Preventive Consequences

1) Preventing Theft. This is the most straightforward of financial control’s economic benefits. After all, control systems are explicitly designed to prevent company funds from being stolen. Such standard procedures as duplicate signatures for disbursement of funds, levels of authority matched to expenditures of different sizes, and special resolutions governing the opening/closing of bank accounts clearly aim to forestall theft of company cash.

Since cash is not the only asset that can “walk out the door,” theft prevention ends up applying to other classes of assets. Near monetary assets, like receivables and customer loans, must be watched carefully. Physical assets that can be monetized must also be controlled. Obvious examples include maintenance items such as tools and stores, and certain types of product inventory, such as fuel products or easily marketed finished goods. Company computer equipment, software, and peripherals make especially tempting theft targets. Intellectual property can also be stolen and sold to competitors or used by the thief in some new venture.

Employees can also steal from the company by abusing expense accounts, company policies, and benefit plans. Employees can collude with customers, suppliers or competitors to sacrifice their employer’s interests in return for rewards paid “on the side.” Employees can cheat in what they indicate they have accomplished, either by misrepresenting facts, reporting misleading data, or gaming incentive compensation systems.

This list of theft possibilities barely scratches the surface. Employees repeatedly demonstrate their capacity to devise creative ways to pilfer their employers. The point here is this: Weak or ad hoc controls usually fail to contain this employee “creativity.” Conversely, strong controls create an environment that becomes largely self-governing. It reinforces the basic honesty of most employees and recruits them as willing allies of the formal controls structure. Together, they form a system that is strong everywhere, because it is internalized and voluntary.

Thus, strong controls preempt what would otherwise be a bewilderingly diverse set of losses by a firm. Employee theft becomes highly exceptional; when it does occur, it usually is discovered and ended quickly.

Theft is not usually highlighted as one of Enron’s major problems. On closer inspection, however, a staggering amount of theft went on. Employees spent expense money extravagantly. Human Resources policies on travel and expenses were often ignored. More serious was the widely reported practice of closing poorly conceived deals for the sake of achieving personal bonus targets. Risk controls and approval authorizations were evaded; dubious projections were served up—all in the name of closing transactions whose size would directly bear upon individual annual bonuses.

The breaching of trading limits almost destroyed Enron shortly after its inception. In 1987, Enron discovered that oil traders were more than $1 billion in the hole. Enron held its breath while it traded the position back to a pre-tax loss of “only” $140 million. That sum alone could probably have funded a good controls system at Enron for decades.

Finally, there were Andy Fastow’s related-party transactions, which netted Fastow more than $37 million and certain colleagues over $12 million—money that the Powers Committee Report labeled shareholder value that would not have been surrendered in arm’s-length transactions.

Of course, the ultimate cost of Fastow’s thefts turned out to be far more than the cash he took from Enron’s shareholders. This point brings up the next preventive benefit of sound controls.

2) Avoiding Administrative and Judicial Judgments. Many employee theft schemes involve breaking the law. Sometimes, laws or regulations, such as those prohibiting price fixing, stand directly in the way. Sometimes, employee schemes run afoul of disclosure rules that would expose dodgy practices to public scrutiny.

The first point here is that questionable practices often add legal risks to the problem of misappropriating company assets. This creates the possibility that the illegal activity will be discovered by agents outside the firm, thereby exposing the company to the full weight of the legal system. External discovery multiplies by orders of magnitude the company’s potential for losses.

The legal thicket surrounding public companies creates litigation possibilities on multiple levels. When a scandal breaks out, many actors declare open season on the company. Depending upon the particulars, the criminal justice system can prosecute. A wide variety of regulatory agencies enjoy jurisdiction over some portion of a firm’s activities; these agencies are experienced in discovering a “cause for action” when a scandal becomes public. Shareholder litigation has become a developed and lucrative activity for the legal profession. Customers and suppliers may sue because they have been injured, because it will advance their own strategies, or because they want to see what they can get. Individuals can and do sue for similar reasons.

The cost associated with defending and resolving such disputes is often enormous. Suits attack both the firm and its responsible executives. Depending on the incident, both compensatory and punitive damages can result. Litigation can drag on for years, driving defense costs into the tens of millions of dollars. Adverse judgments can impose not only monetary penalties but also new restrictions that hamper the business going forward.

Although Exxon’s Valdez debacle can be characterized as a safety incident, the ensuing litigation turned on a controls matter: Did Exxon exercise proper control in permitting a former alcoholic to resume his duties as ship’s captain? The merits of this matter are not the issue here. What is of interest is the nature and cost of the litigation. Exxon was fined $150 million, agreed to criminal restitution of another $100 million, and settled civil liability with the federal and state governments for another $900 million. Private compensatory damages of several hundreds of millions came on top of these governmental settlements. Finally, Exxon was assessed $5 billion in punitive damages, an award that was litigated in the appellate courts for more than 10 years.

