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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.

Tuesday, 17 November 2015

The Rise and Fall of BP

The tale of BP is a story of a sleepy British corporate, transformed by Lord Browne into one of the world's largest and apparently most successful oil companies, only to be cut down to size by a series of tragedies.

When it emerged that BP's apparent success was built on foundations of charisma, a flawed safety culture, cost-cutting and lost internal expertise, its reputation and its market value, were destroyed.  It became a pariah, publicly berated by a US President, downgraded to BBB by Fitch and discussed as a take-over target.  It was probably saved from takeover by its toxic litigation legacy, only recently resolved at a cost estimated at more than $50 billion.

Journalists have feasted on stories from the Texas City explosion and the Deepwater Horizon disaster.  We deconstructed the root causes from reports internal and external, to extract more lessons from these stories than from almost any other company in crisis.

But to our delight, Professor Andrew Hopkins has done better.  He taught the US Chemical Safety and Hazard Investigation Board, charged with investigating the Texas City refinery explosion, about culture, safety cultures and learning cultures.  His insider knowledge of the investigation and track record of thinking and teaching about oil industry disasters put him in a good position to write about both disasters.  But he also identified, which we had not, a treasure trove of material: depositions and internal BP documents on a US website devoted to the Texas City disaster by Eva Rowe in memory of two of its victims, her parents James and Linda Rowe. 

The result is two exceptional books.  The first, 'Failure to Learn' takes apart the story of Texas City with a confidence that comes from direct contact with the evidence of witnesses and other primary sources.  Based on these sources he devotes a chapter to the failure of BP's top leadership

'Disastrous decisions' the second of this pair of books, deconstructs the Deepwater Horizon disaster.  It is worth quoting its opening words, which we endorse:
The blowout in the Gulf of Mexico on the evening of 20 April 2010 caught everyone by surprise although it shouldn't have."
Before the Deepwater Horizon disaster, BP was sufficiently riddled with systemic behavioural and organisational risks and reputational risks that a bad accident was to be expected even it was not possible to predict timing or the precise accident.  This is not an uncommon situation: systemic risks typically lie latent for years, sometimes decades, before causing what can be catastrophic damage.  In the meantime, the absence of a catastrophe leads insiders, particularly leaders, to be complacent, believing that "it won't happen to us" because it hasn't - yet. Outsiders, and frequently lower level staff, know otherwise.  But no-one listens to them until luck takes a day off.

Whereas the special focus of 'Failure to learn' is leadership, Hopkins uses 'Disastrous decisions' to explain and illustrate the power of error management and root cause analysis to find out why accidents happen so that their root causes can be dealt with before they cause harm. He also focuses on decision-making by middle-mangers, using the community of engineers to illustrate his points.

Both books make striking contributions to the literature.  Their additional sources have reinforced our analysis by strong evidence. Both should be compulsory reading for business leaders, board members and everyone with risk responsibilities.

And unlike most required reading, they tell a captivating story too.

Anthony Fitzsimmons
Reputability LLP

Friday, 23 October 2015

Why Government Repeats Mistakes - and What to Do about it

We are delighted to be able to post, with his permission, an essay by Richard Bacon MP.   Richard is Member of Parliament for South Norfolk, Deputy Chairman of the Public Accounts Committee, its most long-serving member and, with Christopher Hope, the author of Conundrum.   Richard has probably been involved in the study of more governmental mishaps than any other parliamentarian. 

Sir Michael Barber once observed that the “How” question is relatively neglected in the writing of history and politics. A textbook would say of some medieval king that “he gathered an army and hastened north” without pausing to consider just how difficult that was to do. Yet when governments embark on anything  new, it is quite normal for things not to turn out as planned – and the problems are nearly always to do with the “How” question.

We have seen an NHS dental contract which left large numbers of people without a dentist; a new system for marking school tests where up to three quarters of the marking was wrong; a pension regulatory body which had no objectives; and an urban regeneration project which had no budget. People have died because flawed hospital computer systems meant they were not told about their next vital check-up until it was too late. Holidays have been ruined because the Passport Office couldn’t issue passports on time. Failed asylum applicants with no right to be in the country – who happened to be murderers, kidnappers and rapists – have been released from jail to wander free in our community because no one could be found to deport them.

