There have in recent years been a number of catastrophic failures involving large, heavily-regulated organisations, including the 2007 worldwide collapse of financial institutions, subsequent scandals involving major UK banks, the 2010 Gulf of Mexico Oil Spill, the collapse of Enron, Bernie Madoff's Ponzi scheme, and the mis-management of the Mid-Staffordshire Hospitals. Can any general lessons be learned?
It would be a great mistake to seek to avoid all regulatory failure. Although it is clearly necessary to regulate the behaviour of organisations that are in a position to do serious damage to wider society, we must not over-regulate such organisations and so impede their growth and innovation which are in turn so important for employment and the wider economy. It is extraordinarily hard to get this balance right. Every significant regulatory failure is followed by calls for stronger regulation, inevitably followed some time later by equally strident calls for regulators to adopt a lighter touch, and be more pragmatic. But the catastrophes listed in the first paragraph of this note were surely so dreadful that they cannot be characterised as the result of risks which were worth taking.
This is accordingly one of a several notes which seek to explore these questions in some depth, and consider what might be done to avoid future catastrophes within heavily regulated sectors. In particular, should more attention be paid to the psychology of regulation:- to the behaviour of large organisations and their interaction with those who regulate them? This first note accordingly examines the behaviour of large organisations. Other notes look at ...
• the psychology of regulatory institutions, before turning to ...
• examples of the problems that can arise because of that psychology, before finally considering ...
• lessons that might be learned from the above analysis and examples.
This note argues that it is a mistake to approach the regulation of large organisations as though they are merely supersized versions of individual-led smaller firms. Most senior managers do not know (and some do not want to know) what is going on outside their head offices, nor what risks (financial, environmental and other) being taken by their staff. Internal communications difficulties, compounded by the incentive to report good results, and senior executives' aversion to taking responsibility for errors, mean that senior managers are often the last to learn what is going wrong. Regulators therefore need to take account of organisations' internal communications problems; the existence of herd behaviour and groupthink; and the culture and tensions that are typical of most large organisations.
[The Centre for Analysis of Risk and Regulation approached regulatory failure in a rather different way when it published the discussion paper Regulation scholarship in crisis? in 2016. Its authors recognise public concern about the effectiveness of regulation:-
... the past two decades have witnessed acute and salient crises that might be seen as major challenges to scholarship on regulation. One is that regulated sectors have witnessed considerable crises, especially following the financial crisis since the late 2000s. Other crises involve food, such as the horsemeat scandal which involved mislabelled products, nuclear safety (Fukushima) or mining (River Pike). The question was not whether regulatory scholarship failed to predict these incidents, but whether the literature was pointing to the kind of vulnerabilities that were identified post-crises, and whether existing approaches and theories have proven sufficiently robust to analyse the aftermath of these various crises. In other words, it is worth questioning whether the financial crisis and other crises associated with regulatory failings constituted rude surprises for regulation scholarship.
But they go on to be optimistic about the way academia is responding to these concerns - see in particular Martin Lodge's contribution beginning on page 1 of the paper.]
Principal and Agents
It is particularly important to be aware of the principal-agent problem. This arises when a principal hires an agent to pursue its, the principal's, interests but the agent develops priorities of his/her own. The principal-agent problem is found in most large organisations, including in the way that shareholders and senior executives find it very difficult to ensure that middle managers, foremen etc. work to the corporate agenda as seen from head office. There is a strong tendency for humans to align their goals and behaviour to that of the team or work group around them. As a result, it often seems that corporations are in practice run in the interests of the firm's managers who have grown to regard their firm's economic interests as entirely coincident with their own. (See Note 4 below for a comment on organisational design.)
It is for instance almost universally common for middle managers to focus on what they see as the long term good of their factory, office or other small part of the organisation. When asked to find efficiency savings they will fight hard to retain their budget and their staff numbers. They will often enter into an implicit bargain with their teams, allowing the use of material for personal ends, providing generous expense accounts, etc. so as to generate a better (non-confrontational) climate within the team - often characterised as 'high morale'. Such teams resist change - especially if it might lead to greater efficiency (working harder and/or job losses).
