Skilling's Appeal and Enron's Legacy

(page 2 of 3)

• Pay-for-performance systems that ignore rigorously applied subjective judgments often promote gaming behavior and otherwise provide insufficient direction to executives.

• Stock options that are not indexed to both the movement of capital markets and gains in the price of competitors' stock can give executives unearned windfalls for uncompetitive performance and promote unwarranted overconfidence.

• Awarding stock grants without restricting the amount and timing of their sales weakens their incentive effects, allows executives to benefit from short-term rises in stock price, and creates conflicts of interest for corporate insiders vis-à-vis ordinary shareholders.

• Pay-for-performance systems that lack provisions for rescinding bonuses if companies revise their past or expected performance invite people to lie and game the system.

• Turbocharged incentives require turbocharged controls.

Board Oversight

One of the mysteries in the Enron case is how Enron's board of directors failed on so many levels to detect or deter questionable applications of accounting principles and rules. It failed to question the wisdom of using its own stock to hedge merchant investments rather than contracts with bona fide counterparties. It failed to monitor the conflicts of interests that the board itself had approved involving Fastow's dual role as Enron's chief financial officer and the managing partner of several off-balance sheet partnerships that purchased assets from Enron. And it failed to see and react to many "red flags" indicating that Enron's economic performance and its public commitment to ethical values were deteriorating.

Enron had a distinguished board—all hand-picked by former Chairman Kenneth Lay. At least some directors understood the natural-gas and power-generation business. How many actually understood derivatives, derivatives trading, and derivatives accounting is not clear. What is clear, however, is that the effectiveness of Enron's board was diminished by the following factors: Skilling's and Lay's intolerance of dissent, an incestuous relationship between Arthur Andersen auditors and Enron, weaknesses in Enron's esteemed risk-management process, a notable lack of rigor in examining the use of off-balance sheet partnerships, group norms against criticizing Ken Lay, and outmoded board processes. This mix of factors was sufficiently toxic to put the corporation in mortal danger.

To deter further Enron-type breakdowns in board oversight, public companies need to consider four innovations:

• Expanding their cohort of directors to include retired executives and entrepreneurs, independent of age, who have the time to serve as truly focused directors;

• Increasing the level of director compensation to keep attractive directors and candidate directors from drifting to the profitable world of private equity or other less risky assignments;

• Requiring that a different degree of directors' wealth be at risk through meaningful investments in company shares to ensure they have interests totally aligned with those of shareholders;

• Completely separating the role of CEO and board chairman.

This last innovation is the most important one. It is simply contrary to human nature to expect total objectivity from a CEO regarding his or her performance. One cannot expect a CEO in the role of chairman to prepare the board to evaluate lapses and failures on his or her part, or on the part of his or her management.

Today, a full 94% of the Standard & Poor's 500-stock index companies now have nonexecutive chairs or "lead" directors that coordinate the work of all independent directors, up from 36% in 2003. But the lead director solution is not adequate. Without a truly independent board chair who controls the recruitment and tenure of directors, sets the board's agenda, selects the information that flows to the board, and oversees the process of evaluating CEO performance, directors will be unable to shift the power environment of the board so that they no longer see themselves as employees of the chairman and CEO.