This year isn't shaking up to be a good one for corporate innovation. Since the bankruptcy of Enron-Fortune magazine's 2001 choice for America's most innovative company-2002 has seen a torrent of share-price devaluations. Investors are concerned that other companies—whether legally or illegally—may have also misrepresented their liabilities, revenues, and earnings.

Even shares of General Electric, an industrial icon, have stumbled as investors fret over the potential for conglomerates like GE to use mergers and creative accounting to inflate revenues. Meanwhile, the Enron débâcle has brought renewed focus on managed earnings—the use of accounting wizardry to manipulate profits.

But let's hope that, after the investigations by the Securities and Exchange Commission (SEC), the FBI, and a dozen or so congressional committees have sifted through all this alleged skullduggery and called the villains to account, so to speak, innovation is not what lingers in our minds as the cause of all the trouble. A hammer can be used to build a house or to break into one. Likewise, innovation can be beneficent or baneful.

At its worst, innovation is a license to exploit anything in the name of enriching oneself. A holder of a license such as that will have no compunction about straying into unethical business practices, especially if those practices have legal sanction. At its best, innovation is a passion and commitment to do something better differently.

Enron's brand of innovation seemed beneficial but turned out baneful. Months or even years may elapse before we know all the details of how this company operated, but it apparently misled investors by allocating debt that belonged on its balance sheet to the balance sheets of supposedly independent partnerships and by using complex securities that masked debt as shareholder equity on its own balance sheet.

Having thus deflated liabilities, Enron executives inflated revenues by exploiting a freedom granted to market makers in the trading of energy derivative contracts. Unlike a regulated commodities market such as the New York Mercantile Exchange, Enron's over-the-counter exchange was allowed to book as revenue the full value of the contracts that it sold, not the much smaller value of its commission on each transaction. Needless to say, this freedom is now under review by the Financial Accounting Standards Board (FASB).

The devil's in the details

The SEC and the FASB to which it delegates much responsibility clearly need to instigate some major reforms in U.S. accounting standards. They might begin with the FASB's generally accepted accounting principles (GAAP). Principles in name only, GAAP are really a set of detailed and prescriptive rules. As such, the only responsibility that GAAP imposes on accountants is a duty to conform to the letter of its multifarious rules.

In this way, the FASB's standards differ from the alternative international accounting standards of the International Accounting Standards Board (IASB), whose less detailed and less prescriptive rules permit a wider scope for interpretation in return for a greater degree of responsibility by the accountants who implement them.

IASB standards would have forced Enron to greater disclosure about its off-balance-sheet dumping ground for liabilities. Indeed, adoption of international standards in the United States would have prevented or at least ameliorated many of the accounting scandals that have lately so damaged investor confidence in U.S. capital markets.

So the trouble with the GAAP system resides, paradoxically, in the very details and prescriptiveness that many until recently had presumed were its strengths. By creating such a system, the architects of GAAP have in effect given America's accountants the right to prepare and audit statements while relieving them of the responsibility to prepare and audit those statements to the highest level of integrity. This is equivalent of driving a car in obedience of posted road signs but still killing a pedestrian.

When rights exceed responsibilities

The expedience of balancing rights and responsibilities applies to legislators, corporate innovators, executives, non-executive directors, landlords, tenants, physicians, parents, judges, jurors, and, not least, accountants.

As knowledge-intensive companies, financial and professional services firms rely, perhaps more than in any other industry, on their employees to balance bold action and responsible behavior. These companies have historically been among the most adept at maintaining such a balance. (Indeed, this accomplishment goes a long way to explaining the high margins of investment banks, brokerage houses, and commodities traders like Enron.) But occasionally the balance is broken and calamity ensues.

Barings—one of London's oldest investment banks—plunged into sudden bankruptcy in 1995 when the rights of rogue trader Nick Leeson exceeded his level of responsibility by a considerable mark. Who was to blame? Well, Leeson, of course, and Barings too according to an independent inquiry by the International Financial Risk Institute, a Geneva-based research foundation supported by the financial-services industry and regulators. But companies have to put some trust in their employees. Moreover, in order to maximize value for their shareholders, companies need to tap their employees' ideas and creativity.

In other words, to prosper in today's increasingly competitive business environment, companies must grant their employees a right or license to innovate, circumscribed by a countervailing level of responsibility. At the same time, they must guard against creating a culture in which responsibilities are not taken seriously—either through wanton contempt or, more commonly, when employees are embroiled in the heat of a business. In such a culture, a license to innovate can become—as in Leeson's case—a license to kill.

When responsibilities exceed rights

Whereas the converse, an excess of responsibilities over rights, could never induce the types of calamity that befell Barings and Enron, it does pose the more insidious threat of stasis—the situation in which companies go nowhere for lack of innovation.

