Enron’s Board Gives Black Eye to Efforts Aimed at Improving Corporate GovernancePublished: February 13, 2002 in Knowledge@Wharton
The deception, hubris and possible criminal fraud that led to the decline and fall of Enron was bad enough, say several Wharton faculty members and a former CEO. But just as appalling was the performance of Enron’s board of directors.
By not keeping Enron from barreling down the wrong track to a rendezvous with catastrophe, the board has given a black eye to efforts by other American firms to improve corporate governance in recent years.
The failure of the Enron board should send a strong signal to directors at other companies that they must be energetic in questioning management about suspect or little understood activities that can harm the company, these observers say.
"I feel absolute and complete disgust" at the Enron scandal, says Robert H. Campbell, former chairman and CEO of Sunoco, the Philadelphia-based energy company. "The fallout from this is just going to be unbelievable, even beyond the impact on shareholders, employees and creditors of Enron." Campbell says Enron’s activities confirm the stereotypical view of boards, a view that is much less true today than years ago. "People used to be on numerous boards," he says. "Being on a board was like having a merit badge. You’d fly in for dinner, pat the CEO on the butt and fly out."
Adds Michael Useem, head of Wharton’s Center for Leadership and Change Management: "Kmart and Global Crossing have gone bankrupt, but those bankruptcies were a product of poor management and unrealized expectations. Those events were a 3.0 on the corporate Richter scale. Enron is more like 8.0."
Campbell, Useem and two other faculty members – finance professor Franklin Allen and Robert E. Mittelstaedt Jr., vice dean and director of Wharton’s Aresty Institute of Executive Education – said all of the board members should resign. Their comments were made prior to the announcement on Tuesday that six of Enron's directors are in fact resigning, effective March 12. The six include four people who sit on the company’s beleaguered audit committee. Once the resignations take effect, Enron will be left with eight board members. Enron said it would search for a non-executive chairman and new candidates to join the board and assist in the restructuring process.
It is not surprising that some directors are staying on the job as the company tries to emerge from bankruptcy court protection. But Campbell and the three faculty members say all of the directors should eventually step aside. "I would expect them all to step down within a year," says Allen. "At some point, they all should publicly acknowledge that they messed up."
Allen says that even board member William C. Powers Jr. should resign. Powers was chairman of a special three-member Enron committee that investigated transactions between Enron and its controversial investment partnerships and issued a report critical of the company’s senior management.
The Powers report represents an attempt by the board to ferret out and disclose some details of what went wrong inside Enron. "It’s remarkably hard-hitting, which is a sign of how big the inside problem was," Useem says. But he adds that there is an "awkwardness" about the report because it was written by board members. "That’s an inherently insider document and you have to read it like that."
Those interviewed – all of whom except Useem serve on boards – acknowledge that it is simply not possible for directors, who typically meet six to eight times a year, to know everything that takes place inside the companies they serve. Yet there are times when they must be more assertive. The unwillingness to challenge management by asking tough questions is one of the shortcomings of boards across corporate America.
"It is very difficult to be a member of an audit committee when you know there are questions you need to be asking but you can only ask them in a general sense because you’re not in the company every day," says Mittelstaedt, who sits on two such committees. "But there are some things that raise big red flags. When Enron crossed the line and got into self-dealing in setting up partnerships that had corporate executives as general partners, they clearly crossed the boundary of good business practice. Once they did that, the board should have asked for far more detailed information."
The big question from a governance standpoint, Mittelstaedt adds, "is what would have happened if this board had the guts to step up to this problem [when Enron employee Sherron Watkins wrote the now-famous memo to former CEO Kenneth Lay that raised questions about Enron’s accounting practices], and make Lay perform or fire him at that point? Would they have saved the company and the jobs of the people who were there and perhaps been able to rebuild it?"
Useem, Mittelstaedt and Campbell say it was inappropriate for some members of Enron’s board to serve as directors at the same time that Enron made donations to not-for-profit organizations with which they were associated. Such arrangements can lead to conflicts of interest, they say, and render a director less than independent.