There are two consequences for regulators. First, it can be very hard to obtain reliable information from the intermediate levels in any hierarchy. Second, regulators need to be aware that agents and their teams often resist the introduction of (what they see as) tedious protocols aimed at improving quality or safety. Rail and marine accident reports include many examples of such behaviour. It is quite common for teams to falsify data, including quality and safety data. New recruits are told by experienced colleagues that formal instructions - or things they learned in an induction program - can safely be ignored as out-of-date or impractical.
It can therefore be very hard for a regulator to find out what is really happening inside a regulated entity, not least because the entity's own senior executives probably do not themselves know what is happening and, if they do, will be very reluctant to admit their partial loss of control. Much the same applies to compliance officers, whose creation is too often regarded by their Board as a box which has been ticked, and so a good reason to ignore regulatory issues.
It is important be aware that teams' failure to comply with safety, financial and other protocols does not necessarily mean that such teams are responding to pressure from above, such as to meet financial or other targets, complete work quickly, maintain production etc. Leaders of rule-bending teams may themselves be keen to work quickly, or to impress seniors with their achievements, or to get home on time, or to avoid a small amount of work running over into the next day. It is truly very difficult for regulators and company directors to know that this is happening unless there are robust and unpredictable inspection arrangements backed up by a strong compliance culture, and opportunities for whistle-blowing.
The principal-agent problem also means that regulators need to take into account how the middle and lower reaches of an organisation might react to regulatory pressure. The need for change and/or improvement may be accepted by senior executives, but this does not mean that the necessary changes will be accepted or implemented at the working level. The regulatory intervention needs to be designed with this problem in mind.
Here are some examples of the principal-agent problem. (Others may be found here.)
- 'Rogue trader' Kweku Adoboli nearly destroyed UBS in 2011, at one point exposing the bank to losses of £7.4bn. A colleague had reported Mr Adoboli's breach of financial trading limits in 2010 but found that this soured their relationship and so did not report him again when (a) the same thing happened in 2011, and (b) he learned that Mr Adoboli was using 'an umbrella fund' to hide his losses. "I felt as though I had stitched him up ... I think that maybe he didn't trust me as much [after he was reported] ... "I went to a school where people didn't grass," said the colleague.
- Manhattan's prestigious Stuyvesant High School provided another good example in 2012 when caught up in what was described as a pervasive cheating scandal. The New York Times reported that "Although students enter the school knowing they are among the best in the city, they must compete with hundreds just like them. ... They described teachers as being relatively sympathetic, discouraging cheating, but not always punishing it as severely as school policy dictates." One consequence may have been that Stuyvesant's results became less trusted after this episode, thus damaging the academic and career chances of all its alumni.
- And investigations into the LIBOR scandal unearthed some juicy emails showing junior (but extremely well paid) staff's willingness to disregard ethical and other rules. 'Its just amazing how LIBOR fixing can make you that much money ... it's a cartel now in London' wrote one trader. The Financial Services Authority subsequently concluded that some bankers had decided that 'the rules did not apply to them' and noted that 'In March 2011, RBS attested to the FSA that its controls and systems were adequate. The attestation was inaccurate.' It took another year before RBS concluded that the bonuses of the back-room staff who submitted LIBOR figures should not have their bonuses linked to those of the traders who might make money out of manipulating those same LIBOR rates.
- There are inevitably lots of examples in formal accident reports. Here is a nice one, following a collision in the English Channel in which one ship's collision avoidance technology had been partly disabled: "The settings in the 'guard zone' and 'target alarms' areas ... were locked. The adjustment of these settings was password protected and [the] deck officers ... were unaware of the password. The crew considered the resulting absence of alarms to be beneficial."
- An HSE Inspector reported that a contributory factor to a serious roller-coaster accident at Alton Towers had been that the frequency of false alarms meant that staff tended to assume that all alarms were false, and so restarted the ride without carrying our proper checks.
