6. Cultures that Create “Accidents”

We have examined a number of mistake chains that were related to execution or strategy in companies. We have also seen examples of physical disasters that were created or made worse by organizational cultures that failed to detect and correct mistakes that led to “accidents” that were really due more to incompetence and neglect than anything accidental.

There were some common traits in the mistake sequences in the physical disasters of Titanic, Three Mile Island (TMI), and Columbia that we see over and over in business situations as well:

• Each organization or operating entity thought they knew what they were doing. In fact, they were very confident that they knew what they were doing.

• Each was operating a system (or business) that was state of the art for its time.

• Each ended up in a disaster of their own making, created and/or amplified by multiple mistakes.

• Each failed to act on numerous warning signs and thus essentially guaranteed exponential damage from the mistake chain.

• Each created a disaster that left blight so significant that the company (or organization) will be remembered in business history in a negative light for some time.

There is much we can learn from each physical disaster, and yet most business people do not recognize that these accidents have something to teach them, preferring to believe that “they are too far removed from my business.”

While the mistake parallels are present between physical and business disasters, the business situations can be more complex because, in many cases, there is nothing physical like a ship or plane to make the problem quite as obvious to those involved. In many business situations, we see that the entire culture of a company becomes supportive of a serious mistake waiting to happen. Observe the examples presented in this chapter and remember the parallels to the physical disasters we have examined.

Myopia as a Fatal Business Disease

For nearly 10 years during the 1980s, I did part-time consulting for a large, growing, multihospital company named American Medical International (AMI) with operations in the United States and the United Kingdom. My work was with a consulting firm, Friesen International, owned by AMI. Friesen had a large team that conducted market needs analysis, program planning and design, conceptual facility planning, and assistance in obtaining regulatory approvals for hospitals and health systems. Friesen did work for outside clients unrelated to AMI, but as the growth in the hospital business accelerated in the early 1980s, AMI needed more time and resources devoted to its growing empire. Friesen ceased doing outside work and became a large planning department with only one client—AMI and its 100+ hospitals and a smaller number of outpatient facilities.

AMI began with one hospital. An entrepreneur in the laboratory business took over a small, less than stellar, for-profit facility in California to satisfy debts owed to him as a supplier. From that humble start, he began to grow a chain of hospitals by purchasing individual facilities from physicians, investors, or local governments looking to exit the business of owning hospitals. He brought in professional management and the growth continued, eventually acquiring other small hospital chains. Typical of the for-profit hospital industry at the time, most of the facilities were located across the southern half of the United States with heavy concentrations in California, Texas, and Florida. Facilities were also scattered across most of the states in between but in lower concentrations. The prime market areas had high growth, and AMI’s hospitals in those markets did well while meeting the needs of growing populations.

AMI was number three in an industry that was growing overall but consolidating rapidly. The executives had their sights set on being number one. A few new hospitals were built in higher-growth areas, but they still saw the growth needed to reach the top spot in the industry as coming primarily from acquisitions. The buying spree continued even as the attractive higher-quality, better-performing facilities became harder to find.

By the mid 1980s, it became obvious to a few of us in the planning group that there was a pattern to AMI’s overall profitability that was of concern. The team at Friesen conducted a detailed analysis and discovered that about 40 percent of the facilities were providing more than 110 percent of the company’s profit. It also turned out that unit profitability was size dependent along with location, classified broadly as rural or urban. This was not immediately obvious because, like many companies, especially in service businesses, a geographic operating organization made the most sense and was in place. This meant that virtually all metrics were tracked and aggregated on a regional basis, in some cases masking patterns.

Each individual regional vice president knew that their larger hospitals generally did better than their smaller ones, but the magnitude of the problem was not appreciated across the company. It turned out, not unexpectedly, that most of the smaller hospitals that did not perform well were in less populated, rural areas. Most were formerly owned by county governments that sold them when they encountered financial difficulty as farm populations continued to decline and the higher quality of medical care in cities made patients more interested in traveling to receive the benefits of larger, better-equipped facilities and medical staffs.

We had the team at Friesen put together some “packaging” scenarios, bundles of assets that might be sold together to a strategic buyer. The results nearly leapt off the page. If you were to create a division with certain hospitals that were small and rural, plus a few facilities located in states where the company had limited operations, it might be possible to sell the whole package since other firms also wanted to grow by acquisition. The result would be a company with only 50 to 60 percent of the current revenues but with dramatically improved profitability. The plan would also release some capital that could be used to invest in existing markets and facilities.

Our group at Friesen believed this was a spectacular business suggestion for AMI. How could it lose? The hospital mergers and acquisitions (M&A) business was hot so there would be buyers, and it would be a real win for the company. We made the presentation and came back to the office to tell our eager and hard-working team what top management had said.

They said “NO”—not politely, not with conditions, not with apologies—an unequivocal “NO.” The reason was clearly articulated, “We want to be the biggest company in this business and that means growing, not shrinking. That means buying more facilities, not selling them off. We buy facilities and operate them better than their previous owners; we don’t want to see AMI shrink.” That was it—the revenue of AMI was the only criterion in the executive committee’s sights at that point.

This point of view was not quite as irrational as it sounds since, at that time, most government-funded business (Medicare in particular) was billed on a cost-plus basis, meaning that more facilities with more cost meant more revenue and more profit, albeit limited to a contractual amount. The problem was that our team at Friesen believed the industry was starting to change, likely to move away from cost-plus accounting, and that the changes would accelerate.

Following our presentation, some jokes about career-ending presentations were made, at which the head of Friesen and I laughed since he was very mobile and I was a consultant who had a full-time job in a top business school. The rejection was disappointing, though, because we believed the plan would have left the company in a stronger position for the long run.

