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Enron/Andersen: Slamming Into the Political Reality Wall

By Evan M. Dudik

It happened to the railroads.
It happened to the auto industry.
It happened to Big Oil.
It happened to meat-packing.
It happened to mortgage banking.
It happened to the savings and loan industry.

In each of these industries the same competitive dynamics that shape industry structure also sent them hurtling against what I call the political reality wall. That is what is happening today in the Enron/Arthur Andersen Congressional hearings where thirteen separate committees plus truckloads of FBI agents are investigating a moderately gargantuan but otherwise garden variety Wall Street swindle.

It’s happening to managed care
It’s happening to pharmaceutical industry.
It’s even happening to the snowmobile industry.
It might be happening to your industry.

Why should executives and corporate strategists care? Because once an industry hits the political reality wall, competition takes place in a hall of mirrors—mirrors placed in a crazy quilt of angles by people who haven’t the foggiest idea of revenue, profits or payrolls. When you look over your shoulder to see whether the competition is gaining, you see instead the face of Big Brother—and those highly informed folks from the Fourth Estate. Not that you don’t have competitors—they’re still there, only they gain advantages that seem to spring from outer space. Or they are subsidized by taxpayers. Or taxpayers subsidize you—something not nearly as sweet as it sounds. Business practices get 3rd-degree scrutiny. Even the appearance of “unfairness” discourages innovation. The shallowest interpretation of the “public interest” becomes the touchstone of whether a company—your company—should even exist. And executives spend as much time in Washington as in the corner office.

Whatever happens, profits decline, regulation increases and corporate freedom shrinks. And with them, your company’s strategic options.

How does this happen?

Companies struggle every day for revenues, profits and market share. Classical economics and standard strategic thinking provide a satisfactory account of how competition forces industries to evolve. But they ignore the unfortunate fact that in many cases these very same forces lead entire industries to overlook the political reality wall that encloses every industry’s strategic micro-environment—until they smash into it.

We are seeing this dynamic with Arthur Andersen. Here, the competitive dynamics of the Big Five accounting oligopoly squeezed down the profitability of public accounting (at least relatively speaking). So these firms launched consulting practices, particularly IT/systems integration and tax consulting, a natural enough adjunct to their auditing practice. To attract and retain top talent, to maintain share and to reward their partners, the Big Five disregarded years of warnings about conflicts of interest: how can an auditor be objective when an IT consulting engagement worth tens of millions of dollars hangs on a fairness opinion? In fact, so ineluctable are the dynamics of industry competition that some Big Five firms, including Andersen, Deloitte Touche, Pricewaterhouse Coopers continue to consult—in IT, strategy, capital-raising and taxes—despite years of finger wagging from the SEC, the Federal Reserve and folks inside the profession itself. Andersen spun off the Accenture only to turn around and reconstitute another consulting division.

Former Fed Chairman Paul Volcker testified that: “Company management [an audit company’s client] urgently wants to meet market expectation to present results in the most favorable light and to demonstrate a consistent pattern of earnings. Too often the emphasis is on finding ways to meet the letter of the technical accounting requirements at the risk of violating the spirit. Large and profitable consulting assignments may, even subconsciously, affect auditor judgment. Companies want to minimize accounting costs.”…. “The crisis in the accounting and auditing professions is not a matter of the failure of a single company or perceived problems in a single audit. It demands attention to fundamental flaws basically reflecting the growing complexities of capital markets and pressures on individuals and their companies to improve financial results.”

The accounting profession, unhappily, is following the same path trod by glorious industries of the past. The dynamics of competition and the thirst for growth have led whole industries to ignore the warnings of the public and its political henchmen in state capitols and Washington. The car companies ignored safety because “Ford sold safety and Chevy sold cars” until Ralph Nader, well known for his mechanical engineering expertise, published Unsafe at Any Speed and Pinto gas tanks burned teenagers. Lee Iacocca, then Ford President, directed that “The Pinto was not to weigh an ounce over 2,000 pounds and not cost a cent over $2,000." Ditto on fuel economy and pollution, leading to much ludicrous regulation, including Corporate Average Fuel Economy (CAFÉ) and classifying PT Cruisers as SUVs.

