"Roads to Ruin"

Described as "Groundbreaking" by Julian James, CEO of Lockton UK, this study examines the underlying causes of over 20 major corporate crises.  This Cass Business School report was researched on behalf of Airmic.  The team, led by Professor Chris Parsons, included Anthony Fitzsimmons and Professor Derek Atkins, two members of Reputability's own team.

The Executive Briefing, released on 6 June 2011, is based on 18 case studies of high profile crises. They were triggered by events ranging from product contamination, explosions and crashes through derailed projects and IT failures to executive fraud.

Companies studied include AIG, Arthur Andersen, BP, Cadbury's Coca-Cola, Airbus, Enron, Firestone, Independent Insurance, Maclaren, Northern Rock, Shell and the French bank Societé Générale, with aggregate pre-crisis assets of over $6 Trillion.

Most companies involved had their reputations damaged or wrecked.  Only a few avoided immediate reputational damage, but that is to igonore latent damage.  Owners saw the value of their shares destroyed on a massive scale.

After stripping away the immediate triggers for the crises, the Executive Briefing  identifies seven key areas of underlying risk that are not captured systematically even by state-of-the-art risk analysis.  All are risks to reputation - and potentially to the long term survival of the business.  These underlying risks, which all have to do with the behaviour of people individually and in the context of their organisation, arise from:

1. Inadequate board skills and inability of NED members to exercise control
2. Blindness to inherent risks, such as risks to the business model or reputation
3. Inadequate leadership on ethos and culture
4. Defective internal communication and information flow
5. Organisational complexity and change
6. Inappropriate incentives, both implicit and explicit
7. ‘Glass Ceiling’ effects that prevent risk managers from addressing risks emanating from top echelons 

These findings present three challenges to the risk community:

1. To develop a systematic approach to finding these 'missing' risks;
2. To develop the requisite new skills in risk analysts and managers; and
3. To persuade boards that there is a problem - and to deal with it.

They also present a challenge to boards:

"[T]hese risks will remain unmanaged unless boards - and particularly chairmen and NEDs - recognise the need to deal with them.  Boards will also need risk professionals with enhanced vision and enhanced competencies to help them do so."

The role of the risk manager has evolved over the last 50 years. This report shows that the techniques of risk analysis and management will have to evolve further.  And those in charge of analysis will have to learn how to bring sometimes unpalatable truths to Power.

The full report will be published in July.

For further reading, try this for more on the information disconnect between boards and their companies; and this on changes in incentives in the banking, legal and accounting sectors; and this for ideas on how the role of Chief Risk Officer might develop.


Anthony Fitzsimmons
www.reputability.co.uk

Berkshire Hathaway's Dilemma

It isn't often that a company publicly - and rapidly - reports on a breach of its ethical code.

On 30 March, the FT reported the resignation of David Sokol, hitherto seen as a possible heir to Warren Buffett.  Buffett's response to the resignation seemed mild given that there appeared to be a cloud over Sokol as he left.

The sky has now cleared - with a robust report by Berkshire Hathaway's Audit Committee.  Trenchantly critical of Sokol, the report was published partly to clear the air and partly to illustrate how Berkshire views threats to its reputation.  Sokol has protested his innocence.

Even if the Audit Committee is right, there is no evidence that this was anything more than an isolated breach of Berkshire's ethical principles.  But if there was any other impropriety at Berkshire, they must get on top of it before anyone else discovers it.  The reputational risk is particularly high.

Buffett's bienniel letter to his top managers wisely includes the following (here at page 26)

"If you see anything whose propriety or legality causes you to hesitate, be sure to give me a call. .....[and] let me know promptly if there’s any significant bad news. I can handle bad news but I don’t like to deal with it after it has festered for awhile. "

Buffett has a choice.  He can hope that his staff revisit his letter and voluntarily tell him if they are aware of any possible impropriety; or he can actively make sure that Sokol's act was an isolated one. 

