Article 5

Why companies
fail
CEOs offer every excuse but the right one:
their own errors. Here are ten mistakes to avoid.
By Ram Charan and Jerry Useem
HOW MANY MORE MUST FALL? EACH MONTH SEEMS TO BRING ring true. But a close study of corporate failure suggests that,
the sound of another giant crashing to earth. Enron. WorldCom. acts of God aside, most companies founder for one simple
Global Crossing. Kmart. Polaroid. Arthur Andersen. Xerox. reason: managerial error.
Qwest. They fall singly. They fall in groups. They fall with the We’ll get to the errors in a moment. But first let’s acknowl-
heavy thud of employees laid off, families hurt, shareholders fu- edge that, yes, failures usually involve factors unique to a com-
rious. How many? Too many; 257 public companies with $258 pany’s own industry or culture. As Tolstoy said of families, all
billion in assets declared bankruptcy last year, shattering the happy companies are alike; every unhappy company is unhappy
previous year’s record of 176 companies and $95 billion. This in its own way. Companies even collapse in their own way.
year is on pace, with 67 companies going bust during the first Some go out in blinding supernovas (Enron). Others linger like
quarter. And not just any companies. Big, important, FORTUNE white dwarfs (AT&T). Still others fizzle out over decades (Po-
500 companies that aren’t supposed to collapse. If things keep laroid). Failure is part of the natural cycle of business. Compa-
going like this, we may have trouble filling next year’s list. nies are born, companies die, capitalism moves forward.
Why do companies fail? Their CEOs offer every excuse in Creative destruction, they call it.
the book: a bad economy, market turbulence, a weak yen, hun- It was roughly this sentiment that Treasury Secretary Paul
dred-year floods, perfect storms, competitive subterfuge— O’Neill was trying to convey when he said that Enron’s failure
forces, that is, very much outside their control. In a few cases, was “part of the genius of capitalism.” But aside from sounding
such as the airlines’ post–Sept. 11 problems, the excuses even insensitive, O’Neill got one thing wrong. Capitalism’s true ge-