- An investigation into an accident on a heritage railway, in which a child was nearly killed, found that there had never been an audit of the Safety Management System. "Had SDR [(the train operator) carried out this audit], it would have identified that the engineering staff within the carriage and wagon workshop had not been signing the fitness to run forms for some years. Although SDR staff conducting the fitness to run examinations were confident in their own ability and competence to identify if a fault required a carriage to be removed from service, they did not feel comfortable in signing and dating the forms to show that they had examined the condition of the carriages and were authorising that they were fit to run. They stated that this was due to the number of faults being identified, the ‘fix and patch’ culture, and the perceived possible personal implications for them of signing the form and an incident or accident occurring subsequently."
- The consequences were commercial rather than damaging to health, but I was struck by Nick Butler's comment, in the FT in January 2014, about a profits warning by Royal Dutch Shell: 'At the heart of the .. problem seems to be the gap between operational reality and top management, including the board. Big problems capable of triggering a profits warning in a company this size do not arise over 80 days. They grow more slowly and are often invisible to boards meeting every six weeks who have to trust whatever data they are given. .. The rest of the industry should avoid gloating. It would be much more useful for the boards of the other majors to ask themselves if they really know what is happening in the companies for which they are legally responsible'.
- And the principal-agent problem is hardly a new one. CE Montague tells the delicious story, in his book Disenchantment, of the old hand sergeant-major who, instead of taking his young recruits on a long training march, takes them to a pub where they are surprised to find that 'arrangements for serving a multitude are surprisingly complete', and that their sergeant-major is clearly well acquainted with the publican. I suspect that armies have suffered from, and Generals will have cursed, this sort of problem right back to the beginning of armed conflict.
See Jean Tirole's Hierarchies and Bureaucracies: On the Role of Collusion in Organizations for a lengthier discussion of the Principal-Agent problem.
Herd Behaviour, Group-Think and Cognitive Dissonance
"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one." (Charles Mackay)
There is a separate problem as follows. It almost goes without saying that the majority in government, in regulation, and in the financial services industry were supported in their rosy view of the 1990s financial world by the fact that all 'the great and the good' shared their optimistic analysis of corporate behaviour and of the virtues of 'light touch regulation'. This was despite the fact that there were nevertheless a good number of perceptive commentators who did their best to warn of the forthcoming catastrophe. This is a good example of two very common psychological behaviours, often called 'herd behaviour' or 'group-think'.
Herd behaviour is not necessarily irrational. Herds usually run together for a good reason, and there is nothing irrational about humans seeking to watch and learn from what others are doing. Rational investors in an efficient market will therefore produce frenzies and crashes from time to time - but regulators are surely responsible for ensuring that herds to do not crash over cliffs and take lots of innocent (customer/taxpayer) victims with them.
Group-think is more pervasive but also highly undesirable, for it is essentially the unquestioning acceptance of obviously wrong answers simply because it is socially painful to disagree. Large organisations require a good deal of conformity, of course. You can't have every single person asking questions. Decisions have to be made and implemented. And if everyone you know, every newspaper you read, every person you once admired, are all saying the same thing, it takes a real effort of will, and real courage, to argue back. But someone has to do it - and yet it is uncomfortable to be a contrarian. Indeed, dissent can lead to the dissenter becoming the subject of personal and sometimes humiliating attack. Camilla Cavendish (who had run Prime Minister David Cameron's Policy Unit) told the Today Programme in December 2016 that some officials "became very very angry and took it viscerally personally" when it was suggested that there might have been a better way of negotiating with the rest of the EU in advance of the 2016 Brexit referendum. Questioning their strategy was perceived by them as questioning their commitment.
For further information, you might like to read Mannie Sher's paper on The Psychology of Regulation, the first part of which deals with this subject.
The British reluctance to offer overt challenge or criticism doesn't help. Industrialist Sir Denys Henderson was famed for his unforgiving tongue but appears to have had little impact as a non-exec of the Board of Barclays Bank. One scholarly director told him "You are essentially an oratio recta [direct talking] man but Barclays is essentially an oratio obliqua [indirect talking] company." No doubt this contributed to Barclays' subsequent troubles. (The Senior Civil Service, too, suffers from too much indirect talking.)
