Interview with Sherron Watkins

Constant Warning

By Dick Carozza

Though the main Enron characters have received their prison sentences, there's no closure for corporate fraud. Sherron Watkins, Enron's sentinel, describes the debacle's details and warns that it could happen again.

Dec. 3, 2001. Black Monday. The day that Enron declared bankruptcy. CEO Ken Lay had left a voice mail on the phones of all Enron employees asking they come into the office regardless. Nearly 5,000 were called to a massive meeting and told that the paychecks that they had recently received would be their last. Three weeks before Christmas.

In August of that year, Sherron Watkins, an Enron vice president, had sent an anonymous memo to Lay that read, "I am incredibly nervous that we will implode in a wave of accounting scandals."

Of course, that's exactly what happened. After the company's demise, the investigating U.S. Congress discovered Watkins' memos to Lay and other top executives. (After sending the memos, she had met with Lay with no results.) Watkins was soon lauded as an "internal whistle-blower," brought before Congressional and Senate hearings to testify against her former bosses, and heralded by TIME magazine as a "Person of the Year," with WorldCom's Cynthia Cooper and the FBI's Coleen Rowley.

Five years after Black Monday, Sherron Watkins talks with Fraud Magazine about what went wrong, why it could happen again, weakening moral underpinnings, and the lack of ethical business leaders.

The Enron debacle was anything but simple, but what were a few of the reasons why it happened? Had management lost its way or was it a ticking time bomb from the beginning?

Many experts summarize "what happened" at Enron using two words, greed and arrogance. An accurate summary, I agree, but it fails to help others learn from Enron's demise. How did greed and arrogance run amok at Enron? How did a company's culture breed not only corruption from its own employees but also disreputable behavior from the outside auditors, lawyers, consultants, and lenders?

Enron was at one time the seventh largest company in the United States, based on Total Revenues. It collapsed into bankruptcy without ever reporting a losing quarter. More than $60 billion of shareholder investments became worthless; Enron owed $67 billion to its creditors, 20,000 of them who will or have received on average, 14 to 25 cents on the dollar. Nearly 5,000 employees lost their jobs with no severance pay or medical insurance, and far too many of Enron's employees also had all their retirement monies invested in Enron, losing not only their jobs but also their retirement savings.

What happened? It was a complete breakdown in moral values. But the scary part is that the breakdown was not done by outright intention but more by small steps in the wrong direction.

Certainly, Enron was not a ticking time bomb from its beginning; in fact, the company started life in 1985 as a merger of two large U.S. regulated gas pipeline companies that had been in existence for decades. One of Enron's early mission statements was "to become the premier natural gas pipeline company in North America," a laudable, non-arrogant goal. However, by the mid-90s, Enron had changed that mission statement, first, "to become the world's first natural gas major" and then in 1995, "to become the world's leading energy company." Pay attention to the words a company uses to define itself and its goals. A great deal of arrogance can be seen in the 1995 mission statement. Enron was a large company, but primarily it was still a natural gas company and nowhere near the size of the Exxons and Shells of the energy world. [In 2001, Enron's mission statement was "to become the world's leading company."]

By 1995, the company had been very successful. It had transformed itself from a stodgy regulated pipeline business to a state-of-the art energy trading shop, which eventually handled more than 25 percent of the country's gas and power transactions. The natural gas market had deregulated and Enron came out on top of the newly created energy trading industry. Folks were fairly cocky at Enron. The company was the top dog in energy trading; competing companies either moved to Houston or at least moved their trading operations to Houston. Enron made the city of Houston the Wall Street of energy trading.

Enron's ability to evolve and shape the energy markets in the United States earned the company accolades from many sources. Harvard University did a case study; Business Week, Forbes and Fortune routinely covered the company in a favorable light. In fact, Fortune named Enron the most innovative company in America for six years in row, beginning in 1996. Unfortunately, the dark side of innovation is fraud.

