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Skilling's Appeal and Enron's Legacy

Regardless of the outcome—which very well may be favorable to Skilling—the question remains: Why didn't Enron's board pay more attention?

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

The latest chapter of the Enron story opened on Apr. 2 at the Fifth Circuit Court of Appeals in New Orleans. Lawyers for former Chief Executive Officer Jeffrey Skilling argued that his 2006 conviction on 19 counts of fraud, conspiracy, insider trading, and lying to auditors—along with his 24-year prison sentence—should be overturned. Some four months later, 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, the judges' ruling 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 dropped.) 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 what Owen D. Young—the founding chairman of RCA and NBC, and later chairman of GE (GE)—once called 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. Former SEC Commissioner Arthur Levitt made this savvy observation in the immediate aftermath of Enron's collapse, and this judgment looks as correct today as it did seven years ago. 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 persistent 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: It encouraged growth over profitability. It rewarded employees for closing commodity deals and power-generation projects without concrete evidence of their future profitability. It deepened a deadly addiction to pumping up the price of the stock through a variety of obfuscating maneuvers. It helped encourage a corporate culture that tolerated and sometimes encouraged deception. 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—drawn directly from Enron's experience with perverse incentives—that collectively address the potentially perverse effects of turbocharged financial incentives.

That awarding "up front" bonuses—before cash and profits flow from commercial endeavors—invites employees to maximize their short-term pecuniary 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 security.

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 give executives 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 interests that the board itself had approved involving Fastow's dual role as Enron's chief financial officer 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.

Enron had a distinguished board—all hand-picked by former Chairman Kenneth Lay. At least some directors understood the natural-gas and power-generation business. How many actually understood derivatives, derivatives trading, and derivatives accounting is not clear. What is clear, however, is that the effectiveness of Enron's board was diminished by the following factors: Skilling's and Lay's intolerance of dissent, an incestuous relationship between Arthur Andersen auditors and Enron, weaknesses in Enron's esteemed risk-management process, a notable lack of rigor in examining the use of off-balance sheet partnerships, group norms against criticizing Ken Lay, and outmoded board processes. This mix of factors was sufficiently toxic to put the corporation in mortal danger.

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

Expanding their cohort of directors to include retired executives and entrepreneurs, independent of age, 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 the profitable world of private equity or other less risky assignments;

Requiring that a different degree of directors' wealth be at risk through meaningful 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 is the most important one. It is simply 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.

Today, a full 94% of the Standard & Poor's 500-stock index companies now have nonexecutive chairs or "lead" directors that coordinate the work of all independent directors, up from 36% in 2003. But the lead director solution is not adequate. 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 be unable 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 Lay failed to understand as leaders is that compliance with espoused ethical and legal standards is an organizational achievement. Or, to put it put slightly differently, despite the values and ethical guidelines published in Enron's Code of Ethics (available as a collectible on eBay (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 (such the protection of corporate integrity and reputation, respectful behavior, truth telling, legal compliance, and a host of other possible social goals) 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); and

Continuous monitoring of senior executives for evidence of what sociologist Philip Selznick has identified 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. In Enron's case, the overgeneralization of purpose—at first, to be the best energy company in the world and, next, to be the best corporation in the world—provided few business-specific decision criteria for Enron executives. In their absence, personal preference tended to replace decision-making based upon the espoused ideals and distinctive competences of the company. In short, the utopianism of Enron's leaders created an environment where personal opportunism ran rampant.

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 elected directors to the ethical discipline of executives who are accountable to them.

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