Enron i n n o v a t i o n

Innovation Corrupted: How Managers Can Avoid Another Enron

July 7, 2008:    Martha Lagace, Q&A with Malcolm S. Salter

"In the end, Enron was at the center of a truly delinquent society. Once Enron's ethical drift took hold, its collapse was only a matter of time," says HBS professor emeritus Malcolm S. Salter. As he explains in this Q&A and in his new book, Innovation Corrupted: The Origins and Legacy of Enron's Collapse (Harvard University Press), the devastation of Enron was total—yet there is much that business today can gain from a postmortem of the once-triumphant company.

Salter had access to an extensive library of public information, including volumes of technical analyses and sworn testimonies in court documents, sources that were not yet available for earlier books on Enron. In addition, he interviewed former Enron executives and acquired internal Enron documents, which extended and deepened his research.

"Earlier descriptive narratives of Enron's collapse either downplay or fail to analyze the utter breakdown in board governance and Enron's internal controls, and the failure of credit rating agencies to blow the whistle," he says. "They also overlook the collusion of investment banks in misrepresenting the true financial condition of Enron, the inattentive regulatory agencies, and the absence of Enron's ethical discipline while choosing to live in the murky borderlands of the law."

Our Q&A follows.

Martha Lagace: In a nutshell, why did Enron succeed insofar as it did? How did it collapse, and was its downfall inevitable?

Malcolm S. Salter: Enron was an innovative company, and its downfall can be traced to supreme arrogance bred by considerable success, some extremely poor diversification decisions, and poorly conceived and implemented administrative practices that led, over time, to reckless gambling and ethical drift. This drift was facilitated by Enron's bankers and advisors and largely missed by its board of directors and other watchdogs. Here are some "high level" details:

Jeffrey Skilling had begun working with Enron in 1986 as a consultant with McKinsey & Co., and joined Enron in 1990 when then-chief executive officer Ken Lay made him president of Enron's new trading operations. In 2001, Skilling was named CEO. Before 1997, Enron was an innovative and profitable player in the newly deregulated natural gas industry. Skilling's big idea was to create fluid and transparent markets for commodities like natural gas that were burdened with highly inefficient delivery systems. In time, the company supported his basic concept with EnronOnline, a Web-based trading platform that instantly became the world's largest e-commerce system in 1999. Skilling also created what was known as a gas bank to provide a "reserve requirement" to back up supply commitments. Enron had a major advantage over competitors as a middleman between producers and consumers because it operated one of the nation's largest natural gas pipeline networks.

These innovations enabled Enron to develop and run a futures market for natural gas, and to create derivative supply contracts that could help customers manage the risks of demand volatility and price swings more effectively than before. In this way, Skilling and his colleagues solved a major contracting problem between the producers and the users of natural gas, and the rewards were great.

This initial success prompted Enron to extrapolate its business model to other markets. In 1994, Enron officials started trading wholesale electricity after Congress deregulated the industry; Enron analysts estimated the electricity market to be 10 times larger than the natural gas market. Diversification into water utilities and broadband soon followed, as did expansion to other countries that promised to deregulate and privatize energy production and distribution.

Unfortunately, applying the company's middleman skills to other commodities and developing power projects in diverse markets proved a significant challenge. Still, supreme overconfidence and perverse financial incentives led to a gladiator culture in which executives proposed—and risk managers and the board of directors approved—a growing number of risky gambles with high expected returns. Meanwhile, building on intense lobbying to encourage further domestic deregulation and limit federal oversight of the energy industry, Skilling encouraged Enron executives to exploit to the hilt recent Securities and Exchange Commission rule changes as well as then-current tax rules.

