Failures of leadership and governance created a shock so toxic, that it ultimately led to the demise of Enron. Peter Lawson investigates what went wrong and looks at the lessons that can be learnt from the Enron experience.

It would be comforting to think that what happened at Enron could be simply explained, but the truth is both complex and tragic. The tale of Enron “is a story of weakness; of hubris and greed and rampant self-delusion; of ambition run amok; of grand experiment in a de-regulated world; of a business model that did not work; and of smart people who believed that their next gamble would cover their last disaster – and who could not admit that they were wrong.”¹

A veritable archive of books, newspaper investigations and articles has sought to recount the Enron narrative. One explanation, which cites ‘hubris’ as a prime cause of failure in business leadership, recalls Napoleon’s attempt to conquer Imperial Russia that ended in failure with fewer than 5% of his army able to get home alive. Many reasons have been proffered to explain the tragedy of Napoleon’s Russia campaign, but hubris – exaggerated pride, self-confidence or arrogance, frequently resulting in retribution – played a central role.

It is easy to see how the 21st century world of business may be subject to hubris. It is a world of takeovers, mergers, expansion and corporate recovery programmes. It is a world where the business strategies of corporations with revenues larger than many a nation state are reported and analysed ad nauseam. It is a world where its celebrities are feted and also where disregard for the rules and a belief that the ‘trend can be bucked’ are all familiar features. It is in such a world that ‘hubris’ may flourish and one can see how heads may be turned and risks taken. Enron is a case in point. Let’s take a closer look at the Enron collapse.

The beginning of the end

Enron was created in 1985 when Houston Natural Gas merged with InterNorth, a larger pipeline company. During the first few years of its life the new company found the going tough. De-regulation was seen as the solution to Enron’s difficulties, but eventual de-regulation spawned new problems – new suppliers came to the market and with them came volatile prices. What was needed was a new business model and Enron found someone with the vision to create one and his big idea was the so-called ‘Gas Bank’. The designer of the model was Jeffery Skilling, a McKinsey consultant who would go on to become Enron’s CEO.

The basic idea of the ‘Gas Bank’ was that the energy producers (acting as depositors) would contract to sell their gas to Enron (acting as the Bank). Gas consumers (acting as borrowers from the Bank) would contract to buy gas from Enron who would capture the profit from the price it paid the ‘depositors’ and the price it sold gas to the ‘borrowers’. As long as Enron had a balanced portfolio of contracts everything would be okay.

Following the creation of the energy market through the ‘Gas Bank’ model during the 1990s, Enron went on to create markets in energy related products such as iron, steel, oil, coal, pulp, paper and even weather derivatives. Enron planned to trade bandwidth capacity as the dot-com economy prospered. Enron began to trade online in 2000 and within two years the value of this trade was $800 billion per annum.
During the first full year of trading online, Enron handled some 550 million transactions with a notional value of $345 billion.

Innovative or toxic

By 1999 Enron was presenting itself as a new economy company and its Annual Report that year stated: “When you define a new economy company you define Enron.” That same annual report provided insight into the Enron culture: “We support employees with the most innovative culture possible, where people are measured not by how many mistakes they make but how often they try.”

Generating profit was rewarded fabulously at Enron. Its executives and directors sold $1 billion worth of shares in the three years before the company collapsed; the company secretary who was in charge of organising board meetings and taking the official minutes was paid $600,000 per annum in salary and bonuses. One executive sold $270 million worth of shares in his last 16 months with the company.

Those who failed were culled; Enron liked to hire ‘guys with spikes’; team players were not required; there were lots of ‘designers of ditches’ but few ‘diggers of ditches’. The workplace was described as ‘deeply dysfunctional’, with creativity running wild – a mixture of brains and hubris – but with an absence of grey hairs and structure.

Enron was not cost-conscious, regarding itself as the ‘Mercedes Benz of the natural gas business not the Wal-Mart’. And the CEO said, “If you are focusing on cost you are ****ing up.” Eventually spending was seen as largely out of control and in 2000 a procurement czar was appointed to get a grip. He established that Enron was spending $750 million per annum on consultants alone.