Enron's leaders set the wrong tone, so did Arthur Andersen's leaders. [Arthur Andersen was Enron's external auditor.] In the end, both companies put revenues and earnings above all else -- the means by which those earnings were generated did not matter. Were laws broken? Yes. Were lives devastated by it? Yes.

You've said that Ken Lay would force all Enron employees to book corporate travel through his sister's travel agency even though it was more expensive than more competent agencies. Can you tell me your thoughts about the importance of a proper "tone at the top"?

What I've come to realize is that leadership is tough “ very tough." All eyes are on you and the slightest erosion in values at the CEO level is magnified in the trenches.

Ken Lay was well known for his charitable giving and his verbal commitment to Enron's four core values -- respect, integrity, communication, and excellence -- but he was not quite walking the walk. He always had us use his sister's travel agency. Trouble was that it was neither low cost nor good service. Domestically, you could manage, but when it came to international travel -- that agency was very nearly incompetent. I was stuck in Third World countries where I didn't speak the language without a hotel room or with an insufficient airline ticket home despite paperwork that indicated otherwise. The incompetence was hard to understand. I would try using a different agency, but after one or two expense reports, I'd get a finger-wagging voice mail or e-mail reminding me that I needed to use Enron's preferred agency, Travel Agency in the Park; we all called it Travel Agency in the Dark.

Ken Lay was setting the wrong tone. He was in effect letting his managers know that once you get to the executive suite, the company's assets are there for you to move around to yourself or your family. In some perverse way, Andy Fastow [Enron's CFO who was originally indicted on 98 criminal counts], could justify his behavior, saying to himself, "Well, my creative off-balance-sheet deals are helping Enron meet its financial statement goals. Why can't I just take a million here and there for myself as a 'structuring fee,' just like Lay has been taking a little Enron money and transferring it to his sister for all these years?"

The CEO of a company must have pristine ethics if there is to be any hope of ethical behavior from the employees.

CFO Andy Fastow operated (and partly owned) LJM partnerships. He used these partnerships to mask hundreds of millions of dollars of losses on Enron investments. How was Fastow able to construct such complicated deceits with the tacit approval of top executives plus accountants and attorneys inside and outside Enron?

That's an excellent question that many still do not understand, me included. How in the world did a qualified and talented independent board of directors waive Enron's code of conduct twice, to allow Fastow, to form and run an investment partnership [named LJM] which for the most part did nothing but buy, sell, and hedge assets with Enron?

Enron had allowed Andy Fastow to enter into an unprecedented conflict of interest. Because he was CFO, his fiduciary duties included looking out for the best interests of the company while also becoming the general partner of this investment partnership, LJM, where he raised $500 million of limited partner monies and was charged with maximizing returns for limited partners.

Trouble was that LJM's business was to do business with Enron. In every transaction Fastow had to choose: Enron or LJM. No human being should be put in such a conflict. Why did Enron's board allow such a conflict of interest? I must conclude that their judgment was severely clouded by the fees they received as directors. Each director received nearly $350,000 per year for serving on Enron's board. That amount was double the high end of normal large public company director fees. The board routinely bragged about Enron's management team. How much of their "Enron can do no wrong" attitude was impacted by the fees they received?

The reason so many Enron executives, and finance, legal, and accounting professionals went along with the questionable -- and, in some cases, fraudulent -- off-balance-sheet vehicles is multi-faceted. Sometimes, their reasoning was similar to the board's: their judgment was clouded by high salaries, bonuses, and stock option proceeds. Another cause was diffusion of responsibility; it was Arthur Andersen's job to opine on complicated accounting structures, or the lawyers' job to vouch for the legality of certain arrangements, or the board of directors' role, etc.