The acquisitions continued over the next few years, along with the hoped-for revenue growth. But numbers one and two in the industry were doing the same thing, so there was no net gain in position against the leaders. To make matters worse, the shift away from cost-plus government reimbursement was accelerating with a move to fixed price by condition, regardless of the cost incurred in delivering care. Health maintenance organizations (HMOs) and other delivery mechanisms gained market share from traditional indemnity insurers and became tougher negotiators, driving margins down for hospitals.

Suddenly, having the most facilities with a cost base that could be recovered with a guaranteed profit was not a viable strategy. AMI decided that vertical integration looked good since those controlling access to the system would be in a better position to make money. They made a feeble attempt—that was a complete failure—to enter the health plan/insurance business.

Within three years of our suggestions to management, the head of Friesen and I had moved on to do other things. Our departure was unrelated to the restructuring suggestion, but we continued to believe it had been a great idea.

A few years after our unwanted suggestion to restructure AMI, a group of dissident shareholders began a proxy fight to oust management and replace the board. The company’s performance had deteriorated, and while it was a bitter struggle, the dissidents eventually won. Management was ousted, a new CEO was installed, and the turnaround began. AMI was split into two pieces, one of which was sold off and included the smaller, predominately rural hospitals with a couple of attractive jewels thrown in to make the package salable. AMI survived as the larger, more profitable, predominately urban hospitals in higher-growth areas. AMI itself was sold in a takeover a few years later. The shareholders did well, but they probably would have done better if the idea we had proposed had taken place a few years earlier.

To summarize this cultural mistake sequence:

• AMI management was fixated on a previously successful business model and ignored changes in the market that threatened the core of that model—in this case, cost-plus reimbursement.

• Top management firmly believed they knew what they were doing, did not take advice easily, and delighted in management by intimidation.

• Company headquarters was in Beverly Hills, the perfect place for the most senior executives to be completely out of touch with a business that operated in less affluent southern and southwestern cities and towns.

• The executives arrogantly believed they could enter a related, but totally different, industry (health insurance) without understanding that the competencies required were not present in the company.

In fact, this list can be explained not so much as separate mistakes but as one giant cultural mistake that manifested itself in myriad ways. This is the problem with organization culture: It is frequently the most powerful factor in determining the success or failure of an organization, and it often helps both success and failure occur—in sequence.

Knowledgeable employees throughout the company were talking in the halls saying, “We don’t understand the strategy.” In fact, they understood the strategy, but they also understood that it was the wrong strategy and needed to change. Despite attempts by many, including the Friesen team, top management was the last to realize the mistakes, and it is not clear that they realized what the mistakes had been even after they were ousted in a rarely successful shareholder coup. It was all about mindset and an isolated “We know the right answers and don’t need advice” corporate culture that insiders were powerless to change, although many tried and were rebuffed.

This story is typical of companies where culture becomes the worst enemy of success, especially when that culture is one that is driven and controlled from the very top and is out of synch with the reality of the business environment. It is no different than NASA’s problems with Challenger and Columbia. It is repeated in numerous examples in companies and organizations continually, and it is the most difficult form of mistake chain to stop.

Ford/Firestone—When the Rubber Leaves the Road

Today’s steel-belted radial tires are a bargain. If you buy a good tire, keep it properly inflated, and drive reasonably, you will get 40,000 to 50,000 miles per set or more. At $100 to $125 or less per tire for most cars, that works out to about one penny per mile for all four tires, probably less than 3 percent of the cost of operating your automobile. Depending on what and how you drive, you probably spend 10 times that much on gasoline. But even though the relative cost of tires is not that high, they may be one of your most important safety items.^*

^* The differences in tire quality and performance are striking—and confusing. While there are data sources to help consumers make choices, the many consumers simply replace worn out tires with the same brand that was on the vehicle when it was delivered, which is why selling to auto manufacturers is so important to tire makers. Reliable information sources include the NHTSA Web site (www.nhtsa.dot.gov/cars/testing/) and Consumers Union and its magazine Consumer Reports.

Most of us take the performance of our tires as a given, expecting that we can drive at, or above, the speed limit for many hours without concern. As a pilot, I inspect the tires on my airplane prior to every flight, but I rarely give the tires on my car more than a casual glance as I walk up to rush off somewhere. I check the air pressure in my automobile tires every three or four weeks, but my observation is that the average person does so even less often.

The biggest enemy of tires is heat, and it builds up significantly when driving at high speed in hot weather. Heat buildup is even more of a threat if a tire is underinflated. Thus, when Ford began to see tread separation problems on the Firestone tires mounted as original equipment on Explorer sport utility vehicles and many light truck models in Venezuela and Saudi Arabia in 1998 and 1999, they likely attributed the problem to excessive heat and speed since both were climates with nearly continuous moderate to high heat conditions.

As failures mounted, Ford did send failed tires to Firestone in an effort to understand the problem. In 1999, Ford replaced tires on Explorers in Saudi Arabia, against Firestone’s advice. Ford documents later showed that Firestone had warned Ford against replacing tires in Saudi Arabia in fear of alerting U.S. regulatory authorities.⁵⁰

Ford decided to replace the tires on over 39,000 Explorers in Venezuela in May 2000 with Goodyear tires because there was still no resolution from Firestone on the cause of the problem. Then it got worse—the problem began showing up in the United States. An increasing and disturbing number of fatal accidents involving Ford Explorers seemed to be initiated by the same tread separation Ford had seen overseas. There was no longer any way to rationalize that the problem was due to local driving conditions not present in the United States.

Unknown to Ford, a State Farm Insurance staff member whose job was to look for recurring causes of accidents had noticed, as early as 1998, what he believed was an excessive pattern of tread separation in certain types of Firestone tires in the United States. He notified the National Highway Traffic Safety Administration (NHTSA) as early as the summer of 1998.