1
 Article 5. Why companies fail

nius is to weed out companies that no longer serve a useful pur- told them that most mountaineering accidents happen on the
pose. The dot-coms, for instance, were experiments in whether way down.
certain businesses were even viable. We found out: They Consider the case of Cisco Systems. While by no means a
weren’t. Yet many recent debacles were of companies that failure, Cisco suffered a remarkable comedown in the spring of
could have lived long, productive lives with more enlightened 2001—remarkable not only for its swiftness (its shares lost 88%
management—in other words, good companies struck down for of their value in one year) but also because Cisco, more than any
bad reasons. By these lights, Arthur Andersen’s fall is no more other company, was supposed to be able to see into the future.
part of the “genius of capitalism” than the terrorism on Sept. 11 The basis of this belief was a much vaunted IT system that en-
was part of the “genius of evolution.” abled Cisco managers to track supply and demand in “real
By “failure,” we don’t necessarily mean bankruptcy. A dra- time,” allowing them to make pinpoint forecasts. The tech-
matic fall from grace qualifies too. In the most recent bear nology, by all accounts, worked great. The forecasts, however,
market, for instance, 26 of America’s 100 largest companies did not. Cisco’s managers, it turned out, never bothered to
lost at least two-thirds of their market value, including such blue model what would happen if a key assumption—growth—dis-
chips as Hewlett-Packard, Charles Schwab, Cisco, AT&T, appeared from the equation. After all, the company had re-
AOL Time Warner, and Gap. In the 1990 bear market, by con- corded more than 40 straight quarters of growth; why wouldn’t
trast, none did, according to money management firm Aronson the future bring more of the same?
& Partners. The rosy assumptions, moreover, persisted even when evi-
The sheer speed of these falls has been unnerving. Compa- dence to the contrary started piling up. Customers began going
nies that were healthy just moments ago, it seems, are suddenly bankrupt. Suppliers warned of a coming dropoff in demand.
at death’s door. But this impression may be misleading. Con- Competitors stumbled. Even Wall Street wondered if the In-
sider, for instance, a certain Houston institution we’ve heard so ternet equipment market was falling apart. “I have never been
much about. There was no one moment when its managers sat more optimistic about the future of our industry as a whole or of
down and conspired to commit wrongdoing. Rather, the disaster Cisco,” CEO John Chambers declared in December 2000, still
occurred because of what one analyst calls “an incremental de- projecting 50% annual growth.
scent into poor judgment.” A “success-oriented” culture, mind- What was Chambers thinking? In The Challenger Launch
numbing complexity, and unrealistic performance goals all Decision, her definitive book on the disaster, Boston College
mixed until the violation of standards became the standard. sociologist Diane Vaughan notes that people don’t surrender
Nothing looked amiss from the outside until, boom, it was all their mental models easily. “They may puzzle over contradic-
over. tory evidence,” she writes, “but usually succeed in pushing it
It sounds a lot like Enron, but the description actually refers aside—until they come across a piece of evidence too fasci-
to NASA in 1986, the year of the space shuttle Challenger ex- nating to ignore, too clear to misperceive, too painful to deny,
plosion. We pull this switch not to conflate the two episodes— which makes vivid still other signals they do not want to see,
one, after all, involved the death of seven astronauts—but to forcing them to alter and surrender the world-view they have so
make a point about failures: Even the most dramatic tend to be meticulously constructed.”
years in the making. At NASA, engineers noticed damage to the
crucial O-rings on previous shuttle flights yet repeatedly con- Even when a boss doesn’t intend
vinced themselves the damage was acceptable. Companies fail
the way Ernest Hemingway wrote about going broke in The Sun to quash dissent, subtle signals
Also Rises: gradually, and then suddenly. (For some solutions,
see box “Three Quick Fixes.”)
can broadcast the message that
What undoes them is the familiar stuff of human folly: de- bad news is not welcome.
nial, hubris, ego, wishful thinking, poor communication, lax
oversight, greed, deceit, and other Behind the Music plot con- For the perpetually sunny Chambers, that “piece of evi-
ventions. It all adds up to a failure to execute. This is not an ex- dence” did not come until April 2001, when cratering sales
haustive list of corporate sins. But chances are your company is forced Cisco to write down $2.5 billion in excess inventory and
committing one of them right now. lay off 8,500 employees. Chambers may have been operating in
real time, but he wasn’t operating in the real world.

Softened by success
“Those whom the gods would destroy,” Euripides wrote nearly See no evil
2,500 years ago, “they first make mad.” In the modern update, With $6.5 billion in cash and a strong competitive position,
the gods send their victims 40 years of success. Actually, it’s a Cisco will live to fight another day. Polaroid may not be so
proven fact: A number of studies show that people are less lucky. Like its fellow old-economy stalwart Xerox, Polaroid
likely to make optimal decisions after prolonged periods of suc- was a once-highflying member of the Nifty Fifty group of
cess. NASA, Enron, Lucent, WorldCom—all had reached the growth stocks that lost their luster over the years. Eventually the
mountaintop before they ran into trouble. Someone should have question “What does Polaroid make?” became a latter-day ver-

2
ANNUAL EDITIONS

Ten big mistakes

They are the standard stuff of corporate folly.
Chances are, your company has made at least one.

