Rotten apples or rotten orchard? Non-compliance is strangling firm performance

Sandra Damijan

Just like in the old robber baron days, today buddy capitalism and corporate corruption is front-page throughout the world. Deregulation, especially in the financial markets, has distorted incentives and exposed conflicts of interest among market participants. Corporate environments are increasingly getting divorced from values and morals. What does ethics have to do with compliance? A lot. Because ethics is the foundation for law. Poor ethical culture breeds integrity breaches, which then often lead to legal violations and too often accompanying financial collapse.

Consider this

You are an investor searching for purchase of high valued company stock. After reading external revision report of well recognized auditing firm, you decide to invest in military company that has $30 million profit, $145 million of assets, $77 million ownership capital (ROE 39%), 675 employees. The company has been for sixty years recognized for quality business earning awards such as sustainability reporting, pwc stakeholder communication, etc. CEO of the company has big business ambitions, wants to expand to other markets and does not have time with this new trend of introducing corporate compliance. Would you invest? Most of us would. Shortly, this would show as very bad business investment. The CEO of the company would be arrested for embezzling company funds. The stock prices would immediately drop and we would lose large sums of money.

Unfortunately, many investors lost this money in 2007. Above mentioned is the case of company DHB Industries, the leading body armor provider to U.S. soldiers in Iraq, whose CEO David Brooks was arrested based on 21 counts of alleged securities fraud, insider trading, tax evasion and obstruction of justice. He inflated his company stock and bilked his firm out of tens of millions of dollars to bankroll his fairy tale lifestyle.

This is not a lonely case. Just like in the old robber baron days, today buddy capitalism and corporate corruption is front-page throughout the world. This naturally raises the question of what is responsible for this trend. Is the surge in corporate corruption a result of the extensive market deregulation of the last two decades or a reflection of the increased corporate appetite and no integrity?

Some argue that corporate wrongdoing has today come to be seen as a routine occurrence and is no longer surprise. According to Transparency International, nearly three people in four believe that corruption has increased over the last few years. Others take different position that things have never been cleaner. What has changed is how strenuously governments are cracking down on corruption.

Whether glass is half empty or half full depends on how you look at it. But the answer lies somewhere in between. While the intensity of regulatory crackdowns has risen, it cannot be denied that there has been a proliferation of corporate misdemeanors in recent years. Deregulation, especially in the financial markets, has distorted incentives and exposed conflicts of interest among market participants. Corporate environments are increasingly getting divorced from values and morals.

Bad apple or bad orchard?

Good employees at great companies often can be driven to do really unethical things and breach the integrity. We can all be occasionally bad apples. Sometimes it is because we employ multiple roles, where we hold ourselves to different standards (i.e. home vs. work). Or we lack courage to do what is right, or do not have all of the information we need and in the end our choice we make might look unethical. And yes, we can all make mistakes. Our wrongdoing is not necessarily evidence of a bad intent.

Much greater problem is when we question our ethical choices if majority is acting differently, when we make consensus with the company’s bad orchard. It is that phase when a company is in danger, on its way to collapse. The red flags are when you hear employees in company repeating I do not get paid enough, They owe me, No one will know, No one will be interested, and similar.

What does ethics have to do with compliance? A lot. Because ethics is the foundation for law. Poor ethical culture breeds integrity breaches, which then often lead to legal violations and too often accompanying financial collapse. Moreover, just because something is legal, does not mean it is ethical. Rules are necessary but not sufficient. The rule-based system is at best reactive, preventing a recurrence of a problem that is also known as compliance. It is falsely predicated on being able to anticipate each situation. This is where ethics based system enters. The latter is truly proactive, equipping employees with knowledge on how to deal with ethical situations.

In reality companies must have both systems in place. If a behavior or an action is legal, it does not mean that it is ethical. However, rules are not intuitive. If behavior or action breaches rules, you cannot rely on your moral senses. In order not to have too many bad apples in the company that would eventually rotten other employees we need to trust each other within company, to trust in company’s strong professionalism, commitment to ethics, avoid preferential treatments, not to deviate from right doing, to have strong sense of loyalty to company and its employees. If the system is set up on these values, bad apples will leave themselves. So, how do you identify these bad apples? The answer lies in introducing efficient and cost-effective system of corporate integrity.

Walking the talk

It is not enough for companies to be aware of integrity meaning on a paper, they also have to make sure their employees are complying with laws and daily behaving so they do not expose the company to potentially costly headaches.

Companies will often say that they have ramped up their compliance programs because of the recent trend on cracking down on corruption, fraud, and other irregular activities. The truth is many companies only talk and only few walk the talk. This does not safeguard companies from becoming unsuccessful corporate story. Past is the evidence, remember DHB Industries, Enron, WorldCom, Siemens and more recent such as Wal-Mart, Goldman Sachs, Glaxo SmithKline, BP, Barclays, etc. After being exposed for wrongdoings, their business performance decreased. Some picked up by introducing efficient corporate compliance, while others are no longer among listed companies.

Research published in 2012 by the Center of Ethical and Legal Compliance confirms companies with higher integrity standards perform better. They experience bigger profits,are more productive and have higher shareholder returns (Figure 1).

Figure 1: Returns to assets of World’s Most Ethical firms v. S&P 500 firms

CELC

Source: CELC 2012

Efficient corporate integrity is detrimental for better performance. Employees work harder, are more innovative as they are in trust environment. Employees have better relationship among themselves, with management. They are proud to contribute to company’s success that also shows through their loyalty to it. Last but not the least, investors want now more than ever to have ethical investments.

