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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.

Thursday, 24 March 2011

Limited Liability, Increased Risk

Once upon a time, most financial, law and accounting firms were true partnerships.  The partners shared all the profits, but if anyone in the partnership made a really bad mistake, the firm would lose its reputation and all the partners could lose their shirts.  This gave partners a viceral interest in managing risks to the business.  Risks to their reputation were the biggest.

Along came the Big Bang, and most financial firms became limited liability companies. Partners became shareholders with limited liability.  If disaster struck, they could lose their shares - if they retained any - but only the person who actually made the mistake was at any risk of losing his shirt.  Corporate reputation no longer matters so much to most individuals since most can move if their firm loses its reputation.

Since then, most big accountants have become limited liability partnerships.  Law firms are following closely behind.  A few professional firms have welcome external capital, and more will do so.

When you add the way in which profit is distributed, the effect is increasingly similar to the Big Bang, though its slow motion is more like a prolonged whimper.  Most of those who run or trade through financial firms, law firms and accountants now take a full share of the upside but only limited or no downside risks.

For individuals, a system that offers "vast risk-free payouts" (as Geraint Andersen described them) is as attractive as it is valuable.  Banks have learned just how disastrous it is to separate the depths of downside risk from reward; but accountants and lawyers seem to be going, blindly, down a similar route with one important difference:  no audit or law firm is "too big to fail".  No-one will rescue them from oblivion.

Bankers are starting to shape a partial solution.  The FT reports that HSBC is considering forcing top bankers to hold increasingly large amounts of stock until retirement.  Goldman already obliges its senior leaders to hold up to 75% of share awards until they leave with many more senior staff obliged to hold at least 25%.

UBS has gone further.  Not only does the bank have a 'bonus/malus' sytem.  UBS has moved to pay its leaders' bonuses in bonds and insists, amongst other measures that Executive Board members hold at least 350,000 shares, and its CEO holds 500,000 shares.

Since reputation is one of the big drivers of share price, this personal risk of losing money may well influence behaviour, particularly as accumulated unsellable share awards become a substantial proportion of the personal wealth of influential individuals.  Even so, there will be unintended consequences, such as increasing the reasons for stars to move regularly.  Identity economics points to one way to solve this problem.  And to be effective, the system  needs to draw in all important players, not just 'top bankers'.  Goldman has already got that point.

But for lawyers and accountants, this approach is not likely to work.  Unlike banks (not to mention the likes of BP), law firms and accountants are often fairly thinly capitalised; and few are quoted companies.  Their most important asset by far is their reputation. Without that, they can't attract clients, get credit or retain their valuable but mobile talent.

For professional firms, reputation is the key to life.  For them, finding, understanding and controlling sources of reputational risk is the key to surviving almost any kind of crisis, as professionals' personal interests increasingly diverge from those of their firms.

The trouble is that current risk analysis techniques were not designed systematically to find let alone manage risks to reputation.  As one sage put it, conventional risk assessment does not address reputation risks adequately, but produces an incomplete picture of susceptiblity and escalation potential.  Nor does it present a sufficiently joined-up picture.

When that kind of reputational risk becomes a reality, they call it a Black Swan.  But it isn't.  The risks are there to be found.  If you know how to look for them.

Anthony Fitzsimmons

Updated 28 March 2011

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