Enron’s bankruptcy prevented the full weight of litigation from bearing down on the company. One wonders what a solvent Enron would have ended up paying out for its California electricity manipulations or to shareholders for its deceptive accounting. However, one can get a sense of the potential losses by looking at the judgments assessed against banks that funded Enron’s accounting manipulations: Citigroup: $ 2 billion; J.P. Morgan: $ 2.2 billion; Canadian Imperial Bank of Commerce: $ 2.4 billion. These amounts do not include each firm’s defense costs nor damage to current business or reputation.

From an economic perspective, if sound controls forestall even one major legal scandal, this can pay for many years of running the internal control system. Depending on the size of the firm, a well-organized internal control function will cost anywhere from several million dollars to perhaps $10 million to $20 million annually for a large multinational. One $200 million settlement avoided is going to fund such a system for a generation. Moreover, sound controls don’t typically forestall just one incident. As Enron demonstrates, weak controls eventually yield multiple scandals with multiple litigants, defense costs, and settlements/awards.

This rationale for controls highlights monetary costs. A close reading of this material should also identify another, potentially greater, cost of avoidable scandals. That is:

3) Preventing Disruption of the Normal Course of Business. When irregularities are discovered, considerable disruption is inflicted on the business. Should a scandal break, the disruption is far worse. Costs from distraction and lost opportunities can multiply on so many fronts that they become difficult to quantify.

Anyone who has gone through a significant irregularity knows that the business suffers. Irregularities force organizations to give priority to repairing the controls breach. It must be investigated and evaluated. Responsible parties must be identified, dealt with, and replaced. Often, new procedures must be put in place. The reconstituted organization must then be monitored to ensure that it functions as intended. All this takes the time and attention of business unit management, which must also satisfy higher management that the repair job has been done right.

When scandal and litigation break out, the disruption becomes orders of magnitude worse. Now senior management must divert attention into managing a whole new set of risks. Litigation risks are difficult to quantify and cap. Consequently, managing these risks can consume huge amounts of management time in disclosure, discovery, deposition, trial planning, and settlement negotiations. This is all time that senior managers won’t have available to devote to strategy or operations.

Meanwhile, suppliers, partners, and customers all recalibrate their relations with the firm; their instinct will be to hedge those what-we-don’t-know-yet risks. Financial markets do the same. Stock prices typically suffer. Financing transactions under development will see delays, higher costs, and even cancellations. Business opportunities can be similarly affected.

Such distraction can have a devastating effect on strategy implementation. Strategy typically depends on achieving milestones within a timetable. Managing scandals and their fallout often puts deals and timetables on the shelf. When a scandal is finally put to bed, management returns to find that it faces a new business situation.

With consequences mounting on so many fronts, the total costs of a scandal can climb in a fashion that is both difficult to define and open-ended. One need not look at Enron’s meltdown to encounter the disruption costs of weak controls. Enron’s manipulation of the California electricity markets provides a dramatic earlier example. Enron booked huge profits from dubiously named schemes, such as Fat Boy, Death Star, Get Shorty, and Ricochet. It also began to anticipate being sued. A large defense team was mobilized in October 2000. Enron retained Brobeck Phleger, a firm experienced in complex business litigation. Shortly thereafter, this firm wrote to Enron’s internal counsels, noting that six investigations of events in California’s electricity markets were already under way and warning:

“If Enron is found to have engaged in deceptive or fraudulent practices, there is also the risk of other criminal legal theories such as wire fraud, RICO, fraud involving markets, and fictitious commodity transactions … In addition, depending upon the conduct, there may be the potential for criminal charges prosecuted against both individuals and the company … We believe it is imperative that Enron understands in detail what evidence exists with respect to its conduct in the California electricity markets as soon as possible.”¹

From there, both Ken Lay and Jeff Skilling would become personally involved in managing the California fallout. Lay would meet multiple times with Governor Gray Davis and federal officials. Skilling visited the state, attempting to manage the public relations fallout. Both devoted major time to internal consultations on legal defense and public affairs strategies. This was all time taken away from managing the failure in Broadband, preventing trading losses at EES, selling off non-core assets, and reversing the general deterioration of Enron’s financial condition. When the final crisis hit in October, a depleted, distracted management reacted clumsily to events.