By May 2000, with mounting evidence of Firestone tire failures on Ford vehicles in the United States, the NHTSA announced a formal investigation into tread separation of certain Firestone tire models. Ford finally began their own internal investigation in July 2000 and soon figured out that older tires produced in Firestone’s Decatur, Illinois plant had a disproportionate failure rate.

Once the correlations became visible more local data surfaced, and it became clear that especially in warmer, southern states there was an alarming number of Ford Explorer/Firestone tire-related fatal accidents. By late summer 2000, various news reports were attributing 75 or more known deaths to the Ford/Firestone combination. Estimates are that this number eventually rose to 200 or more.

The Ford Explorer SUV is marketed as a family car. Heat buildup, a common occurrence on longer trips in warmer climates, was clearly involved. Thus, many of the accidents were heart-wrenching stories of families on vacation losing a mom, dad, kids, or a whole family in an out-of-control accident. Once the pattern was clear, the press coverage was fast and brutal. State officials, consumer advocates, and the U.S. Congress were all making accusations, holding hearings or investigations, and calling for action.

Ford and Firestone, a unit of Japan’s Bridgestone Corporation since 1988, both swung into action but in very different ways. While Ford could have seen the patterns earlier, once faced with the data, Ford understood the need to maintain customer confidence and pushed fairly openly to have the tires replaced, eventually agreeing to have tires replaced on Explorers even if they had to pay for them from manufacturers other than Firestone.

Firestone was not convinced that the problem was theirs and was also worried about production capacity to meet the demand for replacement tires, so the recalls began with priority given to owners in hotter states such as California, Arizona, Texas, and Florida where Firestone claimed 80 percent of the problems had occurred. As the controversy got more press, consumers everywhere demanded replacements, did not want to wait for production to catch up, and were not sure they wanted Firestone tires as replacements.

Other manufacturers saw an opportunity and ramped up production, but even with additional capacity in the system, there were still temporary shortages in meeting the massive 6.5 million tire recall in the specific sizes required.

The continuing pressure from consumers caused Ford to tell all their dealers in August 2000 to replace tires if requested by customers despite Firestone’s attempt to limit replacements to the priority states. Under pressure, Firestone began flying tires to the United States from Asia where they were manufactured by parent Bridgestone and authorized reimbursement for consumers who purchased tires from other manufacturers. Despite this, Firestone was perceived as dragging their feet as a result of their attempt to set priorities on exchanges because of supply problems. Significantly, their senior executives were nearly invisible in the process. In particular, Bridgestone’s CEO, Yoichiro Kaizaki, did not make any pubic statement on the problem until September 2000, more than four months into the most public phase of the crisis. Even then, while expressing regret for the incidents, his tone was defiant regarding Ford’s attempt to shift blame for the crisis to Firestone.

Firestone continued to minimize their responsibility by pointing out how few tires had failed out of the nearly 15 million produced in what was one of the most popular tire models ever manufactured. This effort had little impact, however, as the daily news reports of the problem persisted. As more data emerged, it turned out that the Ford Explorer had a high rollover rate, and Firestone tires had failed in about 10 percent of fatal Explorer rollover accidents. This added some credibility to Firestone’s claim that the problem was not solely the fault of Firestone.

In hearings before the Senate Commerce Committee on September 12, 2000, Bridgestone/Firestone testified:⁵¹

During the same hearing, Bridgestone/Firestone executive vice president John Lampe gave some further clues that Firestone did not accept full blame for the debacle:⁵²

Implied in this statement are some facts that were not obvious to the public and the news media at the time about a series of mistakes that had led to the problem faced by Ford and Firestone. Those mistakes and others that were revealed later included:

• Ford’s design for the Explorer evolved from the Bronco in the late 1980s. The Bronco had a history of rollover accidents, and while Ford wanted an improved vehicle, pressure for time to market led to compromises and the continuation of a number of existing design mistakes that was the likely beginning of the problem chain.

• Explorer’s design continued Ford’s oft advertised “Twin I-Beam” frame design, touted as making their vehicles tough. The downside was that this design provided less flexibility for engine mounting, resulting in an engine that was higher above the ground than in other vehicles. This raised the vehicle’s center of gravity, which was already high in comparison to sedans, making it more susceptible to rollover.

• Criticism of the Ford Bronco from Consumers Union (CU) made Ford sensitive to the need to pass the CU rollover test, so they experimented with various combinations of tires, springs, and other adjustments that could be made without affecting the basic design. After debating the merits of different tires, an internal memo from a Ford engineer was prescient about the fact that the company was taking a risk installing size P235 tires, apparently suggesting that the tires might help pass the test but might not solve the problem under real-world conditions.⁵³

• The Firestone tires that Ford specified met only grade “C” in the NHTSA standard for heat resistance on a scale of ABC, where C is the lowest level allowed by Federal regulation. Of all tires sold in the United States, only 14 percent have a C temperature rating.⁵⁴ This rating evaluated tires loaded and properly inflated at 50mph for two hours and then 90 minutes at speeds up to 85mph. This standard seems adequate for a vehicle used mainly for local errands, but the average consumer does not understand the standard. Would you drive a vehicle with tires that said “not suitable for sustained use for more than 3.5 hours?” Many of the families killed or injured in crashes were on long trips and had been on the road for many hours at the time of their accidents.

• In order to reduce rollover tendencies, Ford stiffened the springs in the suspension and specified inflation pressure for the tires at 26psi (pounds per square inch). Firestone’s recommended inflation for the tire was 30psi. Firestone testified that Ford did not request high-speed testing from Firestone at 26psi, choosing to do this at a Ford facility with the understanding that any problems would be reported to Firestone.⁵⁵

• Firestone did experience manufacturing quality problems for a period in the mid-1990s. This was a period when Firestone was in a very bitter dispute with unions at their Decatur plant. It is clear that some of these deficient tires failed and initiated an accident sequence in many vehicles, but it may have been a survivable sequence had it not been for the vehicle deficiencies noted above.

