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What Really Went Wrong with Enron?

On March 5, 2002, the Markkula Center for Applied Ethics convened a panel of four Santa Clara University business ethicists to discuss the Enron scandal. Panelists included Kirk O. Hanson, executive director of the Ethics Center and University Professor of Organizations and Society; Manuel Velasquez, Dirksen Professor of Business Ethics, Department of Management; Dennis Moberg, Wilkinson Professor of Management and Ethics, and Martin Calkins, S.J., assistant professor of management. Edited excerpts from their conversation appear below:

Manuel Velasquez: What went wrong at Enron? In ethics, explanations tend to fall into three categories: personal, organizational, and systemic. Personal explanations look for the causes of evil in the character of the individuals who were involved. Did this happen, for example, because the people involved were vicious? Were they greedy? Were they stupid? Were they callous? Were they intemperate? Were they lacking in compassion?

Organizational explanations look for causes in group influences. They take seriously the ways that we influence each other when we do things as a group. These influences include the shared beliefs that groups develop about who is important, what is permissible, and how things are done here in this group. These include also the shared values that we call a group culture, the rules or policies groups develop to govern their interactions with each other and the rest of the world.

Finally, systemic explanations look for causes outside the group, for example in the environmental forces that drive or direct groups or individuals to do one thing rather than another. These include the laws and the regulations that provide the framework in which people act, the economic and social institutions that give meaning and direction to our lives, and the culture that shapes the values and perceptions of people and groups.

I am going to concentrate on the third kind of explanation for what went wrong with Enron-the systemic explanations….

I think that one of the obvious systemic causes of the Enron scandal is our legal and regulatory structure. First, current laws and SEC regulations allow firms like Arthur Andersen to provide consulting services to a company and then turn around and provide the audited report about the financial results of these consulting activities. This is an obvious conflict of interest that is built into our legal structure.

Second, a private company like Enron currently hires and pays its own auditors. This again is a conflict of interest built into our legal system because the auditor has an incentive not to issue an unfavorable report on the company that is paying him or her.

Third, most large companies like Enron are allowed to manage their own employee pension funds. Again, this is a conflict of interest built into our legal system because the company has an incentive to use these funds in ways that advantage the company even when they may disadvantage employees.

And fourth, most companies like Enron have codes of ethics that prohibit managers and executives from being involved in another business entity that does business with their own company. But these codes of ethics are voluntary and can be set aside by the board of directors. Our legal structure today largely allows managers to enter these arrangements, which constitute a conflict of interest. The managers and executives, of course, have a fiduciary duty to act in the best interest of the company and its shareholders, But the law leaves considerable discretion to managers and executives to exercise their own business judgment about what is in the best interests of the company.

A lot of the Enron story developed during the booming '90s. The stock market was shooting upward. Start-ups were rolling in venture capital, established businesses were expanding, consumers were spending, and it seemed like everyone was making lots of money. I would suggest that during periods like these, our moral standards tend to get corrupted. The ease with which we see money being made leads us to cut corners, to take shortcuts, to become focused on getting our own share of the pie no matter what because everybody else is getting theirs. This general boom culture, I believe, was part of what affected Enron and led its managers and executives to think that anything was okay so long as the money kept rolling in.

Dennis Moberg: Manny talked about the importance of looking at this case from a lot of different vantagepoints. I'd like to concentrate primarily on the character of the individuals in question: Kenneth Lay, Jeffrey Skilling, and Andrew Fastow. Character ethics focuses on the ethics of the person rather than the ethics of the action in question. It distinguishes between individuals who might be called good or virtuous and individuals who might be called bad-at the extreme, evil people or people who are vice-ridden or vicious….

The best list of vices is the classic seven deadly sins: pride, anger, sloth, avarice, gluttony, lust, and envy. Do we see any of these elements of character displayed among the executives at Enron?

  • Pride: Jeffery Skilling once said, "I've never not been successful at business or work...ever!"
  • Anger: When interviewed by a Fortune reporter, Skilling said, "The people who ask questions don't understand the company." When this reporter persisted a bit, Skilling called her unethical for even raising the question and abruptly hung up the phone. Later, he called another reporter an "expletive deleted."
  • Sloth: One of the most critical board meetings at Enron in 1991-where they were giving approval to set aside their ethics statements on behalf of these shenanigans with partnerships-that meeting lasted one hour. That's barely enough time to get a Coke.
  • Avarice: Fastow, the CFO, sold $36 million of his Enron investments before the company tanked. Lay had a whole bunch of sweetheart deals with family members. I'm sure tempted to call that greed….

Add to this…a tendency toward cronyism. Managers at Enron's divisions grew arrogant, thinking themselves invincible. We see this insular tendency of the company to seal itself off from forces on the outside. They had something called a rank-and-yank performance appraisal system, which eliminated anyone who fell behind-a real Darwinist system that took care of anyone who might potentially disagree. All of the internal whistleblowers were rebuffed, humiliated, or treated in an intimidating way by the various players. And finally, one of my favorites-their 1999 annual report in which all of the members of the board of directors are listed by their nicknames, again suggesting that tendency towards cronyism….

In terms of fixing the system from a character viewpoint…, we need reforms that discourage cronyism-this insular tendency in too many American corporations to seal themselves off from the realities beyond themselves. Jeffrey Skilling, Andrew Fastow, and Kenneth Lay all live in the same gated community in Houston, which I think is a great metaphor for what happened at Enron.

Martin Calkins, S.J.: Corporate governance relies on the state of mind and personal relationships of managers, not a list of empty procedures or principles. In the Enron case, the rules were in place, but were willfully and skillfully ignored.

