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Editor’s note: On June 10, Sherron S. Watkins, former vice president of Enron Corp., spoke to more than 200 people in the ballroom at the Magnolia Hotel in Houston. Watkins is known for alerting then-Enron chairman Ken Lay to accounting irregularities within the company. She was one of Time magazine’s 2002 Persons of the Year and is the co-author of “Power Failure: The Inside Story of the Collapse of Enron.” The Houston event was presented by Executive Legal Adviser and Texas Lawyer. A portion of Watkins’ speech appears below, edited for length and style. I think the Enron story remains so interesting because it cannot be boiled down to six people under pressure in the CFO’s office that [allegedly] just … cooked the books for a period of time. Enron’s activities really involve hundreds of employees, from the accounting departments, the legal departments, the finance department, from the outside, the outside auditors, the outside lawyers, the commercial bankers, the research analysts. When I have spoken at fraud conferences, I have learned some interesting statistics, and for white-collar crime to happen they say it’s a three-legged stool. First is extreme pressure to cheat, to make earnings, to make the numbers, you know, some particular pressure that is extreme. Secondly, it’s an opportunity to cheat. But the third leg is the most important, and that is a rationalization that what you’re doing is OK, that it’s not wrong. And that certainly was what happened at Enron with Enron’s finance and accounting transactions. There was always a rationalization that … we are following the accounting rules somehow. Now, when you take a look at it, those accounting rules were twisted and perverted in ways they were never meant to be used and applied, but there was still some shred of accounting rules to hang onto that this might have been OK. At least that’s what people comforted themselves with. With Enron … the company was known as the most innovative company by Fortune magazine for seven years in a row. The company was always pushing to innovate, innovate, innovate, and in the long run they ended up looking at their accounting department as a place to innovate and the tax department as a place to innovate. And of course the lawyers were drafted to help in those arenas. And the dark side of innovation is fraud. When you push people too far and too long, that’s what they come up with. [A]lthough I wrote “Power Failure,” I do want to use one analogy out of a competing book. “The Smartest Guys in the Room” was written by Fortune magazine, and they had a quote from one of Enron’s accountants that I think … typifies how Enron’s accounting got so far out of hand. And, really … my warnings to Ken Lay, to be truthful, were too little too late. I was warning about an income statement manipulation that I had run across, but unbeknownst to me and loads of other employees and certainly all of our shareholders, Enron had become horribly overleveraged. When Enron declared bankruptcy, the company had reported $13 billion of long-term debt on its balance sheet. Well, Enron told its creditors in December 2001 that the true long-term debt picture was $38 billion … triple the level that was reported. Most of that off-balance sheet growth had happened since around ’98, ’99. The company was way too overleveraged to live. … I even think if Ken Lay had listened to my concerns, the company would have still ended up in bankruptcy. But to explain how Enron’s debt grew to such incredible numbers, “The Smartest Guys in the Room” is a great analogy. And what it says is that let’s say Enron is trying to offload some assets into in an off-balance sheet deal. It wants sale treatment. Enron wants to book that off-balance sheet transaction as a true sale, recognize cash flow from operations and revenues. However … it really is a debt deal. The assets just don’t stand on their own. The bankers aren’t going to just buy those assets, lend against them on their own. So what this Enron accountant described is Enron has a dog. It’s a debt deal; it’s a dog. Enron needs a revenue deal, and let’s call a revenue deal a duck. Well, what Enron’s accountants and lawyers and financial professionals would do is pore through the accounting rules and say, well, you know, the accounting rules, granted it is 30,000 words and it is … a lot of information, but it can be boiled down to these three concise facts. … [T]aking away everything else, a duck deal … the duck has to have yellow feet, a white feathery back and an orange bill. The rules clearly define that you can book a deal as a duck if it has yellow feet, white feathery back, orange bill for a nose. So Enron would take its dog, glue yellow feet on, paste some white feathers on its back, and tie an orange bill to its nose and say, “Aha, we have a duck. We get to book this as a revenue deal.” Well, everyone would look at it and [say], “Oh, it looks like a dog.” And then in Enron’s normal fashion they would get a little hostile and say, “No, you cannot deny we have yellow feet, a white feathery back and an orange bill. Why do we have accounting rules in this country if they’re not to be followed? We meet the rules, we get to book this as a revenue deal.” [T]he trouble with a lot of Enron’s deal[s] were as soon as Arthur Andersen left the room, the orange bill tended to fall off. The deals were a little bit rickety. But that’s really how so many transactions got pushed through and closed and how debt grew off-balance sheet to $25 billion, double the debt level that was reported. My discussions center on … how I was at Enron for eight years and blinded to this fact. What are the rationalizations that you begin to hear? How can you recognize when you’re hearing them? Because, in Enron’s case, there are loads and loads of inside folks and outside professionals that [allegedly] play along. And I am lucky in the sense that I did move within Enron when I ran across outrageous behavior, and I guess that’s what has kept me … in the clear. I try to explain for business leaders … how do you instill an ethical value system in your company [and] make sure Enron doesn’t happen to you. Because it is the tone at the top. You can’t change the value system from the bottom, the middle or even close to the top. It has to be the tone at the top. But