Enron and other capitalist calamities
An ironclad rule of American business is that eras of great profit give rise to fantastic excess in the executive suites, and then someone gets sent to the slammer.
In June, while I was reading the book under review, we witnessed the first major indictments from the subprime mortgage fiasco: once-mighty financiers shuffled into federal court in Brooklyn in the tender grasp of deputy U.S. marshals. This particular pair from the disgraced and sold-off investment bank Bear Stearns was charged with misleading investors about the plummeting value of complex securities linked to mountains of home loans that should never have been made in the first place. Leaving the question of criminal liability to one side, it’s fair to say that Wall Street and the mortgage industry conspired to inflate a housing bubble that inevitably, and violently, exploded. As foreclosures proliferate in California and Florida, and tens of thousands are laid off on Wall Street, many ask how we didn’t realize sooner that a real-estate market that seemed too good to be true was… well, you know.
Recent decades have brought us the savings-and-loan scandal, the Michael Milken insider-trading skein, the first-generation dot-com frenzy, and a series of corporate debacles related to the Internet boom of the late 1990s. And who could forget Enron: hands down, the most byzantine saga in memory of hubris, greed, and deceit? The tale of the shiny Houston energy-trading juggernaut that crashed in late 2001 has been told so often that it has entered the realm of mythology. But Malcolm S. Salter, an authority on corporate management and Hill professor of business administration emeritus at Harvard, argues in his new volume that lessons from Enron’s rise and fall can guide business leaders—and the rest of us—in pondering how to regulate the great engines of capitalism in a way that will generate jobs and income without all the felonious mayhem.
As its title may suggest, Innovation Corrupted: The Origins and Legacy of Enron’s Collapse is not a brisk read; nor is it meant to be. Salter offers instead a sober case study that steers clear of narrative thrills and puckish personality portraits. His confidence that better-constructed boards of directors following common-sense principles will protect against future Enrons strikes me as overly hopeful, if not downright naive. But Salter’s heart is in the right place, and his exceedingly rational dissection of Enron will be instructive for any aficionado of big business and human frailty.
Enron had its roots in prosaic natural-gas operations that merged in 1985 and fell under the control of an amiable and eggheadish executive named Kenneth Lay, a Ph.D. economist better known for his enthusiasm for deregulating the energy business than for his managerial mastery. Lay hired Jeffrey Skilling, M.B.A. ’79, a brash and charismatic consultant from McKinsey & Company, to oversee Enron’s expanding gas-trading business. In the words of a former colleague, Skilling “could out-argue God.”
In the 1990s, Enron grew into an innovative and prosperous force in the newly deregulated natural-gas industry. It rode the Internet wave to create an on-line trading system that swiftly became the world’s biggest e-commerce site. This digital system allowed producers and users of natural gas to manage their risks more efficiently. Enron profited handsomely, as it should have.
Then Skilling and Lay let their success blind them. They directed Enron’s traders to branch out into the buying and selling of wholesale electricity. Diversification into water utilities and trading broadband capacity soon followed. Skilling, who rose to serve as Lay’s number two, exhorted his subordinates to exploit Securities and Exchange Commission (SEC) and tax rules, squeezing every possible advantage from the deals he struck at a furious pace. But Enron’s skill as middleman in the natural-gas trade simply failed to translate to other realms. Skilling’s investment gambles didn’t provide adequate cash to fund the commodity-trading operations, and by 1997, profits were declining.
Rather than rethink and retrench, Lay and Skilling unleashed their chief financial officer, Andrew Fastow, to sell overvalued and underperforming assets to off-the-balance-sheet partnerships, some of which Fastow himself controlled in a blatant conflict of interest approved by a somnolent board of directors. The plan, such as it was, involved “managing” the company’s reported earnings, minimizing its reported debt, and preserving its pumped-up credit rating and stock price. It all worked for a while—the deception part, anyway—transforming Lay and Skilling into heroes of the business press and heroically compensated icons of a supercharged, digitalized economy, circa 2000.
You remember the rest. In 2001, Arthur Andersen, Enron’s auditor-turned-enabler, suddenly “discovered” accounting irregularities related to the off-balance-sheet partnerships. Massive charges against earnings and write-downs of shareholders’ equity ensued. Its trading partners quickly losing faith, Enron collapsed into bankruptcy in what Skilling described as an energy-industry version of a “run on the bank.” Before they shut off the lights, he and Lay personally cashed in more than $200 million from sales of Enron shares and exercised stock options.