Margaret Heffernan offers an interesting - almost hilarious - analysis of group-think in her excellent book Wilful Blindness. "I've even heard boards discuss how, and why, they are invulnerable to groupthink, oblivious to the irony inherent in their confidence. ... Dennis Stevenson, then chairman of HBOS, eulogised the outstanding board he chaired [at a time when] everyone knew the bank teetered on the edge of collapse. ... [Lord Stevenson cited as evidence] the fact that, even in this crisis, 'we are as one'. He seemed oblivious to the notion that the unity of his board may have been a contributory factor to the bank's mess in the first place."
The same book introduced me to the related concept of cognitive dissonance. This phrase refers to the stress that we all encounter if we try seriously to consider two incompatible views at the same time. We all therefore fiercely hold onto our preconceived beliefs even in response to intense external pressure. One result is that - as we almost all regard ourselves as good people, and essentially honest - we find it very hard to admit to ourselves that we or our organisation is behaving badly. Senior executives typically therefore push back very hard against any regulator's or other suggestion that their actions maybe doing unnecessary harm, including risking their own business.
Cognitive dissonance almost certainly accounts for the failure of many, including Alan Greenspan - a deep believer in the power of the markets, and a fan of financial instruments such as derivatives - to react to all the warnings that something was going very badly wrong in the period before the 2008 financial crisis.
See also this note on behavioural economics for a further discussion of herd behaviour etc.
The MacWhirr Syndrome
There is a separate though closely related syndrome, personified by Captain MacWhirr in Joseph Conrad's Typhoon who chose to sail straight through a devastating storm because he recognised that his employers would criticise him for delaying their cargo if he sought to sail round it. "Suppose", he says, "I went swinging off my course and came in two days late, and they asked me 'where have you been?' 'Went round to dodge the bad weather,' I would say. 'It must have been dam' bad, they would say. 'Don't know,' I would have to say, 'I've dodged clear of it.'"
The armed forces have often taken similar decisions. Andrew Lambert, discussing the 1812 loss of HMS Guerriere and the deaths of 21 seamen, noted that "Facing an opponent 50% more powerful in guns, tons and men, [the captain's] only hope of avoiding defeat lay in running away, a tactical choice that would have seen him cashiered, or shot." But the classic case was perhaps the sinking of HMS Victoria in 1893 with the loss of 358 lives, following a collision which resulted from Admiral Markham following an order which he knew to be catastrophic. As another admiral wrote some time later: "Admiral Markham might have refused to [obey the order but he would] have been tried by court martial, and no one would have sympathised with him as it would not have been realised that he had averted a catastrophe".
Modern executives who mimic MacWhirr do so because company Boards and stakeholders are very likely to criticise delay and expense, even if the organisation eventually achieves its objective. Executives therefore prefer to take uncertain and dangerous risks rather than face certain (unjustified) criticism.
There was a classic example in late December 2012 when Shell chose to tow the Arctic drilling rig Kulluk through treacherous waters all the way from Alaska to Seattle in the middle of winter, at least in part to ensure that they avoided a $6m Alaskan tax charge which would otherwise have fallen due on 1 January. The loss of the rig cost Shell around $200m.
There were also a number of senior financiers who understood that they were running their companies into serious trouble in the years before the 2008 financial crisis, but felt they would face unacceptable criticism if they were to follow a less risky course. Citibank's Charles Prince famously told the Financial Times that "As long as the music is playing, you've got to get up and dance. We're still dancing." This led the same paper's John Kay to conclude that "The man who held the most powerful position in the financial services industry was the prisoner of his own organisation." And Andrew Ross Sorkin, in Too Big to Fail notes that Lehman's Dick Fuld "had known for years that Lehman Brothers' day of reckoning would come ... But, like everyone else on Wall Street, he couldn't pass up the opportunities."