Many of Enron's investment gambles failed to satisfy its voracious appetite for cash to support its commodity-trading operations, and in 1997, profits declined. This prompted the company to sell overvalued, underperforming assets to off-balance-sheet partnerships controlled by chief financial officer Andy Fastow—a conflict of interest approved by the board. The idea was to use these mind-numbingly complex entities to manage reported earnings, minimize reported debt, and maintain the company's all-important credit rating and overvalued stock price. Enron also used the off-balance-sheet entities to hedge its more successful investments—to avoid having to report any declines in their value. The problem was that many of these hedges were not real, because Enron was essentially hedging with itself.

To help disguise the company's deteriorating financial position, many outside advisors and bankers either colluded in or acquiesced to these questionable transactions. Enron's sophisticated risk analysis and control system also experienced serious breakdowns. These breakdowns, along with management's increasing aversion to truth telling, isolated the board from many evolving realities. In addition, Enron's supernormal growth and skyrocketing stock price made it difficult for most directors to challenge management's strategy and tactics.

Still, board members understood that Enron was trying to move underperforming assets and potential investment losses off its balance sheet. Red flags should have alerted them to the fact that the company was short of cash as well as profits. Yet Enron's board failed to detect and prevent violations of accounting principles and rules.

In the third week of October 2001, Arthur Andersen, Enron's highly compromised outside auditor, "discovered" several large accounting irregularities related to the off-balance-sheet partnerships. This forced Lay—who returned as CEO after Skilling resigned that August—to announce a $544 million charge against earnings, and a $1.2 billion write-down in shareholders' equity, largely related to the impending closure of Enron's Raptor partnerships. Within weeks, Enron collapsed into bankruptcy as its trading partners quickly lost faith—proving, once again, that even a hint of negligence or misconduct can be devastating to a company.

In the end, the Justice Department took more than three years to master the financial complexities and legal ambiguities of the Enron case, and to indict Skilling, Lay, and former chief accounting officer Rick Causey. Federal prosecutors claimed that Enron used the Raptors and other off-balance-sheet entities to inflate its reported earnings from the third quarter of 2000 through the third quarter of 2001 by more than $1 billion. The government also claimed that the Raptors did not hold the required amount of independent equity, thereby invalidating their purpose. An examiner appointed by the bankruptcy court claimed even larger-scale violations of Generally Accepted Accounting Principles and SEC regulations.

"Even a hint of negligence or misconduct can be devastating to a company."

Throughout the ensuing trial, Skilling and Lay strenuously denied knowledge of any conspiracy to defraud shareholders, despite the fact that 15 of 34 other Enron executives indicted for conspiring to defraud shareholders had already entered guilty pleas. Skilling and Lay argued that these 15 plea bargainers were all honest men who had been bullied into false confessions by the "witch hunt" tactics of the Justice Department. Lay maintained to his dying day that he was innocent of all charges brought against him. Skilling held fast to a similar position. On September 14, 2007, Skilling submitted a 60,000-word appellant brief demanding that his conviction be reversed and that his case be either dismissed or retried outside Houston under "lawful procedures and a properly instructed jury." The appeals court is scheduled to report within weeks.

Q: What does Enron's collapse mean for the future governance and control of public companies?

A: The lessons of Enron relate to

(1) Strengthening board oversight
(2) Avoiding perverse financial incentives for executives
(3) Instilling ethical discipline throughout business organizations

With respect to strengthening board governance, I argue that a potentially powerful remedy for the governance breakdown that afflicted Enron as a public company can be found outside the legislative and legal arena, in the neighboring world of private companies. This remedy is best observed in formerly public companies that—aided by professional buyout firms—have been taken private and armed with active directors who pursue commonsense governance practices that have stood the test of time.

In arguing for the private-equity model of corporate governance, which I describe in detail, I do not suggest that boards of public companies can or should copy it directly. Public and private companies clearly differ markedly in their ownership structures and in the rules governing director independence. I do suggest, however, that directors of public companies can adapt key aspects of the private-equity governance model to ensure that they fulfill their oversight responsibilities.

With respect to avoiding the perverse financial incentives that corrupted Enron, my book makes specific recommendations for designing executive pay in public companies, including the effective use of stock-based compensation and comparative performance measures, and the need to balance turbocharged incentives with turbocharged controls.

