The Blind Leading The Blind
February 2020 marked the abrupt end of Tidjane Thiame’s reign as CEO of Credit Suisse. He quit after news broke of a spying scandal involving an ex-employee. In the wake of Thiame’s resignation, the bank has found itself in a period of instability, reflected by a 44 per cent drop in its share price between February and March 2020. In the last two decades, globalization has heightened the need for proactive corporate governance and has accentuated the failures of deceptive and illegal corporate tactics. A study by PwC examining chief executive turnover at the world’s 2,500 largest publicly traded companies found that in 2018 more CEOs were dismissed for issues of ethics than for financial performance.
Companies like Enron, WorldCom, HSBC, Volkswagen, and now Credit Suisse, have demonstrated that a lack of internal checks, cultures that don't value integrity, and misaligned incentives are the drivers behind many scandals that often lead to forced CEO turnover. Such scandals are characterized by lawbreaking coupled with an effort to hide the misdeed. Therefore, to reduce the risk of scandals and reinforce ethical conduct, companies should restructure their organizations and policies to realign employee incentives.
Often, scandal-prone organizations don’t have effective protocol for ousting rule breakers. Clearly, the threat of fines and jail time is not enough to deter rule breaking. This is largely because offenders think they won’t get caught; approximately 76 per cent of criminals perceive zero risk of apprehension. It is therefore critical for companies to look inward to try and find signs of misconduct. Such introspective work is increasingly relevant as it is often the case that a number of employees are actively involved in such activity while others are merely bystanders.
Allowing and incentivizing employees to report rule breaking without reprimand is important if companies are serious about avoiding scandals. While some may argue that such strategies could erode trust within a company, this should not be concerning to companies who want to follow rules and enhance integrity and responsibility at all levels of the corporate ladder. Employees should work together, but only to the degree that they aren’t breaking the law. If the alternative is crime, a breakdown of cooperation becomes a necessary evil for organizations to face. Furthermore, it is often in a company's best interest to hear of its own misdoings rather than forcing a disgruntled whistle-blowing employee to go public. This was exactly what happened at WorldCom when Cynthia Cooper, Vice President of Internal Audit, discovered US$3.8 billion in fraud that her own Chief Financial Officer was responsible for. WorldCom’s lack of an internal reporting infrastructure left Cooper with no options and forced her to report to an external agency.
External whistle-blower programs such as that of the U.S. Securities Exchange Commission’s (SEC) pose a serious risk for companies that can be avoided if issues are solved independently. To illustrate, the SEC’s program has been extremely effective in identifying fraud and other securities law violations by paying up to 30 per cent of recouped money to whistle-blowers. It has collected back over US$2 billion and in turn paid out US$387 million in commissions. Consequently, the program has resulted in violators facing large fines and penalties. Thus, having an internal reporting system allows executives the opportunity to correct issues before unnecessary damage to the company’s reputation is inflicted by regulatory bodies and news reports or reflected in stock prices.
Companies should consider implementing an internal policy similar to the SEC, even with smaller payouts. A strong whistle-blowing service can encourage an open culture of accountability by demonstrating that the company appreciates the concerns of its employees, which can lead to higher employee retention. An effective internal policy can foster greater accountability within a company by publically lauding whistle-blowers and awarding them with consideration for promotions. Moreover, offering long term incentives like consideration for higher stature and promotions can compensate for a potential cash reward smaller than the SEC might offer without creating massive costs for the company. The effectiveness in an internal policy in encouraging employees to recognize unethical behaviour however also lies within its ability to ensure that whistle-blowers do not face reprimand. Public Concern at Work, a British whistle-blower support group, recently found that over the past five years, four out of five whistle-blowers have experienced a negative outcome. Therefore, internal policies should include the prohibition of reprimand not limited to but including termination, demotion, intimidation, or threats to employees who have provided information or sought advice about doing so.
Companies should allow for anonymity within the reporting infrastructure so employees have multiple options to bring forth their concerns. This strategy was used by Waste Management; after getting caught in 1998 for falsifying its earnings, it hired a new CEO who set up an anonymous company hotline for employees to report transgressions. While this would make it nearly impossible to deliver a financial payout to the whistleblower, it should nonetheless be available. Both of these systems should be well publicized within the organization to ensure their success. Making it clear how the system works is especially important for companies that operate in geographical regions of hierarchical cultures where the norm might be to not oppose superiors.