Farmers have committed suicide because of the Kafkaesque horrors of the Rural Payments Agency. The NHS mismanaged its recruitment of junior doctors so badly that medics – whose training had been paid for by British taxpayers – were forced to flee abroad in search of work, only to be urged to return soon afterwards, at the highest agency rates, due to a government-induced shortage of doctors. Some failures are so infamous they have become household words – the Child Support Agency or the Criminal Records Bureau (CRB) – even surviving Orwellian rebranding efforts to stamp out memories of a fiasco; no one I know calls the CRB the “Disclosure and Barring Service”.

Ministers routinely enter office with no knowledge of why things have gone wrong so often in the past. Few civil servants are around long enough to tell them. After only eighteen months as an education minister in charge of academies policy, Andrew Adonis found he had been in post longer than any of the officials who were supposed to be advising him. The Department for Transport somehow managed to have four permanent secretaries in two years. Given the track record, one might expect the quality of government spending to be a matter of sustained national concern. One can’t say “Oh, that’s management” and expect someone else to do it. It turns out that the “How” question can seriously affect the “What” question or even “Whether” anything happens at all.

The case for examining much more closely the quality of what we are doing has never been stronger. In a rapidly changing world there is an almost perfect storm of problems. As we get better at keeping people alive longer, we face inexorable rises in the cost of pensions and healthcare systems. As our population gets older and the tax base shrinks, our need to invest in better infrastructure – including better broadband connections, roads, railways and airports – only grows more urgent. We have an ongoing skills crisis. Our people need to be more numerate, literate and IT-savvy. We need to produce more housing but we have a dysfunctional model that fluctuates between near-stasis and a market bubble. Across the globe we face a burgeoning population and the need to produce more food on less land with much less water. We also know that if we can’t help the world’s people in situ they will instead come to us, compounding the pressures we already face. And we grapple with all these problems while struggling under a growing mountain of public debt, because successive governments seem quite unable to live within their means.

Squeezing much more out of the lemon is simply essential. We know that our governments must cost us less while being much more efficient and effective, to help us to deliver the changes we need. All this is probably common ground among most political parties, but the truth is that we are very bad at learning from our mistakes. Many politicians, civil servants and journalists are more interested in getting on with the next policy initiative, the next project or the next story.

Who is responsible for all this failure? Many screw-ups are plainly the result of poor decisions by ministers, who either try to do things too quickly or who won’t listen. Officials advising ministers on the Common Agricultural Policy were explicit that using the “dynamic hybrid” method for calculating single farm payments would be “madness” and a “nightmare” to administer; ministers chose it anyway.

The big regional contracts in the NHS’s National Programme for IT were agreed at indecently high speed – and duly signed before the NHS knew what it wanted to buy and the suppliers knew what was expected of them – because of pressure from Downing Street; the result was an expensive catastrophe. Tax credits still cause misery for thousands of low income families who have been overpaid, because HMRC demands repayments they cannot afford; the policy was Gordon Brown’s from its inception.

But what about civil servants? When managers at the Learning and Skills Council failed to count the money for the FE Colleges building programme while handing it out – thus pledging billions of pounds which they didn’t have – the Innovation and Skills Secretary John Denham said grimly that “there was a group of people that we might have expected to know what was going on who did not themselves have a full grasp of it”. In the InterCity West Coast franchising competition, the officials in charge at the Department for Transport were unaware of advice from external lawyers that the Department’s actions were unlawful. And even in the case of the Rural Payments Agency, where decisions were very ministerially driven, the choice of the “dynamic hybrid” method for determining single farm payments was made – as Dame Helen Ghosh, the Permanent Secretary, eventually told MPs – because “ministers were being told it was possible when it was not in fact possible.”

The reality is that there is more than enough blame to go around. We need to spend less time blaming and more time seeking to understand what is going on. In recent decades there has been a whole string of attempts to reform the Civil Service, including Continuity and Change, the Citizen’s Charter and Taking Forward Continuity and Change. Then came Modernising Government and Civil Service Reform: Delivery and Values. Imaginatively, this was followed by Civil Service Reform: Delivery and Values – One Year on, which in turn was followed by the “Capability Reviews”, then Putting the Frontline First: Smarter Government and The Civil Service Reform Plan. Now we have The Civil Service Reform Plan – One Year on. That’s roughly one white paper or major initiative every two years for twenty years. And eight years after the Capability Reviews – more than the time required to fight the Second World War – the Government launched the Civil Service Capabilities Plan. A year later the new head of the Major Projects Authority identifies that there is “a lack of distributed capability around delivery across Government”. The problem is not a lack of "to do" lists.