"Enron's leaders perpetuated a kind of utopianism that ended up distracting them from hard choices."

With respect to the challenge of how to preserve ethical discipline when the legal rules of the game are ambiguous and executives stand to reap enormous rewards by exaggerating or camouflaging a company's true economic performance, I outline organizational processes that are required to reinforce the kind of discipline that was noticeably lacking at Enron.

These processes include:

(1) Liberating evaluation processes by adding qualitative judgment to whatever standard quantitative measures of performance that business plans may require
(2) Designing and implementing incentive systems that reward accomplishments other than economic performance, and penalize failures
(3) Conducting routine, systematic audits of critical decisions by key executives where the rules of the road are clearly ambiguous
(4) Helping senior executives avoid the two sources of leadership failure at Enron: personal opportunism and flights to utopianism

At Enron there were many opportunities for enormous personal gain that distracted top executives from the essential tasks of maintaining institutional integrity and building stable relationships with shareholders and employees. Similarly, Enron's leaders perpetuated a kind of utopianism that ended up distracting them from hard choices by a flight to abstractions. In Enron's case, its stated purpose—at first, to be the world's best energy company, and later to be the world's best corporation—was too general to permit disciplined and responsible decision-making in the face of difficulty. In this vacuum, abstract definitions of purpose unrelated to corporate ideals, distinctive competences, and organizational opportunities easily gave way to uncontrolled criteria such as personal preference and opportunism. As a natural result, immediate exigencies came to dominate actual choices. This loss of ideals sums up Enron's history and its enduring legacy.

Q: Can an Enron-type calamity happen again? Why or why not?

A: Perverse incentives are legion throughout our system today. For example, perverse incentives for both mortgage brokers and investment bankers helped create the subprime crisis that we are now living through. Many boards are also still struggling to improve their oversight. Preventing future Enron-type disasters will require the kind of attention to board oversight, financial incentives, and ethical discipline that I address in Innovation Corrupted.

Q: As you note in your book, there is much that we still do not know—and may never know—about Enron's failure. Having studied the company intensively for years, what would you most like to know?

A: There is still much that we do not know about the perceptions, intentions, thought processes, and apparent failings of Enron's leaders and its board of directors. For example, why didn't Skilling and Lay see more clearly the risks and increasingly adverse effects of the extreme, performance-oriented management system that they had created? How could Skilling—a very public proponent of earning more money with less assets (the so-called asset light strategy)—rationalize Enron spending so heavily, and so beyond established capital budgets, on capital projects with highly speculative returns?

According to what logic did Skilling and Lay, and ultimately the board, approve using the company's own stock to capitalize its own hedging counterparties? (This was an extremely risky hedging arrangement that required Enron to issue more stock if either the current value of its stock or the future value of its commodity contracts declined and that, in addition, left Enron with no effective hedge on its contracts if both values declined at the same time—which they did.) Why did Skilling, at critical moments, treat differences of opinion, pushback, and penetrating questions from both insiders and outsiders as either stupid comments or narcissistic insults rather than opportunities for constructive dialogue?

Why did Skilling, Lay, and Enron's board of directors fail to understand and act decisively upon increasing internal evidence that Enron was financially distressed and heading toward insolvency? Why did Lay's espoused faith and Christian values fail to guarantee his moral leadership and protect the enterprise from increasing immoral behavior? How did Skilling and Lay imagine that their personal conduct could influence the behavior of others within the company? What internal images of personal leadership and stewardship did their behavior reflect? How did they reassure themselves that they were doing "the right things" all along?

Congressional hearings and courtrooms are not venues conducive to revealing deep insight to these lingering questions. The only window of inquiry to these questions leads to Skilling himself (since Lay has died).

A deep biography or autobiography, linked to the essential questions of Enron's conduct and performance, is the missing link in a full understanding of Enron's collapse and its lessons for the leaders of 21st-century business enterprise.