• The NHTSA indirectly admitted, through an additional funding request to Congress in September 2000,⁵⁶ that it had limited ability and/or authority to gather and analyze information on safety problems such as the Explorer/Firestone situation, on foreign experience with tires (or other products), and on safety information communicated between manufacturers and dealers. This lack of any central information repository contributed to the time it took to identify and understand problems.

This scenario that seemed ready to bury Firestone was a sequence of mistakes made by both companies. Contrary to what the public might have believed from early reports, Ford may have had the larger responsibility for the outcome, but it did not look that way because Ford did a better job of handling the public relations than Firestone. Neither company would have been in trouble without the mistakes of the other, but both companies’ mistakes were a result of cultural intransigence.

If we reduce the preceding technical mistakes to something the average person can understand, it might look like the following for Ford and Firestone:

• Ford was facing competitive pressure to bring a new and improved SUV to market. In an effort to decrease development time, minimize cost, and simplify manufacturing, they adopted as many designs and technologies as possible that were already in production, even though they knew these designs had deficiencies.

• Despite warnings about vehicle safety issues from their own staff, Ford engineering managers made decisions to make what they considered small changes in springs and tire pressures to overcome the design deficiencies.

• To minimize ongoing cost, the least expensive tire acceptable under federal regulations for temperature resistance was specified for the vehicle. There does not seem to be any plausible explanation for this other than saving money. Ford also saved some time by not having Firestone test the tires under the conditions that Ford was specifying for operation.

• Ford apparently assumed that consumers would keep tires properly inflated and not drive beyond the limits of the minimally capable tires, a very dangerous assumption given the high proportion of drivers who exceed speed limits and the small number who care about or understand tire ratings.

• Firestone manufactured a tire for Ford that met minimal federal regulations but had limited resources devoted to tracking failures and warranty claims.

• Firestone did have quality problems while attempting to cut costs in the mid-1990s. Firestone resisted union demands and demanded wage concessions during a 1994 labor dispute at the Decatur plant. During the ensuing strike replacement workers were used, many of whom were retained even after the strike was settled. A study published in 2003 proved statistically that there were significantly higher failure rates of tires produced at the Decatur plan during the labor strife than before or after or at other nonstriking plants. The highest failure rates on a monthly basis were associated with tires produced during the month when Firestone made the demand for wage concessions in early 1994.⁵⁷

Significantly, there were Explorer accidents initiated by failures of other brands of tires but very few. It appears that most of the non-Firestone tires on Explorers were replacements purchased by consumers, and these tires from other manufacturers had the higher “B” rating for temperature resistance. Explorers did not have the worst rollover record for SUVs, but their tires were implicated in a significant number of the accidents that did occur.

The bottom line is that the vehicle system that was produced with a questionable design by Ford and the cheap tire specified was probably adequate if everything worked perfectly. The problem was there was no margin of error if consumers abused the vehicle or tires in any way or if there were any defects in the tires. Unfortunately, this is what we see in so many mistake sequences—no margin for error. How many business situations or plans have you seen where you realized too late that the assumptions made were so narrow and demanding that there was no margin for error?

This multiple-mistake chain resulted from both companies’ cultures that sought to “meet customer needs,” where the definition of “needs” was minimal. Ford’s cost-driven culture produced a vehicle that was attractive from a customer standpoint but minimally acceptable technically. Firestone’s focus on cost control caused it to lose sight of the quality responsibility of its business, especially for the legal, but marginal, product they produced for Ford. The problem was that many people in both organizations seemed to know that problems existed, yet no one wanted to take the lead for fear of incurring cost, administrative hassle, and reputation risk.

In this case, the two companies involved traded safety to satisfy customer pressure for price in a very competitive business that was already in serious oversupply on a global basis. This meant that a heavy emphasis on cost control, almost regardless of impact, had begun to creep into these and other organizations in the industry. Automotive original equipment manufacturers (OEMs) began pushing suppliers harder, and suppliers became more compliant in meeting minimum specifications to keep the business.

I observed this firsthand as a member of the board of a medium-size automotive supplier that, along with others in the industry, saw its margins shrink as OEM purchasing departments gained more power than engineering departments through the 1990s. It is quite common in the industry, especially in the United States, for an OEM to award a contract to a supplier with a reasonable starting price for the first year and a decrease in price for each of the subsequent contract years. The supplier is expected to improve productivity or find other ways to reduce cost if they wish to maintain their margins or even stay in business.

For industries that are mature, these are normal economic forces at work, but they put companies in serious bind. The question for senior executives in these hypercompetitive industries becomes, “How do I find the money to fund new product development when my margins are shrinking, the competition is moving fast, and customers are demanding higher-quality products at lower prices?” This is the reason that companies in the automotive industry, and others, have little incentive to spend money on anything that does not sell more product. Until recently, safety was in that category.

In fact, it was Ford that first brought seatbelts to mass-produced automobiles in the mid-1950s but pulled them out when they found customers did not care. If it did not sell more vehicles, it was simply an unnecessary cost. The playing field was leveled on seatbelts for all manufacturers when the federal government began requiring them in the front seat of new vehicles with the 1965 model year.

Exciting product design and new features are needed to attract customers, but cost efficiency is needed to make a profit in price-sensitive auto markets. Over time, cost became the mantra for the U.S. auto industry, and other things took a back seat. The real question that cannot be answered is, “Was Ford ahead financially by saving on the design and manufacturing, despite the recall and legal costs?” Probably not, but they may be ahead in other areas where they have skimped that have not been catastrophic.