Absolute Power Corrupts Absolutely
One commonality amongst scandal-ridden companies is their organizational structure; while the direction of causality is not always clear, companies with highly complicated and decentralized leadership structures tend to have a propensity for rule breaking. Especially when such companies are large, it becomes easy for subsidiaries to hide cash flows from internal management that often intends to comply with laws and regulatory bodies. This is a major chink in the armour against fraud because even if the company’s leadership is intent on preventing rule-breaking, it may be unable to due to convoluted organizational charts that leave room for corruption to go undetected. This was demonstrated famously in 2015 when HSBC Chairman Douglas Flint commented on how the secrecy of local managers and Swiss laws made it difficult to oversee the actions of the bank’s Swiss subsidiary. He blamed the systematic tax avoidance practiced by the subsidiary for causing severe reputational damage to the bank.
High degrees of separation between departments with individuals reporting only to their boss also introduces problems within a business. It gives single leaders enormous amounts of control over a large number of employees and therefore over the flow of information to higher-ups. This was the case with Volkswagen’s 2015 emissions scandal, where Board members were only informed that their company was purposely cheating emissions tests shortly before the media. Therefore, rigid hierarchies are detrimental if they obscure management's view of their company’s workings.
Companies should seek a middle ground between rigid hierarchies and being overly decentralized in their leadership. Having an internal audit independent of the CFO coupled with having employees report to more than one individual is crucial for boosting departments’ efficacy in discovering improprieties. In the case of Credit Suisse, the internal audit department initially launched an investigation into the spying allegations and concluded that CEO Thiame was not aware, only for him to get caught hiring spies several months later. While it’s not yet certain if the internal audit was influenced by Thiame in their initial findings, it is clear that the Board of Directors was not as vigilant of its executives as it perhaps should have been. It’s especially easy for a well performing company to not bother asking “why?”. However, stakeholders at every level must do so; it shouldn’t be assumed that nobody is breaking the law.
Back To Basics
While there is no clear formula for what a better corporate structure should look like, companies can avoid such issues by maintaining internal policies of financial transparency across its branches. Effective policies are simple and easy for employees to understand; straightforward examples should be included to demonstrate compliance standards and procedures. The policy should also be continuously reiterated so that it evolves with the company’s needs. As demonstrated by Enron’s praiseworthy policy statements, a policy is only as effective as its enforcement. Further, employees should be engaged in interactive training that involves discussion of actual cases to help them better internalize the company’s values, identify risks, and comply with standards and applicable laws.
An effective training program would involve short, 15 minute long bi-weekly meetings. Studies have shown that regular short meetings are more effective than longer, less frequent ones, given that employees tend to have short attention spans in the domain of lectures. These meetings should occur on the department level and be company wide. Employees should be familiarized with the code of conduct during these meetings, reinforcing that honest behaviour must occur at all levels in the company. It should also make known the actions employees should take if they discover improprieties as well what warning signs they should be vigilant of. These include inaccuracies in expense reports and lying, even on seemingly inconsequential matters. Continuous reinforcement will let employees know that policies are taken seriously and enforced, and will help make the enforcement of policy a burden carried by the entire company.
The Bottom Line
One of the reasons why some companies seem to undergo scandal after scandal is that public memory for scandals is short. One-time accounting giant Arthur Anderson was fined US$7 million by the U.S. Securities Exchange Commission for its role in the 1998 Waste Management scandal. Only four years later, the auditing portion of their business became defunct as a result of their involvement in the 2001 Enron scandal and their involvement in a similar incident with WorldCom in 2002.
Why did Arthur Anderson make the same mistake over and over? The reason is perhaps that people and companies don’t mind doing business with a company who they know to be dishonest, so long as they are being dishonest in a way that doesn’t hurt them. The calculus that companies make is that being caught in a scandal is not that bad. But this mindset is short sighted. Fines and the loss of independence in capital structure decisions are serious matters. While Volkswagen was able to recover, Enron, WorldCom and Arthur Anderson have all since become extinct as a result of their actions. By incentivizing whistleblowers, avoiding unsuitable corporate structure, and reinforcing rules, organizations can create a strong culture of honesty and avoid such catastrophes.