FORTUNE TABLE

sion of “Who’s buried in Grant’s tomb?” Polaroid, that is, made Jim Collins, author of the influential management books
Polaroid cameras—period. Built to Last and Good to Great, has spent years studying
Time had passed the company by, you might say. Not ex- what separates great companies from mediocre ones. “The
actly. Think about another company that once seemed doomed key sign—the litmus test—is whether you begin to explain
to fail: Intel. Back in 1985, competition from Japan was away the brutal facts rather than to confront the brutal facts
turning Intel’s memory chips into cheap commodities, and ob- head-on,” he says. “That’s sort of the pivot point.” By
servers were all but writing the company’s obituary. Instead of forcing themselves to think like outsiders, Grove and Moore
going the way of Polaroid, though, Intel decided to exit the recognized the brutal facts before it was too late. Polaroid
memory business entirely and become a maker of micropro- and Xerox didn’t.
cessors. The key insight occurred when Intel founders Andy
Grove and Gordon Moore sat down and asked themselves
some tough questions. “If we got kicked out and the board Fearing the boss more than the
brought in a new CEO,” Grove asked Moore, “what do you
think he would do?” Get out of memory chips was the answer. competition
From there, they said later, it was just a matter of doing what Sometimes CEOs don’t get the information they need to make
needed to be done. informed decisions. The main reason, says Daniel Goleman, a
Polaroid and Xerox, by contrast, were slow to confront the psychologist and author of the book Primal Leadership, is that
changing world around them. Executives at both companies re- subordinates are afraid to tell them the truth. Even when a
peatedly blamed poor results on short-term factors—currency boss doesn’t intend to quash dissent, subtle signals—a sour
fluctuations, trouble in Latin America—rather than the real expression, a curt response—can broadcast the message that
cause: a bad business model. By the time Xerox President (and bad news isn’t welcome. That’s why, according to a study by
now CEO) Anne Mulcahy came out and spoke the truth—the Goleman and two associates, higher-ranking executives are
company had “an unsustainable business model,” she told ana- less likely to have an accurate assessment of their own per-
lysts in 2000—Xerox was flirting with bankruptcy. formance.

3
 Article 5. Why companies fail

Three quick fixes

THE RECENT CORPORATE COLLAPSES HAVE IN- a greater incentive than anyone to act as company watch-
volved many breakdowns: in ethics, in trust, in common dogs. Yet few companies tap this built-in alarm system.
sense, to name a few. But perhaps the most troubling Too often, front-line employees smell something rotten
breakdown is in corporate oversight. Directors, senior but do not, or cannot, convey the message upward. That’s
executives, and Wall Street analysts all failed miserably why companies need a mechanism to make it happen.
by missing—or concealing—danger signals until it was Whistle-blowing does not count as a mechanism.
too late. Regulators will no doubt have plenty to say on Whistle-blowing is a last resort—one that’s frequently
the issue, but the most zealous reformers should be the harmful to the whistle blower’s health. What’s really
companies themselves. They can begin with three needed is a survey, carefully designed and administered
changes that, taken together, will provide a better early- by an outside agency, that regularly solicits employee
warning system against failure: feedback on sensitive questions. Do people trust manage-
ment? Is there any reason to doubt the reported revenue
1 Reengineer the board. Remember reengineering? It numbers? Are the company’s values out of whack? Think
was applied to every corner of the corporation at one of it as a human audit. Send the results directly to the
point or another—except the board. That needs to board. And give employees a chance to inspect company
change. Incompetence is not the problem. Boards can be finances directly—say, by holding Q&A sessions with
full of very capable people yet be totally ineffective as a the CFO. Corporate governance should ideally include
group. The problem is that directors are too nice. Boards all a company’s stakeholders, and employees hold the
seldom convene without the CEO, and raising troubling biggest stake of all.
questions can simply seem rude—which is often the way
the CEO wants it. Directors need a forum where they can 3 Banish Ebitda. Companies hit the skids for all sorts
talk frankly without the CEO. Ten minutes at the end of of reasons, but it’s one thing that ultimately kills them:
each meeting would be a good start. Better yet, an annual They run out of cash. Yet most managers are too preoc-
retreat where the board can assess its own performance as cupied with measures like Ebitda (earnings before inter-
well as the CEO’s. Collectively, the directors are sup- est, taxes, debt, and amortization) and return on assets to
posed to serve as a company’s peripheral vision. Often at give cash much notice. Boards don’t ask for it. Analysts
least one director suspects trouble before it becomes a don’t analyze it. Corporate financial statements do typi-
crisis. The trick is getting him or her to say it out loud. cally include a statement of cash flow, but it’s a crude
Boards should also appoint the chairperson of the gov- snapshot that excludes off-balance-sheet items and
ernance committee as lead director. This especially doesn’t show where the cash comes from. The solution is
makes sense when the CEO and chairman are the same a detailed, easily readable cash-flow report. Give it to the
person, as is the case with most U.S. companies. The lead board. Give it to employees. Break out cash flow by divi-
director would be from the outside, reappointed every sion, letting people track the company’s blood flow
two years or so, and authorized to convene a meeting themselves. Warren Buffett pays close attention to cash
anytime, any place, with or without management. flow because, among other reasons, he knows cash is
hard to fudge. That’s why creative accountants hate it—
2 Turn employees into corporate governors. As the and why you should learn to love it.
Enron debacle has proven, regular employees—not exec- No system survives for long without feedback and con-
utives, not directors, not shareholders—have the most to trols. So corporate America has a choice: It can implement
lose when a company fails. With their jobs, pensions, and these controls itself. Or it can wait for regulators and poli-
stock-option wealth on the line, it follows that they have ticians to impose them. Which sounds better to you?

