Seven Signs of Ethical Collapse-M Jennings

 Lazily, this is an exact copy of a piece I have downloaded, I have added a comment at the end.

In her presentation at the April 5, 2007 meeting of the Business and Organizational Ethics Partnership, entitled “Seven Signs of Ethical Collapse: How to Spot Moral Meltdowns Before it’s Too Late” (based on her book by the same title), Jennings noted common characteristics of the misguided companies. Had they heeded the warning signs, she said, they could have employed potent antidotes (which she also presented) to prevent the moral meltdowns.

These were not close calls, she emphasized. “These are companies that really crossed very bright lines.”

The common threads that she’s found that make good people at great companies do really dumb, unethical things include:

1. Pressure to maintain numbers
2. Fear and silence
3. Young ‘uns and a bigger-than-life CEO
4. Weak board of directors
5. Conflicts of interest overlooked or unaddressed
6. Innovation like no other company
7. Goodness in some areas atones for evil in others
   
   

1. Pressure to maintain numbers

“In all of these companies, they had enormously high rates of return—double-digit growth—and they said, ‘We’re going to keep it rolling,’” Jennings said. Many had so-called “Monday morning beatings,” where employees had to account for not meeting their numbers. Such expectations scream for ethical breaches, she cautioned.

Instead, focus on the long-term and realistic expectations. For example, a grocery store chain just outside Hurricane Katrina’s path experienced a 300 percent growth in earnings after the storm as thousands of people flooded their service area. Consequently, huge employee incentive bonuses kicked in due to the phenomenal and unsolicited growth in business. The biggest challenge the CEO faced the following year was in convincing employees to face up to the fact that there was no way they could achieve those numbers the following year.

“If you’re getting those numbers because you’re better, you’re smarter, and you’re working harder, more power to you,” Jennings said. But managers have to be careful not to be sending the message that higher numbers must be achieved at any cost. Slogans like “find a way,” “whatever it takes,” and “sharpen your pencil,” emphasise short-term gain over long-term sustainability and encourage employees to cut ethical corners.

“Help employees distinguish between superior skill and foresight, versus cheating,” she advised.

2. Fear and silence

Jennings noted that front-line employees never miss an ethical issue. “To front-line employees, the line between right and wrong is very bright. Something happens to people as they climb up through management, she said. The bright line seems to fade. The challenge is getting information about ethical breeches from the front line up to the right people who will take action. Too often, fear and silence thwart those efforts.

Jennings recently worked with a company that had quite an impressive ethics program in place. Best practice. An ethics hotline. An anonymous on-line reporting system. “Technically, it was beautiful,” she said. But an employee revealed an issue in talking with Jennings that the professor felt management should know about.

Jennings suggested she use the hotline. No, the employee countered, they’d trace the call. Use the online reporting system. No, the employee lamented, they’d trace the IP address. Send an anonymous letter, with no return address and mail it from another city. No, the employee protested, they’d trace it back to her by analyzing the DNA on the envelope.

“That is profound fear,” Jennings said.

Companies intentionally or unintentionally foster that fear in a number of ways. If an employee raises an issue and nothing is done, the whistleblower feels stupid and management signals that they’re not listening.

If an employee raises an ethical issue and they’re terminated, the company intensifies that fear and signals that employees should just remain silent. And silent employees “shoot your safety record to heck. If they’re coming to work upset about something, they start messing up, so you don’t want that,” Jennings said.

Another possibility, much more insidious and more difficult to address, is when an employee raises an ethical issue and instead of being terminated, they’re “flat-lined,” labelled a troublemaker and transferred into corporate oblivion.

The way to avoid fear and silence is to encourage open dialogue, allow anonymous reporting without repercussions, provide swift response and follow-up, have the issues reviewed by the board, hand down appropriate disciplinary actions to wrongdoers, and reward whistleblowers.

Key to making this work is ensuring that enforcement is absolute, unequivocal, and egalitarian. As one of Jennings’ students observed during a discussion about tolerance for a manager who “borrowed” three bottles of vodka from the company on a Friday night for a party outside of work and brought in replacements on Monday morning, “If the janitor had taken the liquor, he would have been fired.”

If it’s wrong for the janitor to do, it’s wrong for the CEO.

3. Young ‘uns and a bigger-than-life CEO

Often, Jennings pointed out, companies that get into trouble have a CEO a full generation older than the direct reports. The inexperienced underlings tend to lack the moxie to question the iconic boss.

“I hire them just like me: smart, poor, and want to be rich,” she quoted former Tyco CEO Dennis Kozlowski as saying.

“People say GE was a mess after Jack Welch left,” she went on. “Actually, they were a mess when Jack Welch was there, but we really weren’t looking at the numbers. As long as the CEO is so highly regarded, we don’t ask the questions.”

A bigger than life CEO need not spell trouble. Question the icon, and help the inexperienced direct reports. “Ethics requires daily effort, reinforcement and training. Without it, you slip, because everyone believes they’re ethical, no matter what they’re doing,” Jennings said.

Introspection is the key. “Everyone in the company has to look long and hard at what you’re doing,” she said. The company is on the right track if it’s willing to let anyone in the organization say, “Wait a minute, is this really something we should be doing?”

4. A Weak Board of Directors

Weak boards tend to have inexperienced members, often ones who are too young to have experienced a complete business cycle, which was often the case with companies in the dot-com boom.

Often they have ethical conflicts of interest as well, in terms of consulting arrangements, related party transactions, even incestuous philanthropy in which huge donations are made to board members’ favourite charities.