The many disbanded incubators, skunkworks, corporate venture funds, and other ad hoc innovation initiatives that litter the hallways of corporate America are testament to the frequency with which companies endow these groups with a responsibility for innovation while simultaneously denying them the freedom to fulfill their mandate by, for example, not allowing the incubator access to key expertise in the firm. Indeed, according to anecdotal data, corporate innovation programs typically last no more than three years before succumb to cyclical resource cuts.

As AT&T has discovered, activism is likely to prevail as the instinctive reaction of responsible individuals when corporations deny them a license to innovate. Founded in 1995, AT&T's Opportunity Discovery Department (ODD) comprised a band of heretics, employees who were impassioned by their company's failure to address new regulatory, competitive, technological, and societal realities in the telecommunications industry.

Affiliated to AT&T Labs rather than to the legitimate strategic planning function, the group lacked a license to innovate—specifically, to propose alternative strategies. In consequence, ODD was unable to save AT&T from itself. Today, companies like AOL Time Warner, Nokia and Microsoft seem much more likely to shape the future of the telecommunications industry. (For the full ODD story, see http://www.strategos.com/news/perspectives01.htm).

Measuring innovation integrity

Innovation that is driven by passion and commitment to do something better differently has integrity. The kind of innovation that enriches a select few, in contrast, is likely to end in acrimony with maybe time in the clink for the enriched few to boot. Nick Leeson served three years for defrauding Barings investors of $817 million. Messrs. Lay, Skilling, and others implicated in the Enron implosion might well serve jail time too.

So by what criteria should prospective investors assess the integrity of a company's innovations? In answer, investors should not seek a check list because innovation is fundamentally the outcome of human behavior, and, as the failure of GAAP suggests, no check list can adequately contain the devices of human behavior. With that caveat in mind, consider the following as guidelines.

Begin by looking for a wider qualitative value of the innovation. Does the innovation address a market need—making life-enhancing products and services more accessible, for instance—or does it merely generate paper profits with no associated benefits for the company's customers and consumers? In other words, does the company excel at counting its money or making it?

Next ask whether the innovation is self-sustaining. Clearly, the Ponzi scheme of Enron executives to drive the company's share price ever upward by inflating earnings and concealing liabilities was not. Also, marking to market—booking the full value of contracts as revenue at the time of the sale—creates ever-increasing pressures to do bigger and bigger deals while the capacity to deliver on those deals may go unsecured.

Also, investors should try to understand as much as possible about the internal relationships within the company. Have the style of top management and the company's unique corporate culture diminished the rights of employees to innovate? Like those GAAP accountants, employees in such companies probably think of themselves as having diminished responsibilities too. At AT&T, where the employees took charge of innovation without having a formal right to do so, the strategic labors of the ODD group went mostly unacknowledged, and ultimately, did not fully benefit the company.

Finally, avoid any company whose board is unwilling to challenge top management. To this end, Walter Hewlett, a non-executive director of Hewlett-Packard, has recently proposed some reforms in corporate governance that may provide better representation of shareholder interests. For example, Hewlett suggests that the board of directors appoint independent financial and legal counsel rather than rely on counsel that is appointed by executive management. If such reforms promote honest dialogue at the top of the corporate hierarchy, they should also do much to promote responsible innovation.

Enron and the Consulting Industry:
Mea Culpa?

Most of us admired Enron's innovative management practices: the pioneering use of idea and talent markets inside the company, the pocket money that newly hired associates received to invest in compelling ideas of their choosing, the semiannual reviews to assess employees on the strength of their innovations, and a company culture that encouraged creative minds to challenge orthodoxies. But in the spirit of mea culpa, we management consultants should have looked not only at Enron's management practices but also at its financial practices. That the latter were mired in murk does not absolve us of our responsibility for due diligence.

Nevertheless, note that Enron's demise was not the work of innovative rank-and-file employees, many of whom developed valuable and ethically sound new business ideas. Rather, it was the work of Enron's top management, the foxes guarding the hen house. Doubtless, if employees had been aware of the risks that the company was taking, few would have wanted to associate their ideas, their careers, and their retirement savings with such a house of cards. But in opposition to the very ethos of the company's much vaunted internal markets, employee judgment fell victim to a lack of full disclosure by Enron executives. Such non-disclosure spoils markets.

Indeed, how apropos that the 2001 Nobel prize for economics was awarded for research on lemons—products that don't function as promised. The ground-breaking study by professors at Stanford, Columbia, and University of California, Berkeley, showed how markets malfunction when buyers and sellers operate under different information. In the case of Enron, shareholders were the buyers and executives were the sellers. The lemons? They, of course, were Enron's shares.

Strategos is a management consulting firm founded by Gary Hamel. The Strategos Institute is a member-based research organization that develops innovative management practices. Contact information: lvalikangas@strategos.com, tel. 1-650-851-2095