The MacWhirr syndrome is just as common in politics. US Congress Representative Barney Frank commented as follows, when talking about Hank Paulson's dilemma in the middle of the Lehman crisis: "The problem in politics is this: You don't get any credit for disaster averted ... Going to the voters and saying, 'Boy, things really suck, but you know what? If it wasn't for me, they would suck even worse.' That is not a platform on which anybody has ever gotten elected in the history of the world".
The implementation of the Brexit referendum strikes me as an excellent example of the syndrome, whatever you thought of the original decision. Ministers appeared much more concerned to avoid being criticised for delay in implementing the referendum result than interested in getting to a safe and sensible future relationship with the EU 27. And others have noted that if Margaret Thatcher had acted to deter Argentina from invading the Falklands, rather than ordering a taskforce to remove the occupying forces after they had landed, she would probably have been remembered as an unsuccessful one-term Prime Minister.
But there are some interesting examples of individuals and organisations refusing to succumb to the MacWhirr Syndrome, even though they were bound to be criticised for avoiding the likely disaster.
- Various governments and most businesses were, for instance, to be congratulated for taking action to near-eliminate the Y2K 'Millennium Bug'. Subsequent evaluation has shown that the effort was very worthwhile, but the public and media reaction was that it had all been a waste of time and money because so few examples of the bug were discovered on 1 January 2000. This is a classic example of commentators not realising that disaster might well have ensued had no avoiding action been taken.
- And a good naval example was Lord Jellicoe's caution throughout World War I, and in particular in the Battle of Jutland. He knew that he could have lost the war through one disastrous engagement with the German fleet. But his failure to take unnecessary risks was much criticised, especially by the British press.
Knowledge of, and/or responsibility for, problems is often widely shared within large organisations, but it is then often the case that no-one feels responsible for addressing or even highlighting the problem. One example was the poor maintenance and terrible safety record at BP's Texas City Refinery, where an explosion in 2005 killed 15 and injured over 170 more. The problems were readily apparent to most employees and managers but - partly under pressure to save money - no-one felt responsible for doing anything about them.
Much the same was true of Bernie Madoff's Ponzi scheme where quite a few financial professionals had worked out that something fishy was going on, but saw no need to do anything more than avoid dealing with him.
And just about everyone in Westminster knew that Members of Parliament were receiving over-generous expenses payments as recompense for their low salaries, but hardly anyone saw much wrong with this ... until Heather Brooke and the Daily Telegraph published the expenses claims in 2009 - triggering immediate uproar outside Westminster, and a few prosecutions. Indeed, many MPs had previously supported an attempt to exclude their expenses claims from the Freedom of Information Act.
The diffusion of responsibility is exacerbated if there are frequent changes of management. This was part of the problem at Texas City as the over-worked men 'close to the valve' stayed put, whilst their managers generally moved on very rapidly, away from an old refinery which lacked the prestige of many of BP's other locations. Managers were not therefore in post long enough to both understand the issues and then have the time and inclination to do much about them.
It can often be difficult to tell whether your regular contacts within large organisations are truly speaking on behalf of their Board or other senior staff. Senior executives, senior partners, senior aircraft and ship captains, hospital consultants etc. are so powerful that they easily become isolated from ordinary people, and even more so from their front line staff and their concerns.
Some of them overcome the problem better than others. Crew Resource Management, mandatory protocols and generational change are making a big difference in hospitals and transport. But many other top executives have too much confidence in their own judgement and opinions, whilst the scale of their operations or responsibilities mean that they have to think in abstract terms where risks, and even death rates, become mere numbers that have to be managed. This can easily cause whole management teams to characterise as naive or unworldly anyone - and in particular a whistle blower or journalist - who expresses any concern about organisational culture. Lord Browne, BP's Chief Exec at the time of the Texas City disaster, was said by his executive assistant to show 'no passion, no curiosity [and] no interest' in safety.