For example, Powers, who joined Enron’s board last year, is dean of the University of Texas School of Law, which has received $252,000 from Enron since 1996. Another Enron director, John Mendelsohn, is president of the University of Texas M.D. Anderson Cancer Center. The center has received $92,500 from the Enron Foundation since Mendelsohn joined Enron’s board, according to The New York Times. In addition, according to the newspaper, the Linda and Ken Lay Family Foundation gave the center $240,250 since Mendelsohn became its president.
Allen, however, expressed some disagreement. He says conflict-of-interest issues would arise only if the amount of money donated to an organization contributed a substantial percentage of an organization’s budget. "The Powers case doesn’t sound egregious to me," Allen says. "And for a cancer center, I would imagine that [Enron’s contribution] is a fairly small proportion of the budget."
The Times quoted Mendelsohn as saying: "During that same period, we’ve gotten pledges and gifts of more than $233 million. Every gift is important, but our operating budget is $1.4 billion."
The Enron case underscores the need for corporate boards to be mindful of their purpose and to address existing and potential problems before they explode:
Boards exist to represent the interests of shareholders, not management. "Above all, it is the board’s sacred duty to protect shareholders’ equity," Useem says. "And their first action to ensure that is to pick the right CEO and to review his or her choices for the top management team. Enron’s board did not see that they had a couple of scoundrels, one in the role of chief financial officer [former CFO Andrew Fastow], in their midst." Directors also must have the courage to stand up to domineering CEOs.
Companies must adopt strong ethics codes and directors must stand firmly behind them. "You need a culture that reminds everybody that not only can’t they break the law or the ethics code, they can’t even get close to the edge," Useem says. "After putting the right people in place, the second thing board members have to do is make sure they establish and reinforce the principles by which the company is to be run."
Enron’s ethics code apparently had weaknesses. The Powers report said Enron’s board had approved the arrangements that allowed Fastow, who allegedly collected $30 million in improper payments, to serve as general partner in controversial partnerships that participated in financial transactions with Enron. Oddly, Enron’s Code of Conduct of Business allowed Fastow to do so – as long as he obtained permission from the board, which had the power to waive the ethics code.
Campbell, the former Sunoco CEO, says he was stunned that an ethics policy would be so weak as to permit such activity. "If you can put aside the ethics policy, then you have no ethics policy," Campbell says. "In my wildest dreams, I can’t imagine how a director can sit there and approve that. It seems that if that kind of thing is proposed, a director has to stand up and scream ‘no’. And if they approve it, you walk the hell out."
Boards should not automatically retain the same outside auditor year after year just because they feel comfortable with the arrangement. "First, you need to remind auditing firms that they work for the board, shareholders and the audit committee – not management," Campbell says. "Second, when you sign up an auditor for five or seven years, you let them know that at the end of that time, you’re going to re-bid the contract with other auditors. You may decide to bring back the same firm, but at least you’ve gone and looked at others."
Board members should bring different skills to the table. Active CEOs can strengthen a board. Other attractive board prospects: retired executives from other companies, who can devote a lot of time to their board responsibilities, and former officials from the public sector who know their way around the regulatory environment. Less appealing as directors are retired executives from inside a company. The board should be seen as a resource to help management lead a company in a complex world. Says Useem: "Good governance means having lots of independent directors."
The board should periodically, perhaps once a year, meet without the chairman or managers present. Such an arrangement would give directors a chance to discuss important issues in an atmosphere of candor and independence.
Directors should not be afraid to trust common sense and gut feelings. "People who have never sat in a boardroom don’t realize that it’s not always an objective process," Mittelstaedt says. "Some board actions are based on quantitative data and analysis. But other things have to do with understanding human relationships. Sometimes you have to ask yourself, ‘Is there something here that requires further investigation? Is there a creeping cancer we haven’t identified yet?’ You have to be careful how you raise these questions because once you raise them you change the tenor of the relationship with the management team. But sometimes the issues have to be raised. At Enron, no one felt very compelled to raise questions. That’s what I find stunning."
Campbell says companies have made great strides in recent years in addressing the need for better corporate governance. "CEOs and chairmen view boards in one of two ways. It’s a necessity required by the [Securities and Exchange Commission]. Or it’s a resource you ought to tap into to help you lead your company in a complex world. I think in recent years more CEOs have come to see boards as a resource."