For sure, it is down to the Civil Service and its accounting officers to make sure there is a system that works. As Richard Heaton, Head of the Cabinet Office put it: “It is our job, without ministerial pushing, to create a civil service that has the capabilities that the Government need”. But what should a civil servant do when a powerful minister is on the rampage and demanding the impossible? The epic scale of the failures should tell us that the problem is systemic. As the former Head of Tesco Sir Terry Leahy put it: “Management and democratic process are not a good mix”. But we will only solve the problem when we stop looking in the wrong place. As Bill Clinton nearly said: “It’s behaviour, stupid.”

Of course, influencing behaviour is almost a new Holy Grail among policymakers. We are told it will help us reduce crime, tackle obesity, ensure environmental sustainability and make sure people pay their taxes on time. It works – and it’s not that new. Making unleaded petrol cheaper than the leaded stuff sees more people buying it. Making it easier for people to recycle achieves better results than moral hectoring.

But what about the behaviour of civil servants and ministers? And the behaviour of Parliamentarians? What about the behaviour of suppliersto government such as big IT firms, who – unsurprisingly – have a preference for large IT projects regardless of what might actually be best for taxpayers. What if you have a civil servant running an IT project whom no one dares challenge? Or a team of civil servants foisted on a project without the right skills? What should you do when you have a permanent secretary and a Cabinet minister who barely talk to each other for months? Just as in Margaret Atwood’s novel The Handmaid’s Tale, this has all actually happened, somewhere, sometime.

As HM Treasury’s Permanent Secretary, Sir Nicholas Macpherson, has observed: “I have worked under Tory governments where Chancellor and Chief Secretary weren’t really speaking to each other. I have certainly worked under Labour governments where that was the case”. Many billions of pounds have been squandered this way. If we really want better outcomes, then understanding this – and changing it – is much more important even than policymakers’ efforts at “influencing” the behaviour of citizens.

Economics has seen a big shift towards studying how people actually behave, rather than how they are supposed to behave. We need a similar shift inside government and politics. The London 2012 Olympics showed we can get it right. The outstanding feature of the Olympics, as Head of Programme Control David Birch put it, was that “we worked hard to generate and recognise one source of truth”.

The world’s most successful organisations, whether in manufacturing or in services, spend a disproportionate amount of time and effort developing people. Our governments need to do the same. MPs are among the most determined people you will meet – otherwise they would rarely have become MPs – but as a class they need much better preparation for ministerial office. In the British Civil Service we have one of the world’s best talent pools but we don’t get the best out of them. Instead of incessant exhortation, we need to think harder about what makes people tick. Sir Ken Robinson, a teacher renowned worldwide in the development of creativity, wrote that “human resources, like natural resources, are often buried deep. In every organisation there are all sorts of untapped talents andabilities”. Don’t we need every hand on deck in order to get out of the mess we have landed ourselves in? It is always sensible to make the most of what you have. The answer is to look more closely at ourselves and our nature – and to act on what we find.

This essay was first published by Reform in "How to run a country: a collection of essays".  

You will find our blog on the competence of civil servants here

Wednesday, 23 September 2015

First Lessons from Volkswagen

Volkswagen, scion of German industry, has fallen off its pedestal after revelations that up to 11 million of its diesel cars were fitted with software designed to deceive regulators about levels of toxic NOx emissions. 

It all began to unravel last in May 2014 when Virginia University's Center for Alternative Fuels, Engines & Emissions (CAFFE) discovered that NOx emissions from two of three diesel-powered cars it was testing produced between 5 and 35 times more than the official emissions standard, though in laboratory conditions they complied.  This was the first whiff of rat.

According to a Californian Air Resources Board (CARB) letter of 18 September, CARB took up the case and pursued investigations.  Discussions ensued with VW, who solemnly carried out tests and provided fixes, which did not work when CARB tested them.