Besides money-clouded judgments and the diffusion of responsibility, I often explain how Fastow and his team got away with it by recounting the "Emperor's New Clothes" fable. In that fable there is an emperor focused on his appearance not his kingdom -- that fits Ken Lay. And there is the swindle -- incredibly beautiful cloth but it is impossible to see it if you are stupid or not fit for your office. The swindlers play into people's insecurities. The emperor sends a minister to check on the progress of the weaving. The minister panics when he doesn't see any cloth. He knows he's not stupid, but maybe he's not fit for his office so he lies and says he sees it. Ditto for the second minister, and so on, until the whole town exclaims about the beautiful new clothes the Emperor is wearing in the parade.

Fastow's team of accountants, bankers, and lawyers devised very complex structures -- so complex, in fact, that when I was first looking into them in July of 2001, it took two hours for a business manager to walk through just one of them with me. When these structures were created, intimidation was used to keep people silent. CEO Jeff Skilling was well known for his accusation that those who didn't understand Enron or a particular structure were not smart enough to "get it."

Creating a highly competitive environment where employees did not want to appear weak or unintelligent was a root cause of Enron's problems. Smart people stopped asking questions for fear of looking like they didn't "get it."

You once said that you had no desire to take your fears of fraud outside Enron. In "The Smartest Guys in the Room," you were quoted as saying, "When a company cooks the books, their only chance of survival is to come clean themselves." Do you still believe that about the Enron situation or any corporate fraud situation?  

Yes, I do. I think when a company has committed fraud, its most meaningful chance of survival is to find it, disclose it, and fix it themselves. By the year 2001, Enron was primarily a financial trading house. A financial trading house lives on its investment grade rating and its reputation. Any hint of trouble and business disappears like water through a sieve. When I met with Ken Lay, I was both optimistic and naive. I not only expected that a thorough investigation would occur but I also expected Enron to establish a crisis management team to address the financial peril Enron would face when the accounting was exposed, which in my opinion was sure to happen. In the long run, companies rarely get away with "cooking the books." But no other top executives came forward to back me up and Ken Lay gravitated toward good news and didn't quite accept what I was saying.

Many probably think that you wrote just one memo to Ken Lay but you actually sent seven pages of memos to him and memos to other top executives. In many of those memos you listed intricate details of the situation with several recommendations. And then you met with Lay face to face. How could it be that in a company of that size there was no one else who was willing to, as that old adage says, "speak truth to power"?

After all of the Enron investigations and trials were completed, I did discover that others had sounded the warning bells and some very early on. There were managers within Enron, actually in the room when Enron's questionable accounting structures and schemes were hatched, and they complained -- they tried to stop their birth. But in every case that person was shot down. Others soon realized to protest was fruitless and they just left the company. Or they reacted the only way they knew how -- they posted comments on Yahoo's message board.

On April 12, 2001, the following message appeared on Enron's message board: "The Enron executives have been operating an elaborate con scheme that has fooled even the most sophisticated analysts. The first sign of trouble will be an earnings shortfall followed by more warnings. Criminal charges will be brought against ENE executives for their misdeeds. Class action lawsuits will complete the demise of Enron." And that's when Enron was selling for $50 to $60 per share.

You had a final meeting with Lay, at which you actually gave him one more memo with proposed action steps: "My conclusions if we don't come clean and restate: All these bad things will happen to us anyway; it's just that Ken Lay will be more implicated in this than is deserved and he won't get the chance to restore the company to its former stature." What made you finally realize that he, too, was implicated in the fraud?

The last meeting I had with Ken Lay was at the end of October. The company had written off the structures I was concerned with but as a current period write-off, not in the correct fashion, as a prior period restatement. The Wall Street Journal had run very lengthy exposé-style articles, the stock price was tanking and Enron, primarily Ken Lay, was not being honest about things. Ken Lay was making comments like, "We have no accounting irregularities." "Now is a good time to buy the stock." "I have the utmost faith in Andy Fastow." "We could have done the related party transactions with an outside third party." These were all statements that eventually helped the Department of Justice win a criminal conviction against Lay.