Throughout 2000 and into 2001, the relationship between Ford and Firestone deteriorated from one of joint responsibility and concern to finger-pointing acrimony. The companies had been linked for almost 100 years, going back to the friendship of their respective founders. Firestone had been the exclusive provider for new vehicle tires for Ford for nearly 75 years, but they were clearly at odds over who was to blame for a significant and growing problem.

In May 2001, Firestone CEO John Lampe fired his customer, ending the long relationship with Ford over what he characterized as significant concerns about the safety of the Explorer vehicle. Ford’s CEO, Jacques Nasser, did not shrink from the confrontation, publicly indicating that Ford no longer had confidence in Firestone’s tires.⁵⁸ Perhaps Nasser should have said, “We were too cheap to buy a better tire or fix other problems, so we are blaming the tire supplier while we quietly fix the problems that should have been fixed some time ago.”

On May 22, 2001, Ford voluntarily expanded the recall and announced it was prepared to spend up to $2 billion to replace 13 million Firestone tires. For a time, Ford looked like the good guys, the responsible company that was going beyond requirements to make sure the customer was served well and protected. But as time went on and more investigations took place, the background on Ford’s design and decision process began to paint a different picture.

As this is written, Ford and Firestone have settled a number of lawsuits out of court, but many others are still wending their way through the court systems of various states. If they had it to do over again, would Firestone have provided Ford a higher-quality tire at the same price to get the work? Would Ford have made some of the changes to the Explorer’s design that they made later to correct the problems? The debacle has cost both companies billions of dollars in direct costs of the recall, lawsuits, and shareholder value as well as adverse publicity that will continue for some years via lawsuits.

Their PR departments would have you believe that Ford and Firestone acted to break the mistake chain. The argument is specious, however, because they were already “in extremis” with damage mounting exponentially by the time they took any serious action, despite numerous early warnings over a number of years.

The cultures of Ford and Firestone worked against doing things that could have prevented the whole mistake sequence. The cultures of the companies also worked against one thing that would have stopped the mistake chain—analyzing and believing the scenarios that could unfold if these somewhat predictable events were to take place and what the likely costs might be. The combination of a dominant and focused culture tends to reinforce its biggest weakness—the inability to look at alternatives.

An important lesson here is that, once something has spun out of control to the point that customers feel panicked about their situation, it is time to stop the excuses and get on with the fix. Regardless of the truth, management has to deal with the reality of perception. But often on advice from lawyers, resistance to this concept is widespread.

One of the recent rare exceptions has been Boeing’s admission that ethics principles and perhaps laws were violated in their 2003 Air Force tanker lease crisis. Executives were terminated, and board members Lewis Platt and Harry Stonecipher both came out of retirement to serve as chairman and CEO, respectively. Both immediately went on a public campaign to admit the wrongdoing and get on with rebuilding confidence. This did not erase the crisis or some damage, but it was a definitive step to break the multiple-mistake chain and stop any further damage.

Enron—Living on the Edge and Loving It

Enron management came to believe that they were unique in business and that their company had extraordinary capabilities possessed by no others. Enron was “changing the rules of the game” and, as told by insiders who were there, believed they had developed unique business models that the rest of the world had not been smart enough to see.⁵⁹ Between 1985 and 2000, Enron transformed itself from a Houston-based natural gas distribution company into an internationally known behemoth that was the largest trader of electricity and natural gas, with operating entities in or planned in many of the developed and developing countries of the world. Enron was on a roll and believed they could expand their trading prowess to virtually every type of business and become the dominant middleman and market maker to the world.

They were proud of being ranked among the top companies in the world on the basis of market capitalization, and almost everyone in the world was cheering, albeit with a combination of admiration and envy. Almost everyone was cheering—except John Olson, who was the natural gas researcher and analyst with Merrill Lynch who dared to downgrade Enron stock in July 1997. In 2001, Olson, by then working at another firm, told the press that he had become skeptical about Enron because he could not really figure out how they were as profitable as they appeared. He was one of very few analysts who were correct to be suspicious as far back as 1997.

After a 2001 news story published in U.S. News & World Report, Ken Lay, Enron’s chairman, tore the story out of the magazine and sent it to Olson’s boss with a handwritten note that said, “John Olson has been wrong about Enron for over 10 years, and he is still wrong, but he is consistant [sic].”⁶⁰ Olson joked with his boss about the fact that at least he knew how to spell “consistent” properly even if Ken Lay did not. The purpose of the note, spelling errors or not, was to make sure that investment bankers understood that criticism by their analysts would not be tolerated by Enron and that lucrative business with Enron was tied to favorable ratings.

A “we can do no wrong” culture had developed with Enron’s impressive growth and success, but somewhere along the way it changed from legitimate pride in accomplishment in a competitive industry to arrogance and a feeling of invincibility.

It had not always been this way. In the mid-1980s when deregulation of natural gas first appeared, Houston Natural Gas (HNG), as it was known then, was not on top of the world. Ken Lay was hired as CEO by the board following the founder’s death. Internorth, based in Omaha, was the country’s largest pipeline company and saw the instability in management at HNG as an opportunity. Shortly after Lay took over at HNG, he was confronted with a very attractive takeover offer from Internorth. The offer was so overpriced that it could not be refused. But Ken Lay’s ambition emerged as he skillfully changed what had started as an acquisition of HNG by Internorth into a merger. Additionally, the deal started with assurances that the headquarters of the combined company would be in Omaha but ended up with Lay as the CEO of a renamed company called Enron and based in Houston.

