In 2000, Enron was number 18 on the Fortune 500 list of the largest U.S. companies. Their stock price was defying gravity and their leadership team was featured on the covers of Business Week, Fortune and Forbes. Enron’s rise was being studied by business schools and many considered the company to be a model of the 21st-century economy. Then everything changed.
Enron’s incredible rise and the buzz surrounding the company is part of what made their collapse on the heels of an accounting scandal such an enduring symbol of corporate greed. The investigation and legislation that followed the fall of Enron, ushered in a new era of c-suite accountability, auditor independence and transparency.
Although it was nearly 20 years ago, this story still has a lot to teach us today.
Enron has long been a source of fascination in the legal, compliance and academic circles. For the inaugural episode of FTI’s new podcast series: Fraud Eats Strategy I connected with famed Enron whistleblower Sherron Watkins. She’s an incredibly insightful financial crime scholar with a lot to share.
Enron had been wildly successful, and that type of success can lead to a lax attitude toward compliance. This lax attitude can lead to people not being as alarmed by obvious red flag behavior as they should be. Ms. Watkins cited a truly stunning example to illustrate her point. Enron’s board of directors was asked to waive the company’s code of conduct prohibition against conflicts of interest in favor of then CFO Andy Fastow and they agreed. Fastow proposed raising a $500 million investment partnership fund for the sole purpose of doing business with Enron. She described this extraordinary move by the Enron board as: “absolutely shocking” and said that had the board not approved what was an obvious conflict of interest, the Enron fraud would have never happened.
Ms. Watkins explains why the Enron case still has a great deal to teach us about greed and corporate fraud.
Unlike some other major accounting frauds such as Worldcom, where six or seven people in the CFO’s office were responsible for making topside entries and cooking the books, what made Enron so unusual is they had what she described as a “wrapper of legitimacy”. While the off-balance-sheet debt should’ve been on the books, there was no second set of books or anyone making topside entries. And unlike other accounting frauds at the time, Enron’s incredibly complex accounting fraud was known by their outside accountants, attorneys, lenders as well as in-house compliance and legal teams. The banks were lending Enron billions of dollars when they knew or suspected that Enron was putting it into these complicated structures and booking it as free cash flow as if they had sold assets.
I asked her what steps organizations should take right now to avoid the possibility of a major fraud scandal and the damage that comes with it. She said there needs to be a system for bad news to be reported up the chain of command and the roadblocks removed. The best-run organizations put their general counsel in that position. In Enron’s case, CEO Ken Lay let it be known that he did not want to hear bad news. As a result, Enron’s human resources department had an unwritten policy that if bad news came from a former employee, it was presumed not to be valid since it was coming from a disgruntled former employee. Not only was this information not communicated upward, but it was also “chunked in the trash”. What happened at Enron embodies a lot of the fears and anxieties of many whistleblowers. What if they do nothing and instead shoot the messenger?
At Enron, Ms. Watkins was the head of corporate development which meant she oversaw all mergers and acquisition activity. I asked her what steps she would recommend companies take that go beyond typical financial and legal due diligence to avoid inadvertently purchasing ongoing fraud or corruption schemes. She cited the number one activity is to talk to the target’s customers, find out if they like doing business with the company and if they feel they are being treated fairly. She described Enron as a counterexample of good customer relationships and reputation. At the same time, the accounting fraud was ongoing, Enron was manipulating the California energy market which prompted the California Governor at the time to remark: “I can’t wait to see their CEO sitting in a jail cell”. Enron’s customers certainly didn’t like doing business with them and didn’t feel they were being treated fairly. Enron’s customers used unflattering nicknames to describe Enron like the “Death Star” which is also the name Enron traders used to describe one of their trading strategies along with “Get Shorty”, two trading strategies that exploited weaknesses in the California Energy market to the detriment of the State and its utility customers.
When Sherron Watkins was a whistleblower, there were very few resources available to corporate whistleblowers and they were frequently retaliated against and vilified. I asked her what advice she would give to a would-be whistleblower. Ms. Watkins stated that the best thing to happen since the collapse of Enron is the whistleblower bounty provision of Dodd-Frank. It provides SEC whistleblowers with 10% to 30% of the fines the SEC collects as a result of their information. This infusion of money has attracted a lot of legal talent to the cause of whistleblowers since there is a mechanism for them to be paid. Her advice to whistleblowers is to seek the advice of counsel.
Ms. Watkins also offered advice regarding the expected wave of accounting fraud as a result of the current economic downturn. She recounted hearing an SEC commissioner speak who said once that when you put any kind of fluff in your numbers, you’re the one that’s putting the pressure on the organization. She elaborated that next year when you want to grow your numbers, you will be growing your numbers on real numbers plus fluff. The next year and each succeeding year, that same fluff is carried forward. Once there’s a downturn, your schemes are then exposed. Ms. Watkins’ advice is to come clean, form a crisis management team including the right experts, shore up cash and develop the right plan. Don’t cover up and don’t deny what has happened.
This financial crisis will undoubtedly expose dozens of major accounting frauds that have been going undetected for years. Enron’s lessons are as important and relevant now as they were then. Don’t allow your prior success to blind you to obvious red flags. Conflicts of interest, even if they are sanctioned by the board, are never ok. Make sure that there are multiple mechanisms in place to ensure that bad news is reported to company leadership. Listen to what your customers are saying about you. And if the company is enveloped in an accounting scandal, remember the saying: “Good men are bound by conscience and liberated by accountability.”
Click here to listen to our Fraud Eats Strategy episode with Whistleblower Sherron Watkins.