Bad to Worse: Why Some Companies Survive Corporate Scandals . . . and Others Don’t

1. Bad to Worse: Why Some Companies Survive Corporate Scandals . . . and Others Don’t Timothy J. Coleman © 2006 Timothy J. Coleman

3. Enron • 1989: Former pipeline company headed by Ken Lay begins transition into commodity trading company. • Aug 2000: Stock price hits record high. • Dec 2000: Transformation architect Jeff Skilling named CEO. Resigns after six months. • Nov 2001: Partnerships run by CFO Andrew Fastow wrought with conflicts of interest result in large losses. • Nov-Dec 2001: Company revises five years of financial statements. Files for bankruptcy. • Jun 2002: Auditing firm Arthur Andersen convicted of obstruction of justice. • Oct 2002: Fastow arrested. Company’s electricity traders indicted. • Feb-Jul 2004: Lay and Skilling indicted.

4. WorldCom • Apr 1998: Long-distance reseller WorldCom, run by Bernard Ebbers, buys MCI for $47 billion. Stock price soars. • Jul 2000: Merger with Sprint abandoned due to regulatory issues. • Mar 2002: SEC begins investigating accounting practices and loans to executives. Ebbers resigns. • Apr-May 2002: Reported profits drop 78%. Ebbers quits. Debt downgraded to junk. • Jun 2002: $3.85 billion in expenses revealed as misreported. CFO Scott Sullivan fired. • Jul 2002: Company defaults on debt, files for bankruptcy. • Aug 2002: Ebbers, Sullivan and accounting officials Myers, Yates indicted.

5. Adelphia Communications • 1999: Company pays $8.5 billion on acquisitions, doubling the company’s size and ballooning its debt. • 2000: CEO, John Rigas, buys a controlling interest in the NHL Buffalo Sabres. • Mar 2002: Adelphia discloses its provision of collateral for over $2 billion in loans to the Rigas family. • Jun 2002: Stock price plummets. Company files for bankruptcy. • Jul 2002: Rigas, two sons, and two other company executives arrested and charged with fraud. • Jul 2004: CEO John Rigas and CFO Tim Rigas convicted. Sentenced to 15 and 20 years.

6. The Country Reacts • Media and public response • Investigation by DOJ, SEC, Congress, Others • White House Corporate Responsibility Initiative • Corporate Fraud Task Force • Sarbanes-Oxley Act • Prosecution of executives and others

7. Corporate Fraud *2004 three-quarter figures annualized A Deeper Look • Fraud can be explained by failures in corporate ethics, greed, inadequate regulatory system. • But the corporate debacles of the past few years had deeper, more fundamental causes. • What did these companies have in common? Fundamental failures in leadership and management.

8. Good to Great • Remains a fixture on best-seller lists more than four years after publication. • Jim Collins: former management consultant and Stanford professor. • Research shows most of the stellar firms were led by low-profile CEOs. • Jump in performance usually wasn't triggered by a radical strategy shift.

9. Research Design: Good to Great • Identified companies that had not always been great, but made the leap to sustained excellence. • Used public statistical data to identify such companies and their “transition point.” • Performed a deep analysis of each, to find out what characteristics they shared that distinguished them from comparison companies that had not made a similar leap.

10. Research Design: Bad to Worse • Conducted interviews with federal prosecutors and other government officials. They emphasized that each company we studied: • Was headed by an “overpowering” or “larger than life” executive; the Board was disengaged. • Was driven by explosive short-term growth, with an inadequate foundation for the future. • Viewed business, financial, legal problems as a “bump in the road,” not as systemic failures. • Examined public court documents related to each case: • Indictments • Evidence • Trial Transcripts

11. Conclusions • Good to Great • Level 5 Leadership • Confront the Brutal Reality • Culture of Discipline • Hedgehog Concept • Bad to Worse • Imperial CEO • Deny, Delude, Defraud • Emperor’s New Clothes • Expansion Without Discipline

12. Good to Great Principles • Level Five Leadership: • Highly capable individuals • Contributing team members • Competent managers • Effective leaders • Ambitious but not for themselves

13. Good to Great Principles • Confront the Brutal Facts (Yet Never Lose Faith): • The “Stockdale Paradox” • Encourage “dialogue and debate” over “coercion” • Do not ignore “red flag mechanisms.”

