New scandals, old lessons financial ethics after Enron. (Ethics).

In 1997, former Christian Coalition leader Ralph Reed joined Enron Corp. as a consultant, apparently to help Enron build support for electricity deregulation in Pennsylvania. Perhaps Reed might have been more usefully employed had he compiled a reading list for Enron's board, brass, auditors, analysts and attorneys, such as the passage from Biblical Book of Proverbs that notes: "The false witness will not go unpunished; the man who utters lies will meet his end."

Of course, the Enron story was not simply about people telling lies and getting due comeuppance. In the first place, technically speaking, no one has proven that anyone at Enron lied or even failed to disclose problems. "It was easy to meet your legal responsibility for disclosing what happened, but also easy to know nobody would understand it," remarks Alan Anderson, senior vice president and Member in Public Interest of the American Institute of Certified Public Accountants. Especially when those few who could understand -- analysts and auditors, in particular -- weren't eager to make waves by clueing in the general public.

Secondly, those who appear to have suffered most from Enron's fall were not the masters of manipulated numbers but innocent bystanders guilty of nothing more than investing in Enron stock, especially through the company's 401(k) program. Pedro Reinhard, executive vice president and CFO of Dow Chemical Co., fumes that Enron's former management seems to have gotten off lightly. "At the end of the day, we've seen that the ones that have committed the offenses are still walking around and managing their own fortunes," he says.

The Enron story doesn't quite fit the mold of a good old-fashioned morality tale. It's much worse than that. One of the world's biggest and most admired corporations imploded, scandalously. Collateral damage included not only the destruction of a once-reputable Big Five audit firm but also any lingering post-tech-bubble faith in the integrity of securities analysts, as well as rampant growth of suspicion about much current corporate reporting. Despite evidence of economic recovery, stock prices have stalled -- many say because investors lack confidence in the general integrity of those who prepare, vet and/or analyze financial information.

"Enron is a very vivid illustration of how fundamental ethical standards are to a well-functioning capitalist system," says Prof. Lynn SharpPaine, John G. McLean Professor of Business Administration at Harvard Business School. "Ethics are necessary for trust, and without trust the whole thing falls apart."

Enron also puts some of the most cherished business orthodoxies of the past two decades in a harsh new light. Take, for example, the notion that managers should think like shareholders. "Enron shows the dangers or risks involved in trying to align everybody's financial interest," Paine says. "In this case, we have not only managers with incentives tied heavily to investors' interests, but also legal advisors, financial advisors, accountants. When everybody's financial interest is aligned, it makes it difficult for anybody in the system to say 'these other considerations should take priority.'"

Reconsider, too, the notion that managers should think like entrepreneurs. "Enron had a slogan that everybody was always to ask 'why?'" notes Daryl Koehn, executive director of the Center for Business Ethics in Enron's hometown, Houston. "On the one hand, it's good to encourage people to be inquisitive, but on the other hand, asking 'Why?' can slip into asking 'Why not?' If you're not careful, entrepreneurial cultures can become cultures of contempt." Entrepreneurs have to believe they're smart enough to see opportunities others have overlooked, Koehn says, but confidence can morph into hubris.

As has been widely reported, Enron had a voluminous code of ethics. But when the code got in the way of doing what management wanted done, Enron's board was easily persuaded to lay aside certain provisions of that code -- most notoriously, the conflict-of-interest provision. "The company was riddled with conflicts," Koehn says, "What's the point of having a conflict of interest policy if you're going to overturn it when an executive asks?"

Unfortunately, the answer suggests that other companies might easily find themselves, despite good intentions and strong ethical codes, on a path similar to Enron's.

Defining Moments

Koehn suggests that Enron, like many other companies, developed what she calls a "good times" code of ethics that "presupposes that everything is going well with the core business, but doesn't address what happens when the core business is under attack."

Joseph Badaracco, the John Shad Professor of Business Ethics at Harvard Business School, speaks similarly of the defining moment when Enron's managers realized that the core business wasn't what they had led investors to expect.