Innovation Corrupted at Harvard University Press:
http://www.hup.harvard.edu/catalog/SALINN.html

Enron's Lessons For Managers

July 12, 2004. by martha Lagace

Some events mark a generation. If a marker is a source of deep learning about ourselves, as Malcolm Salter believes it is, then the Enron crisis is exactly that for business people.

Political scientists have the Bay of Pigs; engineers have the Challenger disaster. And now managers have Enron, a tragedy and a point of departure for thinking more carefully about the institutions humans have created to organize our economic lives, according to Salter.

In a wide-ranging talk with Harvard Business School alumni on June 4, weeks before former Enron CEO Kenneth Lay was indicted by a federal grand jury, Salter discussed Enron's legacy: What happened, why, and what has been learned?

"I want to stress one point: Enron is all about us," said Salter. "It's not just about some Dummkopfs in Houston. If it were just about some Dummkopfs in Houston, then it's [just] an odd duck or a five-legged cow; it doesn't really make sense. I think that Enron's pathologies are not unique, save in their collective occurrence and collective impact. Very few of us who engage in competitive endeavors have not in some way been subject to or affected by these social pathologies that became so widespread and so toxic in Enron."

Salter, a specialist in corporate strategy and corporate governance who is also writing a book on Enron, said he is trying to operate as a sort of forensic analyst. Forensic scientists usually fill out a simple form containing the subject's cause of death and time of death. His own task for Enron is complicated by the fact that the patient was constantly evolving long before it collapsed. Its business model, control system, and culture were in continuous motion, and by 1997 these factors were exacerbated by bad luck, incompetence, and the entrance of Jeffrey Skilling as COO.

Putting aside the matter of business models and controls, "The main story," he said, is a case of "ethical drift."

If you look at a lot of the fraud cases, before fraud there was terminal incompetence.

The broad strokes of Enron are familiar. First, when it collapsed on December 2, 2001 it destroyed over $60 billion in market value, he said. Second, its accounting fraud was "massive." Reasonable men and women might quibble over some of the finer points in accounting, but in FY 2000, 96 percent of Enron's reported net income and 105 percent of its reported funds flow were attributed to accounting violations, he added. Third, Enron's debt was underestimated by one half: $10 billion reported versus $22 billion actual debt. However, these factors, he continued, were "dwarfed" by bad strategy and management.

Incompetence before fraud

Salter said Enron's legacy of corporate reforms in the U.S. since its fall is deep and wide and not necessarily reassuring. Steps to curb Enron-like corporate abuses, such as the shift from a principles-based corporate governance system to one that is rules-based, may not address the core of the problem, he warned. In Great Britain, the accounting system is typically a principles-based system.

"Here, we've got a rules-based system where we get more and more rules in a larger and larger code with smarter and smarter people figuring out how you can push the outside of the envelope."

Other new rules, such as the documentation of internal controls as dictated by the Sarbanes-Oxley Act, are turning out to be extremely expensive to implement.

The new rules for the corporate governance system highlight three assumptions, he said:

But the new rules will not prevent Enron-style debacles, he continued.

"The big headline about Enron is that before fraud, there was terminal incompetence. As a matter of fact, if you look at a lot of the fraud cases, before fraud there was terminal incompetence. When we teach the governance and ethics course [at HBS], the point I make is that you can have great values, but if you don't have the competence [to implement them], forget it. You need both character and competence. If you don't have the competence, you're going to get yourself in real deep trouble."

"Enron is a case about how a team of executives, led by Ken Lay, created an extreme performance-oriented culture that both institutionalized and tolerated deviant behavior. It's a story about a group of executives who created a world that they could not understand and therefore could not control.

"It's a story about the delinquent society—and I use that phrase intentionally—that grew up around the company, and here I'm referring to the collusion of Enron's various advisors and financial intermediaries. And most importantly, Enron is a story about how fraud is often preceded by gross incompetence: where the primary source of that incompetence is inexperience, naiveté, an ends-justify-the-means attitude toward life, and so on. And most importantly, an inability to face reality when painful problems arise."