Making sure is a tougher way to go: but were Berkshire pre-emptively to discover and deal with any other impropriety, they could well suffer modest or no reputational damage.  Were such mis-deeds to emerge independently, the damage would be far greater.

Buffett has repeatedly emphasised that Berkshire's appetite for reputational risk is zero.  The active investigation route is the only way in which Berkshire can be reasonably confident of keeping their reputation substantially undamaged.

And that reputation has a distinct value to its shareholders.  It is one of the reasons why Berkshire Hathaway shares trade at a significant premium to their reported asset value.

Anthony Fitzsimmons
www.reputability.co.uk

PWC appoints Reputation Tsar

It takes years to build a reputation and minutes to lose it. Since it gives a company its 'licence to operate' as a respected citizen of the world, its loss can be devastating.

Things are far starker for pure service providers such as lawyers and accountants.  They have few assets beyond human wits and their reputation.  Their ability to attract clients and to borrow depend on it.  It is by far their most valuable and important asset.  The redoubtable Lex has suggested that regulators should attack accountants' reputations, and the House of Lords has been critical of the "disconcerting complacen[cy]" of the Big Four in relation to their role in the financial crisis.  

Now PWC is appointing a reputation tsar,  Richard Sexton.  To judge by the Telegraph's report, Richard Sexton's focus will be on reputation management.  If so, PWC is making a common mistake in trying to fix its reputation.

The task PWC needs to address is more profound.  They need to fix the fundamentals.  That means finding - and admitting to and dealing with - more profound problems than how regulators and politicians see you.

The stakes are high, and not just for PWC.


Anthony Fitzsimmons
www.reputability.co.uk

Performance related pay

Here is a thoughtful  FT article by the LSE's Richard Layard on performance related pay.

Once you have read that, you may wish to look at "Limited liability, increased risk", "Does bonus size matter?" and "Extracting bankers from the doghouse", which look at incentives such as bonuses through a variety of lenses.

Happy reading

Anthony Fitzsimmons
www.reputability.co.uk

Unknown Knowns

 Berkshire Hathaway is having a surprising spot of bother.  One of its leaders - some say Buffett's preferred successor - has left under what looks like a cloud.  The commentariat is pontificating

Warren Buffett clearly understands the principles.  For many years he has published these instructions (see page 26 here) to his CEOs.

"The priority is that all of us continue to zealously guard Berkshire’s reputation. We can’t be perfect but we can try to be. As I’ve said in these memos for more than 25 years: “We can afford to lose money – even a lot of money. But we can’t afford to lose reputation – even a shred of reputation.” We must continue to measure every act against not only what is legal but also what we would be happy to have written about on the front page of a national newspaper in an article written by an unfriendly but intelligent reporter."

Implementation is harder.  It is well nigh impossible for a group to see itself as others see it, and this is as true for leadership groups as for scout troops.  And it is easy for a sense of "this is what is normal around here" to develop.  Buffett foresees that too, in the same letter:

"Sometimes your associates will say “Everybody else is doing it.” This rationale is almost always a bad one if it is the main justification for a business action. It is totally unacceptable when evaluating a moral decision. Whenever somebody offers that phrase as a rationale, in effect they are saying that they can’t come up with a good reason. If anyone gives this explanation, tell them to try using it with a reporter or a judge and see how far it gets them."

Leaders need more than Buffett's principles to guide them.  They lack a means of discovering unknown truths.  Some are things that the organisation can't see.  Others are truths that can't be told to Power.  Some leaders find it hard to listen and others tranlsate what they hear to fit their world view.  But without the knowledge, leaders have no chance to fix the problem before an "unfriendly but intelligent reporter" reports it.

Uncovering these uncomfortable truths is not easy, but success is worthwhile.  What Donald Rumsfeld might have called "Unknown Knowns" (see the first Q&A here) includes potentially catastrophic risks that are often fundamental to the business and its reputation.

