Running Like Enron

Regular visitors will get a pretty good sense of the books I am reading. I find that books on subjects that aren't directly related to software development or any other topic I'm 'really' writing about can offer deeper insights than a dry analysis of the actual topic. It forces you to look for patterns rather than just grabbing direct quotes. It also provides some distance. It's much easier to think discuss the leadership abilities of Lincoln than it is to analyze someone in your direct management chain. So please bear with me if my posts seem a bit like a book report. I promise there is a point in there somewhere.

Anyway, on the way back from a customer in Chicago, I was looking for a new book. The selection wasn't that great at the airport Hudson store. And of course I can't download an Audible title there, so I had to pick something that looked like I had a good chance of finishing it. After much browsing, I eventually settled on "The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron." I'm quite enjoying it. Despite the rather arcane details of a company that no longer exists, It's a surprisingly readable book.

One thing I found very revealing is how human all of the main players are. Sure they stole millions and defrauded an industry, but for the most part they thought they were doing the right thing. They thought they were special and they were entranced with the idea of transforming the energy industry and becoming enormously wealthy in the process. The point of the Enron story is not that there were some evil corporate masters who stole money from good working people. The real case study is how smart and ambitious people can transition so easily from innovation to criminality without ever knowing exactly when they crossed the line, or indeed for some even knowing that they crossed the line at all.

The Enron story is about delusion. It wasn't just a single person or even a group of people maliciously fabricating information to defraud customers and investors. Instead it was entire system of delusion. Executives deluded themselves into believing they were part of a new economy where the normal rules no longer applied. Investors and analysts were full parties to this delusion and didn't look at the data with an appropriately skeptical eye. The consultants and accountants were all part of this vicious cycle. It's easy from a distance to talk about the rapacious and illegal practices of all involved, but who among us is strong enough to speak the truth when there are millions of dollars available for playing along? Even the lowly frontline worker who lost their retirement savings were party to the delusion by putting everything in their 401K plans in Enron stock.

How does this happen? With Enron it happened when the primary goals were shifted from the fundamental economics of value offered and revenues obtained to abstract secondary metrics like earning statements and the stock price. They moved from looking at data that can't be forced to lie and instead generated metrics that gave ample opportunity to make things up. Almost everything they did was tainted by this approach. For example, they bought companies and held them like a private equity firm. This in itself isn't wrong, but when you do this you have to report the value of the companies in your earnings statements. Privately held companies are notoriously hard to value and it really comes down to a judgment call when you put a final number on them. Opportunities to make judgment calls are opportunities to go astray.

Similarly, when deals go bad, you are supposed to track write off the loss in your earnings statement. But at Enron it was common to keep them off the balance sheet in the hope that the deals might come back in the future. Again it was a judgment call. It's not a hard line when a deal is no longer recoverable, perhaps the negotiations are just stalled. Another practice that helped enable Enron's downfall was the use of 'mark to market accounting.' This is an accounting practice where you count the eventual lifetime inflows from a deal at the time you make the deal before the cash has ever started to flow. In conventional accounting you only count the money as it actually comes in and out the door. Mark to market account also gives the opportunity to adjust the value of the deal over time to reflect changing economic circumstances. Again much of the valuations that show up on earnings reports came down to judgment calls.

These and other practices had two fundamental traits that eventually erupted into the biggest bankruptcy in history. First, there was enormous latitude and judgment required to give assets and earnings a proper valuation. In a highly money-charged environment like Enron the ability to use judgment essentially amounts to giving yourself a license to lie. This natural tendency was magnified enormously because Enron valued earnings reports and stock valuations, not economic fundamentals. In an environment like this, it's almost inevitable that things will go bad.

It's an insidious effect. Let's imagine that you are an Enron executive charged with making a certain target. One of your underlings reports the value of an asset that doesn't help you make your goal. You know full well that a different set of assumptions will enable you to hit your target. Not only that, but there is nothing wrong with your new assumptions. They just happen to be a shade more optimistic. Add to this to small fact that millions of dollars of your own bonus are on the line. What do you do? Let's just say that it takes a remarkable fortitude to go with the pessimistic estimate. The thing that's most insidious about this latitude in judgment is that the first person you lie to is yourself. You fully believe you are providing greater insight and greater knowledge to your underlings analysis. The fact that this makes you enormously wealthy in the promise can perversely give you 'proof' in the value you add in dispelling fear, uncertainty, and doubt. You go home that night reveling in your superior judgment and leadership abilities.

The other aspect that ties these practices together is the tendency to 'double down.' Every time you close on a mark to market deal you have to close a bigger deal in the next quarter to keep the profits up. Because you also have the freedom to use your judgment in the deal valuations, it doesn't always matter if these deals are good or not. You just have to keep making them at an ever increasing rate. The same thing happens when you defer writing off bad deals. Not only do you still have this deal hanging around next quarter but you probably have another one as well. The dirty laundry keeps piling up until economic reality imposes its will. The thing to remember in cases like this is that reality will impose its will eventually.

How do you avoid the perils of Enron? For one thing, no matter how nice it sounds judgment is a dangerous thing. Let's imagine that the leadership team says "Use your judgment to decide how many bugs to punt. And by the way we think that about 30% of them can go away because we really want to do this other feature and we have to ship by such and such a date." What are you going to do? It's quite likely that by playing along, punting bugs, and implementing a feature you can get a promotion. Even if the software is ultimately a failure, there is a good chance you will be on another team by the time that happens anyway. You can leverage that new promotion to get a lead gig somewhere else. Even if you stick around long enough for the project to truly tank, we all know of careers where failed project builds on failed project but the individual keeps climbing the ladder. Who among us would really choose the greater good? Sure, the use of good judgment is critical, but you should NEVER construct a situation where there are implicit pressures to make a particular call. Since there are always schedule pressures, restricting the use of judgment calls to truly critical and rare events is very important. If everything becomes a judgment call, then what kind of call are people going to make late in the cycle when they are over-worked and feeling beat? The best way to solve this problem is to have a culture that values the underlying reality rather than abstract metrics. This can be hard to implement, but an easy way to start is to have strict procedures and rules to guide judgment. Even in the most accomplished teams, the majority of decisions should be driven by objective, real criteria. Make the rules precise enough so that it is enormously obvious when management decides to exercise judgment and overrule the procedures.

The other key practice is to never defer pain. Don't use the next milestone as a dumping grounds for bugs you can't fix in this one. You can do this for a while without paying a cost, but eventually you will ship and real customers will use your products. Every time you use the schedule constraints to defer issues to the next milestone you are doubling down every bit as much as Enron did with its bad investments. Reality will come. Perhaps you as an individual can get a new job before things really hit the fan, but that certainly isn't the way I would want to run a project.

Most importantly you have to foster the right culture. All of the things that I discuss above predate Andrew Fastow's overt earnings manipulations. But because Enron fostered a culture of pushing the rules without reference to underlying reality, the transition to blatant fraud was subtle and unnoticed. Ultimately rules and procedures are just beacons to warn you of the real dangerous areas. They operate much like lighthouses. The real concern of any ship's captain is to avoid the rocks, not the lighthouse. Indeed the false security provided by a complex set of rules can lead people to think that as long as they can hew to the letter of the law, they are protected from danger. It's easy to think that breaking the rules are the actual danger. But if you start to feel that the rules are the reality, you are headed for the rocks.