It can be worse if an organisation is highly focused on the power and influence of a single individual, often someone with a heroic leadership style. Their direct reports then spend all their time trying to second guess their hero's wishes, rather than think for themselves or commission analysis which might challenge their leader's views. This was certainly a problem at Toshiba where investigators into a huge accounting scandal found "a corporate culture where it was impossible to go against one's bosses' wishes".
The wider the power gap, the more difficult it can be to communicate even urgent concerns. Junior doctor Rachel Clarke* describes her distress when she failed to challenge the appalling behaviour of one senior consultant doctor.
Mr Skipton ... stared up in trepidation as my boss, impatient to get to theatre as quickly as possible, alighted at the bedside. ... Without so much as an introduction, he broke the news to the patient of his terminal illness by turning away to the bedside entourage and muttering, perfectly audibly, "Get a palliative care nurse to come and see him". No one had even told 'him' he had cancer.
As panic began to rise in Mr Skipton's face, I remember catching the ward sister's eye to see her cringing alongside me. But trying to undo the damage would take so long and the ward round was already sweeping on. I had a moment to act decisively. I could have chosen to earn my consultant's wrath by remaining at my patient's bedside. Instead, to my shame, I scuttled dutifully after my boss, leaving someone else to pick up the pieces.
(*The above extracts are from Rachel's book Your Life in My Hands.)
Even if middle managers (the agents) are trying hard to achieve the aims set for them by their seniors (their principals), it is absolutely certain that their communications to their seniors will be less than totally honest or frank. Tim Harford puts in nicely in his book Adapt:
'There is a limit to how much honest feedback most leaders really want to hear; and, because we know this, most of us sugar-coat our opinions whenever we speak to a powerful person. In a deep hierarchy, that process is repeated many times, until the truth is utterly concealed inside a thick layer of sweet-talk. There is some evidence that the more ambitious a person is, the more he will choose to be a yes-man - and with good reason because yes-men tend to be rewarded.
Even when leaders and managers genuinely want honest feedback, they may not receive it. At every stage in a plan, junior managers or petty bureaucrats must tell their superiors what resources they need and what they propose to do with them. There are a number of plausible lies they might choose to tell, including over-promising in the hope of winning influence as go-getters, or stressing the impossibility of a task and the vast resources needed to deliver success, in the hope of providing a pleasant surprise. Actually telling the unvarnished truth is unlikely to be the best strategy in a bureaucratic hierarchy. Even if someone does tell the truth, how is the senior decision-maker the honest opinion from some cynical protestation?
A much more detailed analysis of the difficulty of 'speaking truth to power' may be found on my sister 'Civil Servant' website.
At another level, the behaviour of large companies' senior executives has become quite fascinating. One begins to wonder whether big business has succeeded warfare as the most exciting form of competition between human organisations. Some modern boardrooms appear to attract those who would, in previous generations, have sought to command large armies. Instead of invasions, we nowadays have corporate takeovers; instead of gold braid and military honours, we have executive salaries. The leading actors therefore remain the odd combination of hugely ambitious, sometimes inspirational, but too often also highly self-absorbed and disastrously inept. For Haig, Montgomery, Patton and MacArthur substitute Dick Fuld, Fred Goodwin, John Gutfreund, Tony Hayward, Jeffrey Skilling, Bob Diamond, Rajat Gupta? Indeed, I understand that Turkish Islamists rather bitterly note that the mujahids or aspiring warriors of old have become the muteahhits or construction tycoons of today.
It certainly seems to be the case that power changes the behaviour of previously decent men and women. 'Power corrupts ... etc.'. It is perhaps inevitable that powerful CEOs' sense of right and wrong becomes aligned with the norms and expectations of others who are similarly rich and powerful. Neuroscientist and psychologist Ian Robertson goes further and draws attention to research which shows that power increases testosterone levels which in turn increases the uptake of dopamine in the brain, leading to increased egocentricity and reduced empathy (New Scientist 7 July 2012). Power also reduces anxiety and increases appetite for risk.
