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Reputability LLP are pioneers and leaders globally in the field of reputational risk and its root causes, behavioural risk and organisational risk. We help business leaders to find these widespread but hidden 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.

Monday, 27 July 2015

Shareholders and Short-termism

Are shareholders responsible for slowing corporate growth?

Andy Haldene is bothered that as dividends have risen, profits retained by quoted companies for reinvestment have fallen from 90% in 1970 to about 35% today, leaving firms with far less money for growth-boosting invetment and risking "eating themselves".  This is bad for the long term health of UK Plc.

As Terry Smith lucidly explained in a recent FT article, a firm with a 20% return on capital that reinvests 100% of profits will grow by about 4000% over 20 years.  If the same firm reinvests only 10%, its 20 year, growth will not even reach 1000% over the period.  This matters to long term investors such as the many saving for a pension in 20 to 40 years.  It also matters to governments since a growing economy means more money to spend without increasing tax rates.

It is a subject that Anthony Hilton raised in 2012.  He aired Andrew Smithers' concern that the 'craze' for trying to align CEOs' incentives with their company's interests by paying 'massive' bonuses linked to measures like earnings per share and return on equity gives CEOs corresponding incentives to cook the books by using share buy-backs as a quick-and-easy way to improve earnings per share.  Reinvesting earnings to promote longer term growth takes time to produce results and tends to depress share prices in the short term.  So CEOs with short term bonus schemes (and in this context three to five years is short term) are systematically tempted to shun what is better for the long term good of the company in favour of the short term good of their wallets.

You might think that boards are to blame for this.  After all, they design and set bonus systems with 'long-term' targets including relatively short-term returns on equity.  This despite (in the UK) the Corporate Governance Code, whose opening words are:
"The purpose of corporate governance is to facilitate effective, entrepreneurial and prudent management that can deliver the long-term success of the company."

But things are not that simple.

Incentives set for professional asset managers are usually mis-matched to the decades-long horizons of the many future pensioners investing their funds; and investment managers can be influential in the appointment of boards.

These managers' incentives usually mean they get bigger bonuses if boards deliver short term gains.  Anthony Hilton recently reported the egregious case of an otherwise successful chief executive who was told by a senior shareholder that an unexpected rights issue and subsequent share-price drop had robbed him of his performance bonus and he would have his revenge. The CEO was out soon after. 

This mis-match is widely recognised.  In his review of UK equity Markets, John Kay wrote that:
"short-termism is a problem in UK equity markets, and that the principal causes are the decline of trust and the misalignment of incentives throughout the equity investment chain."

But Con Keating has recently pointed out that there is another layer of complexity.  As he puts it:
"Shareholders are not a homogenous group; their motivations and strategies can vary significantly. Some have even developed strategies, such as the “washing machine”, where engagement and activism seek to achieve short-term gains before the manager then moves on to the next. Heterogeneity among shareholders will tend to reinforce collective preferences for the short-term. In times of corporate action, such as hostile take-overs, groups of activist short-term shareholders, often hedge funds, do have a tendency to arise naturally, through self-interest, without any formal co-ordination or collusion. By contrast, when engagement is concerned with the long-term, formal co-ordination through bodies such as the Investors Forum is deemed advisable or even necessary"
With such a range of shareholder motivatations, Keating believes the short-termists win; and since the long term is a series of short terms, long-termists are also likely to lose in the long run.

Keating toys with weakening the power of shareholders.  This is a tricky approach since if shareholders are unable to hold a board to account, who is left to prevent a malign or incompetent board from wreaking damage?

To escape this conundrum, Keating asks whether a system that discriminates between short- and long-term shareholders might give boards greater practical power to put the long term interests of the company ahead of the shorter term interests of shareholders.  France has attempted to do this with the Loi Florange part of which may have made it easier for shareholders who have held a company’s shares for more than two years to claim double-voting rights. 

States have a huge interest in promoting the long term health of enterprises in their economies.  They have also given enterprises the precious ability to limit their liability, invest collectively on huge scales and overcome mortality.  Is it unreasonable for States to insist on measures that discourage short-termism from ovewhelming the long term succcess of enterprises on which long term national prosperity depends?

And if it is reasonable, what is the best solution?  Loi Florange is one approach that has gained some support, but Sherlock Holmes would recognise this another three pipe problem. 

Anthony Fitzsimmons
Reputability LLP

Thursday, 23 July 2015

Structural Weakness at the FCA Board

Writing about the departure of Martin Wheatley, the Chief Executive of the Finanical Conduct Authority, Anthony Hilton, the renowned city columnist recently suggested that the FCA board shows signs of being dysfunctional.   As he put it:

"No FCA board member has uttered even the feeblest cheep of protest, let alone done the honourable thing and resigned.
Yet if directors were happy with Wheatley, they should resign in protest at this external interference; if they were unhappy with Wheatley, they should have done something themselves to improve his performance or secure a replacement.
Either way, the board appears dysfunctional."

That is certainly an explanation of the conduct he observed but there is a deeper issue.

The FCA's corporate governance framework confirms that:
"The FCA is governed by a Board with members comprising: a Chair and a Chief Executive appointed by HM Treasury (Treasury); the Bank of England Deputy Governor for prudential regulation; two non-executive members who are appointed jointly by the Secretary of State for Business, Innovation and Skills and the Treasury, and at least one other member appointed by the Treasury. The majority of the Board members are Non-Executive Directors (NEDs)." (1.5)
In other words if a board member takes a line that offends the Treasury, they risk not being re-appointed.

