Thursday, May 25, 2006

Despite today's Enron convictions, the fox is still guarding the henhouse

This afternoon's guilty verdicts in the Enron trial of Ken Lay and Jeff Skilling are emotionally cathartic. But I doubt these verdicts will prevent future Enrons.

Public outrage over Enron resulted in the passage of Sarbanes Oxley (SOX). While SOX is intended to make executives more accountable -- it was not the basis for their conviction. Instead, Lay and Skilling were convicted on conspiracy to commit securities fraud, among other charges.

Unlike Starr Jones, I'm not a lawyer and I certainly don't know the technicalities on which such a conviction would be based. According to MSNBC, Lay's securities fraud conviction reflected juror's conviction that he "lied to employees, credit rating agencies and analysts with claims that Enron was healthy or that its books had been sanitized of problems when he knew otherwise."

But in simple terms, Lay and Skilling were convicted for inventing financial results that were at odds with reality and then sharing those false results with Enron's constituents. My interpretation is that their motivation was to meet, if not exceed, Wall Street's earnings expectations so they could get Enron stock to keep rising.

Every CEO of a publicly traded company has to be concerned about such expectations. And given the extreme complexity of the financial accounting for many public companies, some CEOs might view the complexity as an opportunity to exploit a gray area wherein they choose accounting policies that increase their odds of beating Wall Street expectations. Today's convictions will surely scare CEOs away from such a gray area.

The Enron conviction will fade over time as a deterrent. As I noted in Value Leadership, there is a more fundamental problem here. Allowing companies to prepare their own financial statements is analogous to allowing students to grade their own papers.

While there are accounting policies and auditors intended to keep companies on the straight and narrow, I don't think this fundamental problem can be solved unless a completely independent entity produces a company's financial statements. As I proposed in the book, such entities might be paid for from corporate fees. The quality of their work would be assessed and publicly graded by public shareholder watchdog groups.
Despite today's conviction, as long as the fox is guarding the henhouse, those hens ultimately won't be safe. It's time for the guardian of a company's financial statements to be completely independent of the CEO.


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