fears are the function of the culture -- the above two factors must be addressed before we can get at the problems.


You cannot correct misdeeds if you don't know they are going on, and you need employees to tell you what's happening. If they are not telling you, you are not doing much in the way of prevention.


Keim: This is at its heart a leadership issue. Leaders send clear signals. This also emphasizes the importance of whistleblower procedures and ombudsmen that allow concerns to be aired anonymously without retribution. This reduces the likelihood of straying into gray areas by accident.


Mittelstaedt: Beyond good controls, the best investment a CEO can make is in a culture that values integrity and enforces it by dealing severely with those who lack it. It always boils down to the quality of the people.


Reckers: Strong internal controls ... aggressively monitored. A strong internal audit

department that reports to a strong, active, independent corporate board (and audit subcommittee) with financial expertise. A strong corporate culture based on honesty and ethics, not greed. Strong external auditors. Discontinuation of aggressive incentive compensation plans that place temptation in front of management. A policy of audit firm rotation possibly.



K@WPC: Doesn't an inherently dishonest leadership of an organization send out signals that only those willing to "play the game' need to apply for advancement to the inner circle?


Cannella: This is a provocative question, but things really aren't that simple. There are several important issues to consider. The first is probably culture. It is very well known that police officers don't like to testify against each other, and doctors don't like to testify against each other. However, I don't know anyone who would claim that these groups are "inherently dishonest." 


Second, dishonesty is in the eye of the beholder. If a news person puts out a story that he or she knows to be incorrect, that is dishonest. However, many stories might be incorrect, or perhaps are incorrect and the news person should have known it to be incorrect. How far do we go in assessing blame here? These are tricky situations, because they can almost all be argued from several vantage points. Third, there is always an element of "playing the game" in every promotion ... including those in newsrooms.


To some extent, a person's roles change as he or she is promoted. A wonderful illustration of this is in the movie "Good Night, and Good Luck" in which Edward R. Murrow wants to confront a liar publicly, and William Paley doesn't. Paley (the executive) is worried about his network, while Murrow seems to have the ideals of his profession in mind.


Finally, everyone plays the game at times. This is also illustrated in the movie "Good Night, and Good Luck." Here, Paley also reminds Murrow that he (Murrow) also played to the public's whims, like McCarthy. As evidence, Paley points out that Murrow didn't correct the statement made on his show that Alger Hiss was convicted of treason. In fact (and Murrow knew this well), Hiss was convicted of perjury, not treason. However, Hiss was extremely unpopular at the time, and to have corrected the statement would have made Morrow seem like a sympathizer. Great movie, and important illustrations. Who is being dishonest here? These situations have been with us for a long time, and will long outlast the implications from any Enron trials.


Jennings: Again, from recent surveys, 70 to 100 percent of employees believe that meeting numbers and goals is the only factor in their performance evaluation. From managers the figure is 40 to 60 percent -- managers believe they are counting other things in performance evaluations, and employees do not believe that to be true. These are surveys that individual companies are now doing to determine where they stand -- I get the ranges from the ethics officers who call wanting to know where they stand in terms of corporations generally.


Kinicki: Yes it does. An organization's culture is created and reinforced by the behaviors exhibited by managers, and particularly senior leaders. If employees see that management is acting unethically, employees learn that it's OK to act unethically. This behavior will in turn be reinforced if employees see executives like Fastow being financially rewarded for what amounts to unethical behavior.


Mittelstaedt: Leave quickly if you see this in your company.


Reckers: The tone at the top sends signal to everyone. A strong ethics culture encourages ethical conduct. A weak culture of ethics encourages/mandates untoward behavior. Those who don't fit leave or change. There has never been adequate protection for whistleblowers, and whistleblowers in our society still tend to be looked down upon and retaliated against.



K@WPC: Other comments?


Jennings: Now comes the hard part -- really creating a culture in which ethical behavior is expected and rewarded. We are not there yet. And until we do that, we have not learned the deeper lessons of Enron, WorldCom, Adelphia etc.


Reckers: This topic is so big. Months of congressional testimony preceded legislated reform. Innumerable conferences have occurred in the aftermath. The ripples of all this spread far and wide ... international competitiveness ... extent of society savings vis à vis consumption (confidence in markets) ... association of corporate corruption and political corruption (corporations buy "corrupt" policies, or buy weakening of policies).