How to Restore the Trust

Wednesday, October 30, 2002
Illustration by Taylor Jones for the Hoover Digest.

The best outcome of Enron’s collapse would be to confirm ethics as crucial to business decision making. Rather than an isolated occurrence, Enron has become a symbol for a rash of incidents demonstrating corporate greed and distrust.

The bad practices at Enron did not emerge all at once but developed incrementally. Innovation and success can generate a hubris that distorts reality. Only people of exceptionally strong ethical discernment, courage, and character will blow the whistle when, at least superficially, everything appears to be going well. In finance, Gresham’s Law states that bad currency drives out good currency. Likewise, without ethical leadership, bad practices can drive out good ones.

Large public accounting firms, for example, have gradually changed their role from obstruction (telling clients what they cannot do) to facilitation (helping clients to “interpret” laws and regulations). There is increased pressure to conform to the wishes of aggressive clients because there is always the shadow of another accounting firm that will do what the client wants. At the same time, as is the case at law firms, billable hours become increasingly important to accounting firms, as do “value-added” and “success-fee” billings, which ignore hours and seek to obtain a percentage of additional revenues generated. With an eye toward the ongoing success of management consulting firms such as McKinsey & Company and Boston Consulting Group, public accounting firms have engaged in the higher-margin business of consulting, and the revenues generated have become more important than accounting fees. In theory, accounting and consulting can be maintained in the same firm, so long as the conflicts are identified and a culture is created to manage them. Investment banks are filled with conflicts, but the best firms actively manage them. The gradual deterioration of the independence of stock analysts within investment banks, however, is another example of bad practices prevailing over good ones. Enron appears to have suffered a pandemic of bad practices engaged in by its senior management, public accountants, board of directors, and independent law firm.

A great deal of the upcoming public discourse concerning Enron will focus on whether laws were broken and who broke them. During the insider trading scandals of the 1980s, individuals such as Drexel Burnham Lambert’s Michael Milken were imprisoned on arcane and highly technical infractions of securities regulations. The issues were murky enough to allow some of those convicted to continue to protest their innocence after their release from prison.

The situation is similar with Enron: The rules and regulations have not been written definitively to cover all the technicalities of hedging and use of derivatives, and Enron appears to have created some de novo. Professionals can argue about the extreme limits of “shell corporations”; many industrial corporations and financial institutions have failed to disclose fully their off-balance-sheet liabilities; and there are plenty of weak boards of directors. Like some Enron executives, movie stars and athletes are sometimes paid unconscionable sums in relation to their contributions to society. However, the main issue at Enron, as it was with the insider trading scandals, does not lie in technical aspects of laws and regulations; one can live within them and still commit fraud. Like insider trading, fraud is a state of mind, and a state of mind is beyond the scope of the legal system. The great crime at Enron is the breaking of the public trust.

In the insider trading scandals, the public became incensed at the hubris, greed, and abuse of power and insisted that something, anything, be done to stop the excesses. As generations change, so do the types of behavior the public can condone, and the public has changed its attitude toward insider trading, monopolistic behavior, price fixing, payment of taxes for part-time help, and the like. Thirty years ago, the U.S. Supreme Court ruled that it was not a violation of insider trading rules for a chief investment officer of a financial institution to “front run” the news tape, giving him or her advance knowledge, or to purchase stock in a corporation for the institution’s pension fund clients, because he or she had not personally gained from the transaction. In recent years, just overhearing a conversation about a stock and acting on it could send one to prison. That is an immense swing in public attitude from what once was expressed by the nation’s highest court. Those who live close to the edge can find themselves in deep trouble when society’s attitudes change.

The insider trading issue was so important in the 1980s that a partner of Goldman Sachs and two employees of Kidder, Peabody were handcuffed on their respective trading floors and their photos plastered on the front pages of newspapers. The Goldman Sachs partner went to prison, though the firm continues to protest his conviction, but the two from Kidder were never indicted. Soon afterward, the chief agents of the U.S. Treasury, the Securities and Exchange Commission, and the Federal Reserve Bank of New York convinced the money-center banks to pull in their overnight broker call loans to Drexel. Drexel was left short of funds and could no longer use overnight bank borrowing to fund long-duration positions of junk bonds. The withdrawal of bank support caused Drexel to declare bankruptcy, and 10,000 employees lost their jobs. In effect, the federal government caused Drexel to cease business just as in the more recent situation at Arthur Andersen.

Why did society throw everything it had at the suspects in this scandal? The issue was the breaking of public trust. America has the deepest, most transparent capital market in the world, and that market is based on trust. Trillions of dollars trade by phone or computer, with paperwork following a few days later. When settlement occurs, one party is in the money and the other party is out of the money. If the lost trust in the capital market system had not been restored, the country never would have experienced the economic growth of the 1990s and individuals would not have returned to the market with their retirement plans.