As CARB relates in its letter, on 3 September, after a year's prevarication, VW confessed.  As the world now knows, large numbers of VW's diesel-powered motor cars were "designed and manufactured with a defeat device to bypass, defeat or render inoperative elements of the vehicle's emission control system" whilst meeting official testing procedures.

When the news became public, on 18 September, it was met with a mixture of incredulity and a drop in the VW share price of about 25%.  After defending an almost indefensible position for almost five days, VW's Chief Executive Martin Winterkornstood resigned.   Some began asking whether VW would survive.

Beyond VW there was collateral damage.  The share prices of other car makers dropped, though less than VW's.  A discussion began as to whether diesel technology, held responsible for large scale health problems, was a wrong turning that should be abandoned.  And questions were asked whether, after a long string of governance failures in Germany, German industry was really the paragon represented by its good reputation

But the intriguing question is: why did this happen?

We do not yet know what happened but it is not unknown for major corporate scandals to have their genesis in the board room.  Think of the Olympus and Toshiba scandals.  That said there is no evidence of active boardroom involvement and Mr Winterkornstood's protestations of surprise imply that he first learned of the problem very late in the day.  But the composition of the supervisory board, which does not seem to have been chosen with skill sets as its primary concern, has echos of the boards at Airbus at the time of the A380 crisis and at the UK's Co-operative Group when it almost collapsed.

If that is so, he must have been in the dark, unaware of what seems to have been a piece of deliberate skulduggery going on under his nose - but without his knowledge.

This sadly is a very common state of affairs.  We call it the Unknown Knowns problem.  There are things that leaders would dearly love to know - but they cannot find out until it is too late.  In our research, 85% of leaders were taken by surprise when a serious crisis engulfed their company. Yet most of these crises were caused by systemic failures that had lain unrecognised for years, sometime decades.

The most telling example is that there have been at least 14 rogue traders, averaging one every eighteen months, since Nick Leeson broke Barings in 1995: most recently the London Whale, who breached in 2012.  JP Morgan sustained losses of $6 billion on positions said to amount to about $160 billion.  All the rogue traders operated in an environment where risk teams are huge: JP Morgan's risk team ran to thousands but they didn't spot the Whale; nor did the astute Jamie Dimon - until an even more astute hedge fund spotted his problem from the outside and began to trade on his misfortunes.

What seems to happen is that some combination of character, culture, leadership, targets, incentives, corner-cutting, complexity, groupthink - and the slippery slope from gently bending rules to breaking them - leads an individual or team to start doing something that, as Warren Buffett put it, you "wouldn't be happy to have written about on the front page of a national newspaper in an article written by an unfriendly but intelligent reporter."  It doesn't help if regulators are not robustly independent.

Once the wrongdoing has begun, it is very hard for participants to confess - doing so will probably lead to unpleasant sanctions - so it continues.  The hole gets deeper.

The wrongdoing is rarely known just to the participants.  Others usually know, but are unwilling to rock the boat.  This may be because the wrongdoer has higher status; or it may be because they are in the same 'tribe', but as time passes unwillingness becomes tacit complicity.  Many may know things are wrong but they won't tell anyone above them.  Often the root causes are visible to the thoughtful, perceptive outside observer, such as a hedge fund or professional investor.  We call these companies 'predictably vulnerable'.

There may be a potential whistle blower; but anyone who researches whistle blowing as an activity will discover that it is commonly terminal if not merely frustrating.  It takes courage and determination to blow the whistle; and it takes an exceptional leader to listen and understand what a whistle blower is alleging with an open mind.

This is one of the ways in which leaders find themselves in the dark.  Breaking this silence is difficult.  It takes an insider-outsider, as anthropologists term it, armed with trustworthiness, skill and understanding of human behaviour to learn what insiders think and know but won't tell.   A sensitive investigation should uncover the root cause behavioural and organisational risks that lead to Unknown Knowns so that leaders can fix at least the root causes before they can cause more harm.  And as our research also shows, they usually do have some time.

An investigation may uncover things you wouldn't be happy to have written about on the front page of a national newspaper.  If so, you should listen and learn; and be grateful for the opportunity to deal with them before they blow up and destroy your personal reputation as well as that of your organisation.