The key to finding unknown knowns is to make it safe for people to tell and ensure that those who need to listen do.  This is the aim of  'Resilience Evaluations'.

But as unknown knowns they remain unrecognised and unmanaged by leaders.  When the wrong kind of spark arrives in the wrong place at the wrong time, they will discover another unknown known.  They were sitting on a powder keg primed with a painfully short fuse.

Anthony Fitzsimmons
www.reputability.co.uk

Reputation and Nuclear Power

The reputation of the nuclear power industry and its regulators has been shaken by the Fukushima nuclear power station crisis in Japan, which brings back memories and concerns that followed the Three Mile Island (1979) and Chernobyl (1986) disasters.  Here are a few thoughts on how the nuclear industry can bring its reputation to that which it deserves.

First, the public needs reliable facts.  The nuclear power industry is notoriously secretive.  The resulting lack of transparency is not likely to encourage good safety practice. To start recovering its reputation, the industry needs to be inspected thoroughly and independently with the conclusions published.  And independently means independently of regulators.  History has too many tales of ineffective and incompetent  regulators, not to mention regulatory capture, for regulators to be universally trusted.

Here are some key questions.

• What is the physical condition of each nuclear facility
• How well is it run? 
• How robust is the system, particularly if something starts to go wrong?
• How could it go wrong?
• How well is it prepared for mishaps or worse? 
• How effective is its regulator?

BP was a highly respected company, but the authoritiative and independent  enquiries into the Texas City and Deepwater Horizon disasters showed unacceptable levels of equipment maintenance and management even if some of it had been inherited.  And Deepwater illustrated regulatory ineffectiveness, capture and worse.  If the nuclear industry is as good as it claims to be, it has nothing to fear from transparency.

Second, there needs to be a thorough, dispassionate assessment of the economic up- and down- sides of nuclear energy at the economic level, including a life-cycle analysis and risk.  Nuclear power reduces dependence on oil and coal, but a nuclear accident can bring huge cost and disruption to an economy.

• How comparable, economically, is a serious nuclear accident to a major oil shock?  
• How frequently can we expect one to happen?
• With what economic consequences? 
• How should we value the long term benefits and disbenefits?

Nuclear accidents are thankfully of low frequency - three in the last 32 years.  But the nuclear industry may well have been foooled by randomness into thinking that it is safe and well run. If the population of reactors doubles, it is quite possible that a major nuclear energy disaster every 5 years will come to be expected - just as there is a major banking crisis somewhere in the world every ten years. 

This is a serious task for independent multidisciplinary teams since the assumptions made must be realistic.  Poor modelling on inappropriate assumptions is one of the reasons that so few foresaw the latest banking crisis.  (Regulatory failure and capture were others.)

Third, governments must move beyond prevaricating about the long term storage of nuclear waste to constructing and using long term storage.  Temporary storage of nuclear waste dumps the problem on future generations.  This weighs heavily on how the public views nuclear power because the public is at times surprisingly - perhaps reassuringly - concerned about bequesthing dangerous problems for its grandchildren and beyond.

Fourth, since nuclear radiation does not stay within borders, nuclear regulation must become international.  There needs to be a network of nuclear industry policemen and regulators. They should linked internationally and, ideally, be independent of government and the military.  They need teeth, including the power to shut nuclear power stations if they are not being operated to the required safety standards.

Without information on the first two areas, there can there be no well-informed public debate on the risks and benefits of nuclear power to current and future generations.  Without resolution of all four, the nuclear industry and its regulators are unlikely to be trusted.  And without trust, the industry will face continual opposition from the public.

Whilst politicians can be won over by the industry's lobbying, politicians regularly face re-election. Nearly ten years ago, the perceptive Anthony Hilton observed that technology now allows public to mobilise against the Establishment.  That keeps pressure on politicians between elections.


Anthony Fitzsimmons
www.reputability.co.uk

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
www.reputability.co.uk

Updated 28 March 2011