then as someone in the organization, as an employee, how do you recognize when your company’s culture is growing rotten and get out? Because that’s what you really should do, get out. Or from an in-house counsel perspective or from an outside lawyer perspective … when should you recognize those business rationalizations that need a little role-playing? And I can tell you from my own personal perspective that whenever Enron was pushing a questionable transaction, it almost always was accompanied by someone saying, “Well, you know, it’s not illegal, not technically. I mean, we could justify this in a court of law.” Well, whenever I heard those words … I almost always said, “Fine, then, let’s role-play this. Let’s pretend we are in that court of law and let’s do a little role-playing, and I’ll play the adversary setting, and I’ll play what that other side is going to say about this transaction.” And it wouldn’t take long. It wouldn’t take even more than five minutes. But role-playing, what the adversary was going to say, usually got us on a better track and we didn’t move toward that questionable transaction. I mean, it doesn’t take much, but you can get a lot of people comforted with the words, “Well, it’s not technically illegal and you could justify it.” In this day and age, I don’t think juries are listening too comfortably to anything associated with financial fraud and cooking the books. And we’re going to stay that way I think for quite some time. I think that the CEO must realize that he will not have a value system that’s worth anything if he’s not living it and breathing it himself, in every single instance. And even if it seems minor and really … not a significant issue … it can send all the wrong messages. But, also, I have the privilege of speaking at a number of really incredible CEO leadership conferences, and I am struck by the same story over and over and over again, and that is the CEOs that are sitting atop companies that are known to be highly ethical, that have a very robust value system that everyone knows is top priority, each one of these CEOs has a heartbreak story. And I think this is the most difficult thing for a leader, to make sure your value system stays in place when you have an employee, particularly a well-performing executive, that violates that value system, you have to let them go. [O]bviously, if someone is not performing and they violate your value system … they’re gone. But, you know, the trouble is always when that star, that person that’s great with the customers or great with generating sales numbers violates your value system. There’s always, always a push to try to save that person … to come with excuses for them, to give them that second chance. But when that happens, you send the message that the value system is second to making the numbers. The value system is second to being good with customers. And once that happens, you’re already on the slow road to ruining your company. And I have been amazed that these CEOs talk about what really seems like minor things. In one instance, a consumer products company was in a heated competition with another company. A very highly valued executive — his wife phoned up the competitor, pretended to be a disgruntled customer, to see how the competitor treated a disgruntled customer. Well, of course, the competitor found out, was making a lot of noise, you know, had violated various rules in place. This executive, this CEO, was really grooming this executive for great things, and it really broke their heart to have to let that executive go. But the CEO said, “You know, I’m never going to know what happened in that household. The executive told me he had no idea his wife was going to do that, no idea she had made that call, but none of us will ever know what happened in that household. And if I let him stay it sends the wrong message, that if you’re a well-regarded executive you’ll get a second chance.” Another story I heard was … an executive that took some plastic sheeting home. He was a division head; took plastic sheeting home because he was renovating his house. An internal audit found it and [someone asked], “Oh, you know, executive so and so has taken about $700 of plastics home to his house, should we just send him a bill?” And the CEO said, “No, I can’t do that. You know, he should have paid for it in the first place, gone through all the right channels in the first place. If we let him just pay for it now, it says go ahead and steal from the company, hope you don’t get caught, and if you get caught, we’re just going to make you pay for it.” It always ends up being something silly and stupid, but it is momentous and you really have to pay attention to those tiny things. And I have become so much more in tune to that. I don’t know how many of you saw the Ike special that A&E had on Memorial Day. It was about an hour-and-a-half long special on General Eisenhower and D-Day, and there was a scene in that movie that I now recognize for why it is so important. But they’re leading up toward the D-Day planning and … obviously it’s secret, highly secret, highly confidential. They’re trying to put all this disinformation out there for the Germans to think … the plan of attack is for somewhere else. Well, they’re also trying to make the day, exact hour, unknown, and there was a high-ranking officer out at a restaurant in England having a little bit too much to drink and made a very loud announcement that, “Oh, this sorry British wine. At least in four days we’ll be in Paris drinking some good stuff.” And it was overheard by a number of people. The next part of the scene, this ended up being a roommate of Eisenhower’s from West Point, someone he was very, very close to. And they showed the scene of this … officer just begging for his job … really apologizing that … “I’m sorry, I just had too much to drink, it will never happen again, please don’t send me back to the States, don’t send me back, don’t send me back. We go back so long. … [T]hink about our friendship.” And Eisenhower said … “That’s what makes it the hardest. That’s what makes me really have to do this. But, you know, I’m going to have to send you back.” In that moment, everyone else got the message that your lips should be sealed. If he had given his buddy the break … who knows? That would have sent the message that if you’re a close