Keeping the Fish Fresh: Corporate Compliance and Ethical Values
If, in Peter Drucker’s oft-quoted words, culture eats strategy for breakfast, what does it eat for lunch and dinner? Or perhaps, more pertinently, how can we ensure that if it is going to continue to consume strategy that it does so in a nutritionally responsible way?
After a year when numerous companies, from financial services companies to internet giants, have been rocked by ethical scandals, many of which could in hindsight have been predicted, it is worth asking whether any formal metrics for health and hygiene in corporate ethics can make a difference in preventing future outbreaks of malfeasance.
The UK’s Financial Reporting Council (FRC) apparently thinks so. Starting in January 2019, a revised corporate governance code will apply to UK-listed companies requiring the boards of these companies to “establish the company’s purpose, values and strategy and satisfy itself that that these and its culture are aligned”. This new standard is a significant departure from earlier statements by the council’s leadership that requiring such standards would be neither feasible nor acceptable.
In addition to adding the requirement to monitor and assess the health of a company’s culture, the FRC’s revised guidance addresses the risks of formulaic calculations of executive compensation and urges boards to increase their commitment to succession planning and board refreshment, including the recommendation that boards periodically commission external board performance reports.
The FRC’s new guidance has not, of course, emerged in a vacuum. Attempts to measure and monitor corporate culture and ethics have a long pedigree but the need for more accurate tools became urgent after the financial crisis of 2008, in whose aftermath emails from traders and financial executives came to light that dramatically gave the lie to the idea that it was caused by “neutral” market forces rather than conscious fraud. Not surprisingly, the market has responded with a wide array of new tools to manage and monitor corporate culture and corporate integrity. A fascinating new study by Stephen Stubben and Kyle Walsh of Georgetown University analyzes a database of 1.2 million records from Navdex Global, a company that provides whistleblower hotlines and whistleblower management services (yes, there is such a thing) for employees of public US companies. Their findings indicate, paradoxically, that the more whistleblower reports employees of a company register, the fewer lawsuits that company faces and the less money it pays out in settlements.
As the authors point out, this evidence flies in the face of the common goal of compliance officers to reduce whistleblower calls to zero. Their research further indicates that higher levels of whistleblower reports are also correlated with fewer external reports to regulatory agencies. In light of this evidence, the authors suggest that regulatory agencies would do well to encourage companies to strengthen use of their internal reporting systems rather than focusing solely on external reporting.
The consulting landscape is now replete with firms offering a range of metrics, audits and certifications in the ethical culture space. In a form of brand extension out of ESG (Environmental, Social and Governance) consulting, these firms now provide guidance on business ethics, anti-bribery and anti-corruption compliance and related governance topics.
Good Corporation’s “Ethical Culture Checklist” is based on ten key drivers of ethical cultures which are used to identify 25 culture statements to assess the ethical health of an individual organization. From this analysis, Good Corporation generates a “Net Ethical Culture Score” (NEC) that can be used for benchmarking purposes. Meanwhile, the Maturity Institute has created a new approach to organizational health based on what it calls a “new model of responsible capitalism.” As expected, this approach comes with proprietary measurement tools and a ratings index.
Over on the machine learning side of the spectrum, Kai Li from the University of British Columbia and his coauthors have deployed the latest machine learning techniques, including the “word embedding model,” to analyze 217,387 analyst calls to obtain five corporate cultural values – innovation, integrity, quality, respect, and teamwork. While their methodology is primarily designed to identify good or bad cultural fit between companies that have undergone or are contemplating a merger or acquisition, they have derived measurements of integrity from frequency and juxtaposition of “value” words in analyst call transcripts to help identify potential reputational weaknesses.
While we strongly believe that artificial intelligence and machine learning will continue to evolve and generate increasingly valuable insights into patterns of speech and behavior that can predict ethical problems before they occur, we also believe that most of the models and systems that have been developed will become subject to the inverse of the usual adage about measurement and management.
In other words, what is measured will be managed, and not in a beneficial way. The solution to this dilemma is unfortunately both difficult and prosaic. As the Financial Times editors commented in their 2018 year-end editorial on corporate culture: “Culture is not just a snapshot or a spreadsheet, it is a story.” Taking this perspective as a starting point, we believe there are five critical ways for companies to deploy old-fashioned tools to preemptively identify ethical risks before they become full-blown problems.