The Enron situation has raised issues of public trust in respect to public accounting firms, law firms, management consulting firms, boards of directors, financial reporting, business leadership, and the stock market itself. In this age of globalization of money and capital markets, the U.S. capital markets are looked upon throughout the world as the model to be emulated. Enron thus broke trust with institutions throughout the world.

In the Divine Comedy, Dante reserved the lowest circles of hell for public leaders who committed fraud; the lesser crimes—lust, avarice, and the like—were punished less severely. Leaders of large, publicly held companies, especially those who have the gall to claim they are “reinventing” American business, have a huge responsibility to the public that goes far beyond obeying the law. It is a privilege to operate in a position of leadership and power and to reap vast rewards from this society and its market system. Those who set themselves above the will and the trust of the people to focus primarily on themselves are guilty of a sin that goes beyond the law, and society will punish them for it.

An essential quality of professionalism is an enduring ethic that causes the public in general to trust a person’s work. A professional leader must have a set of core values that transcend the drive for wealth or success and that allow him or her to have both the ethical sensitivity and the imagination to perceive a problem and the courage to speak out about it. Such leadership was lacking not only within Enron but in its board of directors and the professionals who advised the firm. A leader, both explicitly and implicitly, creates a context for good or bad practices, and a leader’s actions carry far greater weight than written corporate policies. Certainly unwittingly, Salomon Brothers CEO John Gutfreund, by encouraging macho, high-stakes “liar’s poker” in the 1990s, condoned and strengthened a reckless trading culture at the investment firm that led to the commitment of fraud against the U.S. Treasury. This constituted a breach of public trust of the most serious magnitude, and it cost Gutfreund his job and reputation and Salomon Brothers its independence, almost putting the firm out of business. Arthur Andersen has followed the same course.

Although the jury is still out, the leaders at Enron appeared to encourage a reckless, no-holds-barred trading culture in many ways, not the least of which was encouraging the establishment of a fake trading floor, staffed with clerical and support help, to defraud visiting financial analysts and bond rating agencies. One senses from reports that the leaders at Enron winked at excesses such as bending the accounting and reporting rules. The law was viewed not as a constraint but as something to be gotten around. One employee was quoted in the press as saying Enron “used the accounting rules to make money.”

It is the responsibility of leaders to set limits and establish controls. At its highest level, the role of leadership is to establish a transcendent goal for the enterprise that rises above annual bonuses and momentary success. If leaders encourage employees to take risks, they must back them up when the employees make mistakes, and they must vigilantly help them establish limits, taking full responsibility for employees’ errors in judgment. The oft-quoted phrase of senior management, “I am not an accountant,” is an abrogation of a leader’s responsibility. It is a huge mistake to base annual bonus payouts—which appeared to drive the culture at Enron, just as they do at investment banks—purely on production. Management must retain the discretion to reward and punish professionals based on such criteria as skills in leadership, ethics, training, recruiting, and mentoring. Otherwise, management abandons its role and the inmates control the institution.

The best companies have an almost covenantal leadership structure in which employees know where they stand and what their roles are through both articulated and tacit agreements with management. Such covenantal expectations cannot be forged when a crisis hits but are built over time through consistent behavior. Otherwise, when a crisis occurs, the firm splinters, with every employee operating for herself or himself. A true leader has a deep sense of purpose, calm, and even detachment during a crisis; the aura of trust that has been built up sustains leadership among employees during a time of high anxiety and stress. At Enron, in contrast, the atmosphere seemed to have been one of chaos and confusion, leading to shredding, bailouts, last-minute bonuses, and hasty, false reassurances that all was well.

Recent studies have confirmed that what employees really want from a job is a sense of fulfillment, trust, and personal growth. Money and status are important but less so. Through its lack of leadership, Enron’s senior managers not only broke trust with the public but also with their principal asset, the thousands of employees and stockholders who mistakenly placed their faith in them. It will be interesting to see how the various Enron stakeholders assert their claims for justice.

An entity is either trustworthy or it is not trustworthy. Trust is not easily created, but it is easily destroyed. It is not easily taught; it certainly cannot be legislated. The proper response to the Enron fiasco is not to pile on more laws and regulations; they can be twisted as easily as the old ones by those who wish to commit fraud. Instead, the country needs to rethink the role of the accounting profession and the transparency of financial reporting. More than that, the country needs to honor leadership and values in its business community and in its professions. The teaching of organizational ethics in graduate schools of law and business has been problematic at best; perhaps as a result of the recent round of scandals, it will become possible to elevate the teaching of ethical awareness and sensitivity at such institutions. The best outcome of the Enron mess would be to validate ethics as a crucial component in making business decisions.