Mary Jo White, former U.S. attorney for the Southern District of New York, once said that executives at companies in the "90s engaged in group rationalization" an extrapolation of the third leg of the renowned fraud triangle developed by Dr. Donald Cressey. Despite the changes so far in this century, is that still the case?

I do believe that executives rationalize their pay packages as well as aggressive accounting and other problem areas. My biggest concern for corporate America right now is that we have so few truly ethical leaders. The Enron scandal was the first, followed by a whole slew of others and we discovered with each scandal that the watchdog groups that are in business to protect investors failed: auditors, outside lawyers, Wall Street research analysts, and the nation's largest banks.

After all the corporate scandals, we had the Wall Street scandals -- tainted stock research, among other things. Then the mutual fund scandal with money managers trading against their own customers for personal gain, trading after hours, and giving preferential treatment to larger customers. Next we had the insurance industry scandal unearthed by Elliot Spitzer. Now its outsized CEO pay packages and option backdating.

What has happened? It is very ironic that we get on our high horse and claim to have the world's most moral and fair system and try and force other countries to conform, when in actual fact we have such a broken system.

In order to flourish, a successful capitalist system -- really any system, be it education, medicine, business or government -- must be predicated on fairness, honesty, and integrity. In fact, many scholars describe the capitalist system as a three-legged stool -- one based on economic freedom, political freedom, and moral responsibility. A weakness in any one leg and the stool topples.

Michael Novak, a former Catholic priest, wrote "The Spirit of Democratic Capitalism" in 1982. In his well-regarded book, he praises the virtues of a democratic capitalist system for its ability to raise the standard and quality of life for those less fortunate, for the poor. He assumes, however, that an appropriate system of checks and balances actually exists such that a challenge or a weakness to either the economic and political freedoms within a capitalist system or the moral fiber of its leaders would be almost immediately corrected.

We have seen morality problems in the past addressed with new laws, most notably that of child labor abuse, environmental pollution, and worker safety. Business leaders in those days complained about the restrictions and about the government killing our economic system with overly burdensome regulations. Same song, different verse. But we all survived. However, I see a slight difference today; there is less moral outrage about the pure materialism involved in capitalism. Instead of more outrage about CEO pay packages, there seems to be more envy.

Jeff Skilling and Ken Lay appeared to show no remorse nor accepted any responsibility for their actions. Even at his sentencing, Skilling said, "I believe, deep down, and this is no act, I believe I'm innocent." But even Skilling's mother, as quoted in Newsweek, said, "When you are the CEO and you are on the board of directors, you are supposed to know what's going on with the rest of the company." And when your own mother has suspicions, you know you're in trouble. Can you conjecture what causes that type of faulty thinking in top executives?

I think there are difficult moments of truth when leadership is tested. And if these moments are not faced honestly, if the hard decision is not made at that point, it becomes next to impossible to return to the right path. It is that rationalization we spoke of before. Once you start to rationalize, you're stuck.

I am sure you have heard of the analogy of a frog in boiling water. If a frog is thrown in a pot of boiling water it will jump out and save itself. If a frog is in a pot of cool water that is slowly heated, he'll stay in the pot until he boils to death.

Leaders and employees will never choose wrong when faced with a clear-cut choice between right and wrong, but there are those gray areas that involve rationalization to stop your gut from bothering you. For instance, when Enron's accounting moved from creative to aggressive, the pot of water moved from cool to lukewarm. Unfortunately, nobody protested and those involved with the creative transactions soon found themselves moving onto the aggressive transactions and finally in the uncomfortable situation of working on fraudulent deals. The water was boiling and they were stuck.

From bosses to managers to staff, we must realize when we are in a pot of water that has gone from cool to lukewarm. We must recognize that moment of truth; we must address it and then act. Once the water is heated past lukewarm, we won't have the willpower to jump out.

