It is misleading to imply that there is only one way in which corporations become corrupt. Obviously circumstances matter and the stories of companies gone bad show ready evidence of subjective factors and local conditions. That said, there is a general trajectory which companies going corrupt tend to follow. The Enron story perfectly illustrates this trajectory. Laying out this arc of descent allows students to see more clearly the choices at work and the consequences they can bring.

The descent into corruption almost always begins at the top. There will be a CEO, possibly a series of CEOs, who signal they really don’t care about ethics or financial control. The signals sent can vary. Sometimes they take the form of a yawning gap between the stated ethics policy and the employee conduct tolerated. Ethics policies proclaiming fealty to the law are undercut by employees recognized or rewarded for clever workarounds. At other times the CEO gives a message to top subordinates that “you gotta do what you gotta do” to succeed. A third type of signal occurs in instances where clear wrongdoing is brought to the CEOs attention and the boss refrains from disciplining the bad actor. In all cases, the consistent thread is the CEO prioritizing some other goal above enforcing the ethics policy and practicing good financial control.

The Enron Oil Trading cases illustrate this kind of CEO behavior. These cases are critical to understanding what happened at Enron because they show the seeds of bad financial control being planted early on. They also show CEO Ken Lay’s personal responsibility for planting the seeds. Lay is presented with clear evidence of wrongdoing. He doesn’t punish the guilty. Later on his Internal Control investigators were called off the case because “they are upsetting the traders”. Arthur Andersen’s investigation was then handled as something to be buried. Lay “put on his CEO hat” and said Enron had bigger fish to fry. President Seidl’s message to EOT’s Borget was “keep making us millions”. Lay then shut down Internal Audit, its work “outsourced” to Arthur Andersen.

It is difficult to imagine a more complete and dramatic illustration of CEO indifference to ethics and financial control. When a CEO sends out such signals, they are quickly received and decoded. Corporate executives almost always learn to pay attention to the informal messages disseminated by the boss. Such messages convey information vital to personal survival—which behaviors will be rewarded, which others punished, which messages will not be welcomed in the C-suite. Lay’s messages to Enron’s executives were clear: short-term results are what matter; major violations of the rules will be ignored if the executives in question are seen as producing good results. Meanwhile, those seeking to enforce the rules will be sidelined if they get in the way.

These are not uncommon messages from the top. Many corporations exist in a limbo zone where rules enforcement coexists with selective exceptions. What makes the Enron story such a compelling tale of descent are the extraordinary actors who read Lay’s signals and promptly marched the firm onto a path of decline.

The next stage of descent is properly labeled “The Rise of Agents”. Economists have long talked about “agency behavior” as a corrupting force in corporate life. By this they mean the actions of employees who manage corporate affairs for their own personal gain rather than serving the interests of the company and shareholders. In Enron’s case, the first agent to read Lay’s signals and act was Jeff Skilling.

As the next case shows, Skilling had a personal agenda. He was taking a pay cut to move from McKinsey to Enron. Skilling wanted to make sure he replaced lost compensation by monetizing the “phantom equity” Enron granted in his operating company, Enron Finance. To make sure this happened, Skilling developed a contorted form of “Mark-to-Market” accounting and applied it to long-term merchant contracts in a manner opposed by Arthur Andersen. Skilling then rode roughshod over AA’s opposition.

Skilling’s story graphically illustrates agency behavior in action. In working his personal agenda, Skilling didn’t give a fig about whether good accounting got in the way. This is what happens when agency behavior takes hold. The accounting rules get in the way and then must be overcome or ignored. Powerful agents almost always have to subvert the accounting rules and the auditors. If they succeed, two consequences follow. First, management information systems become corrupted. The more the rules get distorted and the gatekeepers weakened, the poorer the quality of information percolating up to senior management. This has an important feedback effect. Internal accountability is undermined. Poor management accounting makes it easier to evade responsibility for poor performance. Better performance often goes unrecognized or is overshadowed. Then, a second signal goes around the company. Personal agendas can now be advanced by manipulating the accounting results. Personal rewards can be captured by producing the appearance of success rather than actual results.

Such developments set the scene for the third stage of descent. Poorer internal information and weakened accountability usually lead to disappointing business results. Since the causes of underperformance are now deeply rooted in the culture, management struggles to rectify the decline. Meanwhile, a second generation of agents arises. Unlike Skilling, who produced some actual business results, this set of agents seeks advancement primarily by manipulating reported results. In Enron’s case this would take the form of another extraordinary agent, Andy Fastow. However, Fastow was not alone. Jeff McMahon would rise to prominence on the backs of his dubious Whitewing deal. Meanwhile, deal originators and merchant traders had a field day boosting their bonuses by marking their deals “to market” using dubious modeling assumptions.