"Until recently, a lot of people believed quite sincerely that what Enron was doing was of real value," he explains. "They really believed they were on a crusade, innovating, getting traditional practices out of the energy business, and liberating a lot of capital. The defining moment came when they realized the business model wasn't working in the range of businesses they'd committed to make it work in, and told themselves 'we can either admit that and the stock goes down by 75 percent, or we can manufacture profits and hope, or we can merge with somebody who has real assets and real cash flow.'"

The first alternative, just telling the truth, was unthinkable -- as it often has been for many other companies ("Tone at the Top," next page).

So in 1999, Enron began to push the generally accepted accounting principles envelope to the breaking point with special-purpose entities that effectively masked the company's true financial condition. Auditor Arthur Anderson, in what it later called an "error," approved Enron's decision not to consolidate the derivative-related liabilities of these entities with the corporation's overall liabilities. As we now know, these entities not only enriched key Enron executives, but also hid the fact that Enron was massively at risk.

Badaracco suggests it's no coincidence that, also in 1999, Enron tried to negotiate a merger of equals with German utility Veba. "I think at that point, folks at Enron realized that all they had was an overvalued stock, and if they could swap it for real assets, it was better than faking numbers indefinitely," Badaracco conjectures. But negotiations collapsed.

According to The New York Times, a team from PricewaterhouseCoopers conducted due diligence and advised Veba that Enron's complex accounting concealed a house of cards. Reportedly, the PwC team calculated a debt/equity ratio of 70-75 percent, much higher than the 54.1 percent apparent from the company's financial reports.

Alasdair MacIntyre, a philosophy professor at the University of Notre Dame recognized as one of the most important moral philosophers of the 20th century, says Enron's failure is not surprising. "The problem with Enron was, in part, that people trusted those whom they had no good reason to trust," MacIntyre explains. "No code ever works unless its operation is embedded in a culture, and accepted by those in the culture.

"Culture takes time to develop. It involves habits of mind and action that are only produced as a result of the development of ways of doing things over time." In short, Enron had a code of ethics without a culture of ethics.

This past March, FEI issued recommendations for reform in the wake of the headline-making scandals at Enron and elsewhere. Included was a revised code of ethics that requires financial executives to actively promote ethical behavior in their organizations.

Some began immediately. "We took those recommendations and code of conduct and asked all of our employees in finance to sign on to it," says Dow's Reinhard, who served on the FEI committee that drafted the code. "We have a hotline and an ethics compliance committee monitored by third parties, where they can go to blow the whistle if they see something wrong."

But it's important to note that Dow is no recent convert to ethical business. The company already has a strongly rooted culture that encourages people to do the right thing, even when it costs money. Early in his career, Reinhard was country manager for Dow's Italian operations, making it clear when he took the job that Dow would sacrifice business rather than engage in conduct that, while common in Italy, didn't meet Dow's ethical standards. "It was clear at the outset that we lost some business," Reinhard recalls. "But when scandals came up with government officials in Italy, Dow's name never got mentioned."

Lynn Paine points out that the ethical challenge to most contemporary businesses isn't the lack of clearly articulated codes of ethics, but the absence of any clear link between the codes and the daily operations. "That's why I suggest the importance of building adherence to standards into management systems, into performance evaluation, compensation, audit and control," she says.

When Richard Schrader thinks of ethical cultures, he harks back to his West Point and military years. The executive vice president and CFO of Parsons Brinckerhoff, who chairs FEI's Ethics and Eligibility Committee, says, "One thing they instilled is that it's critical to have integrity in relationship situations. If you call somebody and say 'Have you secured XYZ?' and they say 'yes,' you want to know you can believe them. I can tell you that military officers who were unethical were ostracized, no question." That's a response he works to inculcate in his present organizational culture.