And yet, as the FT's Lucy Kellaway points out: "Modern CEOs seem to have no [public] opinions, especially not negative ones. If they feel one coming on, they have been trained by their lawyers and PR advisers to suppress it." It is certainly difficult these days for CEOs to correct the mistakes or improve the behaviour of their organisation without laying themselves open to the charge that previous behaviour was in some sense faulty and so worthy of criticism and/or claims for compensation.
Senior managers are certainly, all too often, very concerned to appear infallible (and un-sue-able). Organisations therefore get locked into defensive modes, from which they find it increasingly difficult to extricate themselves - and so the problems get worse. The reputation of BP's Tony Hayward was for instance badly damaged (yet further) when he failed to answer many of the questions put to him by US Congressmen in June 2010. Barclays' Bob Diamond also did himself no favours when responding so blandly to UK politicians' questions in July 2012.
Sadly, therefore, regulators have become increasingly circumspect (mealy mouthed?) in the way in which they communicate with CEOs, their lawyers and their PR advisers. The financial services 'Big Bang' saw an end to the ability of "the [Bank of England] Governor's eyebrows' to terrify City of London financial services. And I don't think any regulator would nowadays get away with the following behaviour even if, like Sir Thomas Barlow, they were a business man brought into government during World War 2:-
'I chanced to be in Tommy Barlow's room when he had a question for a manufacturer who was suspected of rigging [wartime] restrictions to his firm's advantage. Tommy began his address ... "I wonder if you have any idea, Mr X, how I long to be relieved of this job [or ] if you have any idea of the reason ... It is, Mr X, because I shall never have to meet a man like you again'. [Francis Meynell, My Lives]
Profits or Ethics? - Fiduciary Duty, Caveat Emptor and all that
In the absence of strong regulation, many organisations are not incentivised to behave in a socially responsible manner. Some companies are certainly very good at filling their annual reports with information about their CSR (Corporate Social Responsibility), But most CSR activity is just a way of promoting a brand. The Times' Ian King enjoyed reporting on "a company that won six awards in only one year from the US Environmental Protection Agency. It won a “corporate conscience” award from the US Council on Economic Priorities. It published a Corporate Responsibility Annual Report solemnly detailing its philanthropic activities and its pursuit of “Respect, Integrity, Communication and Excellence” that would “integrate human health, social and environmental considerations into our internal management and value system”. And it placed on the desk of every executive a framed copy of its corporate values. It sounds impressive, until you learn that the company was Enron, the American energy giant whose collapse in October 2001 was followed by revelations that it had been fiddling its figures for years."
Indeed, modern companies seem to exercise much less social responsibility than in previous decades. The US Business Roundtable in 1978 listed CSR as one of the four core functions of company Boards. It had disappeared by 1990.
Instead, corporate managers will quickly remind you that their primary duty is to generate profits for their shareholders, and this fiduciary duty in law (and some would say rightly) often takes precedence over the consequences for the environment, for healthy and fair competition, for customers, for employees, and for wider society if their business were to fail. Non-profits and public sector organisations have their own primary duties, and must also operate in a way which generates income and/or reduces expenditure. But organisations ignore wider, longer term and societal benefits at their peril.
Equally, however, fiduciary duty is (or should be) a long term concept. It is easy enough to maximise short-term profits at the expense of customers and other stakeholders, but directors' and executives' duties are to maximise the value of the company in the longer term. The first paragraph of this note lists a number of examples of where neglect or exploitation of customers, or the environment, has been extremely costly over the longer term.
Farrer & Co (Solicitors)'s advice for the Tax Justice Network in September 2013 makes the point about directors' duty to consider the longer term success of the company very well indeed. Here is an extract:
In circumstances where a director decides that the company will eschew tax avoidance, he or she may do so for reasons that he or she considers to be aligned with the long-term success of the company, including for example:
(i) the adverse risk profile of tax-structured transactions in the long term,
(ii) the desirability of investment in public health, education, infrastructure &c in the jurisdictions where the company's employees live and work,
(iii) the need to foster the company's relationship with tax authorities and with consumers,
(iv) the impact of tax avoidance on the wider community of taxpayers and users of public services, and
(v) the desirability of the company maintaining a reputation for high standards of business conduct.
