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Reputability LLP are pioneers and leaders globally in the field of behavioural risk and organisational risk. We help business leaders to find the widespread but hidden behavioural and organisational risks that regularly cause reputational disasters. We also teach leaders and risk teams about these risks. Here are our thoughts, and the thoughts of our guest bloggers, on some recent stories which have captured our attention. We are always interested to know what you think too.

Thursday, 2 July 2015

A Contrarian Approach to Groupthink

Groupthink is a  well-recognised psychological phenomenon in which people strive for consensus within a group. People may set aside their own personal beliefs or adopt the opinion of the rest of the group.  Groupthink is found wherever people collaborate, and this includes boards and leadership teams, especially if they embrace collegiality. 

Groupthink happens for many reasons.  The group may recruit in its own image.  Members may conform because job security depends on conformity; or for more subtle reasons, such as group culture or well-recognised psychological biases such as status quo bias, confirmation bias, herding and the availability heuristic. And that is before considering the effects of the individual's character and the effect of a dominant or charismatic person in the group.

Modern corporate governance requires boards to include 'independent' directors but this does not necessarily mean that independent directors will think independently.  A recent McKinsey report found that only 14% of almost 700 directors surveyed included "independent thinking" as a selection criterion for choosing a new director.  This is not a propitious starting point.

Add the ability of groupthink to lead 'independent' directors to lose their ability to think and reach conclusions independently and it is no surprise that many of the corporate failures analysed in 'Roads to Ruin' the Cass Business School report for Airmic, included groupthink among their causes.

Whilst some bad decisions remain latent vulnerabilities for years, our research suggests that about half will manifest into a crisis within 5 years.  When it becomes apparent that the board has made a bad decision, the Chief Executive is often the board's first sacrifice, and this is probably one reason why average CEO tenure seems to stick below 5 years.  In bad cases, it is not unusual for the Chairman to be next in line.

Since ignominious ejection from office often terminates careers, it should be important to CEOs and Chairmen to reduce the risk of avoidable bad decisions.

In her prize-winning essay, Siobhan Sweeney, a Judge business School MBA candidate, has suggested a solution: companies should combat groupthink by appointing a "Contrarian Director" (CD) whose explicit role is to be an independent source of critical thought and analysis for the board.  The concept is a development of the roles of Roman Catholic Church's 'Devils Advocate' and the Advocate General of the European Court of Justice.

Ms Sweeney's proposal includes the following elements:
  • The CD's main role is to analyse and report formally to the board on any important proposal;
  • CDs are full voting board members with long experience in independent analytical thinking and the character required to deliver unwelcome views should this be necessary;
  • An 'Institute of Contrarian Directors' (ICD) should be established with robust governance to set standards for CDs and devise a standard Charter under which CDs can operate effectively, including rights to seek information;
  • The ICD will, on request, recommend a suitable CD from a pool of people who have never been directors other than in a CD role and have not departed from the ICD charter;
  • Such CDs are appointed for a single, non-renewable 3 year term and are paid as professionals;
  • Where an ICD-nominated CD is appointed, the ICD Charter is to be incorporated into the company's governance regime and the CD specifically instructed by the board to act in accordance with the Charter, and
  • Where a CD finds the company obstructing his or her effective operation, the CD is required to resign, making a public statement that she or he was unable to operate effectively.

The concept will appeal most to companies whose self-critical leaders embrace success in the long term, measured in decades, as a corporate goal.  Such leaders are keen to avoid avoidable errors.  It will be an anathema to leaders who are insecure, egotistical, arrogant or dominant, especially those whose personal goals share the much shorter time horizon of their incentive plans.

Given patterns of corporate failure, it is the latter's companies who would arguably benefit the most, but they are the least likely to adopt the concept.  Regulators may wish to take note.

We would welcome your comments on the merits and weaknesses of Ms Sweeney's proposal as well as your thoughts on how it might be improved.

Anthony Fitzsimmons
Reputability LLP

Wednesday, 3 June 2015

Are Regulators Damaging UK Productivity?

Are actions by regulators a partial cause of the UK's productivity problem? Anthony Hilton, the eminent City columnist, thinks that the UK's Chartered Accountants may be onto something here.  If so, should the FRC, FCA and PRA adopt a new line in their values statements:- "Do no Harm".

We are delighted to reprint Anthony's recent column in the London Evening Standard with permission.

 Britain has a severe productivity problem.

Output per employee and value added per hour of work are directly linked to the quality of the kit the employee has to hand to help do the job — be it machinery, software or market information.

Our companies do not invest enough in any of these things.

We lead the world in corporate governance and have a fully-developed overarching code supported by subsidiary codes for different sectors — like shareholder engagement, private-equity reporting or how auditors should behave.

Nowhere else in the world are companies so actively supervised, managements so closely monitored and boards so concerned about what shareholders think.

Perhaps the two are connected — some FTSE 100 chairmen of my acquaintance think so. In their view, corporate governance has made company boards excessively risk averse because no one wants to make a mistake and directors are, with obvious good reason given what has happened in recent years, fearful of the consequences to their reputation if they do.

If nothing else, this should provide food for thought for the International Corporate Governance Network meeting in London tomorrow.

Investment is often risky in that, however well-prepared the case, it requires a leap into the unknown. Corporate governance responsibilities that weigh heavily on their shoulders stop boards from taking that leap.

So Britain falls further and further behind its international competitors.

It is a point of view that is not aired as much as it should be, if only because whatever they may say in private, few company directors will come out publicly about the way governance distorts boardroom decision-making.