Ethical characteristics and integrity have not tended to be high on executive search want-lists, though Schrader thinks that's likely to change. "What we're going to see is a re-introduction of integrity as a musthave," he predicts. "If there are people without integrity, I don't want them in my organization. An SOB is one thing, but an SOB can have integrity. I'm talking about the backstabber, the deceptive person, the liar -- you can't have that. If you tolerate that, you are clearly diluting the ethical values of your organization, whatever organization it is."

Prescriptions for Change

Although everyone interviewed for this story agreed that building a more ethical and trustworthy financial system will require widespread changes in the way organizations work, all were skeptical about the wave of legislative and regulatory proposals from Washington.

"I think just as important as what the rules are is who produces them," says Badaracco. "The problem with government is that the rules it produces tend to be late, influenced by all kinds of groups and lobbyists, and clever people can find ways around them. To the extent new standards can be imposed by players in the market, smart, with a lot of money at stake -- that discipline, in the long run, is the most valuable discipline."

Although he's cautious about the rush to legislate and regulate, Reinhard suggests that raising the stakes for top management might provide a deterrent to unethical conduct. "There must be a reconsideration of how the system works," he says. "Italy has an interesting rule. We in the States don't pride ourselves on copying rules, but in Italy, if something goes wrong, the managing director is in jail as a starter. That raises the attention level."

Considering the vast number of people willing to risk serious jail time for a lot less money than, say, former Enron CFO Andrew Fastow made on just one of his partnerships, one has to wonder. It's worth keeping in mind that no one suggested he'd done anything wrong until the stock went down.

RELATED ARTICLE: Tone at the Top

"Lack of ethical conduct and inappropriate 'tone at the top"' headed the list of factors that FEI identified as contributing to the recent wave of corporate scandals. But do CEOs and CFOs set themselves up for ethical pratfall; just by doing what almost everyone takes for granted -- trying to meet Wall Street's expectations?

Maybe, says Michael C. Jensen, Jesse Isidor Straus Professor Emeritus at Harvard Business School and managing director of Monitor Consulting Group's Organizational Strategy practice. "The problem comes when people get excited about a company and make projections that are unrealistically high, impossible to fulfill," Jensen explains. "Most managers can't imagine that having their stock overpriced is a bad thing, but it is bad."

Enron clearly wasn't alone in using creative accounting and intimidating analysts in order to avoid revealing that the company couldn't perform at the impossibly high levels implied by its stock price. Companies in several sectors -- the Internet, telecommunications and, of course, energy -- have generated scandalous headlines after similar over-valuations. Jensen believes the reason is not simply an unethical tone, but the natural tendency of managers to strain to meet the market's "stretch goals."

"What drives it is the unwillingness of human beings to incur short-term pain in order to get long-term gain. CEOs and CFOs are just as subject to that as anybody else. Having to stand up and say, 'We're not that good, not as good as you think, we can't do that' is like Ulysses tying himself to the mast.

"But unless you correct it or stop the organizational dynamic the overpricing creates, we'll witness a set of organizational actions that will damage the firm, sometimes severely, and lose not only the overvaluation but also a substantial amount of what was there to start with."

The phenomenon wasn't just limited to high-flying tech firms in a market bubble. Even a long-established company like Gillette Co. got caught up in it. So said newly appointed Gillette CEO James Kilts when he refused to give analysts earnings guidance in his first appearance before them in June 2001. Instead, he criticized his predecessors for trying to meet unrealistic earnings per share targets by raising prices and cutting advertising, measures that caused a drop in sales and a buildup of inventory, and left the company in crisis.

"The analysts that Kilts was standing in front of were shocked when he refused to make a forecast, but it takes that kind of break. Others can do it in different ways, but the more that do it, the easier it will become," Jensen says. "First, they have to recognize that they are taking risks with the not-very-far-run future by trying to reach stretch goals the analysts are setting. Enron didn't have to end that way. They put at risk their most valuable assets. They were innovators, but to justify a $70 billion total valuation they took bets and played games with accounting and reporting that destroyed the core asset, reputation. That didn't have to happen."

Gregory J. Millman is a freelance business writer in New Jersey who writes regularly for Financial Executive. He can be reached at [e-mail].