Railroads started their long retreat toward mediocre returns on equity by ignoring the political clout of enraged farmers in the latter half of the 19th century. Freight rates swung wildly as railroads tried to cut each other’s throats for freight traffic, and then jacked up prices when the competition was bought or bankrupt. The result was that Midwestern populism put a straightjacket on railroads. The means: installation of the governmental superstructure known as the ICC (Interstate Commerce Commission). Railroads had to issue standard rates and tariffs for thousands of routes and commodities. It is hard to imagine a more cumbersome and unresponsive pricing system. Innovation in freight railroading came to a near-halt until deregulation of the 1970s and 1980s.

Now the big accounting firms and the American Institute of CPAs—having done nothing but fight, fight, fight solutions to the conflict of interest problem—just like the car industry did with pollution and safety—are about to lose everything. Andersen may not survive at all. Pricewaterhouse is spinning off its consulting arm. Deloitte Touche will try to do the same. Meanwhile, companies like Disney are refusing to engage audit firms to perform any kind of consulting. The accountants will certainly, and unnecessarily lose not only their systems integration consulting but even their tax consulting. But they will lose something more--their independence as oversight layer piles on oversight layer. They won every battle until Enron blew up. Now in a matter of weeks, they will lose the war.

Some astute strategists and CEOs--realize that politics trumps economics every time. Once your industry has hits the political wall, concepts like value to customers and profit are divorced root and branch from their original economic meaning.

The reason is that legislation and regulation do not obey economic logic, but other logics altogether. Legislation obeys the logic of politics—what words stuck on paper are just sufficient to get a bare majority of committee and floor votes plus a Presidential signature? What has to be written to facilitate Henry Waxman’s reelection? To cement John Dingell’s claim to chairmanship of the Energy and Commerce Committee when the Democrats return to power in the House of Representatives? None of this has much to do with competitive economics or value to customers. It often has next to nothing to do with public policy. It only has to do with what will play on the evening news in Peoria.

Next, legislation gets translated into executive branch regulation. This, too, has nothing to do with economics or value. It has everything to do with the logic of bureaucratic convenience.

Finally, the regulations are enforced by a police power that is propelled by tradition, politics and budget. These forces alone ensure that it will be more or less capricious in its application. In the State of Oregon, overweight trucks causing $1 billion in highway bridge damage—routinely received $8 overweight permits and $2 citations. (The collapse of the Soviet Union can be traced in no small part to the substitution of political and bureaucratic logics for economic logic. How ironic, since Marxism was supposed to be the new and correct economic logic par excellence).

Once an industry spirals into the political reality wall, it’s simply too late. You can’t unscramble an egg or de-politicize an industry. The most the strategist can hope for is a change in administrations—or at, best, a sea change in public opinion. In the 80’s, for example, greed became good until the Enron-like Milken fiasco hit the front pages. But as a rule, once legislation and regulation has set in, it is a very long time before there’s a chance to un-legislate and de-regulate. And even deregulation is subject to the political and bureaucratic process. Witness California’s energy “deregulation.”

What is the strategy-minded executive to think in this through-the-looking glass world?

The first thing to realize is that the first principle of strategy is not to seek a sustainable competitive advantage (or even an unsustainable one). The first principle is to realize that every company and every industry exists as a public trust for a public purpose.

Now before you think I’ve gone off my socialist rocker, let me explain what public trust and public purpose mean for private companies in America today.

First, a free market can only exist in an atmosphere of trust. Those who betray trust are dealt with severely, by having their industries regulated, shut down or reorganized beyond recognition. The public will not tolerate flagrant cheating in market transactions for any length of time. It will not tolerate even the perception of cheating by a company or an industry.

You may ask, “Doesn’t it all depend on what you mean by ‘cheating’?”

The answer is, “not in the least.” The public (and its political henchmen), not lawyers, are the judge, jury and executioners. The feels no need to define ‘cheating’ in advance and feels it has every right to define it ex post facto. Lawyers believe that it’s important to define what ‘cheating’ consists in. But by the time a case of alleged cheating reaches the law courts, the remedies of the political process, driven by an angry public are already well underway.

Now free market theorists believe that when a company cheats it will pay the piper by losing customers. Perhaps so; perhaps not. But when an industry is caught cheating, the public hasn’t the patience to await the slow justice of the market place.

Instead, the public, spurred by professional politicians (and those queasy about free markets), grab the nearest available tool—the meat ax of government regulation—not the surgeon’s scalpel of intellectual analysis. This is reaction is especially rapid when an industry is perceived to be a utility—something a lot of political constituents think they can’t live without—like accounting. If an industry or a profession—accounting—loses that trust, it will lose its freedom. Its practices will be restructured by meat ax.