Avoiding the loss of focus that comes with scandals is often ignored as a benefit of good control. The good habits that characterize productive corporate cultures take time and focus to inculcate. Sound financial control not only avoids the disruption of business operations, but it also enables the process of inculcating positive intangibles to proceed apace.

It is to these “promoting” consequences that we now turn.

Promoting Consequences

4) Accurate Information for Running the Business. Large organizations can only be managed effectively if management possesses accurate information about the business. Without such information, senior management cannot spot problems or impose coordinated strategies across the firm. When crises arise, management is surprised and has no choice but to go into reactive mode.

Management information systems (MIS) can be put in place, but the value of such systems depends on the controls culture that surrounds them. Temptations to withhold or distort information are ever present. A weak controls environment can allow a culture of “managing the numbers” to take root; then, executives will receive only the information that people lower in the organization want them to see. Needless to say, opportunities and successes will be emphasized while problems are hidden.

One pillar of a sound controls system is management’s insistence that all transactions be recorded completely and accurately on company books. This principle sounds elementary but is in fact continually challenged. When it succeeds in imposing this culture on the organization, senior management establishes the foundation for much more:

• It establishes that both good and bad news must be reported accurately.
• Management can then run the business, based on an accurate understanding of how it has been and is performing.
• Management, including senior management, can then be held accountable for results. Subordinate management is accountable to senior management, and top executives are accountable to investors who react to the firm’s published reports.
• A culture of honesty even when it’s inconvenient is thus established, with spillover effects into the firm’s “go-forward” culture, i.e., the planning of strategy and investments.

One of the less-recognized causes of Enron’s demise was the gradual but steady decline in the quality of the information available to make decisions. Many have pointed to the large amounts of capital expended on uneconomic international projects. These failed projects burdened the balance sheet with massive debts while failing to generate the cash needed for repayment. What allowed these projects to be approved? Certainly, the fact that project developers could submit economics based on whatever assumptions were needed to secure approval was a major contributing cause. This disregard for realistic project-planning assumptions was undoubtedly encouraged by the firm’s adoption of mark-to-market (MtM) accounting. Employees saw the reasons for MtM’s adoptions—the immediate magnification of reported revenues and profits. They then saw MtM deteriorate into what came to be labeled mark-to-model. Reacting to these internal signals, other business units found their own ways to secure convenient and quick results.

Of course, what ultimately brought about Enron’s bankruptcy was the financial markets’ loss of confidence in its reporting. As the Powers Committee Report put it:

“On October 16, 2001, Enron announced that it was taking a $544 million after-tax charge against earnings related to transactions with LJM2 … It also announced a reduction of shareholder’s equity of $1.2 billion related to transactions with that same entity. Less than one month later, Enron announced that it was restating its financial statements for the period 1997 through 2001 because of accounting errors relating to transactions with a different Fastow partnership … and an additional related-party entity, Chewco Investments L.P …” These announcements destroyed market confidence and investor trust in Enron. Less than one month later, Enron filed for bankruptcy”.²

These announcements were quantitative expressions of the extent to which Enron’s MIS had lost touch with Enron’s reality. Only two months before Jeff Skilling and chief accounting officer Rick Causey assured Ken Lay and the board that there were no “unknown problems.” It’s possible that they weren’t intentionally lying. Rather, they had gotten used to viewing Enron’s numbers through the lens of their own devices. They thought, for example, that because Enron accounted for tens of billions of dollars of debt as “off the balance sheet,” Enron wasn’t really responsible for its repayment. This turned out to be fundamentally wrong; there were also items buried in the details of certain deals (e.g., Chewco) that they didn’t know about. When the truth came out, it set off an avalanche of investor flight which an unprepared Enron management could not handle.

As noted, comprehensive and accurate MIS lays only a foundation for a culture of management accountability. To build on this foundation, other components are needed. We thus now turn to these components and the last and most significant intangible contributed by effective financial control.

5) Accountability and Continuous Improvement. Maintenance of sound financial controls requires managers to embrace two elements: (1) acceptance of accountability by operating line management; and (2) a continuous cycle of review, appraisal, and improvement. Controls responsibility “in the line” stands in contrast to relying on the internal audit or controls advisers to bear the primary responsibility. When controls accountability resides in the line, operating management must focus on the details of control structures/procedures. Breaches will be on account of them when performance review time comes around. Thus, they focus on controls for real as opposed to performing last-minute fixes to pass an audit.

Internal audits can then be conducted for their real purpose, the evaluation of current controls and identification of improvements. Although audits always have an adversarial aspect, line management usually becomes receptive to legitimate audit findings when it has accepted responsibility.