1. Employee Churn
There are numerous studies showing that companies with a toxic culture experience higher than average rates of employee churn. What is less frequently discussed is the reverse: increasing levels of employee turnover are a warning signal for a corporate culture with potential integrity issues. As turnover rates provide objectively measurable data points, it is critical for these numbers to be tracked not solely from the perspective of HR and productivity but also as a tool of compliance. Business unit managers with levels of turnover consistently higher than in other parts of the company or industry should be required to provide an accounting of the reasons for the turnover. Nor should compliance leaders be satisfied with the “usual” explanations – uncompetitive salaries, no promotion opportunities, life style choices that are often cited as reasons for employees to seek other employment. Where high levels of turnover persist, representatives of the compliance function should begin to participate in exit interviews and, where appropriate, correlate turnover rates in a given unit with calls to the confidential employee hotline.
It is with good reason that the one thing most abhorred by corporate directors is a surprise announcement with negative consequences (even if first delivered privately). As individuals with fiduciary responsibility to shareholders, they are acutely aware that it is their duty to be informed of all developments that could have a material impact on the company’s short-term share price and long-term reputation. Often explained away by CEOs and CFOs as consequences of market “headwinds,” unexpected write-downs and earnings pre-announcements or surprises need to be examined closely by board members. They need to probe beyond the immediate explanation of the causes for any negative developments and ask company management the classic Watergate questions: what did they know and when did they know it? As in any relationship built primarily on trust, it can be awkward to push hard on these questions for fear of permanently damaging the board/CEO relationship or, in the worst case, pushing a successful CEO away. The consequences of failing to do so, however, too often lead to greater problems down the road.
3. The Insatiable CEO
Stocked as most boards are with successful current or former CEOs and senior leaders of other widely respected organizations, it is not always immediately obvious to them when the behavior and lifestyle of a successful CEO has moved beyond the norm for this peer group and into territory that could become a cause for concern. It is rare for lifestyle excesses to attract the attention of the authorities at the time, as ultimately convicted former Tyco CEO Denis Kozlowski’s $2m “Roman orgy” birthday party did. A better proxy signal may be a CEO insistent on continuing increases in compensation in spite of being at or near the peak for his industry and country of origin. Regardless of their sensitivity to comparisons with their own robust compensations, board directors need periodically to step back and assess whether the CEO’s financial demands may be accompanied by other less benign behaviors to meet his personal lifestyle aspirations. As the Tyco example indicates, they should be especially alert to large loans made to the CEO by the company and be scrupulously attentive to whether they are being repaid.
4. Too Good To Be True
In 2004, after Worldcom was discovered to have committed $3.8bn in accounting fraud, then AT&T chairman, Michael Armstrong, lamented that he would not have done half the deals he did if he had not been hopelessly trying to catch up with what appeared to be WorldCom’s stunning business performance. Worldcom’s board had watched enraptured as CEO Ebbers capped 65 acquisitions with the purchase of MCI in 1997. Behind the scenes, as The New York Times reported after the scandal broke, the company’s finances were a complete disaster, increasingly requiring the accounting magic provided by ever-larger acquisitions to stay afloat. The success narrative finally came unraveled when the Department of Justice turned down the company’s proposed $145bn acquisition of Sprint on anti-competitive grounds. While there are certainly examples of companies that appear to be able to defy the logic of market fundamentals identified by financial analysts, company directors need to be constantly alert to the possibility that their company’s story is in fact too good to be true and devote significant energy to understanding why their CEO seems to be able to deliver against the odds. Otherwise, they may face the ignominy of discovering, as Warren Buffet commented, who is swimming naked when the tide goes out.
5. Continuous Board Engagement
The best boards already understand that their engagement needs to extend far beyond quarterly meetings and they have found the right balance between involvement and micromanagement. They believe it is crucial to stay in touch between meetings on an ad hoc basis to maintain a truly critical awareness of evolving challenges, both operational and reputational. Some companies insist that directors visit at least one corporate site every twelve months. Others have the board conduct annual reviews with the top tier of corporate executives beyond the immediate leadership team in order to get a direct impression of the fiber of the company’s senior talent. Above all, as a discussion convened by the Harvard Business Review with Prium, a New York-based forum for CEOs revealed, directors need to be comfortable asking tough questions. As one participant suggested, an individual director should be designated to think like an activist investor, relentlessly scrutinizing the CEO’s strategy and providing a contrarian view. All of these individual board contributions are essential for directors to understand the arc of the corporate story so they can recognize when even small cracks begin to appear in its plausibility.
Regulatory bodies in major markets have continued to refine their guidance on board independence and board refreshment, but there is no substitute for the time and hard work required to ensure that corporate reality matches a company’s publicly stated commitments to ethics and punctilious compliance with regulatory mandates. The fish does not always stink from the head, but it is not a bad place to keep your eye on.