21 Jul 2006  Op-Ed

Enron Jury Sent the Right Message

Although the actions of Enron's executives were in many areas neither clearly legal nor illegal, jurors sent an unambiguous message that all executives should heed: Truth telling and ethical discipline are the cornerstone values in corporate governance. Key concepts include:

  • Executives can be convicted in a court of law for a pattern of deception, even when it is not illegal.
  • Firms that focus on exploiting the rules rather than building a sound business often lose their way.

 

The most noteworthy message of the Enron trial is that corporate executives can be convicted in a court of law for a pattern of deception that may or may not be illegal. Left unaddressed in the trial were many financial transactions and accounting decisions of debatable legality. The prosecution chose to avoid a scholastic examination of these mind-numbingly complex maneuvers and Enron's observance of equally complex Generally Accepted Accounting Principles and SEC rules.

Following the lead of federal prosecutors, the jury resoundingly concluded that in determining guilt or innocence in cases of corporate fraud, considerations of intent dominate the details of compliance or noncompliance with arcane legal rules.

This is the right message to send to the American business community. The behavior that became so widespread and toxic at Enron is not unique to Enron. Many executives (not to mention those who engage in other competitive endeavors) are fixated on exploiting rules to their advantage, instead of thinking about how best to build a sound business while complying with the principles that underlie the legal rules. And this is where they often lose their way.

This reading of the Enron case should not be taken as a one-off judgment by a business school professor. Many years ago, at the dedication of the Harvard Business School campus on June 24, 1927, Owen Young—a lawyer, visionary capitalist, founding chairman of RCA, and at that time the chairman of General Electric—described how American business raises public suspicions and loses public support: "[T]he law is not a satisfactory censor," he said. "It functions in the clear light of wrong-doing—things so wrong that the community must protect itself against them. Set over against the law on the opposite side is the clear light of right-doing—things which are so generally appealing to the conscience of all that no mistake could be made, no matter how complicated the business. The area of difficulty for business lies in the penumbra between the two."

Principles-based society

Enron operated in that shadowy area between the clear light of right-doing and the clear light of wrong-doing. What the jurors in Houston in effect told us is to forget about pushing the limits of legal compliance. They told us that what we need is a more centered theory of corporate behavior. They reminded us that, at the end of the day, we are a principles-based society rather than a rules-based society, even though rules and referees are important.

Enron's senior management straddled many gradations of ethical and legal behavior. At one end of the spectrum, where no charges of either unethical or illegal behavior could possibly arise, lie many examples of highly innovative management: the successful intermediation of the natural gas market, the "gas bank" created by Jeff Skilling, the development of standardized commodity contracts, and the creation of EnronOnline, the Web-based trading platform that made Enron the top buyer and seller of gas and electricity in the United States and Europe in its first year of operation.

Many examples of extremely inept management are also positioned here—activities for which there is no criminal liability: the na´ve extrapolation of the successful natural gas strategy to the water and broadband businesses, the unprofitable international power development strategy, the perverse financial incentives for executives, the aggressive use of mark-to-market accounting, the performance guarantees in the power plant construction business, the noneconomic hedges, the breakdowns in the company's performance review and internal control processes, the intolerance of internal dissent, and the inability of Lay and Skilling to face the reality of Enron's true financial condition. But under U.S. law, bad management and poor business judgments—at Enron and elsewhere—are not criminalized.

Enron operated in that shadowy area between the clear light of right-doing and the clear light of wrong-doing.

Toward the opposite end of the spectrum are many examples of devious management that are not clearly illegal: the use of off-balance-sheet partnerships and reserves to "manage" reported earnings, the recategorization of investments to enable gains to be booked on the company's income statements, the reorganization of business structures to conceal business failures, the use of "prepay transactions" to bolster reported earnings and disguise debt, and the opaque disclosure and reporting of a wide variety of structured finance transactions and related accounting practices, to name just a few.

Many of these practices are actually "close calls" in a legal sense, because reasonable parties may differ about whether they are actually unlawful. They exemplify what Owen Young was talking about almost eighty years ago. The jury decided, however, that the exquisite legal arguments surrounding these and similar transactions were secondary to their perception of persistent attempts by Enron's leaders to mask the company's declining performance. In doing so, the jury sent an unambiguous message that truth telling and ethical discipline must remain the cornerstone values in the governance of firms.

About the author

Harvard Business School professor emeritus Malcolm Salter is the author of the forthcoming book Innovation Corrupted: The Origins and Legacy of Enron's Collapse (Harvard University Press).