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What went wrong at Enron?

Book cover

by Peter C. Fusaro and Ross M. Miller, Wiley, 2002.

Abstract

How such a high value company lost its way with its strong emphasis internally on cut-throat competition and externally on market value. To appear good overshadowed all other considerations. An instructive story.

(Reviewed by Kevin Barham in July 2002)

(These book reviews aim to represent some of the key aspects of what the author has written. They do not necessarily represent the views of the reviewer or of Ashridge. Equally the author of the book reviewed must not be held responsible for any misperceptions of the reviewer.)

Enron was once the seventh-largest and one of the most admired companies in the US. Its sudden collapse in 2001 sent shockwaves through the financial systems of the world. Investors, including almost every pension and retirement fund in the US, lost tens of billions of dollars after revelations of company internal deals that hid billions of debt and losses from company financial statements. While the precise reasons for Enron’s collapse are still being determined, it is clear that both accounting failures and corporate governance failures have played a significant role. That such a highly esteemed company could fall so far so fast has shocked investors. Confidence in the whole framework of company accounts and in how directors run their companies has been shaken, not just in the US but elsewhere, including the UK.

It seems that no single misstep brought about the downfall of Enron. A series of missteps, both accidental and calculated, coupled with ‘bad luck’ led to some of its more questionable dealings being brought to light, precipitating the ultimate collapse. The story is complex (especially where the detail of Enron’s financial and trading strategies are concerned) but Peter Fusaro and Ross Miller describe it in straightforward terms for the non-specialist reader.

A maker of markets

Enron started in 1985 as a small oil and natural gas pipeline company in Texas. Masterminded by CEO and former economist Kenneth Lay and later by chief operating officer Jeffrey Skilling (both now household names in the US), it grew by promising to deliver gas and oil to a particular utility or business at a fixed future date and at a fixed price. As the energy markets - and in particular the electrical power markets - were deregulated, Enron’s business expanded into brokering and trading electricity and other energy commodities. The deregulation of these markets was a key Enron strategy as it invested time and money in lobbying politicians for access to what traditionally had been publicly provided utility markets. Some of Enron’s top executives became frequently named corporate political patrons. The company became the largest buyer and seller of natural gas in the US, with involvements in power plant and pipeline projects that spanned the globe.

As Enron began to face competition from other energy commodity traders, its business arrangements became more and more complex. The company’s highly competitive atmosphere and the freedom it gave its employees to innovate led to the creation of markets for products that never previously existed. Customers could insure themselves against changing business conditions including changes in interest rates, commodity prices or even a change in the weather. The volume of business from these non-traditional contracts came to greatly exceed Enron’s mainline market in commodity trading.

The firm went on to trade in almost anything that could be traded. At one point, with its rapidly growing revenues and profits, it appeared to be the dream company. Enron Online, the firm’s move into online trading, also made the company a prime internet success story. The stock price soared and Fortune magazine heralded Enron as one of the most innovative companies in America.

Underneath the surface, however, all was not well. In recent years, the business successes at Enron had begun to sour. New ventures, such as its attempt to build a market for broadband communications, turned out to be misjudged, as were some if its major international projects, including involvement in the Indian power market and investments in water businesses in Europe and South America. The company was also suspected of using phoney trades to manipulate the huge California electricity market. Enron was no longer making the profits it hoped for and had promised investors. In response, Enron’s top management began to create partnerships and ‘special purpose financing entities’. These companies were used to keep Enron’s debts and growing losses off the company’s balance sheets, distorting the company’s financial picture for investors.

Enron had used shares of its stock as backing for many of its deals so a high stock price was vital to the firm’s survival. Although Enron’s results released in April 2001 looked healthy enough, fears were growing among some investors and analysts that Enron’s stock was overpriced. At the heart of Enron’s problems was top management’s trust in the power of markets. Enron was organised for innovation but it had lost focus and direction. The extremely competitive culture and the freedom for employees to pursue new ventures may have encouraged innovation, but it had produced a company with a hodge-podge of assets and strategies. Doubts about the company were fuelled by the company’s lack of transparency and the arrogance with which top management treated the increasingly pointed questions from analysts.

Enron’s stock was already falling, when Jeffrey Skilling, only recently promoted to CEO, suddenly resigned ‘for personal reasons’ in August 2001, alarming both Enron’s employees and Wall Street. The fall of Enron stock now accelerated and it finally collapsed when the company announced in November that it had overstated its earnings by $600 million from 1997 through 2000. Among other things, top Enron executives and directors are also accused of selling $1.1 billion worth of stock while knowing the company was in danger of collapse. Not surprisingly this has angered rank and file employees who were blocked by the company from selling the company shares that they had been required to keep in their retirement portfolios.

So where did the cynicism that seems to lay behind so much of the Enron saga come from? Why did no one in the company blow the whistle? And why did the auditors fail to warn of the problems?

Star Wars.

To explain the cynicism, the authors suggest that many of the stratagems used by Enron traders derived from the fantasy world of 1970s youth when the craze for trading Star Wars cards swept America as part of the franchising follow-up to the film. As Fusaro and Miller say, innocent card trading can easily degenerate into gambling and, as the stakes grow larger, the temptation to cheat and steal increases. While most children are honest by nature, the attraction of a quick and easy gain is enough to lure some of them over to the dark side. According to the authors, the story of Enron is the story of how a group of people, who could well have traded Star Wars cards as children, went bad and took the fortunes of a large company, its employees and its investors with them. (Some of the most questionable of Enron’s deals were indeed given names straight from Star Wars such as ‘Death Star’ and ‘Chewco’ - from Chewbacca the Wookie.)