To counterbalance weak boards, management needs “a good mind and a strong backbone.” Dig deep on conflicts. Don’t fall for governance myths of stock ownership, 10-year limits, mandatory retirement, or nomination by shareholders. They don’t work, Jennings says.

Instead, pay attention to perks. Know industry accounting standards. And manage by walking around. “Employees will talk to you face-to-face. Don’t micromanage, but get face-to-face,” she advised.

5. Culture of conflicts

A post Sarbanes-Oxley survey in 2003 by the SEC revealed that 47 percent of companies purchased or sold insiders’ products or services. Thirty-nine percent made loans to executives. Thirty-five percent purchased legal or banking services from directors.
Twenty-one percent bought, sold, or invested in companies insiders owned.

Jennings believes that conflicts of interest affect board members’ decisions, whether consciously or not. “Human nature makes you beholden.”

The antidote is simple, she said. “There are two ways to handle conflicts of interest. Either don’t do it or disclose it. That’s it.”

In geographies like Silicon Valley, conflicts of interest grow rapidly over time. It is impossible to find individuals to serve on boards who don’t have some connection with the company. In many ways, their knowledge and past relationships are an advantage. However, it is critical that these past relationships or activities be disclosed, and an assessment made that the potential director can recuse himself/herself in any matter related to them and still function as an effective advisor, counsellor, and overseer of the organization’s management and business processes.

6. Innovation like no other

Too many companies that meltdown felt they were above the fray because they were so innovative.

Consider the remark of Sanjay Kumar, former CEO of Computer Associates. “…standard accounting rules [were] not the best way to measure [CA’s] results because it had changed to a new business model offering its clients more flexibility.” He entered a guilty plea to fraud.

The dot-com companies amused her the most. “I just love this—at the height of the dot-com losses, they would always say, ‘You know, if we hadn’t had all those expenses, we would have made money!’ In their minds, they were different,” Jennings said.

The antidotes are really very simple. She advised executives to understand business history and economic cycles. Depend on the basics of business: keep costs low; keep quality high; focus on customer service.

“The basics of business and accounting never change. The innovators often fancy themselves immune from the business cycle, but history teaches us differently,” she pointed out. “Also, just knowing the story of the ’29 crash or the gold rush teaches us that the survivors are, for example, Levi’s—the company that sold the gold miners their pants. Dull and certainly not innovative, but quality and low cost keep them going.”

7. Goodness in some areas atones for evil in others

Many companies will tout their culture of diversity, safety, volunteerism, or environmentally-conscious operations as evidence of their overall ethical goodness, despite improprieties elsewhere, as if two “rights” undo a “wrong.”

“It’s more than just money. You’ve got to give back to the community that supported you,” Jennings quoted John Rigas as saying. She also pointed out that while he was CEO of Adelphia, he “gave back” to his daughter and others in business with him.

“I’m enormously sceptical now. When companies stand up and go on about their ethics and social responsibility, I start digging, because the more they say, the more I worry about what’s really going on,” she said.

Remedies for the good/evil balancing act include rethinking the popular notions of social responsibility and business and rethinking company activities, perceptions, and realities. Be very sceptical about “doing well by doing good.” Instead, companies need to rely on virtue ethics and simplicity: truth, honesty, fairness, and egalitarianism.

Avoiding moral meltdowns

Ultimately, Jennings summed up, leadership and example matter. Culture is to the company what character is to individuals. Culture comes from the collective actions and responses of leaders. Ultimately, culture depends on individuals’ characters. “We’re dependent on individuals saying, ‘No, we can’t do that,’” she stressed.

Despite history repeating itself in a seemingly unending cycle of corporate corruption, Jennings remains optimistic. “I’m not willing to give up. I believe this remains fixable. The power of a single person. The power of a story. Just as a rotten apple can bring down an entire company, I’ve seen good apples take it the other way.”

Feb 15, 2012

 

 

 

MY ADD-ONS RE-INVESTING

Sometimes poor behaviour is all too obvious, and the best course of action is to not invest at all. Some of the examples from above, for me, are claiming generally accepted accounting principles are not appropriate for the company involved, aggressive use of accounting, if the CEO is patronising or condescending in public, exacerbated by a poor or weak board or upper management. That is, who is going to question the CEO? As well as, really any form of conflict such as private companies benefiting from the listed entity. Hubris I find very unappealing. High profile philanthropy is interesting, and I can see the case for a quid quo pro taking hold. Anonymous giving is much more defensible.

Many more cases are not so clear. Often, they can be strong and quality companies that start to take shortcuts that grow over time. Whether these actions ever reach a tipping point that undermines the whole investment case may not be clear for years and sometimes never. Often, to the outside observer, there could appear to be no change for years, and then things could deteriorate very quickly. Each instance should, however, require some noting by investors as an increase in the risk of the investment case as they occur.

I intend to add to this list over time, but some signs of potential concern would include;

Free cash flow starting to deviate from accounting profits.

The company declares accounting profits for years but pays no cash taxes.

Continually restating segments, making it nearly impossible to follow the segment profitability.

Growth by acquisitions leads to two concerns, one being the option to utilise acquisition accounting inappropriately and secondly, the outsider may find it difficult to accurately assess the profitability of the underlying operations.

Constant and unexpected management changes, especially the CFO. Especially if the CEO is larger than life.

Significant, widespread, and concurrent board and management stock selling.

Qualifications by the auditor, changing auditors, using unknown auditors.

Many times investors will give the company the benefit of the doubt in the above circumstances, maybe a reduction in position size is more appropriate.