14. Good to Great Principles • Hedgehog Concept: • Identify “one big thing” that: • You care deeply about; • You can be the best in the world at • Drives your economic engine • Stick to it. What you are deeply passionate about What drives your economic engine What you can be the best in the world at

15. Good to Great Principles • Culture of Discipline: • Self-disciplined people • Take disciplined action consistent with the hedgehog concept. Culture of Discipline Low High Low High Ethic of Entrepreneurship

16. Good to Great Principles • First Who… Then What: • The right people matter more than vision, strategy or tactics. • Technology Accelerators: • Become pioneers in the application of carefully selectedtechnologies that fit within hedgehog concept • Avoid fads and bandwagons.

17. Level Five Leadership

18. Level Five Leadership • The three companies’ leaders were flamboyant personalities that were highly compensated: • Enron’s Ken Lay • WorldCom’s Bernard Ebbers • Adelphia’s John Rigas • No correlation between executive compensation and company performance • Negative correlation between charismatic leadership and company performance

19. Imperial CEOs: Lay and Skilling • Jeff Skilling became so sure that he was the smartest guy in the room that anyone who disagreed with him was summarily dismissed as just not bright enough to “get it.” • The broadband business was in complete meltdown. And there were all sorts of other problems that Jeff Skilling as the company's Chief Operating Officer was wrestling with. And in the middle of all this, Ken Lay walks in Jeff Skilling's office holding up fabric swatches for the new G5 $45 million corporate jet he wanted to buy.

20. Imperial CEO: Bernard Ebbers • WorldCom’s operations centered around a charismatic leader, the imposing former basketball coach Ebbers. If Ebbers was the oracle, Chief Financial Officer Scott Sullivan was his high priest. • In 2002, Bernard Ebbers was paid a total of $34.5 million in salary, bonus and stock options--nearly nine times the telecom industry median. He received a grade of ‘D’ for pay vs. compensation. • His assets included: a multimillion-dollar home in Mississippi and his interests in a lumber company, a marina, a golf course, a hotel and several thousand acres of timberland.

21. Imperial CEO: John Rigas • Adelphia leadership did not place the fate of the company above personal gain: John and Timothy Rigas caused more than $50 million in cash to be transferred to John Rigas for his personal benefit. • Every year Adelphia's shareholders effectively spent $6,000 for a jet to deliver a Christmas tree to the New York City home of one of founder John Rigas' daughters. (In 2001, when the first conifer was deemed too stubby, a second one was delivered, also by jet.) • Self-dealing included the use of Adelphia funds to construct a golf course for $12.8 million, pay off personal margin loans and other Rigas family debts, and purchase luxury condominiums in Colorado, Mexico, and New York City for the Rigas Family.

22. Level 5 Leader: Gillette’s Mockler • During tenure as CEO from 1975 to 1991, Coleman Mockler fought off three hostile takeover attempts. • He and other executives forewent $2.3 billion in potential gains from stock options and golden parachutes to stake company’s future on huge investments in new technology (Sensor and Mach 3). • Publicly shy. Declined to be photographed for cover of Forbes magazine.

23. Confront the Brutal Reality

24. Confront the Brutal Reality • Confront the brutal reality. . . yet never lose faith: The “Stockdale Paradox” • Bad to Worse companies denied their problems • Ignored fundamental business, financial, legal problems • Bad to Worse companies deluded themselves and the public about the brutal realities • Used accounting tricks to create the false appearance of unbroken success • Bad to Wose companies defrauded their stakeholders • Hid the true facts from shareholders, employees and others until it was too late

25. Deny, Delude, Defraud: Enron • Everyone in broadband knew the stakes involved in pleasing the market. … though they knew full well that they had met their numbers only by using smoke and mirrors, more than a few regarded the illusion as a genuine accomplishment. • Wanda Curry was moved off of the Enron Energy Services analysis after she raised questions about the unit’s accounting practices. • Ken Lay, 10/23/01: “I and the board are also sure that Andy Fastow has operated in the most ethical and appropriate manner possible. … Our fundamentals are stronger than they have ever been.” Fastow was fired the next day, and Enron filed for bankruptcy Dec. 2nd.

26. Deny, Delude, Defraud: WorldCom • CFO Scott Sullivan:“We have to meet the market expectation.” • CEO Bernie Ebbers:“We have to hit our numbers this quarter.” • CEO Bernie Ebbers:“We can’t just issue an earnings warning without talking about what we’re doing about it.”

27. Deny, Delude, Defraud: Adelphia • He also specifically said, we can’t afford to have a default. And I took it to mean that it was more important to report numbers that showed us in compliance than it was to show the real numbers. • I said, if in fact we’re telling investors that our rebuild percentages are higher than what they actually are, this would be a good opportunity to scale back. … I don’t recall him adjusting the numbers.