Anthony Fitzsimmons
Reputabilty LLP

Monday, 21 September 2015

The Silo Effect

Like our primate forebears, we humans have long organised ourselves into social groups and it is only natural that we form teams at work too.  Trust, a common purpose, shared culture and social norms are likely to develop within the family, tribe, group or team, along with a sense of identity that defines who is an insider and who is not.

As organisations grow so do teams.  The work of Robin Dunbar, an evolutionary psychologist and anthropologist suggests trouble starts as group size extends beyond about 150.  As teams grow and multiply, so do team identities and purposes.  Those in one team can easily come to see those in another as outsiders and rivals.  Cooperation becomes more difficult as their interests increasingly conflict.

When we examine the entrails of crises, persistently asking the question “why?” we often find that the root causes were well known at mid-levels of the company.  Sometimes the actual crisis was predictable, even predicted, from what one individual knew – but for a variety of reasons no message arrived in the consciousness of someone sufficiently senior to take action.   Frequently, key information known at mid-levels was spread among individuals who did not share it - so the information was never joined up. We have dubbed this the 'Unknown Knowns' problem.

We analyse causes of failure such as these by reference to factors such as culture, incentives, structural silos and the resulting non-communication of information.  Risk, psychology and sociology inform the analysis, but we have long suspected that anthropologists could enrich the analytical framework – if only they were interested in the business world. 

As a postgraduate level anthropologist turned FT journalist, some of Gillian Tett’s most perceptive writing has taken an anthropological look at business life.  Her latest book, ‘The Silo Effect’, explicitly brings her anthropological training to bear on it.  As you would expect of an experienced journalist, it is engagingly written.

Tett begins by introducing anthropology and summarises a few core anthropological insights.  Three are crucial:
  • Human groups develop ways of classifying and expressing thoughts, and these become embedded in their ways of thinking;
  • These  patterns help to entrench patterns of behaviour, often in a way that reinforces the status quo;
  • These mental maps are partly recognised by group members but some parts are subliminal whilst others are ignored because they are thought “dull, taboo, obvious or impolite”, leaving some subjects beyond discussion.
These three explain much about how silos work and provide a useful additional perspective. They also imply an important corollary: it is in practice impossible for an insider to gain a reliable view of the world in which insiders live.  Only an outsider can achieve the necessary detachment to see ‘inside’ life as it truly is. 

But the outsider typically lacks crucial information that is available to an insider.  Tett describes how anthropologists attempt to become ‘insider-outsiders’ with access to inside information whilst retaining the relative objectivity of the outsider.   It is no accident that our methodology has much in common with what she describes.  We face the same challenges: except that we also aim to help insiders to understand what outsiders can see when given access to insiders’ knowledge.

The balance of the book consists of case studies, written in Tett’s usual lucid style.  Two of her studies of failure are built on her extensive knowledge of the financial crash of Noughties.  She dissects how UBS, the Bank of England and the host of financial market regulators, experts and economists managed not to see the crash coming.  A third tells how Sony, then a world-leader, reorganised itself into a series of separate business units, each with its own objectives.  By creating what became silos, Sony lost internal cooperation and its way.

Tett tentatively develops her theme to suggest an anthropological approach to mastering silos, from the outside as well as from within.  She begins by describing how, with advice from Robin Dunbar, Facebook has set out to build structural bridges of friendship and trust between what might become silos; and a culture that encourages experiments and cooperation across what might be frontiers in a culture that treats mistakes as opportunities to learn. 

Tett’s second, contrasting tale tackles breaking down long-established silos. Her story concerns one of the most tribally structured professions: medicine.  Structured around disciplines, there is a wasteful temptation for every doctor to try to apply their particular skill to your symptoms rather than beginning with an objective diagnosis and only then prescribing treatment perhaps by another doctor.  Tett tells how a perceptive question led Toby Cosgrove, CEO of Ohio’s Cleveland Clinic to question and dismantle the Clinic's disciplinary silos to deliver care centred on the patient’s need for a dispassionate diagnosis before prescribing the most appropriate treatment. 