Fear can have its uses, of course; Andy Grove has long es- The same problem hampered Samsung Chairman Lee Kun
poused the value of competitive paranoia. But in unhealthy sit- Hee in 1997 when he decided to take Samsung into the auto
uations, employees come to worry more about internal business. Knowing the car industry was a crowded field plagued
factors—what the boss might say, what management might by overcapacity, many of Samsung’s top managers silently op-
do—than about threats from the outside world. Certainly this posed the $13 billion investment. But Lee was a forceful
was the case at Enron, where even alarm-ringer Sherron Wat- chairman and a car buff to boot. So when Samsung Motors
kins chose to express her concerns anonymously rather than folded just a year into production, forcing Lee to spend $2 bil-
hazard one of CEO Jeff Skilling’s famous tongue-lashings. And lion of his own money to placate creditors, he expressed sur-
she was one of the brave ones. prise: How come nobody had spoken up about their reservations?

4
ANNUAL EDITIONS

During World War II, Churchill set Acquisition lust

WorldCom founder Bernard Ebbers liked to eat. He ate MCI.
up an office outside the chain of He ate MFS and its UUNet subsidiary. He tried to eat Sprint.
command whose main job was Wall Street helped him wash it all down with cheap capital and
a buoyant stock price. Pretty soon WorldCom was tipping the
to tell him the unvarnished truth. scales at $39 billion in revenues. But there was a problem:
Ebbers didn’t know how to digest the things he ate. A born deal-
maker, he seemed to care more about snaring new acquisitions
During World War II, Winston Churchill worried that his
than about making the existing ones—all 75 of them—work to-
own larger-than-life personality would deter subordinates from
gether. At least Ebbers was up front about it: “Our goal is not to
bringing him bad news. So he set up a unit outside his generals’
capture market share or be global,” he told a reporter in 1997.
chain of command, the Statistical Office, whose primary job
“Our goal is to be the No. 1 stock on Wall Street.”
was to feed him the starkest, most unvarnished facts. In a sim-
ilar vein, Richard Schroth and Larry Elliott, authors of the forth- The results were frequently chaotic. For a time, sales reps
coming book How Companies Lie, suggest designated from UUNet competed head-to-head with WorldCom sales
“counterpointers,” whose function is to ask the rudest questions teams for corporate telecom contracts. Smaller customers com-
possible. Such mechanisms take information and turn it into in- plained they had to call three different customer-service reps for
formation that can’t be ignored. their Internet, long-distance, and local-phone inquiries. If there
is such a thing as negative synergy, WorldCom may have dis-
covered it.
Not that acquisitions are always so bad. General Electric
Overdosing on risk combines its acquisitive nature with an impressive ability to
Some companies simply live too close to the edge. Global break down acquisitions and integrate them into existing oper-
Crossing, Qwest, 360networks—these telecom flameouts chose ations. But too often CEOs succumb to an undisciplined lust for
paths that were not just risky but wildly imprudent. Their key growth, accumulating assets for the sake of accumulating as-
mistake: loading up on two kinds of risk at once. sets. Why? It’s fun. There are lots of press conferences. It’s
The first might be called “execution risk.” In their race to what powerful CEOs do. And like Ebbers, whose WorldCom
band the earth in optical fiber, the telco upstarts ignored some stock has lost 98% of its value, few wonder if their eyes might
key questions: Namely, would anyone need all of this fiber? be bigger than their stomachs.
Weren’t there too many companies doing the same thing?
Wouldn’t, uh, most of them fail? “People seemed to say,
‘Maybe—but it’s not going to be us,’” says Darrell Rigby, a Listening to Wall Street more
Bain & Co. consultant who studies managing during times of than to employees
turbulence. “Everyone thought they were immune.” No one likes a good growth story better than Wall Street. And
in the late 1990s, no one was telling a better one than Lucent
CEO Rich McGinn. He knew how to give Wall Street what it
Ebbers liked to eat. He ate MCI. wanted—explosive top-line growth—and in return, Wall Street
He ate MFS. Wall Street helped turned McGinn and his team into rock stars. For a bunch of
former Bellheads, it was intoxicating stuff.
him wash it all down with cheap
capital and a soaring stock. Says an ex-Xerox executive:
“I could not present to the
On top of execution risk was another kind, which we’ll call
liquidity risk. Global Crossing—run by Gary Winnick, for- board unless things were
merly of the junk-bond house Drexel Burnham Lambert— perfect. Everything had to be
loaded up on $12 billion of high-yield debt. This essentially
limited Winnick to a cannonball strategy: one shot, and if you prettied up.”
miss, it’s bankruptcy.
Bankruptcy it was. Given the utter violence of the telecom But while McGinn was busy performing for the Street, there
shakeout, you might say it was inevitable. But other telcos did were at least two groups he wasn’t listening to. The first was
manage to escape the carnage. BellSouth, dismissed as hope- Lucent’s scientists, who feared the company was missing out on
lessly conservative during the Wild West years, emerged with a a new optical technology, OC-192, that could transmit voice
pristine balance sheet and a strong competitive position. Its gen- and data faster. They pleaded in vain for its development, then
tlemanly CEO, Duane Ackerman, was guided by a radical idea: watched as rival Nortel rolled out OC-192 gear to thunderous
“being good stewards of our shareholders’ money.” What a success. At the same time McGinn was neglecting Lucent’s
concept. salespeople, who might have told him that his growth targets

