Interview With Sherron Watkins

8/12/2019 Interview With Sherron Watkins

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Interview with Sherron Watkins

Constant WarningDICK CAROZZAJanuary/February 2007Though the main Enron characters have received their prison sentences, there's no closure for corporatefraud. Sherron Watkins, Enron's sentinel, describes the debacle's details and warns that it could happenagain.

Dec. 3, 2001. Black Monday. The day that Enron declared bankruptcy. CEO Ken Lay had left a voice mailon the phones of all Enron employees asking they come into the office regardless. Nearly 5,000 werecalled 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 Laythat 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. Congressdiscovered Watkins' memos to Lay and other top executives. (After sending the memos, she had met withLay with no results.) Watkins was soon lauded as an "internal whistle-blower," brought beforeCongressional and Senate hearings to testify against her former bosses, and heralded by TIME magazineas 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, whyit 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 accuratesummary, I agree, but it fails to help others learn from Enron's demise. How did greed and arrogance runamok at Enron? How did a company's culture breed not only corruption from its own employees but alsodisreputable 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. Itcollapsed into bankruptcy without ever reporting a losing quarter. More than $60 billion of shareholderinvestments 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 noseverance pay or medical insurance, and far too many of Enron's employees also had all their retirementmonies 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 breakdownwas 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 1985as 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


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North America," a laudable, non-arrogant goal. However, by the mid-90s, Enron had changed thatmission statement, first, "to become the world's first natural gas major" and then in 1995, "to become theworld's leading energy company." Pay attention to the words a company uses to define itself and itsgoals. 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 theenergy 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 regulatedpipeline business to a state-of-the art energy trading shop, which eventually handled more than 25percent of the country's gas and power transactions. The natural gas market had deregulated and Enroncame out on top of the newly created energy trading industry. Folks were fairly cocky at Enron. Thecompany was the top dog in energy trading; competing companies either moved to Houston or at leastmoved their trading operations to Houston. Enron made the city of Houston the Wall Street of energytrading.

Enron's ability to evolve and shape the energy markets in the United States earned the companyaccolades from many sources. Harvard University did a case study; Business Week, Forbes and Fortuneroutinely covered the company in a favorable light. In fact, Fortune named Enron the most innovativecompany 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'sexternal auditor.] In the end, both companies put revenues and earnings above all else -- the means bywhich those earnings were generated did not matter. Were laws broken? Yes. Were lives devastated byit? Yes.

You've said that Ken Lay would force all Enron employees to book corporate travel through hissister's travel agency even though it was more expensive than more competent agencies. Can youtell 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 slightesterosion 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 hadus 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. Iwas stuck in Third World countries where I didn't speak the language without a hotel room or with aninsufficient airline ticket home despite paperwork that indicated otherwise. The incompetence was hard tounderstand. 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 Agencyin 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 theexecutive 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], couldjustify his behavior, saying to himself, "Well, my creative off-balance-sheet deals are helping Enron meetits 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 litt le 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 theemployees.


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CFO Andy Fastow operated (and partly owned) LJM partnerships. He used these partnerships tomask hundreds of millions of dollars of losses on Enron investments. How was Fastow able toconstruct such complicated deceits with the tacit approval of top executives plus accountantsand 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 allowFastow, to form and run an investment partnership [named LJM] which for the most part did nothing butbuy, sell, and hedge assets with Enron?

Enron had allowed Andy Fastow to enter into an unprecedented conflict of interest. Because he wasCFO, his fiduciary duties included looking out for the best interests of the company while also becomingthe general partner of this investment partnership, LJM, where he raised $500 million of limited partnermonies 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 tochoose: Enron or LJM. No human being should be put in such a conflict. Why did Enron's board allowsuch a conflict of interest? I must conclude that their judgment was severely clouded by the fees theyreceived 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 routinelybragged about Enron's management team. How much of their "Enron can do no wrong" attitude wasimpacted by the fees they received?