It took the Justice Department more than three years to sort out the mess and start the indictment process, critically aided by Fastow, who turned state’s evidence. The sort-of-repentant ex-financial whiz admitted he had distorted Enron’s earnings and enriched himself at the expense of shareholders. Five major banks that allegedly had colluded with Enron agreed to pay billions to settle civil suits. Arthur Andersen, targeted by prosecutors for obstruction of justice, closed its doors. Skilling and Lay denied any wrongdoing or even knowledge of fraud. In July 2006, 10 days after his conviction in federal court in Houston, Lay died from a heart attack. Skilling was sentenced to 24 years in prison, though his appeals continue. All told, more than 20 people were convicted in Enron-related cases, and a company that once employed 31,000 vaporized.
In painstaking analysis of the foregoing, Salter identifies three central lessons. The first is that a less drowsy board would have blown the whistle on Enron’s shenanigans and prevented disaster. He points admiringly to the typically more vigilant directors he says are installed when buyout firms collaborate with management to take public companies private. (Salter averts his gaze from the fact that so-called leveraged buyouts often result in companies crippled with debt while the private-equity boys make out like bandits, but that’s a topic for another book.) Lesson number two is that Enron executives, led by Lay and Skilling, were paid too lavishly. The reckless spewing of company stock and options—celebrated by some compensation gurus as a way to “align” management’s interests with those of the company—created an incentive for Enron’s leaders to prop up the share price at all costs. Finally, Salter calls for the institution of stringent ethical checks and balances to prevent executives from misbehaving when they operate “in the penumbra between clear rightdoing and clear wrongdoing.”
Fair enough. But as Salter’s careful exposition reveals, all the business-school theory in the world can’t cure the corruption of a devious mind. Enron had codes of ethics, but they weren’t worth the paper on which they were neatly published. (Lay, who saw himself as an academic of sorts, even contributed a chapter to a book on business ethics!) The company had a risk-analysis group stocked with quantitative geniuses who raised plenty of objections to questionable deals and dubious accounting. The objections were derided or ignored. As for what motivates the troops, Salter quotes Skilling as having this to say before everything unraveled: “I’ve thought about this a lot, and all that matters is money. You buy loyalty with money. This touchy-feely stuff isn’t as important as cash.”
Come to think of it, would even our most august schools of business administration dispute Skilling’s blunt assessment? The fact is that money talks, and achievers in corporations and on Wall Street listen. That’s at least a big part of the reason they’ve chosen those pursuits, rather than high-school teaching.
And there’s nothing necessarily wrong with that. We all benefit, some more directly than others, when smart, competent business people invent new ways of trading natural gas or, to choose another example of more immediate interest, finance home loans. We need entrepreneurs as well as algebra instructors.
But cheaters, given a chance to bend the rules, can weaken any enterprise. Lay, Skilling, & Company were cheaters (as well as far less competent corporate strategists than they and a lot of other people thought at the time). Salter helpfully recounts an incident from as far back as 1987, when Lay discovered a rogue oil-trading team manipulating the ledgers to reap substantial bonuses. Rather than fire the miscreants, Salter notes, Lay papered over the situation. His response, widely observed at the company, “became part of Enron’s cultural lore.”
The author puts great faith in rational internal controls and company audit committees. Almost as an afterthought, he notes that what was also missing at Enron was “a deep commitment to ‘quality’ objectives—compliance with the law, the principles underlying the law, and high ethical standards—and thoughtful reflection on how best to achieve those objectives.” Well, yes. This is what tends to be missing when investigators comb the wreckage of a financial calamity. There were countless individuals within Enron who could have quit their jobs and alerted regulators to what was going on. Brave souls were in short supply.
What also tends to be missing—and what Salter might have emphasized more—is skeptical oversight from the outside. An overmatched, understaffed SEC struggles to patrol the beat to which it has been assigned. Neither Congress nor the White House—Republican or Democratic—seems inclined to strengthen the regulators. Tepid reform legislation enacted in the wake of Enron did little to deter the reckless schemes that gave us the subprime mortgage mess. Business journalists, I can confess from within that fraternity, are overly consumed with anointing corporate superstars. Too rarely do we have the fortitude to disentangle telling footnotes in securities filings when it counts—before, rather than after, the bankruptcy courts take over and shareholders are ruined.
Call me a pessimist, but my view is that human nature being what it is, we can expect more Enrons, and more perp walks.
Paul M. Barrett ’83, an assistant managing editor at BusinessWeek, is the author, most recently, of American Islam: The Struggle for the Soul of a Religion (2006), released in a paperback version by Picador earlier this year.
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