They do not think it would be career enhancing. In fact, it would be the kiss of death to their hopes for any further board appointments.

Unconstrained by that problem, Professor John Kay tried four years ago in his report for the then Industry Secretary Vince Cable on the functioning of the equity markets.

He suggested that we look more closely at whether existing systems of governance facilitated “effective entrepreneurial and prudent management that can deliver the long-term success of the company”.

One organisation, the Institute of Chartered Accountants in England and Wales, has also tried. In the past two years, it has published a series of papers as part of what it calls a thought leadership initiative. The aim is to promote a debate about corporate governance.

What the papers outline is an alternative approach to the one currently promoted by the Financial Reporting Council, the body responsible for supervising the operation of the current code.

Relations with the FRC have apparently become somewhat strained as a result.

Yet the Institute makes a powerful case that, however well-intentioned it may be, the current code does not address the world in which we now live. It is, for example, primarily focused on relations between companies and their shareholders, and is driven by the paramount principle of shareholder value — that the responsibility of boards is to deliver the best possible return to investors.

This narrowness may explain why shareholders and non-executives, far from holding bank executives to account in the run-up to the financial crash, appeared instead to be egging them on to greater excess.

In today’s world, companies are no longer financed by shareholders alone — most employ a range of financial instruments some of which have the characteristics of both debt and equity.

All sorts of different groups have the ability to influence a company and a voice that demands to be heard. Bondholders can be every bit as demanding as shareholders, particularly for a company in difficulty.

Financial market regulators tell companies who they can and cannot have on their board, whether they can pay a dividend and whether their business plan is acceptable.

Pensions regulators can seek to block a takeover or disposal or lay down financial terms that will make it acceptable.

There is vagueness in the way these codes apply in practice as opposed to theory in the boardrooms of some of the overseas companies that have a London stock market quotation. And that is before we get to taxpayer involvement via state aid and bailouts and the complications they cause.

Shareholders are different too. Foreign and domestic investors have different priorities, hedge fund and long-only investors are different and there is nothing in common between a passive investment house that replicates indices and promotes exchange-traded funds and an algorithmic trader buying, holding and selling shares for just a few seconds at a time.

This implies that one of the main legs of the British approach to governance, that shareholders take an interest, is as honoured in the breach as in the observance.

Nor does society think that shareholder value should be paramount or that companies have to live in, and be part of, society. In society’s eyes, corporate governance has clearly failed in curbing pubic company executive pay, which most people think of as excessive, unnecessary and undeserved.

It has failed too in curbing aggressive tax avoidance. It is poor in making boards aware of society’s norms about fairness — witness the Thomas Cook row.

Thomas Cook has been criticised over its handling of compensation over the deaths of two children who were holidaying with the firm.

Basically the Institute’s case is that these controversies and other factors are not one-offs which are here for a moment but will vanish like the winter snow.

Rather, the accountants believe there is a fundamental misalignment between today’s markets and the corporate governance frameworks.

What these rows underline is that there is no longer a shared belief about what constitutes good governance, and the structures within the market reflect this confusion and do not, therefore, give the code the backing it needs to work properly.

They believe that the current code does not reflect how companies have to operate in today’s world if they are to survive and prosper in the long term. The original idea of the code was as a high-level set of principles that applied equally to companies and investors.

We need to reinvent this ideal, the accountants say, and produce an over-arching code based on an understanding of what companies are for in today's world, what values they are expected to have, and how they should behave.

Thursday, 28 May 2015

Board Risks in Financial Institutions

Once upon a time, it was widely thought that banks and insurers basically failed because they ran out of money.

The UK's Prudential Regulation Authority has decisively rejected the notion that financial failure is, fundamentally speaking, a money problem.  Its Chief Executive Andrew Bailey, and others, now seem convinced that whilst financially focused regulation remains essential, much more attention needs to be paid to boards.  As he put it in recent speech:
"[it] is uncommon and rare to find a problem in the capital or funding or business model of a firm which cannot be traced back to a failure of governance."
We agree.  In 'Deconstructing failure' we focused on the role of leaders in failure.  We discovered that of the nine prominent categories of board weaknesses investigated, six were influential in the majority of corporate failures.  Three were present in more than 70% of failures.  Even the least frequent factors were present in almost 40% of failures.

The role of leaders in failure, taken from 'Deconstructing failure' © Reputability LLP

This does not mean that board members are 'bad'.  What matters is their influence.  Boards are, or should be, the most influential people in any company.  This means that their activities, whether good or not, are likely to have big consequences. 

Our work confirmed earlier findings by William McDonnell and Paul Sharma, in two much-neglected pieces of research published in 2002 by the Financial Services Authority and the European Conference of Insurance Supervisors.  As McDonnell put it in the former:
"Management problems appear to be the root cause of every failure or near failure, so more focus on underlying internal causes is needed."

The conversion of the PRA to the view that management matters is corroborated by their recent Consultation Paper  CP18/15 on board responsibilities and corporate governance.  Whilst these proposals need refinement to meet best practice, they make it clear that the PRA is putting greater emphasis on individual and collective human behaviour as the 'underlying' cause of failure, with boards seen as an important source, arguably the most important source, of such risks.

The message for boards and risk professionals in the financial sector is clear.  Behavioural and organisational risks matter to your regulators.  Risks emanating from boards are top of the list, which should include risks from all layers of management.

Boards across the sector need to understand and find these risks before working out their potential consequences and how to mitigate them.  Since they too are run and led by people, that includes the boards of central banks and financial regulators.

Anthony Fitzsimmons
Reputability LLP