Deregulation of natural gas provided opportunities for Enron, but there were inherent market inefficiencies that limited growth. By 1990, Enron still generated nearly 90 percent of its revenue from the regulated gas pipeline business. Lay wanted more of the potentially profitable deregulated business, and with the help of a McKinsey consultant named Jeff Skilling, began to put together a more complex and aggressive business strategy. Enron would become more than a trader, in essence creating and owning a gas market through contracts with suppliers and purchasers up and down the value chain. Skilling loved the strategies he helped developed and agreed to join Lay at Enron and head up Enron Gas Services, which became the vehicle that propelled Enron’s growth, profitability, and stock price in the early 1990s.

By 1993, Skilling and others wanted even more growth and control over their markets, so they put together the first partnership designed to leverage their investments vertically in the industry. The Joint Energy Development Instruments (JEDI) were to be used to make investments that were strategically linked to Enron Gas Services business. In essence, Enron had entered some combination of venture capital and investment banking in the energy field. The best news was that their earlier success as traders had attracted a high-quality investor for the new partnership—CalPERS, one of the largest pension funds in the country representing public employees in California.

But the JEDI partnership was the first mistake in a series where arrogance took the company to places it never intended to visit. The leverage was extraordinary because Enron’s capital contribution to JEDI was in the form of $250 million in Enron stock. Since the markets were beginning to believe that Enron was a growth company, the stock was going up, which increased the apparent value of the JEDI investment.

Enron’s team believed they were good—really good—and their apparent success in the gas-trading business supported this belief. They began to believe Enron was destined to change the way business was done, and they set out to change conditions that stood in their way. Enron quietly became a significant lobbying organization in a number of states and at the national level. They sought rule changes to reduce regulation on trading gas and electricity, lobbied states to deregulate their utility industries, and lobbied the SEC to change revenue-recognition rules that were favorable to their business.

They understood that there would be opportunities to grow as the rules changed, and they had to be able to raise substantial capital, but the balance sheet would not support straight debt at the levels of investment they envisioned. They were looking for ways to raise capital without affecting the balance sheet, and JEDI was just the beginning.

Off-balance-sheet financing was not a new concept, but the sophistication and complexity of such deals evolved to a new level with the ever-inventive minds of investment bankers and consultants in the 1990s as special purpose entities (SPEs) became popular. Enron found a number of credible and willing investors, but over time their dreams got even bigger, requiring more capital. During the 1990s Enron came to dominate the deregulated gas markets and then moved on to become the largest player in electricity trading. By 2000, Enron believed their “model” could be extended almost infinitely. They began to describe themselves as a logistics company and tried to turn everything into a commodity that they could possibly securitize and, if necessary, transport and deliver. By 2000, over 95 percent of revenues came from wholesale energy services. They saw no limits and entered the water business, believed they would become a huge broadband player, and even considered a venture with Blockbuster to stream movies to the home. All the while they created more SPEs to fund the growth and to drive apparent profits without (apparently) hurting the balance sheet.

There were some who began to question “The World’s Leading Company” slogan that Enron adopted. In March 2001, Fortune magazine ran an article entitled “Is Enron Overpriced?”⁶¹ pointing out that with a stock price at 55 times trailing earnings, only 7 percent return on capital, and decreasing cash flow, something looked askew. Increasing questions about how they made money and suggestions that the model might not be as profitable as claimed just made Enron executives state even more assertively that their processes were simple but secret and could not be revealed. Many investors continued to buy it—for a while longer.

The financial statements were complex, but the objective was not. Enron wanted to become a growth machine, and the only way they could do it was to do more and more deals. In fact, Enron CFO, Andy Fastow, liked to give out dollar bills with his picture on them, in a western hat smoking a cigar, part of the persona he developed to convince insiders that he would find fuding for their deals.⁶² Fastow tried to make the world believe that Enron was conservative and even said that Enron did not speculate.⁶³ This blatant inconsistency, essentially telling everyone internally that he would fund most any deal and telling those externally that they did not speculate, pointed to the difference between the Enron portrayed to Wall Street and reality.

Enron wanted to be seen by investors as a growth machine but with predictability. The reality was that they did this reasonably well in the early 1990s by taking advantage of changing market conditions. But their aspirations and arrogance, fed by earlier success, got the best of the team, and they set huge expectations, internally and externally. The markets believed it for a while, and then they had to deliver. This led to an internal culture that was “cutthroat, do anything necessary, but get a deal done that makes money.” Risk? Enron began to believe they could manage any risk created with financial engineering because they were not just smart but smarter than everyone else. Maybe some of them actually believed they were not taking much risk because the structures used were so convoluted that it isn’t clear if management and the board even understood them.

There were warnings, though, beyond the few analysts and reporters who dared to risk their careers by criticizing “The World’s Leading Company.” One of the most visible wake-up calls (after the fact) was from Sherron Watkins.

Watkins was an Enron VP who found herself in a new job in summer 2001. She was in Fastow’s organization and had responsibility for going through the assets Enron owned to help determine which ones might be sold to raise cash that year. She came across a complicated group of assets that had been hedged with funds raised through an organization called “Raptor.” When Watkins had others in the accounting organization explain the vehicles and questioned them, her questions were deflected with the defense that the accountants (Arthur Andersen) had approved the transactions.

It was not long before she realized that there was huge risk in the SPE structures that Enron had used serially. Not only did she realize that employees, especially Fastow, were acting in a conflicted capacity on both sides of the transactions, but Enron’s financial contributions to the entities was guaranteed with Enron stock. This was not a theoretical risk because, by summer 2001, Enron stock had lost half its value from the previous fall as investors found the P/E ratio hard to sustain on the facts.