In my experience this is sometimes a real fear of NEDs who enjoy the status or the money that flows from their appointment; and there is an additional aversion to risking 'failure' to be reappointed if the non-reappointment may be given publicity, as in the case of Mr Wheatley.

This government-imposed structure is inherently likely to make a board dysfunctional.

First, minsters like appointees who will be compliant and not rock boats. For a minister, an appointee who enjoys the status or wants the money, and preferably also lacks the character to take a public stand against the minister, is an ideal appointee.  From the perspective of the board and its organisation, such an appointee is a disaster waiting to happen.

Second, board composition matters.  An effective board needs an NED team with not only intelligence but also the knowledge, skills and experience to understand every aspect of the organisation's business.  Unless the board has the spine to spell out the characteristics it seeks in a new board member, and resign if they don't get them, the board will lack essential skills leaving it functionally incompetent and blind to risks that matter. A NED team with significant gaps in its knowledge, skills and experience is also a disaster waiting to happen.

When a government agency fails, an adroit politician, supported by the government's media machine, will deflect blame to the agency and its leaders.  This has already happened at the FCA following a botched press briefing that released a maelstrom of criticism, much of it well deserved.  The FCA chairman has said that the board has learned lessons from the experience.

But the fundamental problem remains.  The seeds of the next disaster may already have been sown by the Treasury's wish to maintain control of its progeny through selecting the FCA's board members.  The FCA board should confront the issue. 

Anthony Fitzsimmons
Reputabilty LLP

Wednesday, 22 July 2015

Loyalty - Virtue and Risk

Cultural differences around the world represent substantial organisational risks with severe reputational risk implications.   The Toshiba accounting scandal provides yet another example of just how badly things can go wrong even in an advanced economy.  These risks can only be addressed by leaders of multinationals if their scale and significance are first understood.

In his introduction to the Official Report to the National Diet of Japan into the Fukashima nuclear accident,  Kiyoshi Kurokawa, a former President of the Science Council of Japan sorrowfully wrote:
"How could such an accident occur in Japan, a nation that takes such great pride in its global reputation for excellence in engineering and technology? This Commission believes the Japanese people – and the global community – deserve a full, honest and transparent answer to this question.

Our report catalogues a multitude of errors and wilful negligence that left the Fukushima plant unprepared for the events of March 11. And it examines serious deficiencies in the response to the accident by TEPCO, regulators and the government.

For all the extensive detail it provides, what this report cannot fully convey – especially to a global audience – is the mindset that supported the negligence behind this disaster.
What must be admitted – very painfully – is that this was a disaster “Made in Japan.” Its fundamental causes are to be found in the ingrained conventions of Japanese culture: our reflexive obedience; our reluctance to question authority; our devotion to ‘sticking with the program’; our groupism (sic); and our insularity."

Accounting scandals are found worldwide, but Toshiba provides the latest in a series of Japanese financial scandals that seem to stem from Japanese culture.  About $1billion of losses have been hidden by overstating profits over many years.  The report of the Investigation Commission is not yet available in English but Toshiba website states that nine directors, including the Chief Executive have resigned, and newspapers carry pictures of those resigning bowing long and deeply in shame. The report apparently spells out “systematic” and “deliberate” attempts to hide losses by inflating profit figures.

As to why, it describes a culture that made employees afraid to contradict their leaders when they demanded unrealistic earnings targets.  Within Toshiba, there was apparently a corporate culture in which one could not go against the wishes of superiors.  Loyalty can be a virtue but not if it becomes blind to reality.  In this case loyalty meant cooking the books. The report apparently states that both Mr Tanaka and Norio Sasaki,  knew that profits were being over-stated but took no action to end the improper accounting.  This is despite the Toshiba Standards of Conduct which states: 
"Directors and Employees shall:
  1. maintain proper and timely accounts in accordance with generally accepted accounting principles;
  2. promote the prompt release of accurate accounts; and
  3. endeavour to maintain and improve the accounting management system, and establish and implement internal control procedures for financial reporting."
The problem of speaking truth to power is widespread and driven by a mixture of incentives and culture, but the cultural dimension seems particularly deeply rooted in Japan. Why?  I am no specialist in Japanese culture but in reading the Analects of Confucius recently I came across the following, written in about 500 to 400 BC:
"The Master said, in serving his father and mother a man may gently remonstrate with them. But if he sees that he has failed to change their opinion, he should resume his attitude of deference and not thwart them; may feel discouraged but not resentful." (IV.20)
"The Master took four subjects for his teacing: culture, conduct of affairs, loyalty to superiors and the keeping of promises." (VII.24)
 "The Master said, first and foremost be faithful to your superiors..." (XI.24)
A Japanese travel guide says:
"According to early Japanese writings, [Confucianism] was introduced to Japan via Korea in the year 285 AD. Some of the most important Confucian principles are humanity, loyalty, morality and consideration on an individual and political level.
This may explain why loyalty is given special emphasis in Japanese society. 

But as Andrew Hill points out in a post subsequent to the original publication of this post, it is important that boards everywhere do not think 'it couldn't happen here'.  A long string of European and US corporate scandals demonstrate that Confucianist loyalty is not the only route to board-led failure.  Complacency is deadly everywhere.

Anthony Fitzsimmons
Reputability LLP

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.  For insurers, the ORSA will develop into the tool through which you will have to confirm to regulators that these risks are under analysis and 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