What are a few of the major points of your talks to groups now and how do they differ from those talks you gave shortly after you left Enron?

The major point I stress now is how and why company leaders must have a zero tolerance policy for ethically challenged employees. It is probably the hardest role of a CEO, but when he or she discovers that an employee has violated the company's value system, that person must go.

That's a tough one for most. Often we feel it's compassionate to forgive and forget and give them a second chance. And if the violator is a star, a superstar, who is great with the customers, or great generating revenues then you really want to forgive and forget.

Trouble is that once you do that, you've sent the message throughout the organization that the value system is second to producing the numbers, second to being great with customers. Go ahead, push the edge of the envelope; if you get caught, you'll get a second chance.

A company's system of internal controls is not supposed to be bulletproof. It should expose ethically challenged employees so you can fire them. If a company does not have a zero tolerance policy for unethical employees then its internal control system will eventually be worthless.

An organization just cannot afford to keep ethically challenged individuals. It is too much of a risk. Giving them a reprimand and stern marching orders to never break the rules again just solidifies for these type of folks that they got away with it. Now they just go into more of a stealth mode, making it harder to catch them before they've wreaked havoc with the company.

Back in 2002, you told the 13th Annual ACFE Fraud Conference that "the financial accounting system has become too rule-based and not principle-based." In addition to the passage of the Sarbanes-Oxley Act, what do you think has changed in the ensuing five years since Enron collapsed?

As a result of Enron and other similar companies -- WorldCom, Tyco, HealthSouth, Adelphia, and the like -- we have a law in the United States, the Sarbanes-Oxley Act of 2002.

The Sarbanes-Oxley Act, in effect, tries to specify, to make totally clear just what existing laws and regulations actually mean. It seeks to make into law what are considered the "best practices" in the area of corporate governance, internal controls, and financial transparency.

The act basically calls for a culture change within companies to a culture that truly attempts to live by the spirit of existing laws and regulations and away from a culture of form-over-substance compliance.

I am afraid that although the purpose of SOX was to legally discourage form-over-substance compliance, what we've got is just more rules to use or justify behavior that still doesn't comply with the spirit of existing laws. I'm not sure we've come very far.

Where were all the fraud examiners at Enron? Were internal controls emphasized anywhere? Were any departments ever audited for fraud? Today, what would a fraud examiner specifically look for to begin uncovering the types of fraud at Enron?

Enron had no fraud examiners. In fact, Enron had no internal audit department; it was outsourced to Arthur Andersen in the mid-1990s. When I speak across the globe, that fact alone always brings gasps of surprise and shock from audiences. The typical response is: No wonder the Enron fraud occurred.

As for where a fraud examiner would start at Enron, it would be the spotty cash flow from operations. Why did all the cash flow from operations come in during the fourth quarter of the year? Why the need for so many related-party transactions, the LJM transactions? Why the waiver of the code of conduct? Why such large audit and consulting fees to the outside auditors? Also, I often suggest answering a set of questions that Fortune once listed for boards of directors. If a company has difficulty answering these questions, then a fraud examiner has identified an area worth investigating.

What could a courageous CFE, with his or her skills, have done to help head off such a disaster? In the wake of Enron, what's the single most important bit of advice you could give fraud examiners?

I am afraid that a courageous CFE would have been fired at Enron. If folks run into Enron-like behavior, I always suggest finding peers who will join you in your quest to correct things. Never go it alone.

How does an organization like the ACFE help train anti-fraud professionals to help prevent the conditions that could spawn another Enron?

An organization like the ACFE exposes anti-fraud professionals to all the tricks, the prior frauds, the outlandish schemes that have been tried in the past. I think most professionals don't really believe what they're seeing. The founder of the ACFE, Joe Wells, has seen it all. Realizing that life is stranger than fiction is more helpful than most realize. I didn't react correctly to all that I was exposed to at Enron because frankly I didn't realize the gravity of some of the actions I was witnessing. I also didn't grasp the depth of the rationalizations and their ability to prevent people from accepting truth. War stories help educate anti-fraud professionals.