The reason so many Enron executives, and finance, legal, and accounting professionals went along withthe 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 ArthurAndersen's job to opine on complicated accounting structures, or the lawyers' job to vouch for the legalityof certain arrangements, or the board of directors' role, etc.

Besides money-clouded judgments and the diffusion of responsibility, I often explain how Fastow and histeam 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 -- incrediblybeautiful cloth but it is impossible to see it if you are stupid or not fit for your office. The swindlers play intopeople's insecurities. The emperor sends a minister to check on the progress of the weaving. Theminister panics when he doesn't see any cloth. He knows he's not stupid, but maybe he's not fit for hisoffice so he lies and says he sees it. Ditto for the second minister, and so on, until the whole townexclaims 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, infact, that when I was first looking into them in July of 2001, it took two hours for a business manager towalk through just one of them with me. When these structures were created, intimidation was used tokeep people silent. CEO Jeff Skilling was well known for his accusation that those who didn't understandEnron 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 unintelligentwas a root cause of Enron's problems. Smart people stopped asking questions for fear of looking like theydidn't "get it."

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


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Yes, I do. I think when a company has committed fraud, its most meaningful chance of survival is to findit, disclose it, and fix it themselves. By the year 2001, Enron was primarily a financial trading house. Afinancial trading house lives on its investment grade rating and its reputation. Any hint of trouble andbusiness disappears like water through a sieve. When I met with Ken Lay, I was both optimistic andnaive. I not only expected that a thorough investigation would occur but I also expected Enron to establisha crisis management team to address the financial peril Enron would face when the accounting wasexposed, 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 gravitatedtoward 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 pagesof memos to him and memos to other top executives. In many of those memos you listed intricatedetails 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 thatold adage says, "speak truth to power"?

After all of the Enron investigations and trials were completed, I did discover that others had sounded thewarning bells and some very early on. There were managers within Enron, actually in the room whenEnron'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 wasfruitless and they just left the company. Or they reacted the only way they knew how -- they postedcomments on Yahoo's message board.

On April 12, 2001, the following message appeared on Enron's message board: "The Enron executiveshave been operating an elaborate con scheme that has fooled even the most sophisticated analysts. Thefirst sign of trouble will be an earnings shortfall followed by more warnings. Criminal charges will bebrought against ENE executives for their misdeeds. Class action lawsuits will complete the demise ofEnron." 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 proposedaction steps: "My conclusions if we don't come clean and restate: All these bad things will happento 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 thathe, 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 thestructures I was concerned with but as a current period write-off, not in the correct fashion, as a priorperiod restatement. The Wall Street Journal had run very lengthy expos-style articles, the stock pricewas tanking and Enron, primarily Ken Lay, was not being honest about things. Ken Lay was makingcomments like, "We have no accounting irregularities." "Now is a good time to buy the stock." "I have theutmost faith in Andy Fastow." "We could have done the related party transactions with an outside thirdparty." These were all statements that eventually helped the Department of Justice win a criminalconviction 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 thethird leg of the renowned fraud triangle developed by Dr. Donald Cressey. Despite the changes sofar in this century, is that still the case?

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


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

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

In order to flourish, a successful capitalist system -- really any system, be it education, medicine, businessor government -- must be predicated on fairness, honesty, and integrity. In fact, many scholars describethe capitalist system as a three-legged stool -- one based on economic freedom, political freedom, andmoral 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 standardand quality of life for those less fortunate, for the poor. He assumes, however, that an appropriate systemof 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 immediatelycorrected.

We have seen morality problems in the past addressed with new laws, most notably that of child laborabuse, environmental pollution, and worker safety. Business leaders in those days complained about therestrictions 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 lessmoral outrage about the pure materialism involved in capitalism. Instead of more outrage about CEO paypackages, 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." Buteven 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 yourown mother has suspicions, you know you're in trouble. Can you conjecture what causes that type offaulty thinking in top executives?

I think there are difficult moments of truth when leadership is tested. And if these moments are not facedhonestly, if the hard decision is not made at that point, it becomes next to impossible to return to the rightpath. 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 boilingwater 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 thepot until he boils to death.