But for me, Tett’s third tale was the most telling.  She relates how a detached but interested outsider, a hedge fund, was able to deduce that JP Morgan’s Chief Investment Office was placing huge bets on credit derivatives – at a time when JP Morgan’s leaders and risk team were completely ignorant of what was going on under their noses, let alone the scale.  The hedge fund, BlueMountain, profited from the insight when the London Whale breached.  The episode cost JP Morgan more than $6 billion in losses on a series of holdings with a value Tett estimates at approaching $160 billion.

This story resonates with our experience.  We regularly find that external analysis can identify organisations that seem blithely to be living on the edge of a cliff.  As with real cliffs, it is rarely possible to predict when they will fail.  But it is possible to predict why and with what consequences they will fail.

Leaders who seek what can be an uncomfortable foresight will usually have time to deal with the issues and avoid disgrace since consequences usually take time to emerge.

Astute long term investors can use such insights to avoid or improve vulnerable investments.  And in those rare cases where the timing seems imminent, there may be opportunities to profit from another’s risk blindness.

Anthony Fitzsimmons
Reputability LLP

Sunday, 13 September 2015

Admitting Mistakes Shows Intelligence

We are delighted that Professor John Kay has allowed us to reprint this column, on how admitting to doubts and mistakes shows intelligence and good leadership, not stupidity.  

When I was much younger and editing an economics journal, I published an article by a distinguished professor — more distinguished, perhaps, for his policy pronouncements than his scholarship. At a late stage, I grew suspicious of some of the numbers in one of his tables and, on making my own calculations, found they were wrong. I rang him. Without apology, he suggested I insert the correct data. Did he, I tentatively enquired, wish to review the text and its conclusions in light of these corrections, or at least to see the amended table? No, he responded briskly.

The incident shocked me then: but I am wiser now. I have read some of the literature on confirmation bias: the tendency we all have to interpret evidence, whatever its nature, as demonstrating the validity of the views we already hold. And I have learnt that such bias is almost as common in academia as among the viewers of Fox News: the work of John Ioannidis has shown how few scientific studies can be replicated successfully. In my inexperience, I had foolishly attempted such replication before the article was published.

It is generally possible to predict what people will think about abortion from what they think about climate change, and vice versa; and those who are concerned about wealth inequality tend to favour gun control, while those who are not, do not. Why, since these seem wholly unrelated issues, should this be so? Opinions seem to be based more and more on what team you belong to and less and less on your assessment of facts.

But there are still some who valiantly struggle to form their own opinions on the basis of evidence. John Maynard Keynes is often quoted as saying: “When the facts change, I change my mind. What do you do, sir?” This seems a rather minimal standard of intellectual honesty, even if one no longer widely aspired to. As with many remarks attributed to the British economist, however, it does not appear to be what he actually said: the original source is Paul Samuelson (an American Nobel laureate, who cannot himself have heard it) and the reported remark is: “When my information changes, I alter my conclusions.”

There is a subtle, but important, difference between “the facts” and “my information”. The former refers to some objective change that is, or should be, apparent to all: the latter to the speaker’s knowledge of relevant facts. It requires greater intellectual magnanimity to acknowledge that additional information might imply a different conclusion to the same problem, than it does to acknowledge that different problems have different solutions.

But Keynes might have done better to say: “Even when the facts don’t change, I (sometimes) change my mind.” The history of his evolving thought reveals that, with the self-confidence appropriate to his polymathic intellect, he evidently felt no shame in doing so. As he really did say (in his obituary of another great economist, Alfred Marshall, whom he suggests was reluctant to acknowledge error): “There is no harm in being sometimes wrong — especially if one is promptly found out.”

To admit doubt, to recognise that one may sometimes be wrong, is a mark not of stupidity but of intelligence. A higher form of intellectual achievement still is that described by F Scott Fitzgerald: “The test of a first-rate intelligence,” he wrote, “is the ability to hold two op­posed ideas in the mind at the same time and still retain the ability to function.”

The capacity to act while recognising the limits of one’s knowledge is an essential, but rare, characteristic of the effective political or business leader. “Some people are more certain of everything than I am of anything,” wrote former US Treasury secretary (and Goldman Sachs and Citigroup executive) Robert Rubin. We can imagine which politicians he meant.

First published in the Financial Times.
© John Kay 2015 http://www.johnkay.com

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