This combination of serial underperformance and a broad rise of agents can be especially toxic. The result is often the “material” manipulation of publicly reported results. We are now talking about fraud. It may be dressed up in some form of accounting justification, but if subsequently investigated by neutral experts it won’t stand the light of day. In Enron’s case, this would take the form of Fastow’s outlandish LJM partnership deals; these delivered timely accounting results to sustain Enron’s image in the markets. Enron’s Powers Committee report would later find it “implausible” that any accountant would find that these deals didn’t violate accounting rules. Similar types of manipulation occurred around the same time at WorldCom, Waste Management and other firms. These firms were now misleading their investors and violating securities laws.

This brings us to the fourth stage of descent. The firm now has skeletons in the closet. It is primed and ready for terminal downward spiral. Management doesn’t dare look closely at what is going on because to do so is to confront the possibility of having to disclose what they see. Doing so would mean facing investigation, removal from office and punishment. Meanwhile, business performance continues to deteriorate due to poor internal information, distorted accountability and agency behaviors. The accounting artifices needed to disguise deterioration grow in size, complexity and extremity. Keeping these realities from public scrutiny grows more difficult, then almost impossible. Fundamental reform is stillborn in the face of undisclosed frauds. The firm has become a house of cards awaiting only a serious external trigger to collapse. In Enron’s case, that came in the form of the October 2001 financial restatements. For WorldCom, it took the form of whistle-blower disclosures. In each case, the subsequent collapse was stunningly quick.

Having traversed this trajectory, a recap is now in order. 1) Firms tend toward corruption when their CEO signals a low priority regarding ethics and financial control. 2) In response, agents arise, testing the boundaries of the permissible. In the process, these agents must breach the accounting systems and suborn or intimidate the gatekeepers. These gatekeepers include not only the company Controllers but also risk management, Internal Audit, the firm’s public accountants and both inside and outside legal counsel. Overcoming these gatekeepers is difficult and time consuming. Within most firms, happily, only a partial or exceptional agent victory occurs. When, as in Enron’s case, the “victory” is more complete, the firm is on a glide path towards corruption.

3) As the weakness of the gatekeepers becomes manifest, internal reporting suffers and agency behavior spreads. In this third stage, serious business problems begin to manifest themselves. This can take the form of poor leadership, poor capital allocation or a series of scandals leading to loss of direction, settlements or fines. As such problems become more evident, agency behavior can take a different turn—towards focusing on covering up what amounts to illegal activity. 4) This leads to a final stage where management becomes disconnected from the firm’s core problems, less and less aware of its actual financial condition, and consumed with covering up past sins. The stage is now set for external discovery, investigation and quite possibly collapse.

The cases that follow illustrate this four-stage process. With Jeff Skilling’s rise, Enron enters Stage 2. The Mark-to-Market case that follows displays Skilling’s agency behavior and tactics towards Enron’s gatekeepers. Adjusting the Forward Curve in the Back Room shows the Stage 3 spread of Agency behavior. This is further documented in An SPE Too Far? This case chronicles Enron’s increasing embrace of dubious structures designed to cover up unfavorable disclosures. By the time of the Chewco deal, the centerpiece of the SPE case, Enron is over the line into Stage 3, accounting fraud. With Lay Back and Say What? we get a look at Stage 4. Business problems are everywhere but real reform is hostage to the skeletons in the closet. Management is disconnected from the firm’s financial reality. It will then act paralyzed in response to the whirlwind set off by Enron’s October accounting restatements.

Two conclusions flow from this assessment. First, sound financial control is an undervalued business asset. Sacrificing controls for short-term results can open a Pandora’s Box of agency behaviors and unsound business practices. It also degrades the business culture, making it difficult or impossible for employees to prioritize company objectives. This discussion is taken up in more detail in Essay 3, Necessary Ammunition, Economic Rationales for Financial Control. The second conclusion is more obvious—the deeper a firm descends along this corruption trajectory, the harder it is for resisters to pull the firm back to solid ground. This will become clear as we confront the stark choices facing Enron resisters Jordan Mintz, Vince Kaminski and Sherron Watkins in the cases that follow.