By John A. Byrne
On Feb. 7, 1999, the audit committee of Enron Corp.'s board of directors gathered in London to hear some rather startling news. The company's auditors described Enron's accounting practices as "high-risk." David B. Duncan, who headed up the Arthur Andersen LLP team at the company, informed the committee that Enron's accounting was "pushing limits" and was "at the edge" of acceptable practice.
None of the directors, including Robert K. Jaedicke, a one-time Stanford University accounting professor who had been chairman of the audit committee for more than 10 years, objected to the procedures described by the auditors, requested a second opinion, or demanded a more prudent approach, according to the Senate Permanent Subcommittee on Investigations after a six-month probe of the Enron board's oversight duties.
In fact, the subcommittee found that similar briefings by Andersen officials occurred once or twice each year from 1999 through 2001 with the same result: The auditors told board members that Enron was following high-risk accounting and no one drilled deep enough to learn the details or object. And despite his long tenure as chairman of the audit committee, Jaedicke rarely if ever had any contact with Andersen outside of official committee or board meetings, as governance experts recommend.
Even worse, Enron's board members knew about and could have prevented many of the risky accounting practices, conflicts of interest, and hiding of debt that led to the company's implosion simply by asking some obvious questions. That at least is the conclusion of the Senate investigators. The panel's report shows no evidence of self-dealing, corruption, or fraud by Enron's directors, who still maintain that they cannot be held accountable for misconduct that was concealed from them. But after looking over thousands of pages of board documents and minutes and interviewing 13 of Enron's outside directors, the Senate panel found a nearly unprecedented breakdown in governance. W. Neil Eggleston, an attorney who is representing Enron's outside directors, called the report and its conclusions unfair. "This board was continually lied to and misled by management," he said. "No amount of further diligence or questioning would have been sufficient to cause management to tell them about these transactions."
Given the subcommittee's findings, laid out in mind-numbing detail, however, the Enron directors' "see-no-evil, hear-no-evil" defense on Capitol Hill becomes even more implausible. And it raises another issue with startling clarity: There are, in fact, almost no real consequences for company directors who fail on the job. Instead of skating by with liability insurance paid for by shareholders, directors who fail to exercise at least a minimal level of oversight should be forced to pay some of the damages, just as executives should. Shareholders have a right to expect directors, who at Enron were paid as much as $350,000 a year in cash, stock options, and phantom stock, to be engaged and active. They should be assured that directors will place investors' interests above those of executives. And certainly, shareholders should expect that the board will follow up when outside experts appear before them to warn of potentially explosive danger. Yet Enron's directors ignored warnings and heaped riches on executives time and time again.
Besides the repeated warnings by auditors of Enron's "high-risk" accounting, the Senate subcommittee made these remarkably damning conclusions:
-- In 2000, over several meetings, the board's compensation committee approved $750 million in cash bonuses to Enron executives in a year when the Houston-based company reported net income of $975 million. In other words, the directors handed over an amount equal to more than three-quarters of reported profits to salaried managers--at the expense of the shareholders. Apparently, no one on the compensation committee had ever added up the numbers.
-- The compensation committee also approved a credit line for Chief Executive Kenneth L. Lay that eventually reached $7.5 million, and then allowed him to repay it with stock instead of cash. Lay proceeded to use the credit line as an express lane for dumping Enron stock. He repeatedly drew down the line, sometimes daily, always repaying right away with stock. Doing so allowed him to delay reporting some stock sales for more than a year. The chairman of the compensation committee, Charles A. LeMaistre, told the Senate investigators that he did not think it was the committee's responsibility to monitor Lay's use of this credit line. If the directors had bothered to look, they would have discovered that as Enron's position became more precarious in the 12 months preceding revelations of its infamous off-balance-sheet partnerships, Lay extracted $77 million in cash from the corporation that he replaced with Enron shares.
-- When the board first heard about a letter from whistleblower Sherron S. Watkins during a presentation by Enron's outside lawyers, the letter writer was not disclosed nor was her letter shown to directors. Shockingly, not a single director asked for her name or for a copy of the letter. The board was unaware of her most damaging charges, the subcommittee found.
Again and again, the red flags went up. Again and again, they were ignored. "They should have inquired further," says Charles M. Elson, director of the Center for Corporate Governance at the University of Delaware. "They were unwilling to ask and pursue tough questions."
For years, a simple standard known as the "duty of care" has guided the behavior of corporate board members. That standard requires that a director discharge his duties in good faith, with the care of an ordinarily prudent person, and in a manner which he or she reasonably believes to be in the best interests of the corporation. By rewarding executives with outsize pay packages and by failing to heed signs of danger, Enron directors failed that standard miserably. The board failed to ask probing questions. Its members neglected to follow up on critical issues that only they could monitor. It malfunctioned in its role as the watchdog that shareholders rely on. As the subcommittee concluded, "By failing to provide sufficient oversight and restraint to top management excess, the Enron board contributed to the company's collapse and bears a share of the responsibility for it."
Trouble is, even when directors fail, liability is largely a myth. Board members are almost always indemnified by insurance paid for by shareholders. Many boards have also passed bylaw amendments to corporate charters limiting their liability. And many states have passed legislation to limit director exposure, even for negligent acts. Rarely does a director have to pay a price for failing to perform his job.
As the facts tumble out of the Enron boardroom, it has become increasingly clear that the directors were not merely misinformed by management or even sloppy in their oversight responsibilities. They were recklessly negligent and should be held at least partly accountable and personally liable for the company's meltdown. Sure, they're already embroiled in litigation, both with their insurance provider and with shareholders, and their reputations have taken a hit. But compared to what the investors they were charged with protecting suffered, it hardly seems enough. Byrne covers management and governance issues from New York.