The results of achieving these elements are the inculcation of precious intangibles. The entire organization comes to accept that controls cannot be faked. It also understands that failure to do so will have personal consequences. Finally, it comes to regard the entire preparation and audit process not as make-work, but as an opportunity to upgrade the organization.

It doesn’t take much stretch of the imagination to see how these attitudes can be carried over into other work processes. Sound preparation, appraisal for real, and the ethic of continuous improvement take root, become habit, and set the standard for performance of all work duties. The fact that maintaining and improving controls is never finally accomplished also combats tendencies toward complacency that materialize in successful organizations.

Enron never valued the detailed work necessary to sustain good control. It didn’t really appreciate the long-term dividends that this work would pay. Enron’s failure to fire those Valhalla oil traders who grossly breached bank account controls evidenced a clear preference for near-term gains over long-term operational excellence. The then president’s telex to head oil trader Louis Borget said it all. Sent before Arthur Andersen reported its findings, it read in part: “Your answers to Arthur Andersen were clear, straightforward, rock solid. I have complete confidence in your business judgment, and ability and your personal integrity … Please keep making us millions.”³ Borget would later plead guilty to three felonies and serve jail time.

For all its flashy conceptual brilliance and trading acumen, Enron never became a good operator. Its safety record was spotty, marred by incidents such as the San Juan gas explosion that killed thirty-three and injured eighty. The week before he resigned, Jeff Skilling had to fly to Teesside, United Kingdom, where a massive explosion during routine maintenance had killed three. Enron built plants in poor locations, such as the Dominican Republic facility that collected city garbage in its water intake. A new Chinese plant never operated commercially. It bought others, such as the Buenos Aires municipal water system, at inflated prices and without the due diligence that would have discovered the absence of a headquarters, customer records, or the ability to collect receivables; there was, however, $350 million in deferred maintenance and investments to address. And, then there was Dahbol.

Jeff Skilling’s asset-lite strategy was not simply a strategic preference; it was a reflection of Enron’s demonstrated inability to grow and operate a hard-asset strategy. This failure was rooted in the same distain for detail, process and integrity that was visible early on in Enron’s approach to financial control.

Summing Up

This essay has argued that the economic rationale for sound financial control is often undervalued. The economic benefits go far beyond avoiding an occasional misappropriation of funds. The benefits include the avoidance of damaging litigation, penalties, and judgments that tend to arise when disregard of the law becomes entrenched. Financial consequences from such suits can be huge. However, even more damaging than any eventual judgments is the disruption of normal business, the damage inflicted by litigation risks that partners and investors can’t quantify, and the diversion of senior management into crisis control.

Second, this essay has argued that even these preventive benefits do not capture the complete rationale for sustaining sound controls. Good financial control can be achieved only by line management accepting responsibility and accountability for this task. It can be sustained only by maintaining focus on the details of control structures and procedures, by inculcating habits of truthfulness into all employees, and by participation in an open-ended cycle of appraisal and improvement.

Accomplish this, and the foundation is laid for extending these values into all aspects of the business. This will bear fruit in the form of complete and accurate information, operating excellence, and an ethic of continuous improvement.

This essay makes the point that any one of these economic rationales can pay for the cost of controls. This equation, though valid, perhaps understates the challenge encountered in the workplace. Often, the trade-off is seen as a huge profit payoff versus allowing controls to operate. The aforementioned president’s note to Borget expressed this very equation: “.please keep making us millions.” Enron’s California gamesmanship also illustrates this test. Enron booked more than $1 billion in profits from its market manipulations. Quite possibly, there was an expectation that regardless of what litigation ensued, Enron would not pay out more than a fraction of this sum.

Because the immediate comparison between profit opportunities and adherence to sound controls can appear lopsided, those who would defend good controls need to be able to articulate the full slate of control rationales. They need to combat the idea that the organization is somehow immune to the perverse effects of embracing questionable practices. These individuals need to assert that management’s making a conscious decision to ignore controls “over here” is likely to lead to someone else making a similar decision “over there”—perhaps for reasons not in the company’s interests and perhaps without making it evident in company accounts. Such people need to make tangible the reality that senior management’s acceptance of weak controls amounts to their risking loss of control over the business, via increasingly suspect MIS, the need to manage future litigation scandals, or because operations never seem to measure up to expectations.

Finally, it needs to be recognized that an immediate argument over some ill-gotten scheme is not the best moment for deploying the full slate of control rationales. These need to be inculcated into management and employees alike as part of the normal course of business. The foundational excellence that flows from good controls must come to define normal. Enron’s example of what can happen when controls are sacrificed may then emerge as one of its few positive legacies.