Furthermore, the same research shows areas where »rotten apples« should be looked for and which areas are most vulnerable (Figure 2). Most misconduct is HR related and more specifically related to preferential treatment. A misuse of corporate assets follows together with the conflicts of interest. Other misconducts are less frequent but it does not mean that their impact is less detrimental for the company.

Figure 2: Observed miconducts by frms

CELC2

Source: CELC 2012

Companies that are still procrastinating in implementing system of corporate integrity will very soon have to do it. Globalization and emerging markets give companies no other options if they would like to perform better, to attract investors or to even exist. Countries are increasingly implementing anti-corruption and anti-fraud regulation; they communicate, have joint investigations and prosecute corporate misdeeds between countries. There is evidence of stepped up efforts to align corruption and fraud awareness, whether locally or in foreign countries, with compliance and ethics systems in place. Regulation has been adopted across countries that demands comprehensive ethics programs (i.e. the Foreign Corrupt Practices Act), that makes companies automatically liable for bribes paid on their behalf and to face criminal sanctions if they cannot demonstrate adequate ethics and compliance programs are in place (i.e. UK Bribery Act of 2010), to reward whistleblowers for reporting information (i.e. the Dodd-Frank Wall Street Reform and Consumer Protection Act), just to name few among other national regulations.

Regulatory framework exists and benefits of implementing efficient system of corporate integrity are more than apparent. However, the biggest obstacles companies face are their self-limited beliefs and neglect of its importance.

Bridging the gap

Efficient system of corporate integrity connects policies and actions that company takes to secure business opportunities. It represents constant learning, prevention and detection of vulnerabilities, with a goal to guide companies and its employees’ daily behavior towards its competitors, suppliers, distributors, and clients in order to secure full respect of legal and ethical business conduct. There are many ways how company can achieve this. Among them is well-known guidance on how to craft a strong compliance system published by the Organization for Economic Co-operation and Development (OECD Good Practice Guidance on Internal Controls, Ethics and Compliance). There is no universal agreement on one type of corporate integrity system. More important is that companies implement what is efficient for them in terms of cost-effectiveness, practicability and true vulnerability management.

Identification of compliance assessment areas (mapping) is first step. If company does not know what to measure, it does not understand its vulnerability and it cannot control it. And if company cannot control vulnerability, it cannot improve its performance.

Company should at least map two compliance risk group areas with its subgroups. First group relates to general business conduct: Corporate governance; Financial accounting/Internal controls; Public procurement/Government contracts; HRM; Records and Information Management; Security/IT security; Intellectual Property; Third parties; and Social Media Related-Risk. Second group relates to corporate integrity: Anti-Bribery/“Greasing wheels”/Extortion; Money Laundering; Conflicts of Interest; Gifts/Hospitality/ Business trips; Code of ethics; Political contributions; Donations/Sponsorships; Whistleblowers protection/Mobbing.

Where to go from mapping the compliance areas is typical approach of risk assessment. Company should assess vulnerabilities of the areas, identify measures for addressing identified vulnerabilities, and monitor their implementation. Typical assessment tools include interviews, questionnaires, focus groups, cross-checking and other reviews depending on the company resources capability. However, work does not stop here, it only begins. Knowing what are vulnerabilities and what controls to put in place is first and important step. Building efficient system of corporate integrity requires company to educate its employees on vulnerabilities and to continuously maintain its ethics and trust.

Corporate integrity system of this sort will result in company’s better performance. On the contrary, those companies that see it simply as a mean of reducing liability in situations where they get caught will soon learn the reality of corruption and its costs.

So why does this all matter for ethical business thinkers and professionals? Because a strong internal compliance program should be an integrated part of companies daily policies. They should be able to identify and mitigate against corrupt beahviour not only to ensure compliance with the law, but also to keep markets competitive and to ensure that their activities are benefiting the societies in which they operate.

One response

  1. Se strinjam. Deregulacija je sigurno velik razlog za neetično ravnanje finančnih institucij in korporacij. Bančni sistem je še toliko bolj problematičen, saj sam ustvarja in usmerja denar. Jasno je, da sam sebe ne bo reguliral, kakršno je bilo pričakovanje mnogih zagovornikov prostega finančnega trga. Zato se mora ta sektor regulirati od zunaj in po moje bi morale bančna oz. finančna praksa zadoščati preprostemu pogoju: »Ali deluje v javno dobro ali ne?« Če ne, je ne potrebujemo.

    Zelo dober point je tudi v zaupanju med zaposlenimi v podjetju in v njihovem osveščanju. Se strinjam, da morajo zaposleni spoznati, da je v interesu vseh (tako podjetja kot širše družbe), da se deluje etično in zakonito. Del rešitve je seveda tudi v tem, da se vse zaposlene obravnava enako, vendar pošteno. In v tem, da so za svoje delo pošteno plačani. Če so ljudje zadovoljni, bodo tudi prispevali več (kreativnosti, pridnosti, idej …) v svoje podjetje. Pri tem seveda sploh ni nujno, da so zaposleni solastniki in soupravljalci podjetja, kar kot rešitev zagovarja določen del vstajnikov. Samo zadovoljni morajo biti z vodenjem podjetja, z medsebojnimi odnosi in s svojo plačo.

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