In governance we trust

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By Héctor Lehuedé – Senior Manager, OECD Corporate Affairs Division

 

 

“Happy families are all alike; every unhappy family is unhappy in its own way,” wrote Leo Tolstoy in the opening lines of Anna Karenina, preparing the reader for the tragic fate of Princess Anna’s marriage to Count Karenin.

It is a stark reminder that for a marriage to succeed it has to juggle many moving parts, any one of which can send the relation out of equilibrium in a different direction. A similar claim could be made about firms’ governance. For governance frameworks to be effective, they have to find the right balance of a number of challenging aspects in a way that suits the features of the individual firm. Get one of them wrong and bad things will happen, sooner or later.

Impact of misconduct

Corporate misconduct is unfortunately a ubiquitous and gloomy by-product of bad governance in today’s markets, so there is no need to describe it here. It may suffice to say that, to a degree, we have become rather unemotional about breaking news regarding the latest scandal, as well as to the sheer magnitude of some of the consequences. One is the impact on trust, not only in business, but on trust in institutions more generally.

When corporate misconduct is uncovered, citizens first blame the company and its leaders, as they should, but then also fault the authorities under whose watch events unfolded as well as the market as a whole, wondering as to the extent of bad practices. Distrust is only more acute if citizens perceive that punishment is not sufficiently proportionate, especially if the culprits walk away free (and with a bonus). Whatever measure is used to assess the level of trust, there is clearly a very strong agreement in the data that it fell significantly in the Organisation for Economic Co-operation and Development’s (OECD) area after the widespread misconduct revealed by the financial crisis, from an already very low starting point. We haven’t yet recovered from this fall and we suffer the consequences in a post-truth and increasingly polarised world.

Drivers of trust

As discussed in a 2017 OECD report Trust And Public Policy, trust is usually understood as ‘holding a positive perception about the actions of an individual or an organisation’.[1] Trust works by giving us confidence that others will act as we might expect in a particular context. It is developed (or lost) on the basis of the individual’s actual experience although, as a subjective phenomenon, it is based on facts as much as on our own perception or interpretation of them. It is also shaped by the opinion of others and influenced by media.

From an economic point of view, trust reduces costs and increases the speed of social interactions, generating tangible benefits for all: a ‘trust dividend’. When present, trust allows us to make decisions without having to renegotiate with and/or reassure our counterparts at each interaction.

The OECD report further discusses what institutions can actually do to strengthen lost trust, which is essential for the effectiveness of public policy. It points in the direction of two fundamental building blocks: competency and values. These two concepts encompass a range of qualities and attributes that have been shown to inspire trust, in particular: reliability, integrity, responsiveness, fairness and openness. They contribute to an individual’s direct sense that the institutions with which he/she deals are trustworthy.

Governance failures

As argued by the G20/OECD Principles of Corporate Governance, the purpose of corporate governance is precisely to create an environment of trust, transparency and accountability necessary to obtain long-term investment, financial stability and sustainable growth.[2] This environment offers households the opportunities to hold equity and participate in the profits and wealth creation of the private sector, while facilitating the channelling of savings to promising business ventures that agree to adopt good governance to receive financing. Robust empirical results, including by the International Monetary Fund (IMF), show how good corporate governance reduces risk for individual firms as for the market as a whole.[3]

This link between risk and governance was also in the Financial Stability Board’s (FSB) mind in 2016 when it created its Working Group on Governance Frameworks (WGGF), chaired by Jeremy Rudin, Canada’s superintendent of financial institutions. The group, that was mandated to explore the use of governance frameworks to reduce misconduct risk, presented a first public report in May 2017 which includes an engaging literature review of root causes of misconduct.[4] For this, the WGGF scrutinised a dozen prominent institutional failures in the financial and non-financial sectors, distilling common governance problems that offer clues into the actual functioning of governance frameworks:

Pressure The WGGF learned that all institutions studied were subject to strong pressures when they failed. These pressures rose from external forces (such as the need to maintain political support for space activity in the case of NASA’s space shuttle disaster, or increased competition threats in the market in BP’s Deep Horizon oil spill) as well as from internal forces (like an overly ambitious growth strategy, as in many financial institutions during the financial crisis). These pressures put governance institutions to a test they didn’t resist

Leadership Pressure found its way into the organisation from the top, usually beginning with the board and senior management. The WGGF notes that this influenced their leadership styles and tone, as well as the strategy and decisions they adopted. Dominant leadership and stressed group dynamics left little room for dissent and constructive challenge, so people didn’t speak up or were ignored if they did. Inappropriate behaviour, or behaviour inconsistent with official policies and values, quickly became tolerated (something psychologists refer to as ‘normalisation of deviance’) and shaped a riskier ‘new normal’

Culture Yielding to pressure, leadership negatively influenced the organisational culture and behaviour of the entire company beyond previously established rules and procedures. Organisational mindsets were realigned with a desire to achieve results at the expense of security, compliance, ethical values ​​or long-term sustainability. As employees perceived few opportunities to escalate concerns, leaders didn’t receive crucial information that, in turn, predisposed their own decision-making. Firms accepted small deviations and misconduct as inevitable risks, assuming that if they didn’t result in a major negative event in the past, they might not cause one in the future