A dysfunctional corporate culture

That nobody on the inside of the firm questioned illicit practices is ascribed to the firm’s corporate culture. Enron was the high-performance, talent-intensive corporation gone wrong. As a market maker, Enron’s top management believed in applying market discipline to the firm’s internal operations. Enron’s culture was focused on two things - the first was profits and the second was how to make even greater profits. Enron looked for recruits who demonstrated a strong sense of urgency in everything they did and employees were expected to maintain high levels of work intensity over extended periods of time. The firm put a lot of effort into attracting top talent but was also quick to fire people.

In particular, it evaluated its people using the ‘rank-and-yank’ principle, whereby employees were ranked every six months on a 1-to-five scale. However, 15 per cent of all employees were required to be in the lowest category (1) and they were yanked from Enron. To give the appearance of fairness, those yanked had until the next semi-annual review to improve. In practice, however, with new waves of 15 per cent yanks coming very six months, it was difficult for those in the bottom category to escape for very long so they usually chose to accept a severance package rather than stick it out. Moreover, those in categories 2 and 3 were effectively put on notice that they too were likely to be yanked within the next year. With half of Enron’s employees in serious danger of losing their jobs at any given time, the result was a cut-throat culture that pitted one employee against another. While many US firms use some form of rank-and-yank - usually yanking the bottom 10 per cent once a year - Enron’s extreme version of the system cast a constant shadow of insecurity over all but the most highly ranked employees.

The same rigours that Enron faced in the marketplace were therefore brought inside the company in a way that destroyed morale and internal cohesion. In particular, it created an environment where most employees were afraid to express their opinions or to question unethical and potentially illegal business practices. As the rank and yank system was both arbitrary and subjective, it could be used by managers to reward blind loyalty and quash dissent.

Accounting failures

One of the most controversial aspects of the Enron case is the failure of Andersen, the firm’s auditors, to raise the alarm. Just why did the auditors fall down on their responsibilities? Fusaro and Miller do not have a lot to tell us here so we have to turn elsewhere to understand what went wrong.

Many major accounting scandals (including now WorldCom) involve the firm’s top management. A study by two US accounting professors (Steve Sutton and Charles Cullinan) says, for example, that the methods used by major auditing firms make it almost impossible for them to catch a client’s highest-level executives from cooking the books. Over the past two decades, auditors have gradually focused more on how companies generate their financial data - the computerised accounting programs and internal controls - rather than on the numbers themselves. This is in contrast to the older style of auditing in which the accountants dug deeply into the corporate accounts, looking at the multitude of transactions, to determine if the bookkeeping was correct. The flaw is that, while the computer programs and internal controls prevent low-level employees from stealing cash, they can be circumvented by top executives seeking to manipulate the books, the people who shift millions or billions rather than thousands of dollars.

'No matter how many locks you put on the door, someone has the keys, and that person is likely to be the chief executive or chief financial officer,’ say Sutton and Cullinan.

The shift has been caused by firms increasingly turning to computers to manage their finances and intense competition between accountancy firms causing substantial drops in audit fees. The latter has forced auditors to cut costs and to cut back on the labour-intensive process of sifting through large numbers of corporate accounts. The implication is that, to find more frauds, companies will have to pay more for their audits in future.

Could an Enron-style scandal occur in the UK? Some observers believe the risk is less because of more rigorous accounting audit standards and better corporate governance in the UK. There are concerns, however, that the relationship between some auditors and their clients is still too cosy and one proposed answer to the current lack of confidence in audited accounts is compulsory rotation of auditors around companies to prevent auditors getting too close to longstanding clients. There is also concern about the practice known as ‘low-balling’, where accounting firms allegedly sustain losses on audit contracts to secure lucrative non-audit work so undermining the quality of audit work. The accountancy profession insists that low-balling is not a problem but agree that audit fees have been driven too low by competition between accountancy firms. Nonetheless, for every high profile audit failure there are tens of thousands of successful, safe and cost-effective audits carried out in the UK each year.

What can be done to prevent more Enrons? There are no simple answers, claim Fusaro and Miller in their book on the company’s collapse. As they say, business schools are a natural target. Previous scandals have led to the requirement that business schools (in the USA) include business ethics in their curricula in order to be accredited. However, many students, according to Fusaro and Miller, are believed to view ethics as about not being caught rather than how to do the right thing in the first place. The traditional view of markets assumes that, while self-interest will determine what people choose, they will not choose to break the rules of the market. While a certain amount of ‘crime and punishment’ can be built into an economic system, there is a growing school of thought that markets can function effectively only in societies where most people are honest. By the time someone gets to business school (or studies to become an accountant), it is already too late to teach the proper values.

The authors conclude that, while Enron may be the most spectacular and scandalous business failure in history, at its core was a good idea that will endure. In an increasingly networked world, companies (like eBay) that make it easier for people and businesses to trade - that set fair rules of engagement and honour those rules themselves - will likely prosper.

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