When companies break the law, the first thing chief executives typically do is plead ignorance and blame everything on rogue underlings. In recent months investors have been treated to a parade of indicted former CEOs -- from WorldCom's Bernard Ebbers to HealthSouth's Richard Scrushy -- claiming such a defense. But few have been quite as aggressive at it as ex-Enron CEO Kenneth L. Lay. A few days after his criminal indictment on July 7, Lay offered up the perfect illustration of the deaf, dumb, and blind defense: "I cannot take responsibility for criminal conduct that I was not aware of," he told CNN's Larry King. "Enron was a company with about 30,000 employees in about 30 different countries."
Lay's defense may ultimately be successful. It is still unclear how much he knew about the company's financial deceptions. But his indictment raises a fundamental question of corporate governance: Just what should a CEO be expected to know about the basic operations of his company? After all, the alleged fraud at Enron was hardly something buried under five layers of bureaucracy. It was allegedly masterminded by Lay's two top lieutenants and provided the very basis of Enron's profitability. While no one exec can be expected to know everything that goes on at a multinational, it is hardly a stretch to argue that a CEO who pocketed hundreds of millions for running a company should bear some responsibility for knowing where its profits come from and that those profits have been earned legitimately.
The combination of Lay's indictment and the conviction of Adelphia Communications Corp. CEO John Rigas on 18 counts of fraud on July 8 should serve to warn Corporate America that the old excuses won't fly anymore. Judges, juries, prosecutors, regulators, and shareholders are holding CEOs to higher standards. Ignoring red flags, accepting suspect or overly upbeat advice, and turning a blind eye to questionable practices as long as the profits keep rolling in are no longer acceptable forms of management.
Unlike Lay and Rigas, the new generation of CEOs must personally vouch for their companies' financial statements. Under the Sarbanes-Oxley Act, inspired by the meltdowns at Enron and elsewhere, any reporting errors may be punishable by imprisonment. CEOs "are not being asked to guarantee their company's performance, but they are being pushed closer to that role," says University of Texas School of Law securities professor Henry T.C. Hu. "That's why they make the big bucks. If you are laying claim to the successes of your company, why not pick up the downside?"
Coming after an era of unprecedented financial scandal, the new executive accountability has plenty of populist appeal. But not every CEO is going to confront such seemingly clear evidence of wrongdoing. In fact, many experts question whether the new climate is placing unrealistic burdens on corporate leaders. Sometimes CEOs really don't know when bad things are happening. Other times they have no choice but to rely upon the specialized expertise of, say, tax lawyers, geologists, or engineers. "CEOs are visionaries and strategists. They are not supposed to get into the level of detail [Sarbanes-Oxley] requires," says Thomas V. Sjoblom, a Washington litigator who has challenged the constitutionality of the 2002 law on behalf of criminally indicted ex-HealthSouth CEO Scrushy.
The legal boundaries of this new world are still unclear. But chief executives are already changing the way they do their jobs. Forced to delve into the details of potential scandals, they're spending more time than ever watching PowerPoint slides about tax shelters, hedging strategies, and arcane accounting issues. "I sometimes complain that it's a pain," says Thomas J. Corcoran Jr., CEO of FelCor Lodging Trust Inc, based in Irving , Tex. "Is some of it stuff that I'd rather not be doing? Yes. But at the same time, I think it's really good."
The question is whether the increased vigilance comes at the expense of long-term strategic planning. At Allstate Corp., CEO Edward M. Liddy says that he has to work harder than ever to meet his commitments. "I do worry that there's a little more focus on the internal control environment and the short term and perhaps less of a focus on the long term," he says.
Are Corporate America's leaders drowning in unnecessary details? It's too early to tell. But it isn't too soon to declare one casualty of the new legal climate: the figurehead CEO, the corporate celebrity who leads charities, hobnobs with politicians, and delegates the minutiae to somebody else. Lay exemplified this type of manager. While Jeffrey K. Skilling ran the company, Lay circled the globe in corporate jets and lobbied in Washington for energy deregulation.
In the old days, such a manager would have been largely immune from prosecution. Why? Because prosecutors have to prove that white collar criminals engaged in intentional wrongdoing. If a jet-setting CEO genuinely doesn't know that the CFO is cooking the books, then he or she isn't likely to wind up in jail. There is no such thing as criminal stupidity. Or criminal obliviousness.
While these rules haven't changed, the enforcement environment has grown tougher. Regulators are more willing to bring legally and factually challenging cases. Consider the aggressive prosecution of Martha Stewart. Or the fact that the Enron Task Force found a creative way to indict Lay even though it could not directly link him with the schemes that happened when Skilling ran the show. "The whole liability climate is different," says St. John's University School of Law securities professor Michael A. Perino.
Another big change is Sarbanes-Oxley, which will apply to future corporate defendants even though it was passed too late to use against Lay, Rigas, or Ebbers. The law does not modify the fundamental requirement that corporate chieftains have to engage in conscious wrongdoing. But it increases the likelihood that CEOs will get wind of illegal shenanigans, since they are required to ensure that their companies establish new reporting mechanisms designed to reveal any legal violations. This more robust information flow undercuts the ability of the boss to claim he didn't know what was going on.
The core issue for the current crop of CEOs is what will happen when a company files a 10-K with materially inaccurate numbers. While the legislators who drafted Sarbanes-Oxley did not intend to hold CEOs accountable for every misdeed in their organizations, they clearly wanted top execs to face increased prospects of jail time. Several months after the act was passed, Senator Joseph R. Biden (D-Del.) read a detailed analysis of its creators' intent into the Congressional Record. "If lower-level corporate officials conspire to hide the true financial health of the company from the CEO for whatever reasons, the CEO will not be held liable," Biden declared. And yet, he noted, "conscious avoidance of certain facts should not provide immunity from prosecution." Biden's guidance will certainly be studied closely by the courts.
In response to the new threat of jail time, many CEOs have tried to offload some of their Sarbanes-Oxley responsibility. One approach is "roll-up" certifications, in which lower-level managers are required to issue subcertifications for every accounting and legal issue that could generate criminal liability. Will this strategy help CEOs avoid prosecution? "No one will know until it's tested in [court], which is inevitable," says University of Delaware governance expert Charles M. Elson.
A similar air of uncertainty surrounds another key CEO defense: that he or she relied on the advice of professionals. Although Sarbanes-Oxley did nothing to puncture this alibi, courts have interpreted it far more narrowly in recent years. In Rigas' case, the fact that outside lawyers and accountants approved of some of his company borrowings didn't protect him. "If somebody from a law firm or accounting firm is telling you something that is too good to be true, then CEOs are not going to be able to rely on it anymore," says Hu of the University of Texas.
This is, in many ways, a brave new era for America's CEOs. Professionals can no longer automatically sanitize everything they do. Nor can they barricade themselves behind a wall of ignorance. If CEOs want to earn the big bucks, they're going to have to put their necks on the line.
By Mike FranceWith Louis Lavelle in New York, Joseph Weber in Chicago, and Stephanie Anderson Forest in Dallas