Leaders and employees will never choose wrong when faced with a clear-cut choice between right andwrong, but there are those gray areas that involve rationalization to stop your gut from bothering you. Forinstance, when Enron's accounting moved from creative to aggressive, the pot of water moved from coolto lukewarm. Unfortunately, nobody protested and those involved with the creative transactions soonfound themselves moving onto the aggressive transactions and finally in the uncomfortable situation ofworking 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 coolto lukewarm. We must recognize that moment of truth; we must address it and then act. Once the water isheated past lukewarm, we won't have the willpower to jump out.


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What are a few of the major points of your talks to groups now and how do they differ from thosetalks 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 forethically challenged employees. It is probably the hardest role of a CEO, but when he or she discoversthat 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 asecond chance. And if the violator is a star, a superstar, who is great with the customers, or greatgenerating 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 valuesystem is second to producing the numbers, second to being great with customers. Go ahead, push theedge 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 ethicallychallenged employees so you can fire them. If a company does not have a zero tolerance policy forunethical 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. Givingthem a reprimand and stern marching orders to never break the rules again just solidifies for these type offolks that they got away with it. Now they just go into more of a stealth mode, making it harder to catchthem before they've wreaked havoc with the company.

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

As a result of Enron and other similar companies -- WorldCom, Tyco, HealthSouth, Adelphia, and thelike -- 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 andregulations actually mean. It seeks to make into law what are considered the "best practices" in the areaof 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 thespirit 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 ofexisting 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 forto begin uncovering the types of fraud at Enron?

Enron had no fraud examiners. In fact, Enron had no internal audit department; it was outsourced toArthur Andersen in the mid-1990s. When I speak across the globe, that fact alone always brings gasps ofsurprise 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. Whydid all the cash flow from operations come in during the fourth quarter of the year? Why the need for so


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many related-party transactions, the LJM transactions? Why the waiver of the code of conduct? Whysuch large audit and consulting fees to the outside auditors? Also, I often suggest answering a set ofquestions that Fortune once listed for boards of directors. If a company has difficulty answering thesequestions, 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 fraudexaminers?

I am afraid that a courageous CFE would have been fired at Enron. If folks run into Enron-like behavior, Ialways 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 theconditions that could spawn another Enron?

An organization like the ACFE exposes anti-fraud professionals to all the tricks, the prior frauds, theoutlandish schemes that have been tried in the past. I think most professionals don't really believe whatthey're seeing. The founder of the ACFE, Joe Wells, has seen it all. Realizing that life is stranger thanfiction 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 thedepth of the rationalizations and their ability to prevent people from accepting truth. War stories helpeducate anti-fraud professionals.

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

I am deeply appreciative of the ACFE. It takes passion and loads of blood, sweat, and tears to start andbuild an organization like the ACFE. Joe Wells firmly believed that it was the job of an accountant to findand 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 goodwork. 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 youensure 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 besure that the company had a mechanism for bad news to get to the top and had effective policies andprocedures 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 topmanagement values the control and risk management function. I would want to make sure they recognizethat control and risk personnel will not be the most popular and that the problems the company avoids asa 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?


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The Department of Justice went after the top executives at Enron. They did the right thing. Without JeffSkilling, I don't believe the Enron fraud would have occurred. If the DOJ had stopped with Enron's CFO, Idon'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 atEnron, 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 andexecutive coaching firms, to hone the next generation of leaders. The program is designed for thoseknocking on the door to the CEO suite. It is a multi-month program, involving peer interaction alongindustry lines. The goal is to equip these leaders with a peer network and an experience that preparesthem 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 businessbooks, 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 OrganizationalSuccess," by Sue Hammond and Andrea Mayfield. "Naming Elephants" dissects the Columbia shuttledisaster and the Enron debacle very effectively. It is a fabulous book to improve the chances thatelephants 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 evenwhen there is much at stake.

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


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Interview With Sherron Watkins

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