In the last year months, the financial markets and investor confidence have been devastated by a series of corporate accounting scandals. The names Enron and Worldcom are no longer respected blue chip titans in the field of energy trading and telecommunications, respectively. To the contrary, accounting malfeasance by a few senior officers has not only consigned these names to the hall of shame, it has driven both entities into Chapter 11. Whether either corporation will survive remains to be seen.
As this article is being written, the extent of the macroeconomic impact of these implosions on the equity markets is still being determined, with the major equity market indexes hitting new lows daily. Although no single constituency is driving this decline, this may be an instance where the Wall Street insiders are in the vanguard of the retreat. Market insiders recognize that publicly held corporations in this country already labor under what is arguably the most complex and comprehensive web of Federal and state corporate disclosure laws in the world. Accordingly, an institutional investor undoubtedly finds it particularly incomprehensible that financial shenanigans of the magnitude perpetrated by Enron and Worldcom could have evaded discovery for years. This in turn raises the destabilizing question: Can the investing public have confidence in the financial statements issued by publicly held corporate America? I would suggest that this basic concern, more than any other factor, is driving the equity markets to subterranean levels.
The historic magnitude of the Enron and Worldcom scandals has generated a tide of commentary from a host of political and financial pundits. The perennial antagonists of corporate America are ecstatic, believing they now have leverage to implement the regulatory equivalent of the Code of Draco. Corporate America’s supporters are either changing their spots, or running for cover. In this blizzard of politically and ideologically charged rhetoric, the commentator calling for a reasoned analysis, or worse still, a solution that actually addresses the problem, is “vox clamantis in deserto”. This article sidesteps this entire debate and instead focuses on the fundamental business wrongs that precipitated the Enron and Worldcom disasters, and suggests that these tragedies provide every business, large and small, an ideal opportunity to remember certain lessons that we may have forgotten.
The evidence that we have to date indicates that Enron and Worldcom engaged in deceptive accounting practices in the preparation of their financial statements (income statements, balances sheets, and statements of cash flow). Accordingly, my inquiry begins with the question - Why are financial statements, and in particular income statements, important? If the financial pundits are to be believed, financial statements are important because they provide Wall Street analysts the ability to generate their oracular prognostications regarding the future value of the issuer’s stock. The legal pundits contend that they are important because the Securities & Exchange Commission says so. And of course we have to remember that the accounting firms do need something to audit.
Forget the analysts, the SEC, and the accountants. Profits are generated and shareholder value is created by good management working together with well led and motivated employees to produce and deliver quality goods and services. All these other folks simply watch, regulate, or ride the train. Accurate financial statements are essential, first and foremost, because they provide management the means to quantify performance. Management needs this data to design tomorrow’s business plan, and to achieve tomorrow’s growth and profits. Without the benefit of these core financial measures to guide their decisions, management becomes speculation. Consider the following illustration. Anyone that relied upon Enron’s financials could well conclude that Enron should allocate more investment dollars to the now infamous “Raptor” partnerships, since these investments appeared to be yielding fantastic returns. Yet we now know that in fact the returns generated from these investments were illusory.
When key members of Enron’s and Worldcom’s senior management elected to incorporate false and misleading data into their financial statements, they were degrading an informational and analytical asset that was essential to the future of their businesses. In summary, the first lesson to be drawn from the Enron and Worldcom scandals is that the falsification of financial records is not only wrong, but ultimately self-destructive, whether or not it comes to light, because it deprives management of the means to manage. Although this fundamental precept should be obvious to even a first year business student, and certainly to any experienced manager, without regard to educational pedigree, recent events involving America’s business elite suggests otherwise. We all need to remember, accurate accounting records are a necessary predicate to any sound business decision.
The second lesson to be drawn from these disasters is illustrated with terrible clarity by the defenses asserted by the respective Chief Executive Officers of these two corporations. In both cases, the responsible managers contended that they were totally unaware that these financial wrongdoings were afoot in their domains. Although these contentions may be true, they reflect a fundamental lack of knowledge regarding data that was essential to their managerial tasks.
Enron invested eighty-nine million dollars into the Raptor partnerships and booked more than a 100% profit from these investments in less than two years. If the CEO of Enron had been doing the management task that he accepted, and was well paid for, he should have had, at the very least, a basic understanding of this investment, and a particular understanding of how such a fantastic yield could be generated from a new business so quickly. Similarly, in the case of Worldcom, the CEO should have at least had questions regarding how Worldcom was avoiding (or more appropriately capitalizing) a connection fee that all other industry players had to pay on a current basis.
By their own admission the Chief Executive Officers of Enron and Worldcom had only a superficial understanding of their own financials. If their testimony is to be believed, they were piloting the corporate ship without an understanding of basic navigational data necessary to perform this task. At bottom, the wrongdoers at Enron and Worldcom and others viewed financial statements as sales tools rather than as critical informational and analytical resources, and if the public representations accepted, the most senior executive officers of these entities lacked a sufficient understanding of this data not only to discover these wrongs, but to responsibly perform their assigned tasks. Given this orientation, it is difficult to see how these corporations had any long term future, even if these shenanigans had never reached the light of day, since management’s decision making methodology was degenerating into the realm of speculation.
This leads to the second lesson. Senior management, and yes the CEO, must “own” the numbers. Unless management has the benefit of both accurate financial data, and an understanding of this data, decisions regarding the future direction of the business are little more than guesswork. Although it is true that the CEO cannot be required wade through the most detailed financial minutiae, it is equally true that the CEO must be more than a corporate figure head. If a modern CEO is going to be tasked with executive responsibility, and the penultimate decision-making power over operations, he or she must understand, as a predicate to making sound decisions, past operational results.
Congress will undoubtedly generate a tide of new regulation in response to the scandals, and the pundits in the press will tell us what it all means. However, I would humbly suggest that every businessperson can and should draw three conclusions from these tragedies:
First, every business, and every member of management must recognize that unless we accurately document where we have been operationally, we cannot determine where we need to go in the future to generate tomorrow’s profits. Accordingly, anyone who even suggests that corporate financials should be anything other than a crystal clear reflection of operating results should be viewed as the equivalent of a corporate traitor – worse a saboteur who would deprive of us of the means to do our collective duties;
Second, every member of management must have a sound understanding of past operating results, and more importantly feel driven to understand exactly what interpretation should be drawn from this data. This means everyone - from the CFO to the Marketing Director to the Senior Research Officer. We are all in the business of generating profits, no matter what title we hold;
Third and finally, the Chief Executive Officer of any company has to be exactly that – the Chief Executive Officer. The CEO must develop the battle plan, lead the fight, and then plan for tomorrow’s fight. Integral to this task is a comprehensive understanding of corporate finances and operational results. Designate someone else to be the celebrity face that prances and preens with the analysts, the press and the beautiful people.
The French writer Michel De Montaigne stated “I do myself greater injury in lying than I do of whom I tell a lie.” This worthy admonition would seem uniquely applicable to Enron and Worldcom tragedies. However, I would suggest that Enron and Worldcom took a giant step down the path of ruin when they ignored another piece of wisdom that every good manager recognizes, but can easily forget: “As a general rule, the most successful man in life is the man who has the best information.” (Source: Benjamin Disraeli).
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Sean A. OKeefe is a shareholder in the law firm of Winthrop Couchot, P.C. Winthrop Couchot, which specializes in the field of bankruptcy and insolvency law. A core part of the firm’s business practice is advising healthy businesses on how to avoid financial problems through sound business practices.