Watkins drafted a memo that outlined her concerns about the structure of the SPEs, the conflicts, the use of stock for the capital contribution, the effect on Enron’s income statement and balance sheet, and the fact that $500 million or more in unrecorded losses were already lurking in the partnerships. She even drafted a plan for recovery that included hiring an accounting firm other than Andersen to help clean up the mess.⁶⁴ She sent the memo, confidentially, to one of her superiors for reaction.

Following much soul searching while others tried to dissuade her, she obtained an appointment with Ken Lay in mid-August 2001 and laid out her concerns. Her meeting ended with Lay’s apparent interest in the problem and an offer to help her find another job in the company since she felt she could not stay as part of Fastow’s group.

Watkins’ warnings had little effect or were too late to have an impact for a company that had already made too many mistakes. A little more than six weeks after Watkins’ warning to Lay, on October 16, Enron made a press release that announced a loss of $618 million in income and made no mention of the fact that it had also written down shareholders’ equity by $1.2 billion.

On November 8, 2001, Enron announced that it would restate earnings for the last 4¾ years because they had not followed generally accepted accounting principles (GAAP) in dealing with the off-balance-sheet partnerships. Enron executives tried to arrange a last-minute merger with Dynegy, a competitor in some similar businesses, to stabilize the financial situation, but Enron was in too much trouble for anyone to take the risk. The end was nigh, and on December 2 Enron filed for bankruptcy, unable to make multibillion dollar capital calls on its various deals plus debt downgrades that triggered covenants with lenders that it could not fund.

The technical cause of Enron’s failure is straightforward—its executives took extraordinary risk by choosing to overleverage the company in an attempt to sustain high growth. Enron’s leverage was achieved with off-balance-sheet smoke and mirrors. These actions were blessed by an accounting firm, Arthur Andersen, that was involved in a greater than average number of questionable audits and no longer exists. This convenient assistance from Andersen meant that it took longer for the markets to figure out something was wrong, and the fall and damage was greater than anyone could have ever imagined.

Management’s actions at Enron did not completely destroy the company’s businesses, a number of which are viable (such as pipelines and local utilities), but they did destroy the ability of the company to function as a viable economic entity. The bankruptcy lead to layoffs, worthless pension plans, massive credit defaults, and ripple effects wherever Enron did business, as shareholders saw virtually 100 percent of their equity wiped out and creditors lost an estimated 80 percent of their claims. Lawsuits will continue for many years, threatening the ability to utilize any remaining assets in a businesslike manner.

Enron is one of the most complex mistake chains imaginable. This was a case of “Multiple Failures to Manage Multiple Mistakes,” perhaps represented as (M³)³ (which would equal M²⁷), which is probably indicative of the damage from Enron when one considers the losses to creditors, shareholders, employee retirement funds, and more than 5,000 Enron employees who lost their jobs. In related events, Arthur Andersen, Enron’s accountants, implicated in the wrongdoing, put 10,000 or more employees out of work worldwide when they went under as a result of their Enron-related activities.

There were multiple examples of mistake chains at Enron, each one of which included multiple mistakes in such significant numbers that this can be considered only a representative list:

• Desire for growth

• Ken Lay had aspirations for Enron to be a high growth/high profit company. He and Skilling initially saw the deregulated gas industry as the engine. With some success there, they began to lobby heavily at federal and state levels for changes that would allow them to grow. It is not clear that Enron had any unique value to add in many of these businesses or geographies, but they had ambition. Enron seemed to see lobbying as a significant success factor in their business plan, something many businesses would see as necessary but not a central part of the strategy as it was at Enron.

• The need for growth pushed them to believe they could securitize almost anything, leading them to aggressively push technology-enhanced trading businesses.

• Enron came to believe much of the dotcom mantra about broadband and made huge bets that they could rapidly control much of the market by becoming a market maker for broadband capacity.

• They believed that many of the same plans would work in other countries and aggressively sought large overseas acquisitions and deals—solely for the sake of growth.

• Aggressive financial management

• The growth objective was so overpowering that they took on huge risk through the SPEs.

• There seemed to be little concern that there was any risk to increased leverage, other than the fact that rating agencies might downgrade their credit rating if they knew about the true exposure Enron had, so it was hidden in the SPEs.

• Buying CalPERS out of an SPE (JEDI) at a profit through another SPE (Chewco) on a leveraged basis amounted to a Ponzi scheme but with the use of Enron stock as collateral.

• Recognizing fees paid by the SPEs to Enron in Enron’s statements, when the money came from Enron’s guaranty of loans the SPEs had taken from an unrelated third party (Barclay’s Bank), without any mention of the contingent liability that was assumed, was not only aggressive, but illegal.

• Recognizing “management fees” paid to Enron as income without accounting for the proper period over which they should have been earned was also a violation of generally accepted accounting principles. Worse, the source of these fees was once again the same borrowed funds that Enron had guaranteed off the books.

• The SPEs (JEDI and others) held Enron stock as collateral for Enron’s investment in the partnerships Enron formed. Enron recognized revenue as a result of the increase in value of this “investment” when Enron’s own stock price was still going up. In the first quarter of 2000, this increased Enron’s income by $126 million. By the third quarter of 2000, Arthur Andersen, which had approved the earlier transaction, had decided that recognizing income in this way was not appropriate.

• Enron, through the SPEs, wrote puts and calls on commodities, equipment, and entire power plants, all done with little legitimate business purpose other than managing earnings.

• Unfailing belief in a new business model

• Enron’s management really began to believe they could enter virtually any business and find a way to dominate it through clever trading and market making.

• Beyond the traditional natural gas business, Enron found itself in electricity, water, pulp and paper, fiber networks, retail broadband, and finally Enron Online, a general-purpose online trading site.

• Push boundaries to win

• Fastow substituted a lower-level employee (Micahel Kopper) as a principal in some transactions to get around proxy disclosure requirements regarding conflict of interest for senior officers.