In the Enron case, we see the result of a growing and pervasive winking at the letter of the law. This winking didn't come out of nowhere. It built up in our society during the 1990s and culminated in 1995 in the Private Securities Litigation Reform Act—a law that eased some of the restrictions put in place after the Great Depression to prevent the sort of behavior we see with Enron. Both the behavior and the rules and laws to prevent it have been around for years. The laws were simply circumvented in the Enron case.

On the issue of character, I agree with Dennis that the Enron debacle seems to be character-based. Unlike Dennis, however, I would be less inclined to judge the character of the Enron people harshly. The Enron people may very well be the good people they present themselves to be. Perhaps it was the corporate culture in which they operated that led to the problem we have today. It may be that we have here an example of the so-called "separation thesis": an incident where individuals, for reasons tied to corporate culture and societal expectations, adopted as their own an ethic associated with their role as manager that was distinct (separate) from their individual ethics. In other words, these may be good people who acted wrongly because they thought their managerial roles demanded they act in a certain unethical manner.

Finally, I would like to make some suggestions and recommendations for reform.

First, I think this issue shows the need for better financial disclosure mechanisms. Perhaps we should institute programs to replace today's peer review process involving the American Institute of Certified Public Accountants. At a minimum, the case seems to show that the Financial Accounting Standards Board, which has responsibility for rule making in this area, needs to establish regulations and standards that are more forthright and understandable to ordinary people such as you and me.

Second, the case illustrates a need for more responsible public servants, not more laws. The 1995 Private Securities Litigation Reform Act relaxed the restrictions that would have checked the behaviors that led to the Enron scandal. Yet government officials now call for more laws. This seems to be a ploy to direct public attention away from what politicians have already done to the law.

For example, Ohio Democratic Representative Dennis "The Menace" Kucinich, former mayor of the city of Cleveland who was almost single-handedly responsible for that city's bankruptcy in 1978-79, is drafting legislation that would create a new independent organization to audit publicly traded companies. Do we really need more legislation and another government office? What about the laws and people to enforce them that are already in place? A proposal such as Kucinich's seems to me to be a smokescreen to protect politicians. In my view, we need to hold these politicians responsible for what they have done, just as we have held the business people to accountability.

Third, the case illustrates a need to amend but not ban all non-audit work. There has been a call lately to eliminate all non-audit services by auditing companies. However, many of these essential non-audit services are so closely linked to the audited information that it does not make sense to ban the auditor from providing these services. Tax advice is one example. The auditor has a familiarity with corporate financial records such that it makes sense for him or her to give certain tax advice.

In addition, there has been a proposal to require firms to change auditors regularly. This seems sensible at first, but it may increase the inefficiencies and risks associated with reporting and thereby reduce financial reporting quality.

In short, I think we ought to go slowly in instituting restrictions on the services auditors can provide. It may be that we should allow them to perform certain services with limitations - such as having a staggered rotation of partners and staff on an audit to assure better financial reporting.

In the end, while the Enron case illustrates a number of flaws in the system of reporting, before we establish new laws and reporting procedures, we ought to look at what, in specific, is wrong with what we are doing now and nuance our responses. Otherwise, we may be creating more harm than good.

Kirk O. Hanson: The collapse of Enron is probably one of the most significant events in the history of American business. Within six months, the company went from one of the most respected in the United States to bankruptcy-an unparalleled failure. What went wrong?

Number one: Enron executives really did believe this is a winner-take-all society-that there was a culture behind them saying, "You're worth nothing if you're not a centi-millionaire."…

One of my friends, a former executive at Enron who resigned in 2000, described what the recruiting process was like…. They recruited just at the major business schools. They wined and dined the prospects. They promised them huge bonuses and fed those young egos as much as they would take.

Once people were hired, it was an up-or-out culture. Those who survived began to think they were gods. And Jeffrey Skilling used to pit them against each other. He knew that as long as he could keep them scared of one another and competing, he would have control. When you create an environment in which, if you want to be among the best and the brightest, you've got to play the game the way the boss has set it up, that's not a culture where people are going to challenge top management.

In addition, the auditors had an incentive not to challenge Enron. Think about your role if you're the manager of the Arthur Andersen audit. Let's say you're the partner in Houston who manages the Enron account. What do you get paid for? You get paid for keeping that client. What do you get fired for? You get fired if you lose that client. The incentives all run in the direction of doing whatever this company demands of you. And if you've got a very aggressive management, like Enron had under Skilling and Andrew Fastow, then it becomes all the harder. You have to give in more and more.

The CEO of one of the big five accounting firms once told me, "My biggest ethical problem is that I incent people to keep clients at all costs. I know that creates ethical pressures on my people. I've got to find a partner who lost an account for the right reason-because it was ethically the right thing to do-and give them the biggest bonus next year."

I saw him a year later, and I said, "How'd it go?"

He said, "Well, I'm still looking for that partner." So you understand the kind of pressures on these auditors. And the pressures are made all the worse if it's not just auditing business but another $10 million in consulting services at stake at the same time. That's why we at least want to get rid of that conflict of interest.

Ten years from now, we'll look back on the Enron debacle and think of it as a morality play on the rights and privileges of the rich vs. the regular employees. One of the most outlandish aspects of the scandal is that the people at the top seem to have gotten their money out, leaving their fortunes intact. In fact, their claim that they were running one of the great risk-seeking enterprises of the new economy was rather hollow. They were running a risk-free company for themselves while the risk was assumed by the people at the lower levels in the organization.

Mar 5, 2002

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