28. Confronted Reality: CA • In contrast to Bad to Worse companies, Computer Associates confronted the brutal reality. • After scope of its scandal became clear, Board conducted independent investigation of accounting fraud. • Ousted its CEO and CFO after misrepresentations came to light. • “Got in front of the problem” by recognizing it as a systemic breakdown, not just a bump in the road.

29. Culture of Discipline Culture of Discipline Low High Low High Ethic of Entrepreneurship

30. Culture of Discipline • As a result of leadership failures and inability to confront the truth, none of our companies created a “culture of ethics.” • Subordinates did not feel free to question what was occurring. • When employees or outsiders did question, dissent was squelched. • …but the Emperor had no clothes.

31. Emperor’s New Clothes: Enron • Whatever Ken Lay wanted the board to okay, they did. • Board waived its conflict provisions to allow Fastow to run private partnerships that would do business with Enron. • Those who raised alarms about the company’s practices, such as Vincent Kaminski and Wanda Curry, were marginalized within the company. • Environment allowed rogue energy traders to manipulate the California energy crisis in 2000. “It’s what we do.”

32. Emperor’s New Clothes: WorldCom • Bankruptcy examiner Richard Thornburgh, a former U.S. attorney general, reported that a “board breakdown” at WorldCom had allowed fraud to flourish. • WorldCom funneled investment banking business to Saloman Smith Barney to influence its top telecom analyst, Jack Grubman, who would issue favorable ratings to Worldcom stock then reap compensation from the investment banking business. • When accounting employees complained about the practices at Worldcom, Scott Sullivan assured them that “it wouldn’t happen in the future.”

33. Emperor’s New Clothes: Adelphia • The Rigas family was able to elect all but one of Adelphia’s directors given that the family controlled almost all of the company’s “Class B” shares. • John, Tim and Michael Rigas, as President, CFO and COO, respectively, exercised day-to-day control over Adelphia with almost no board supervision. • There was no questioning of unprecedented “co-borrowing” loans, which forced Adelphia to assume joint and several liability for new Rigas family loans that benefited only the Rigases.

34. Culture of Ethics: Lockheed Martin • Implementation of Lockheed’s ethics program involves everyone, from board members to lower-level employees. There are yearly ethics evaluations. • There is an almost maniacal focus on ethics; Lockheed sets its standards higher than applicable law. • Lockheed sees this focus on ethics as a competitive advantage, instead of a barrier the company must overcome.

35. Hedgehog Concept What you are deeply passionate about What you can be the best in the world at What drives your economic engine

36. Expansion Without Discipline: Enron • Started as a small natural gas company. • Turned into a massive “trading company” that had projects around the world, such as trying to become “the world’s largest provider of premium broadband services.” • Projects included disastrous power plant project in Dabhol, India and failed water venture Azurix.

37. Disappointing Results Reaction Without Understanding No Buildup, No Accumulated Momentum New Direction, Program, Leader, Event, Fad or Acquisition Expansion Without Discipline: Worldcom • Company started out as long-distance reseller LDDC. Acquisitions: Advantage Cos., MCI and Sprint (attempted). • Strategy: To acquire companies that were building and had built local networks in cities like New York and Chicago and a lot of the cities across the United States. • No buildup of momentum to keep flywheel moving. Debt accumulation led to “doom loop” symptoms.

38. Expansion Without Discipline: Adelphia • Company expanded at breakneck speed, primarily through acquiring other companies. • Capital pressures created by acquisitions put serious financial pressure on company, contributing to environment in which fraud could occur. • Constantly required to raise additional capital as cost of capital skyrocketed.

39. Issues for Directors How to Avoid Becoming aBad to Worse Company

40. Leadership • Does management, especially the CEO, demonstrate “level 5 leadership,” or are characteristics of the “Imperial CEO” present? • Is management ambitious first and foremost for the company, or first and foremost for themselves? • Does management deflect credit and accept blame, or accept credit and deflect blame?

41. Honesty • Has management, and the board, confronted the reality of the company’s position, while remaining optimistic about the future? • Are dialogue and debate encouraged? • Are “red flags” taken seriously, and viewed as important indicators of the ethical strength of the company?

42. Hedgehog Concept • Has management arrived at an understanding of: • What the company cares deeply about • What it can be the best in the world at • What drives its economic engine • Are management’s strategy and tactics clearly based on that “hedgehog concept”?

43. Culture • Are all components of the company (board, executives, employees) involved in the creation of a “culture of ethics?” • Has the company taken steps to measure the company’s culture – and the effectiveness of its ethics and compliance program – periodically? • Is there a top-down commitment to remain faithful to the “Hedgehog Concept” and the principles of honesty and leadership already discussed?

44. Thank You