The gap between the profit levels that managers knew they could deliver to the bottom line and the profit levels their bosses demanded that they deliver was known internally as the ‘stretch’. Even the Tax Department made a huge and unique contribution to the bottom line by engineering a range of intricate tax reduction transactions, which contributed $1 billion to profits between 1995 and 2000.

During the 1990s, Enron’s revenues increased twenty-fold standing at $101 billion dollars in 2000. It was also in 2000 that Enron’s share price peaked at more than $90. This apparently miraculous success story was greeted with astonishment from investors. With the share price soaring 1,700% in 16 years, the analysts were gushing in their praise: “Enron has built unique and, in our view, extraordinary franchises in several business units in very large markets.” The Economist profiled Ken Lay as the ‘Energetic Messiah’. And Fortune magazine ranked Enron, as the US’s most innovative company every year between 1996 and 2001.

Yet amongst all the hype and praise there were doubters. A JP Morgan market strategist said that, “Enron is an earnings at risk story – if it doesn't meet earnings targets, the stock could implode.” Others were concerned about the lack of clarity in Enron’s financial reporting, which “raises a red flag about Enron’s pricey stock.”

'Clever accounting' led to inevitable collapse

In hindsight, it has been seen that the role of Enron’s Chief Financial Officer was really about creating the financial structures that would enable it to meet its profit targets. According to a former Enron accountant, “there was an absolute conviction at Enron that clever accounting could alter the business reality.” Clever accounting in this case meant raising investment against its own assets and stock in order to maintain the impression of a successful enterprise. Enron was able to legally remove losses from its books by passing the assets to independent partnerships.

Similarly, investment money flowing into Enron from new partnerships was treated as profit even though it was linked to specific ventures that were not yet running. For example, $110 million venture capital cash to develop the distribution of Blockbuster Videos through broadband connections was
posted as profit.

In the end the skeptics were right. Enron’s share price started to decline in the wake of the dot-com deflation and energy price instability. In the second half of 2001, as more information came into the public domain, the Enron share price collapsed and the business filed for bankruptcy with $38 billion worth of debt.

Whilst we can discern in the Enron debacle the sources of hubris – narcissism, uncritical acceptance of accolades and a feeling of exemption from the normal rules – it would be a mistake to accept that as a full explanation. The US Senate conducted an enquiry into the role of the board of directors in Enron’s collapse. The investigation found that Enron’s directors were guilty of fiduciary failure by:

• Knowingly allowing Enron to engage in high risk accounting practices;
• Approving clear conflicts of interest;
• Knowingly allowing Enron to conduct billions of dollars in off the books activity to make its financial condition appear better than it was.

The investigation also found that the Board compromised its independence by allowing financial ties between the company and certain Board members; the Board also failed to ensure the independence of the company’s auditor by allowing them to provide internal audit and consultancy services whilst serving as Enron’s outside auditor. In fact, the Board’s own investigation took a much more benign view of its own role. Whichever way you look at it, the failure of leadership and governance on a grand scale, and the toxic shock it caused to Enron, was fatal.

Learning from the Enron experience

Enron’s approach to governance appeared to be one of ‘face’ rather than one of ensuring an integral coherence in values or, if you like, style rather than substance. Enron’s demise seems to demonstrate a failure in board performance to ensure a robust link between internal and external governance, as illustrated below.

ER Consultants have experience in using bespoke frameworks and toolkits that are effective in assisting Boards to ensure a robust coherence between the objectives of external governance and internal behaviours. We have a proven approach to Board Audit, which is flexible and is based on the circumstances of each particular business. It is built upon frameworks relating to Board performance review, Board member review and Board committee evaluation and the approach provides the ability for benchmarking and an external calibration of performance. Furthermore, ER Consultants’ Integrity Toolkit has proved to be invaluable in creating confidence in the current interrelationships between internal and external governance. Reference to the diagram below (Figure 2), shows how our Integrity Toolkit
can really add value to governance issues by offering a sophisticated means of assessing the current interrelationships between external and internal governance.

For further information about ER Consultants’ approach to Corporate Governance and our work with Boards of Directors, contact mark.goodridge@erconsultants.co.uk