Lessons from the Enron Scandal.doc

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Lessons from Enron
  Lessons from the Enron Scandal On March 5, 2002, Kirk Hanson, executive director of the Markkula Center for Applied Ethics, wasinterviewed about Enron by Atsushi Nakayama, a reporter for the Japanese newspaper  Nikkei . Their Q & Aappears below: Nakayama: What do you think are the most important lessons to be learned from the Enron scandal? Hanson: The Enron scandal is the most significant corporate collapse in the United States since the failureof many savings and loan banks during the 1980s. This scandal demonstrates the need for significantreforms in accounting and corporate governance in the United States, as well as for a close look at theethical quality of the culture of business generally and of business corporations in the United States. N: Why did this happen? H: There are many causes of the Enron collapse. Among them are the conflict of interest between the tworoles played by Arthur Andersen, as auditor but also as consultant to Enron; the lack of attention shown bymembers of the Enron board of directors to the off-books financial entities with which Enron did business;and the lack of truthfulness by management about the health of the company and its business operations. Insome ways, the culture of Enron was the primary cause of the collapse. The senior executives believedEnron had to be the best at everything it did and that they had to protect their reputations and theircompensation as the most successful executives in the U.S. When some of their business and tradingventures began to perform poorly, they tried to cover up their own failures. N: Why didn't the company's directors protect the employees and investors? H: The board of directors was not attentive to the nature of the off-books entities created by Enron, nor totheir own obligations to monitor those entities once they were approved. The board did not pay attention tothe employees because most directors in the United States do not consider this their responsibility. Theyconsider themselves representatives of the shareholders only, and not of the employees. However, in thiscase they did not even represent the shareholders well-and particularly not the employees who wereshareholders. N: Why didn't anyone stop Skilling, Lay and Fastow? H: Jeffrey Skilling and Andrew Fastow changed the business strategy and corporate culture of Enron. In theprocess, they appeared to make Enron very innovative and very profitable. When the stock is rising and theshareholders are getting rich, there is little incentive for the board of directors and the investmentcommunity to question the executives very closely. The board is at fault for permitting the suspension of Enron's own code of conduct to permit the conflicts of interest inherent in the off-books corporationscontrolled by Fastow. A few analysts recommended their clients stay out of Enron, but not many. N: Could you tell me how the corporate governance should be changed? H: I do not think the rules of corporate governance will be changed in significant ways. But boards of directors need to pay closer attention to the behavior of management and the way the company is makingmoney. In too many American companies, board members are expected to approve what managementproposes-or to resign. It must become acceptable and mandatory to question management closely. There islittle chance the U.S. governance rules will be changed to make boards responsible to the employees as wellas to the shareholders. However, board members would be foolish not to pay more attention to howemployees and customers and business partners are treated. These greatly affect the long-term value of theshareholders' investment. N: Don't you think this scandal damaged the new economy's fundamental system? H: Enron is a prominent example of a new economy company. Kenneth Lay and Jeffrey Skilling claimedthat Enron was the most innovative company in the United States and at times tried to intimidate reportersor analysts who questioned their strategy. In the new economy, new kinds of companies have been created.Enron's collapse will encourage investors, analysts, reporters, and employees to ask old economy questions about these new economy companies: How does this company make money? Can it sustain this  strategy over the long term? How do those who work in and with this company feel about it? The neweconomy has lost some of its appeal after the collapse of many dot.com companies and of Enron. N: Can we believe analysts' strong buy recommendations from now on? H: Many have questioned the overly optimistic buy recommendations analysts have issued in recent years,fearing they had conflicts of interest because of the underwriting business their firms did for dot.coms orbecause of the investment industry culture which rewarded analysts who were bullish on the new economy.I think there will be much closer scrutiny of analysts' recommendations in the months and years ahead, anda close look at the conflicts of interest of individual analysts. Analysts who are always bullish will be lesslikely to be believed. N: What reforms should Congress, the SEC, and others institute post-Enron? H: I believe accounting regulations should be altered to prohibit ownership of both auditing and consultingservices by the same accounting firm. Accounting firms are already moving to sever their consultingbusinesses. The SEC should probably adopt additional disclosure requirements. Various regulators shouldtighten requirements for directors to be vigilant and provide protections for whistleblowers who bringimproper behavior to public attention. But, in the final analysis, the solution to an Enron-type scandal lies inthe attentiveness of directors and in the truthfulness and integrity of executives. Clever individuals willalways find ways to conceal information or to engage in fraud. N: How can credibility be recovered with investors? H: U.S. firms and foreign firms listed on U.S. stock exchanges will need to demonstrate that they haveeliminated all off-books accounts which distort the public's understanding of the financial health of theorganization. They may need to pledge that they will not suspend the company's code of conduct, or at leastreport to the public when they do. Finally, every company will need to demonstrate that its board of directors is vigorous, vigilant, and that its procedures will enable it to uncover any questionable behavior.Companies may need to adopt a set of governance best practices to regain the trust of the market. N: Some say Enron's collapse was caused by its stock options system. Do you think the executivecompensation system should be reformed, and if so, how? H: The stock option system is not itself the problem. Excessive stock options and excessive corporatecompensation give corporate executives too many incentives to manipulate the financial accounts and thestock price of the company. When huge cash or options bonuses are dependent upon achievement of one ora few narrowly defined profit or growth goals, the temptation to manipulate the numbers to get the rewardswill be too great. The problem is not the stock option system but the excessive compensation given toexecutives in the United States, particularly compared to the salaries of regular employees of the company.U.S. companies should look more like Japanese companies in the ratio of the salaries of top executives tothose of regular employees. N: Will stock prices continue to be down because the investors' faith has been shaken? The other day theblue chips like GE and IBM had to reassure investors about the strength of their financial controls. H: I believe the stock prices of new economy companies will continue to show an Enron effect for manymonths to come. Until an individual company convinces the market that it has rid itself of any questionablepractices and has improved its governance systems, it will not be evaluated fully. N: Don't you think this kind of scandal will be a bad influence on the U.S. economy, whichis recovering from recession? H: Enron has clearly done some damage to the U.S. economy, but it will not hold up recovery from thecurrent recession. The fundamental health of the U.S. economy is strong and now getting stronger. Someindividual new economy companies will have depressed stock prices for some time, but they, too, willrecover as they demonstrate that they are prepared to prevent Enron-like behavior. N: You mentioned in Newsweek magazine that Enron will become the morality play of the new economy.Could you give me a more concrete idea what you mean by this? H: I do believe Enron will be the morality play of the new economy. It will teach executives and theAmerican public the most important ethics lessons of this decade. Among these lessons are:  1.You make money in the new economy in the same ways you make money in the old economy - byproviding goods or services that have real value.2.Financial cleverness is no substitute for a good corporate strategy.3.The arrogance of corporate executives who claim they are the best and the brightest, the mostinnovative, and who present themselves as superstars should be a red flag for investors,directors and the public.4.Executives who are paid too much can think they are above the rules and can be tempted to cutethical corners to retain their wealth and perquisites.5.Government regulations and rules need to be updated for the new economy, not relaxed andeliminated.
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