Pride goes before a fall

Before fraud, he said, there was impressive innovation but it gave way to hubris and reckless gambling of assets. Its hubris was to attempt to commoditize electric power, water, and broadband, despite what Salter called critical points of difference from natural gas. (Electric power and water are politically sensitive at the local level, for instance, and are difficult to transport over long distances, among other differences, he said.) Deceit and denial fostered ethical drift. Enron's ethical drift was further motivated by a desire to manage the credit rating and to manage the need for cash and earnings volatility, in violation of GAPP and SEC rules. The result, according to Salter, was "emotional contagion and the normalization of deviancy."

Among the lessons he highlighted for other managers still shaken by the Enron debacle were the importance of humility and accurate self-assessment. The Enron executives were amateurs trying to play a professional sport, he said. They used "turbo incentives" but turbo incentives also require turbo controls. The innovation they sparked at the beginning was real, but it flew out of their hands. As amateurs, Salter said, "they unknowingly released forces and became subject to forces they could not understand."

"They confused success with excellence," he concluded. "It was a point of confusion here."

Malcolm S. Salter is the James J. Hill Professor of Business Administration, Emeritus, at Harvard Business School.

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In Face of Probe, Judge Kozinski Hires K&E’s Mark Holscher

The fallout caused by the Judge Kozinski story in the L.A. Times has now led to another lawyer joining the fray. The Daily Journal is reporting (link unavailable) that Judge Kozinski has hired Kirkland & Ellis’s Mark Holscher to represent him in a pending judicial misconduct inquiry.

Last week, per the instructions of Chief Justice John Roberts, Chief Judge of the Third Circuit Court of Appeals, Anthony J. Scirica, named four judges, including Marjorie O. Rendell — the wife of Pennsylvania Governor Ed Rendell — to join him on a special committee that’s conducting an inquiry of Judge Kozinski.

Holscher (UC Berkeley, Boalt Hall) is no stranger to high-profile representations. He defended former Congressman Duke Cunningham and scientist Wen Ho Lee. (After Lee spent 278 days in solitary confinement, the charges against him were dropped, and he received a formal apology from Federal District Court Judge James Parker, who branded the government’s prosecution of the case an “abuse of power.”) And alongside Dan Petrocelli, he represented former Enron CEO Jeff Skilling.

Last year, Holscher, 44, decamped from O’Melveny & Myers for Kirkland’s L.A. office. There, he reconnected with Jeff Sinek — a law school classmate, one-time roommate and the best man at Holscher’s wedding — to launch a West Coast white-collar practice at Kirkland.

Holscher began his trial career as an AUSA for the Central District of California, where he worked from 1989 to 1995. During that time, Holscher tried Heidi Fleiss, the L.A. madam who was ultimately convicted of bank fraud and tax evasion.

 

Ex-Refco Chief Bennett Gets 16-Year Term for Fraud:
By David Glovin

July 3 (Bloomberg) -- Former Refco Inc. Chief Executive Officer Phillip Bennett was sentenced to 16 years in prison for defrauding investors out of $2.4 billion in what U.S. prosecutors said was ``among the very worst'' white-collar crimes.

Bennett was also ordered to forfeit the $2.4 billion. U.S. District Judge Naomi Buchwald in Manhattan rejected a government request that Bennett surrender to prison immediately and told him to report on Sept. 4. Until then, he must remain at his home in Somerset County, New Jersey, subject to electronic monitoring.

``You are the architect of the Refco fraud,'' Buchwald told Bennett today at his sentencing in Manhattan federal court. ``Individuals who commit crimes like yours are often staggeringly arrogant.''

Bennett, who turns 60 this month, pleaded guilty in February to bank fraud and money laundering stemming from his eight-year scheme to deceive banks, auditors and investors, including Boston-based buyout firm Thomas H. Lee Partners LP.