5
 Article 5. Why companies fail

were becoming increasingly unrealistic. To meet them, em- February overbid by Mozer and failed to discipline him. Mozer
ployees were pulling forward sales from future quarters by of- evidently took Gutfreund’s lack of action as a green light.
fering steep discounts and wildly generous financing Salomon’s culture of swashbuckling bravado encouraged
arrangements, largely to dot-coms. “As we got further and fur- risk taking without accountability. Enron’s culture encouraged
ther behind,” Chairman Henry Schacht later explained, “we did profit taking without disclosure. Andersen’s culture engendered
more and more discounting.” conflicts of interest without safeguards. Rotten cultures produce
It could only last so long. After Lucent stock had lost more rotten deeds.
than 80% of its value and he had replaced McGinn as CEO,
Schacht sat down with FORTUNE to ponder some hard-earned
lessons. “Stock price is a byproduct; stock price isn’t a driver,” The new-economy death spiral
he said. “And every time I’ve seen any of us lose sight of that, Alan Greenspan has his own theory on failure. Testifying about
it has always been a painful experience.” Top management Enron in February, he noted, “a firm is inherently fragile if its
needs to understand what the folks on Wall Street want—but value-added emanates more from conceptual as distinct from
not necessarily give it to them. physical assets.… Trust and reputation can vanish overnight. A
factory cannot.” The speed of some recent crackups would seem
to confirm his thesis. The first domino falls when questions are
raised, sometimes anonymously. Wrongdoing is suspected.
Strategy du jour Customers delay new orders. Rating agencies lower their debt
When companies run into trouble, the desire for a quick fix can ratings. Employees head for the exits. More customers defect.
become overwhelming. The frequent result is a dynamic that And voilà, you have what former Enron CEO Jeff Skilling has
Collins describes in Good to Great: “A&P vacillated, shifting called “a classic run on the bank.“
from one strategy to another, always looking for a single stroke Is it possible to halt one? Yes, but only if you stop the spiral
to quickly solve its problems. [It] held pep rallies, launched pro- from building up speed. Salomon broke the cycle by hiring
grams, grabbed fads, fired CEOs, hired CEOs and fired them Warren Buffett as interim CEO —essentially a giant credibility
yet again.” Lurching from one silver bullet solution to another, infusion. By waiting several months to step down, on the other
the company never gained any traction. hand, Arthur Anderson CEO Joseph Berardino lost whatever
Collins calls it the “doom loop,” and it’s a killer. Kmart is an- chance he had to avoid disaster. Once started, the spiral can
other victim. In the 1980s and early ’90s, Kmart was all about bring a company whose main assets are people and ideas to its
diversification, shifting away from discounting to acquire knees with breathtaking finality.
stakes in chains like Sports Authority, OfficeMax, and Borders
bookstores. But in the 1990s a new management team divested
those stores and decided to revamp Kmart’s supply chain by in- A dysfunctional board
vesting heavily in IT. That lasted for a while, until a new CEO, What was Enron’s board thinking? Of all the infamous mo-
Chuck Conaway, decided that, actually, Kmart would try to beat ments in the company’s demise, perhaps the least explicable
Wal-Mart at its own game. This unleashed a disastrous price was the board’s decision to waive Enron’s code of ethics to ac-