• Enron pushed its auditors, Arthur Andersen, hard, and they seemed to acquiesce regularly to aggressive, and often incorrect, opinions.

• Enron regularly pushed a number of the world’s top banking organizations to rate their stock favorably or risk losing investment banking business. Most caved to the pressure and hyped Enron stock.

• Lack of oversight

• There was an unbelievable lack of oversight by the board and its committees, which asked few questions about transactions put before them, approved transactions that put Fastow in conflict of interest situations, and even approved an exception under Enron’s Code of Conduct to allow Fastow’s participation as general partner of an SPE (LJM1) because the management team told the board it was good for Enron and they did not see a problem.⁶⁵

• The board failed to see patterns in the large number of SPEs that seemed to have little legitimate economic purpose other than to manage earnings.⁶⁶

• Fastow allowed Kopper to be paid huge fees for his role as partner in SPEs, clearly a serious breach of fiduciary responsibility on the part of both.

• The executive group broadened the group of subordinates who were allow to “invest” in the SPEs, with extraordinary returns essentially guaranteed on a preferred basis over the company.

• The board’s Audit and Compliance Committee was assigned the duty to oversee the transactions the board knew about and approved, but the committee failed to exercise its oversight responsibilities in anything but a mechanical fashion.⁶⁷

Every one of these mistake chains was a direct result of a culture of supremacy that was built consciously by Skilling, Fastow, and others. They believed that the management team at Enron was simply more intelligent, insightful, and skilled in all business matters than anyone else in the world. The supremacy culture began with some large egos (Skilling, in particular) and developed further as a result of legitimate business successes on a modest scale. The outsized egos grew and led these executives to feel that they really knew what they were doing and that competitors were truly ignorant and oblivious to the changes taking place around them. Although Enron was not a dotcom business, the mentality was similar and actually made worse because Enron really did have revenues and profits.

The result was the belief that Enron had found the Holy Grail of business, or what I call the “Silver Bullet Effect.”^* It is surprising how many naïve business people believe there is magic to be found. Based on many years of designing, teaching, and overseeing executive education programs, I would estimate that 5 percent of executives really believe there is a “silver bullet” answer somewhere to their business problems, and if they can just find the right guru or analyze hard enough, they will find it.

^* For many of us who grew up in the 1950s, the weekly episode of The Lone Ranger was a must on television and a source of negotiation with parents since it appeared on a school night (Thursday). The Lone Ranger’s silver bullets were unique and identified him not only as the best at what he did (finding bad guys) but as someone who always won.

This searching for the silver bullet is more damaging than amusing. It leads to the delusional belief that if you find the silver bullet, you don’t need to worry about competition because your advantage will be unquestionable. The fallacy with this line of thought is that, even if you find a silver bullet, the time it takes others to acquire them is nil in a hypercompetitive world.

This is what happened culturally at Enron. Senior management believed they had silver bullets, they told the troops down the line that the company had lots of silver bullets, and the board, outside investors, governments, and magazine editors believed it as their faces showed up in articles and cover stories.

Unfortunately, the silver bullets turned out to be the same lead everyone else used with some silver paint that began to peel off. Worse, when everyone looked a little deeper, they found Enron was a bunch of kids scaring people with toy guns, doing a lot of damage in the process.

There is a fine line between world-class motivation to achieve and destructive arrogance. Good leaders encourage a management team to believe that they are good, that they are capable of doing things they never imagined they could do, that their sights should be higher, that they can do substantially better than competitors, and that they can overcome obstacles others see as roadblocks. Leaders who put their own egos, personal victories, and compensation above the organization’s success cross the line from productive motivation and encouragement to destructive arrogance.

Once arrogance became the dominant behavior for senior management at Enron, another very dangerous effect took place that had to do with pushing boundaries. Enron got so used to believing they could change the rules of the game through lobbying for legislative or regulatory changes that they pushed the principles of influence and negotiation to accounting and legal interpretations. They pushed accounting issues with Arthur Andersen, for example, meeting only minimal requirements to justify the treatment of their SPEs. Even these minimum requirements were ignored later through the use of structures and transactions so convoluted that the only conceivable purpose was to give the appearance of improved performance while obfuscating the truth. This behavior was so out of control that is it unlikely that anyone fully understood what was going on any longer, even Fastow and the other perpetrators of the fraud and deception.

Insight #29: Culture is powerful—what creates success may kill you. The cultures of AMI, Ford, Firestone, and Enron worked for and against them. There are many examples, typically in the early stages of successful companies, where culture helps organizations see things in markets that others miss, get past survival challenges, grow faster, and weather competitive threats. The same powerful, but hard to define, force that binds an organization together for success can also be a catalyst for, or even a cause of, failure.

Ford and Firestone started a century ago as entrepreneurial companies based on unique visions of their founders. They succeeded against great odds and over time became huge corporations. But the cultures that created the successes became bureaucratic and focused primarily on operating efficiency, to their detriment in changing competitive markets.

In the case of Enron, the entrepreneurial visionary spark and culture that created early success rapidly became a fleeting flame. The flame was smothered by the actions of senior executives who took risks to support their egocentric needs for outsized success beyond the laws of economics, and once that line was crossed and they saw the flame being extinguished, they did not know how to stop the process and save their egos. The destruction could have been stopped earlier, in time to save something of the company, but that would have involved personal admissions of imperfection and poor judgment. As a result it became all or nothing—huge success or one of the largest failures in the history of business. Dysfunctional culture and ego lost, as they usually do. The laws of economics won again.

No matter what the culture or circumstances, however, it still generally takes multiple mistakes to cause serious damage. This means there are still chances to break the chain, but it is difficult, if not impossible, when the nearly automatic cultural reaction is to reject any effort to break the chain.