Once the biggest independent U.S. futures trader, New York- based Refco collapsed in October 2005, two months after raising $670 million in an initial public offering. The company, which provided clearing and prime-brokerage services, filed for bankruptcy after disclosing that a Bennett-controlled firm owed hundreds of millions of dollars to Refco.

Some 16 corporate executives have been sentenced to 20 years or more in prison since 2003. Former WorldCom Inc. Chairman Bernard Ebbers is serving 25 years for accounting fraud, and Enron Corp. ex-CEO Jeffrey Skilling got a 24-year term for the same crime. Bayou Group LLC's Samuel Israel was sentenced in April to 20 years for fraud. He jumped bail and fled, only to surrender and start his sentence today in New York.

`Wrong Path'

``I made an unacceptable and appalling error in judgment,'' Bennett told the judge. ``I took the wrong path and crossed a line I never should have crossed.''

A graduate of Cambridge University in England, Bennett built Refco into the largest independent futures brokerage in the U.S. He joined the firm in 1981 and served as president, chief executive officer and chairman since September 1998.

With partner Tone Grant, Bennett transformed Refco from a firm that focused on trading for itself to one that executed transactions for clients. He grew rich along the way, becoming a billionaire with a $20 million plane, an $11 million car collection, and works of art worth more than $29 million, the government said.

Today, Bennett sought leniency, citing his cooperation with investors who have sued Refco's banks, his offer to cooperate with prosecutors and his willingness to take responsibility for his crimes. He said his scheme stemmed from an effort to save the company from bankruptcy long before the fraud was uncovered.

Bennett has paid $1.2 billion to eliminate Refco's debt and repay investors, defense attorney Gary Naftalis said today.

Deported

``Did he do wrong things? Absolutely,'' Naftalis told Buchwald. ``Has he stood tall and admitted it? Yes.''

In court, Bennett's voice quavered as he apologized. He'll be deported to his native England after he completes his term. Under federal sentencing guidelines, he faced life behind bars.

Assistant U.S. Attorney Neil Barofsky compared Bennett to white-collar offenders such as Ebbers and Bayou Group LLC Chief Financial Officer Daniel Marino, who is serving 20 years for his role in the $400 million fraud at that hedge-fund firm. He said the 20-year sentence Israel received should be a ``guidepost'' in the Bennett case.

``The scope and duration of the fraud, the loss that resulted from it, and Bennett's conduct in service of that fraud places him among the very worst white-collar defendants in this jurisdiction,'' Barofsky and Assistant U.S. Attorney Christopher Garcia wrote Buchwald on June 30.

Roots

At Grant's criminal trial in April, prosecutors said the roots of the fraud stretch to 1997, when Refco began hiding massive losses sustained by clients in the Asian debt crisis.

With its viability threatened, Refco began masking its true performance by moving more than $1 billion in debt off the company's books to a Bennett-controlled entity, Refco Group Holdings Inc., prosecutors said. In return, Refco Group Holdings gave Refco worthless IOUs, prosecutors said.

The company hid the scam from Thomas H. Lee, which paid $507 million for a 57 percent stake in Refco in 2004; from banks and debt-holders that extended more than $1.4 billion in financing in 2004; and from investors who paid $583 million for shares when Refco went public.

Grant was convicted. He has yet to be sentenced.

Secretary

Bennett and his aides defrauded victims from all walks of life, including his own secretary, who lost $5,000 she invested in the firm, prosecutors said.

Testifying for the government at Grant's trial were former Refco finance chief Robert Trosten and Santo Maggio, the ex-CEO of Refco's offshore unit. Both pleaded guilty. Refco's ex-outside lawyer, Joseph Collins, has pleaded innocent to criminal charges.

Bennett's lawyer didn't make a request for a specific federal prison. The final choice is made by the U.S. Bureau of Prisons. There is no parole in the federal system, though inmates may reduce their sentence by 15 percent for good conduct.

The case is 05-CR-1192, U.S. District Court, Southern District of New York (Manhattan).