Governance frameworks Tested under pressure and without candid support from the top, frameworks revealed their weaknesses. Unclearly defined roles and responsibilities led to unaccountability, feeble escalating channels to dangerous silence while financial incentives overpowered insufficiently strong or independent control functions. Even when frameworks proved to be robust and well-designed enough to operate under stress, their input was overruled at the top. The WGGF notes that Lehman Brothers had sophisticated policies and metrics in place to estimate risk, as well as extensive staff dedicated exclusively to risk management. However, Lehman’s leaders relied more on their experience and successful track record, leading their company into default and triggering a global crisis in the process

Role of culture

The FSB’s WGGF report concluded noting the symbiotic relation between governance frameworks and corporate culture, which it defines as ‘an institution’s shared assumptions, values, beliefs and norms’. An effective framework can nurture the right culture in a firm, but a corrupt culture can significantly undermine efforts to set up an effective framework running against its current. In a July 2017 post on the UK’s Financial Conduct Authority (FCA) website, former FCA senior advisor John Sutherland argues that for a new culture to emerge, staff members need to understand that the new governance framework will expect them to start behaving differently.[5]

“From an economic point of view, trust reduces costs and increases the speed of social interactions generating tangible benefits for all: a ‘trust dividend’. When present, trust allows us to make decisions without having to renegotiate with and/or reassure our counterparts at each interaction”

Sutherland warns that old habits die hard, but suggests there are four drivers of behaviour that can influence cultural change: trust and trustworthiness, communication, decision-making and incentives (both financial and non-financial). He cautions that leaders can damage internal trust by responding to pressure with objectives that differ from firm values. He quotes employee surveys reporting they ‘don’t always trust senior leaders’, or that they feel it is expected they will ‘have to trade ethics for business’, as evidence of this. To foster a well-working governance framework, Sutherland argues, all four behavioural drivers must be aligned, understood and ideally overseen or controlled by the board.

Leadership in practice

This is also the view of some enforcement agencies. A July 2017 interview of Hui Chen, former US Justice Department (DOJ) compliance counsel, highlights how relevant this relationship between frameworks and the organisational culture is for prosecutors charged with evaluating corporate compliance programmes.[6] Ms Chen describes how investigated companies tend to present binders full of their compliance policies, although DOJ prosecutors don’t really care about what the policy says, but rather about how they actually operate: ‘we want to see evidence; we want to see data of effectiveness’. She goes on to advise firms to make sure their programmes produce actual results that are measured thoughtfully and to assume that prosecutors will see through ‘a programme that’s designed to satisfy them versus a programme that’s designed to work’.

The 2017 DOJ’s manual for evaluating corporate compliance programmes offers a useful guide to corporate leaders committed to building an effective governance framework.[7] The manual lists difficult questions covering issues from ‘analysis and remediation’ to ‘incentives and disciplinary measures’, including ‘autonomy and resources’ as well as ‘continuous improvement, periodic testing and review’ among others. On the role of the leadership, it covers three crucial issues:

Conduct at the top How have senior leaders, through their words and actions, encouraged or discouraged the type of misconduct in question? What concrete actions have they taken to demonstrate leadership in the company’s compliance and remediation efforts? How does the company monitor its senior leadership’s behaviour? How has senior leadership modelled proper behaviour to subordinates?

Shared commitment What specific actions have senior leaders and other stakeholders (e.g. business and operational managers, finance, procurement, legal, human resources) taken to demonstrate their commitment to compliance, including their remediation efforts? How is information shared among different components of the company?

Oversight What compliance expertise has been available on the board of directors? Have the board of directors and/or external auditors held executive or private sessions with the compliance and control functions? What types of information have the board of directors and senior management examined in their exercise of oversight in the area in which the misconduct occurred?

The rear-view mirror

Habitual readers of Ethical Boardroom may recall that the Spring 2015 issue hosted an editorial about a then-recent OECD project exploring what corporate governance frameworks could do to mitigate the risk of corporate misconduct.[8] The piece described the integrity recommendations of the G20/OECD Principles of Corporate Governance and asked, rhetorically, what those recommendations meant in practice for boards that take their responsibilities to heart. It concluded by outlining plans the OECD had to better understand why some companies fail to prevent misconduct and how to build effective compliance into corporate governance. It also promised to report back on the findings.

Looking back, it seems fair to say that we now have a wealth of knowledge and some robust findings from diverse sources at our disposal, which have enriched our understanding of how governance frameworks can succeed or fail. We can argue that we have better assessed the crucial role of trust and its drivers; we have carefully studied the conclusions from previous corporate failures and extracted valuable lessons; we have come to grips with the role of culture in governance and we have sharpened our tools to facilitate meaningful implementation of best practices.

We can declare we are better equipped to balance the many governance challenges, but this is, of course, no guarantee of success. As Tolstoy or anyone who has been in a relationship could attest, the path to success doesn’t only demand learning to juggle the moving parts, but also to find the commitment to keep doing it as consistently as possible for the long run.

 

About the Author:

Héctor is senior manager at the Corporate Affairs Division of the Organization for Economic Co-operation and Development (OECD) where he is in charge of overseeing the work of the OECD Corporate Governance Committee, which brings together experts from all OECD member and partner countries and meets twice a year in Paris. He is also responsible for policy dialogue, research and assessments of the implementation of OECD standards across jurisdictions, as well as manager of the OECD Russia Corporate Governance Roundtable (sponsored by the Moscow Exchange and the Siemens Integrity Initiative) and the OECD Trust and Business (TNB) Project.

Héctor joined the OECD in 2010 after serving as senior adviser to the Chilean Minister of Finance and having practiced for more than a decade as a lawyer at some of the best legal and audit firms in Chile. He has a J.D. degree from Universidad de Chile and holds a Master degree from Stanford University.