If Andersen is caught cheating on its fairness opinions—in appearance or reality--it will have destroyed the basis for its very existence. If the accounting profession as a whole is found to have been cheating, it will have forfeited its claim to independence. It will have lost its status as a profession and joined the ranks of used car dealerships. And again, “cheating” is going to be whatever offends the sense of trustworthiness of the man or woman in the street.

Now to the second, public trust issue. In a problem-solving society such as ours, an industry must “work.” This means it must provide value, or at least not destroy it. It doesn’t have to provide value to everybody, as parents with Pokemon-playing children well know. But it may not destroy value—or be perceived as destroying value--for any significant proportion of the citizenry. This is what I mean when I say that every industry embodies a public trust.

This bears a little examination. Americans are a pragmatic people. Free enterprise is the means Americans have chosen to get value created. But if Americans see (or perceive) value being destroyed or free enterprise to be insufficient to solving problems, they will turn to other means to restore the missing value. This includes taxing themselves (or “the rich”). The tinfoil of free market principles simply cannot withstand the blowtorch of clear and present value destruction.

That’s the scary circumstance of the HMO industry in particular and the health insurance industry in general. The much-bandied-about (but little examined) figure of 39 million Americans without health insurance provides a prima facie case to the public that this industry is destroying value rather than creating it. The industry we have been relying on to provide a certain kind of value just isn’t doing it (as the public sees it).

The accounting industry appears guilty on this count as well. Not only has it been caught cheating (because its interests are conflicted) it has been caught destroying value. That’s because “little investors” relied on Andersen’s (and management’s) financials to make their investment decisions. The value AA destroyed is equal to that amount of Enron’s and (apparently) Global Crossings’ excess market value that can be attributed to inflated financial figures Andersen stated “fairly reflect” the condition of the company. (Not all of the excess market value can be justifiably so attributed; some is due no doubt to conflicts of interest in investment banking).

The pharmaceutical industry is another good example of one that is about to smash into the political reality wall. So far it hasn’t been caught cheating—although the recent rash of drugs that have been withdrawn from the market and occasional reports of fudging on clinical trials make one suspicious.

But Big Pharma is showing signs of failing its mission of public trust by appearing to “gouge” politically active groups like AIDs patients, senior citizens, and self-appointed advocates for the poor. Pharmaceutical companies can be spectacularly profitable. This is tolerated and even lauded by our pragmatic society—as long as the political realities revolving the interests and influences of these constituencies are met. But there are strong signals that they are not being met. Statistics show that roughly 40% of all prescriptions go unfilled or not picked up, in great part due to affordability problems. Newspaper stories talk of elderly folks who have to choose between eating that day or taking their heart pills.

But Big Pharma seems to ignore the political hurricane that’s brewing over pricing. Or it believes boarding up its house with white papers about the horrendous costs of drug development and clinical trials are enough to keep out the storm. In any event, Big Pharma seems so caught up with getting new drugs into the patent pipeline that it displays attention deficit disorder when it comes to political realities.

There is no good excuse for an industry failing recognize that is spinning into the political reality wall. There is usually plenty of notice. For years accountants have been warned about the appearance of conflicts of interest in their consulting. For years stories have appeared about pharmaceutical pricing. For years the media have talked up the problems of HMOs and the astronomical number of uninsured. But competitive dynamics are so strong that far too little attention gets paid and far too little action gets taken.

At the beginning of this piece I mentioned the snowmobile industry. Recently articles appeared in the New York Times or the Wall Street Journal about crowds of earsplitting snowmobiles sending yellow-brown exhaust into the air as they await permission to storm Yellowstone Park. Instead of going toe-to-toe with environmentalists and squeezing the National Park Service in a Custer’s last stand, the snowmobile industry could turn this into a golden opportunity to show how politically and environmentally responsible they are. Perhaps their executives would do well to momentarily suspend thinking about next year’s models or how to persuade dealers to stock more vehicles. Instead they need to think about whether the public will perceive them as cheating and whether they are destroying value—and how far along to being perceived to be cheating or destroying value they are. The profits they save could be their own.

Homework exercise: what are the signs your industry may be hitting the political reality wall? And it is what is your game plan? In the next article, I’ll describe what possibilities exist for industries that are about to smash into the political reality wall of managing a soft landing.

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