01 Dec 2008
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Lesson from the Fall

Why Didn’t Enron’s Board Pay More Attention?
Re: Jeff Skilling (MBA 1979)
by Malcolm S. Salter

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Nearly seven years after its collapse, Enron continues to fascinate those interested in corporate leadership and governance.

The latest chapter of the Enron story opened on April 2 at the Fifth Circuit Court of Appeals in New Orleans. Lawyers for former CEO Jeffrey Skilling (MBA ’79) argued that his 2006 conviction on nineteen counts of fraud, conspiracy, insider trading, and lying to auditors — along with his 24-year prison sentence — should be overturned. A ruling by the appellate court on Skilling’s appeal is near.

A great deal is at stake with the court’s ruling. For Skilling, it will either seal his fate as a convicted criminal or open up possibilities for further vindication. (In the 2006 trial, nine of the ten insider-trading counts against him were struck down by the jury.) However, for the rest of us, the ruling will do much to define the true legacy of the Enron case.

If the appellate court overturns the lower court’s conspiracy conviction, which is possible in light of recent precedent in similar conspiracy cases, such a partial decriminalization of Skilling’s conduct will reopen discussions of what was the real offense committed by Skilling. The answer to this question is important because many of Skilling’s allegedly fraudulent activities fall into the “shadowed space” or “penumbra” between the clear light of doing right and wrongdoing, where the law is unclear and the spirit of the law is open to interpretation.

A close reading of the record suggests that much of Enron’s behavior fell into this penumbra. But that same record also suggests that Skilling lost his way in this shadowed space by encouraging and tolerating aggressive gaming of accounting and SEC rules throughout that portion of the company where he had direct authority and accountability. Since Enron is certainly not the only company to have engaged in such gaming, the important question raised by this marker case is how to rein in the kind of aggressive, but not incontestably illegal, gaming of society’s rules that led to Enron’s collapse.

The answer points to three persis-tent tasks of corporate governance: the avoidance of perverse incentives for executives, the strengthening of board oversight, and the reinforcement of ethical discipline in the conduct of business affairs.

Enron’s approach to compensation and incentives included many perverse features, such as encouraging growth over profitability and rewarding employees for closing commodity deals and power-generation projects without concrete evidence of their future profitability. It created many opportunities for executives to reap enormous personal gains from gaming accounting and SEC rules.

If Enron-type breakdowns are to be avoided in the future, corporate boards need to keep in mind seven propositions that collectively address the potentially perverse effects of turbocharged financial incentives.

  • The awarding of “up-front” bonuses — before cash and profits from commercial endeavors — invites employees to maximize their short-term interests while compromising the company’s long-term interests.
  • Systems of reward that ignore comparative measures of business performance vis-à-vis leading competitors often lead to overcompensation and lull executives into a false sense of superiority.
  • Pay-for-performance systems that ignore rigorously applied subjective judgments often promote gaming behavior and otherwise provide insufficient direction to executives.
  • Stock options that are not indexed to both the movement of capital markets and gains in the price of competitors’ stock can provide executives with unearned windfalls for uncompetitive performance and promote unwarranted overconfidence.
  • Awarding stock grants without restricting the amount and timing of their sales weakens their incentive effects, allows executives to benefit from short-term rises in stock price, and creates conflicts of interest for corporate insiders vis-à-vis ordinary shareholders.
  • Pay-for-performance systems that lack provisions for rescinding bonuses if companies revise their past or expected performance invite people to lie and game the system.
  • Turbocharged incentives require turbocharged controls.

Board Oversight

One of the mysteries in the Enron case is how Enron’s board of directors failed on so many levels to detect or deter questionable applications of accounting principles and rules. It failed to question the wisdom of using its own stock to hedge merchant investments rather than contracts with bona fide counterparties. It failed to monitor the conflicts of interest that the board itself had approved involving Andrew Fastow’s dual role as Enron’s CFO and the managing partner of several off-balance sheet partnerships that purchased assets from Enron. And it failed to see and react to many “red flags” indicating that Enron’s economic performance and its public commitment to ethical values were deteriorating.

To deter further Enron-type breakdowns in oversight, public companies need to consider four innovations:

  • Expanding their cohort of directors to include retired executives and entrepreneurs who have the time to serve as truly focused directors;
  • Increasing the level of director compensation to keep attractive directors and candidate directors from drifting to other less risky assignments;
  • Requiring that a different degree of directors’ wealth be at risk through investments in company shares to ensure they have interests totally aligned with those of shareholders;
  • Completely separating the role of CEO and board chairman.

This last innovation deserves special comment. It is contrary to human nature to expect total objectivity from a CEO regarding his or her performance. One cannot expect a CEO in the role of chairman to prepare the board to evaluate lapses and failures on his or her part, or on the part of his or her management. Without a truly independent board chair who controls the recruitment and tenure of directors, sets the board’s agenda, selects the information that flows to the board, and oversees the process of evaluating CEO performance, directors will find it difficult to shift the power environment of the board so that they no longer see themselves as employees of the chairman and CEO.

Ethical Discipline

What Skilling and chairman Kenneth Lay failed to understand as leaders is that compliance with espoused ethical and legal standards is an organizational achievement. Or to put it slightly differently, despite the values and ethical guidelines published in Enron’s Code of Ethics (available as a collectible on eBay), it was unreasonable to expect that a single individual at Enron, no matter how well-endowed with principled judgment, could be expected to remain untouched by dereliction or excessive gaming of accounting rules without positive, organized support. Skilling and Lay failed to provide that support.

Whatever the espoused intentions of Enron’s leaders, the organization’s commitment to the qualitative aspects of individual and group performance began to break down under pressures to maintain its meager profitability. This breakdown was hastened by Enron’s turbocharged incentives, which offered executives enormous bonuses tied to estimated future profits and a very generous stock-option plan that paid out richly as Enron’s stock became increasingly overvalued. Creating an environment that supports ethical discipline requires precisely what Enron lacked in its governance practices:

  • Sustained attention to the qualitative objectives and ethical standards of the organization;
  • Balanced incentives that reward and penalize results other than economic performance;
  • Systematic audits of decisions made by key executives in areas where the rules are ambiguous (as in structured finance transactions) and the risks to reputation high (as in opaque financial reporting);
  • Continuous monitoring of senior executives for evidence of what sociologist Philip Selznick identifies as two major sources of leadership failure — personal opportunism and utopianism.

Personal opportunism involves the pursuit of immediate, short-term individual advantage while ignoring considerations of principle and long-term consequence. In the end, unchecked personal opportunism and greed ruined Enron. Utopianism enables leaders to avoid hard choices by a flight to abstractions, resulting in few business-specific decision criteria for Enron executives.

Along the way Enron lost track of its ideals. This loss of ideals reveals the most important lessons of the Enron story — that financial success without an ethical foundation leads to disaster and that the governance of public companies requires relentless attention by directors to the ethical discipline of executives who are accountable to them.

— HBS professor emeritus Malcolm S. Salter is author of Innovation Corrupted: The Origins and Legacy of Enron’s Collapse (Harvard University Press, 2008). Reprinted from the August 21, 2008, issue of BusinessWeek by permission and edited for length.

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