friend of Ike, you can have loose lips, but who knows what other lips it would have loosened up. But it was a really incredible poignant moment in this movie because that’s some of the decision-making that makes the leader … shed some tears, you know, really something hard to do. That’s what makes a good leader, that in the small decisions, you take them seriously and do the hard, hard, hard work to really put your organization first, to put your employees, your customers, your business first and not do the easy thing. And I think that’s what’s so difficult in this day and age. It seems like everyone wants the easy way out, and they’re very much focused on themselves. … I worry about the leadership nature in this country, what we’ve developed. I mean, the CEO pay issue. … I certainly agree with Warren Buffett … he said he’ll believe there’s been a spirit of corporate reform adopted when we see CEO pay decline in this country. You know, it’s just outrageous. Our CEOs make … above 300 to 400 times our average worker. In 1990, our CEOs only made 85 times above the average worker. Every other developed country in this world is — Britain is 45 times above the average worker, Canada is 20 times and Japan is 10. We’re up there in the hundreds. This pay is absolutely outrageous, and it signifies a core problem of executives who are in some sort of competition of who can make the most. Their focus is on themselves first and their organization second or third, and we need to focus on that. But I also am concerned about the attitudes toward the Sarbanes-Oxley Act. And the Sarbanes-Oxley Act, really, when you boil it down, it comes up with very, very few new rules. I mean … certainly there are whistleblower protections that weren’t in the law before. It is easier to send a CEO to prison. You don’t have to prove criminal intent for pushing out misleading financial statements. You know, that’s a biggie. It does put some requirements on lawyers. It requires … the outside directors to meet independently of management. … [A] lot of the things that they put into law were really on the best practices list for years. So, when you think about what the Sarbanes-Oxley Act did, it really is clarifying existing laws and regulations and putting best practices into law. But it’s really calling for a culture change within organizations, saying, “OK, if you just don’t … realize that you’re supposed to live by the spirit of existing laws and regulations, then we’re just going to spell it out for you and make it a little more difficult for you not to live by the spirit of existing laws and regulations.” It’s calling for a culture change of financial transparency, push out financial statements that fairly represent your financial condition. Fortune magazine pushed out a short list of every question a board member should ask last fall, last October. One of them — how does bad news get to the top? That’s key. How does the company put in place processes for bad news to get to the top and how is that bad news digested when it gets there? The whistle-blowing protections kind of fall into that. Employees are your best line of defense. You want to be able to hear when something is going wrong and correct it as fast as possible. Well, last fall — I office with an outfit near the Houstonian and they’re in this sector, this space — and on my desk I see a Fulbright & Jaworski half-day seminar and it’s on Sarbanes-Oxley Act provisions and it’s on whistle-blowing and it’s a mailer out to their clients to come hear what Sarbanes-Oxley has to [say] about whistle-blowing. Well, the title of the day was “The Corporation Under Siege,” and that says it all, because corporations are acting like we’re being attacked. How do we combat this horrible, horrible law that’s been put in place? Well … I hate to tell you this, but those ethical CEOs that I hear talking, they welcome the act. They say, “Great, this just puts everyone else on the same playing field that I’ve been playing on.” And really, it’s starting to be a little clue for me that when CEOs protest too much — you know, why in the world are they protesting that this is taking up so much time? Well … there’s the camp of companies that have been doing it right. OK, this takes up a little cost, a little time, not much. There’s a group of companies that say, “OK, I get it, financial transparency.” They put their lieutenants in charge of change and they make it happen. It doesn’t eat up too much CEO time. This third group of companies that wants to keep the status quo in place, they want to keep their same bad behaviors going, but, oops, this act does increase their risk of going to prison, so they’re spending all their time with their lawyers trying to figure out, you know, “am I covered, am I covered? . . . [W]hat does the act say? What are we still doing? … [W]hat’s my risk of going to jail?” If you’re trying not to live by the spirit of existing laws and regulations, then the Sarbanes-Oxley Act is going to eat up a lot of your time because it does increase your personal jail-time risk. That’s the wrong attitude. We need business leaders that embrace it. And I think if they don’t start changing, we’re going to see more regulation, more laws passed, because there’s an angry mob out there represented by the public pension funds. … [Y]ou have these cocky CEOs that say, “Look, if shareholders don’t like what we’re doing they can sell our stock.” Well, those public pension funds … they are not in a position to just sell stock. They really have to dance with everybody at the dance and so they’re trying to improve the whole dance. But they are not going away. You know, they are no-voting people like Sandy Weill at Citigroup, no-voting Michael Eisner at Disney. They’re pushing Bill Donaldson at the SEC for even greater reform. And I don’t see that changing, because behind their back is a whole slew of their plan holders about to retire. Their liabilities are huge. They want a market that works, is efficient. They don’t want any more Enron and WorldCom meltdowns. Enron cost shareholders $60 billion, WorldCom $100 billion. These kind of things are devastating and we’ve got to find the way to avoid them. And we’re going to see some more change if we don’t see the right spirit of reform adopted within our business leaders.

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