war that in the end proved to be one mistake too many. “When commodate CFO Andrew Fastow’s partnerships. “A red flag
you look at companies that get themselves into trouble,” says Collins, the size of Alaska,” says Nell Minow, founder of the board
“they’re often taking steps of great, lurching bravado rather than watchdog group Corporate Library. Even Enron directors belat-
quiet, deliberate understanding.” Did somebody say AT&T? edly agreed with this assessment. “After having authorized a
conflict of interest creating as much risk as this one,” the
board’s special investigation committee wrote in a February re-
A dangerous corporate culture port, “the board had an obligation to give careful attention to the
transactions that followed. It failed to do this… In short, no one
Arthur Andersen, Enron, and Salomon Brothers were all was minding the store.”
brought down, or nearly so, by the rogue actions of a tiny few.
But the bad apples in these companies grew and flourished in
the same kind of environment: a rotten corporate culture. It’s "The great companies don't
impossible to monitor the actions of every employee, no matter make excuses," said Treasury
how many accounting and compliance controls you put in place.
But either implicitly or explicitly, a company’s cultural code is Secretary Paul O'Neill recently.
supposed to equip front-line employees to make the right deci-
sions without supervision. At Salomon Brothers the culture did
"They do well anyway."
just the opposite. The transgressor there was Paul Mozer, a
trader who in February of 1991 improperly overbid in auctions Despite a decade’s worth of shareholder activism, Enron’s
of U.S. Treasury bonds. While it was another improper bid on board was not an anomaly. The sorry fact is that most corporate
May 22 that finally did him in, the critical event occurred in boards remain hopelessly beholden to management. “I was
April, when Salomon Chairman John Gutfreund learned of the never allowed to present to the board unless things were per-

6
ANNUAL EDITIONS

fect,” says a former senior executive at Xerox, whose board in- Paul O’Neill may have been wrong about his assessment of
cludes Vernon Jordan and former Senator George Mitchell. Enron, but he was right about something else. “The great com-
“You could only go in with good news. Everything was prettied panies don’t make excuses,” he said recently, “including ex-
up.” At many boards, the CEO oversees meetings, hand-picks cuses about how they didn’t do well because the economy was
directors, and spoon-feeds them information. “Directors know against them or prices were not good. They do well anyway.”
relatively little apart from what management tells them,” says It’s true. And it’s something to think about the next time you
John Smale, a former CEO of Procter & Gamble and onetime hear a CEO railing at the gods.
chairman of General Motors.
Unless, that is, the board demands more. “The CEO is al-
ways going to want to turn the board meeting into a pep rally,”
says Minow. “You’ve got to say to him ‘Look, I’m a busy
person. I don’t have time for the good news. What I need for you RAM CHARAN advises FORTUNE 500 CEOs and is co-author, with Larry
to tell me is the bad news.’ It’s like what Robert Duvall says in Bossidy, of Execution: The Discipline of Getting Things Done.
The Godfather: ‘I have to go to the airport. The Godfather is a
man who likes to hear bad news immediately.’ That should be
emblazoned on every corporate governance policy sheet.” REPORTER ASSOCIATE Ann Harrington

Reprinted from the May 27, 2002, issue of Fortune, pp. 50-54, 56, 58, 60, 62 by special permission. © 2002 by Time, Inc. All rights reserved.