Lessons from the Enron Scandal

On March 5, 2002, Kirk Hanson, executive director of the Markkula Center for Applied Ethics, was interviewed about Enron by Atsushi Nakayama, a reporter for the Japanese newspaper Nikkei. Their Q & A appears below:

Nakayama: What do you think are the most important lessons to be learned from the Enron scandal?

Hanson: The Enron scandal is the most significant corporate collapse in the United States since the failure of many savings and loan banks during the 1980s. This scandal demonstrates the need for significant reforms in accounting and corporate governance in the United States, as well as for a close look at the ethical quality of the culture of business generally and of business corporations in the United States.

N: Why did this happen?

H: There are many causes of the Enron collapse. Among them are the conflict of interest between the two roles played by Arthur Andersen, as auditor but also as consultant to Enron; the lack of attention shown by members of the Enron board of directors to the off-books financial entities with which Enron did business; and the lack of truthfulness by management about the health of the company and its business operations. In some ways, the culture of Enron was the primary cause of the collapse. The senior executives believed Enron had to be the best at everything it did and that they had to protect their reputations and their compensation as the most successful executives in the U.S. When some of their business and trading ventures began to perform poorly, they tried to cover up their own failures.

N: Why didn’t the company’s directors protect the employees and investors?

H: The board of directors was not attentive to the nature of the off-books entities created by Enron, nor to their own obligations to monitor those entities once they were approved. The board did not pay attention to the employees because most directors in the United States do not consider this their responsibility. They consider themselves representatives of the shareholders only, and not of the employees. However, in this case they did not even represent the shareholders well-and particularly not the employees who were shareholders.

N: Why didn’t anyone stop Skilling, Lay and Fastow?

H: Jeffrey Skilling and Andrew Fastow changed the business strategy and corporate culture of Enron. In the process, they appeared to make Enron very innovative and very profitable. When the stock is rising and the shareholders are getting rich, there is little incentive for the board of directors and the investment community to question the executives very closely. The board is at fault for permitting the suspension of Enron’s own code of conduct to permit the conflicts of interest inherent in the off-books corporations controlled by Fastow. A few analysts recommended their clients stay out of Enron, but not many.

N: Could you tell me how the corporate governance should be changed?

H: I do not think the rules of corporate governance will be changed in significant ways. But boards of directors need to pay closer attention to the behavior of management and the way the company is making money. In too many American companies, board members are expected to approve what management proposes-or to resign. It must become acceptable and mandatory to question management closely. There is little chance the U.S. governance rules will be changed to make boards responsible to the employees as well as to the shareholders. However, board members would be foolish not to pay more attention to how employees and customers and business partners are treated. These greatly affect the long-term value of the shareholders’ investment.

N: Don’t you think this scandal damaged the new economy’s fundamental system?

H: Enron is a prominent example of a “new economy” company. Kenneth Lay and Jeffrey Skilling claimed that Enron was the most innovative company in the United States and at times tried to intimidate reporters or analysts who questioned their strategy. In the new economy, new kinds of companies have been created. Enron’s collapse will encourage investors, analysts, reporters, and employees to ask “old economy” questions about these new economy companies: How does this company make money? Can it sustain this strategy over the long term? How do those who work in and with this company feel about it? The new economy has lost some of its appeal after the collapse of many dot.com companies and of Enron.

N: Can we believe analysts’ strong “buy” recommendations from now on?

H: Many have questioned the overly optimistic “buy” recommendations analysts have issued in recent years, fearing they had conflicts of interest because of the underwriting business their firms did for dot.coms or because of the investment industry culture which rewarded analysts who were bullish on the new economy. I think there will be much closer scrutiny of analysts’ recommendations in the months and years ahead, and a close look at the conflicts of interest of individual analysts. Analysts who are always bullish will be less likely to be believed.

N: What reforms should Congress, the SEC, and others institute post-Enron?

H: I believe accounting regulations should be altered to prohibit ownership of both auditing and consulting services by the same accounting firm. Accounting firms are already moving to sever their consulting businesses. The SEC should probably adopt additional disclosure requirements. Various regulators should tighten requirements for directors to be vigilant and provide protections for whistleblowers who bring improper behavior to public attention. But, in the final analysis, the solution to an Enron-type scandal lies in the attentiveness of directors and in the truthfulness and integrity of executives. Clever individuals will always find ways to conceal information or to engage in fraud.

N: How can credibility be recovered with investors?

H: U.S. firms and foreign firms listed on U.S. stock exchanges will need to demonstrate that they have eliminated all off-books accounts which distort the public’s understanding of the financial health of the organization. They may need to pledge that they will not suspend the company’s code of conduct, or at least report to the public when they do. Finally, every company will need to demonstrate that its board of directors is vigorous, vigilant, and that its procedures will enable it to uncover any questionable behavior. Companies may need to adopt a set of “governance best practices” to regain the trust of the market.

N: Some say Enron’s collapse was caused by its stock options system. Do you think the executive compensation system should be reformed, and if so, how?

H: The stock option system is not itself the problem. Excessive stock options and excessive corporate compensation give corporate executives too many incentives to manipulate the financial accounts and the stock price of the company. When huge cash or options bonuses are dependent upon achievement of one or a few narrowly defined profit or growth goals, the temptation to manipulate the numbers to get the rewards will be too great. The problem is not the stock option system but the excessive compensation given to executives in the United States, particularly compared to the salaries of regular employees of the company. U.S. companies should look more like Japanese companies in the ratio of the salaries of top executives to those of regular employees.

N: Will stock prices continue to be down because the investors’ faith has been shaken? The other day the blue chips like GE and IBM had to reassure investors about the strength of their financial controls.

H: I believe the stock prices of new economy companies will continue to show an “Enron effect” for many months to come. Until an individual company convinces the market that it has rid itself of any questionable practices and has improved its governance systems, it will not be evaluated fully.

N: Don’t you think this kind of scandal will be a bad influence on the U.S. economy, which
is recovering from recession?

H: Enron has clearly done some damage to the U.S. economy, but it will not hold up recovery from the current recession. The fundamental health of the U.S. economy is strong and now getting stronger. Some individual new economy companies will have depressed stock prices for some time, but they, too, will recover as they demonstrate that they are prepared to prevent Enron-like behavior.

N: You mentioned in Newsweek magazine that Enron will become the morality play of the new economy. Could you give me a more concrete idea what you mean by this?

H: I do believe Enron will be the morality play of the new economy. It will teach executives and the American public the most important ethics lessons of this decade. Among these lessons are:

1. You make money in the new economy in the same ways you make money in the old economy – by providing goods or services that have real value.
2. Financial cleverness is no substitute for a good corporate strategy.
3. The arrogance of corporate executives who claim they are the best and the brightest, “the most innovative,” and who present themselves as superstars should be a “red flag” for investors, directors and the public.
4. Executives who are paid too much can think they are above the rules and can be tempted to cut ethical corners to retain their wealth and perquisites.
5. Government regulations and rules need to be updated for the new economy, not relaxed and eliminated.