Chief Financial Officers are financial stewards and often the public face of their companies’ performance as liaisons of Wall Street and regulators. It’s vital for them to be perceived as trustworthy to perform their responsibilities. In an interview with the Markkula Center for Applied Ethics, Brad Buss, CFO of SolarCity Corporation, a Tesla Inc. affiliate, claimed that a CFO’s reputation is so crucial that “once it’s tarnished, you’re unemployable.”
To avoid reaching this point, it is critical to learn from past failures in the position, which can provide valuable insight into how to avoid future missteps in an increasingly important corporate role.
2001 Enron Scandal - Jeffrey Skilling & Andrew S. Fastow
Nearly twenty years ago the actions of Enron’s C-suite executives led to the company’s demise. In a feature story in CFO Magazine in 1999, Andrew S. Fastow, the CFO of Enron Corp., claimed that “our story is one of a kind.” Little did Fastow know how prophetic those words would soon become.
Enron was founded in 1985 when Houston Natural Gas Company and Omaha-based InterNorth Incorporated merged to become Enron. Kenneth Lay, the former CEO of Houston Natural Gas, became Enron's CEO after the merger and immediately rebranded the company as an energy dealer and supplier. In 1990, Lay created the Enron Finance Corporation and appointed Jeffrey Skilling, a former McKinsey & Company consultant to head the new corporation.
One of Skilling's first efforts was to help Enron migrate from traditional historical cost accounting to mark-to-market (MTM) accounting, which the company got official SEC approval for in 1992. MTM is a method of calculating the fair value of accounts that fluctuate in value over time, such as assets and liabilities. Mark-to-market is a legitimate and extensively utilized practice that tries to provide a realistic assessment of an institution's or company's current financial status. However, because MTM is based on "fair value" rather than "actual" cost, the approach can be manipulated in some situations.
Some say MTM was the beginning of the end for Enron since it allowed the company to record estimated gains as actual profits.
Downhill from Here
By the fall of 2000, Enron was starting to collapse under its weight. CEO Jeffrey Skilling used mark-to-market accounting to conceal the financial losses of the trading business and other operations of the company. This technique measures the value of a security based on its current market value instead of its book value. This can work well when trading securities, but it can be disastrous for actual businesses.
This meant that when Enron signed a long-term deal to supply power from a new power plant that was still under construction, they immediately recorded all predicted profit from the arrangement, even though the facility had not generated any revenue. Instead of accepting a loss if the power plant's revenue fell short of expectations, the company would transfer the asset to an off-the-books corporation, where the loss would go unreported. Enron was able to write off unprofitable activities using this method of accounting without affecting its bottom line.
The mark-to-market practice led to schemes that were devised to conceal losses and make the company appear more profitable than it actually was. Andrew Fastow, the CFO at the time, devised a strategy to demonstrate that the corporation was in good financial form even though many of its companies were losing money.
The Scheme to Hidden Debt
Fastow and others at Enron orchestrated a scheme to use off-balance-sheet special purpose vehicles (SPVs), also known as special purposes entities (SPEs), to hide its mountains of debt and toxic assets from investors and creditors. These SPVs were created with the sole goal of concealing accounting reality rather than operating results.
Enron would transfer some of its fast-growing stock to the SPV in exchange for cash or a note in a conventional Enron-to-SPV transaction. After that, the SPV would utilize the stock to hedge an asset on Enron's balance sheet. As a result, Enron would guarantee the value of the SPV, lowering the apparent counterparty risk.
The SPVs were not unlawful, despite their goal of concealing accounting reality. However, they differed from traditional debt securitization in several important and potentially disastrous ways. One significant difference was that the SPVs were wholly funded with Enron stock. This directly harmed the SPVs' capacity to hedge if Enron's stock prices plummeted. Enron's refusal to declare conflicts of interest is just as harmful as the second difference. Enron failed to appropriately disclose the non-arm's-length arrangements between the business and the SPVs when it reported the SPVs' existence to the investing public—though few individuals likely understood them. Eventually, this led to Enron's stock declining and the values of the SPVs plummeting, forcing Enron's guarantees to take effect.
The shock on Wall Street
Enron was in freefall by the summer of 2001. Kenneth Lay, the company's CEO, departed in February and was replaced by Jeffrey Skilling. Skilling resigned as CEO in August 2001, citing personal reasons. Around the same time, analysts started downgrading Enron's stock, and the stock dropped to a 52-week low of $39.95. The company recorded its first quarterly loss on October 16th and shut down its "Raptor" SPV. The Securities and Exchange Commission (SEC) was alerted by this activity and shortly after declared that it was looking into Enron and Fastow's SPVs.
Fastow was later fired from the company and it was found that Enron had lost $591 million and owed $690 million by the end of 2000. Enron filed for bankruptcy on December 2, 2001.
Enron's demise was the largest corporate bankruptcy ever seen in the financial world at the time. The Enron crisis brought attention to accounting and corporate fraud since its stockholders lost $74 billion and its employees lost billions in pension benefits in the four years leading up to its bankruptcy.
The Good that Came from Enron
With everything that was uncovered in the Enron scandal its most salient legacy was its influence on corporate boards. It raised questions like, “How could the board have allowed this to happen?” and "How can we prevent such incidents in the future?" Boards concluded that they needed to improve their game and have a more independent, arms-length relationship with management and external auditors.
Here are five examples of how the boardroom improved its capabilities:
Joining with CEOs in defining strategies. Boards are more informed about the business, more invested in the outcomes, more engaged with aligning pay with performance, and better able to make independent assessments about priorities and people.
Responding to shareholder proposals. Boards have increased their ability to examine trade-offs between short- and long-term results, and they can participate in more constructive dialogues with major shareholders and activist investors.
Approving capital allocation policies. Boards have greater credibility in reassuring investors that they are continuously evaluating the highest and best uses of a company’s financial resources.
Considering non-shareholder constituencies. Boards are better able to deal with reputational issues (e.g. sustainability), assure regulatory compliance (e.g. anti-bribery legislation), and monitor business policy (e.g. employee benefit programs).
Anticipating opportunities and risks. Boards encourage companies to find and engage in attractive development initiatives by providing an outsider's perspective on potential threats to the business (for example, disruptive technology or cybersecurity exposures).
Corporate fraud, bankruptcies, and various illegal acts have always been part of the business environment. Every time fiascos erupt there is a shock, but business history records dozens of major failures, frauds, and other measures of massive corruption each decade.
Although the problems that exist are diverse, they typically incorporate executives: abusing their power and privileges, manipulating information while engaging in inconsistent treatment of internal and external constituencies, putting their interests above those of their employees and the public, and failing to exercise proper oversight or shoulder responsibility for ethical failings.
As can be seen in the Enron accounting scandal, a company’s executives can make or break an organization, and unfortunately, there are many other examples of where their leadership has gone awry. A good leader is more than an eloquent speaker or inspiring motivator – he or she empowers employees to do their jobs effectively and keep the organization going in the right direction.