I started my career in the early 1980s at Arthur Andersen & Co. as an auditor. I have to say that it bothered me that we were told it was not a public accountant's job to detect fraud. We were told to maintain a healthy degree of skepticism, but our audits were not specifically designed to find fraud. The trouble is that most shareholders believe the opposite: that an audit does in fact mean auditors looked for signs of fraud.

I am deeply appreciative of the ACFE. It takes passion and loads of blood, sweat, and tears to start and build an organization like the ACFE. Joe Wells firmly believed that it was the job of an accountant to find and prevent fraud. Because of that passion and hard work, the ACFE is a healthy, thriving, fraud-busting machine, with more than 38,000 members in more than 125 countries.

I often repeat to audiences the saying that, "all it takes for evil to prevail is for good people to do nothing." The ACFE stands for good people doing something and I encourage the organization to keep up the good work. Your organization does more good and "prevents more evil" than you probably realize.

If you ever were to go back to a corporate executive position, what kinds of things would you ensure would be set in place before you took the job?

In addition to the zero tolerance policy I've already mentioned for ethically challenged employees, I'd be sure that the company had a mechanism for bad news to get to the top and had effective policies and procedures for dealing with that bad news. I would also verify that the company's control and risk personnel had autonomy and equal power with top revenue executives. I would want to see that top management values the control and risk management function. I would want to make sure they recognize that control and risk personnel will not be the most popular and that the problems the company avoids as a result of the work of these groups will never be quantified.

You said that Skilling's sentencing of 24 years and four months in prison "feels like closure." What does closure mean to you? How do you reconcile all that happened and move on?

The Department of Justice went after the top executives at Enron. They did the right thing. Without Jeff Skilling, I don't believe the Enron fraud would have occurred. If the DOJ had stopped with Enron's CFO, I don't think justice would have been served.

The media furor has subsided. What kinds of reactions do you get from people now?

People respond very favorably to me. I think most folks see themselves taking the same actions I did at Enron, if they found themselves in my shoes. And just in case they ever do need to follow in my footsteps, they sure like hearing the story directly from me and hearing what I might have done differently, etc.

Do you correspond with other corporate sentinels?

I keep in touch with Cynthia Cooper, formerly of WorldCom; and Colleen Rowley, formerly with the FBI.

What are your plans for your consulting firm?

I am starting a leadership development program, collaborating with other leadership experts and executive coaching firms, to hone the next generation of leaders. The program is designed for those knocking on the door to the CEO suite. It is a multi-month program, involving peer interaction along industry lines. The goal is to equip these leaders with a peer network and an experience that prepares them for anything, even the perfect storm that was Enron.

What are some of the latest books that you've read? Who are you listening to these days?

I have read many Christian books, most notably by Derek Prince and Watchmen Nee. As for business books, I recommend Bill George's "Authentic Leadership," Mike Useem's "Leadership Moments", and "The Go Point: When It's Time to Decide: Knowing What to Do and When to Do It." Also, a must read is "The Thin Book of Naming Elephants: How to Surface Undiscussables for Greater Organizational Success," by Sue Hammond and Andrea Mayfield. "Naming Elephants" dissects the Columbia shuttle disaster and the Enron debacle very effectively. It is a fabulous book to improve the chances that elephants in the room will be recognized and dealt with. You can also read it in 45 minutes. It is a must!

You've been asked this one numerous times, I'm sure, but what's the moral of the story?

Being an ethical person is more than knowing right from wrong. It is having the fortitude to do right even when there is much at stake.

Thanks to Barbara Berman of the AICPA for assistance in arranging Sherron Watkins' photo session during an AICPA conference in Austin, Texas. -- ed.

Dick Carozza is editor of Fraud Magazine.

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