. . Our view that other kinds of impact may constitute a legitimate basis for a director's decision notwithstanding an adverse financial impact may be derived from the clear meaning of the [Companies Act] but it is also supported by the pre-existing case law on the corresponding common law duty . . For example in Re Welfab Engineers Ltd (1990) BCLC 833 the directors were found by Mr Justice Hoffmann . . not to be in breach of their duties when they deliberately sold a real property asset at an undervalue, in circumstances where they did so in order to protect the jobs of the company's employees.
Blueprint for Business argues that UK company law permits a purpose led approach:- "Section 172 of the 2006 Act makes clear that the primary duty of the director is the success of the company, and that in discharging they have to take account of the Interests of shareholders (which may well vary between them) and have regard to a bunch of other stakeholders too. Although it is often interpreted as a duty to maximise shareholder value, our view ( supported by legal opinion) is that they are not agents of shareholders but true fiduciaries, who have to set out what they think success means. The law is certainly not as clear as it could be but it is often narrowly interpreted and poorly understood. For us a key shift in thinking is where profit is not seen as the purpose but one outcome of living out a purpose that serves society."
Blueprint for Business also makes a strong second point about motivation. Their view is that "organisations implicitly operate with a view of the human person, usually unstated, and typically that people are self interested, motivated by money and status. A heuristic then operates to reinforce this as people respond accordingly. The diminishing returns to regulatory reform are one manifestation of this. What we are proposing, drawing on a strong multidisciplinary body of learning and everyday experience is a different view. This is that people are hard wired to seek meaning and fulfillment through work and that the quality of relationships is intrinsically important to us. The link to purpose is then that organisations with a pro-social purpose whose relationships are founded on respect and co-creation will 'crowd in' intrinsic motivation. People associated with it will lean in because they care. This is hard to introduce in large organisations but the conversations are fascinating because people are not used to being asked about what view of the person does the business have. This is a powerful agent of change."
Second, there is a well established business principle that the buyer is responsible for assessing the value and suitability of the thing that they are buying. ('Caveat Emptor' = Buyer Beware!) Although significantly eroded by consumer and other law, it remains the case that many companies feel under no obligation to behave ethically, even when their customers are buying complex financial and other products about which they are inevitably badly informed. This applies big time in dealing rooms. For further thoughts on this subject, see Notes 2 and 3 below.
See also my note on consumer protection.
And then there are the Lawyers
Be aware, too, that too many lawyers, for various reasons, end up unnecessarily terrifying their clients when advising them how to respond to regulatory inquiries. Most directors and senior managers should have little to fear if they make it clear that, if there is a problem somewhere in their organisation, they will address it. No regulator expects directors to know everything that is happening (see the Principal/Agent problem above) but they do expect them to deal openly and honestly with the regulator, and correct problems when they are identified.
- By the end of the financial crisis, the UK taxpayers' support for the banking sector totalled £850 billion, and the cost of the consequential economic recession was estimated by the Bank of England to be up to £7,400 billion (Andrew Haldane speaking in Hong Kong in March 2010).
- Harry Markopolos notes that "... the [financial services] industry is based on predator-prey relationships ... If you don't know who the predator is then you are the prey." (See also Michael Lewis' Liar's Poker.) Even Warren Buffett, normally a stickler for corporate ethics, said "If you have to care who's on the other side of the trade, you shouldn't be in the business of insuring bonds" when answering his shareholders' questions about the accusation that Goldman Sachs tricked another large company into insuring sub-prime mortgage securities, despite privately believing them to be a very bad risk.
- For a very readable account of the origins of the financial crisis, see Alex Brummer's The Crunch in which he notes that "[One particular] episode, with its blatant exaggerations and deceptions, sums up the complete folly of the sub-prime bonanza in America. Bear Sterns, like so many financial firms, had lost its moral compass.".
- It can be argued that the principal-agent problem explains the central issue of organisational design. Although delegating decision-making is an important part of good organisation design, it is of little use unless the decision makers share the organisation’s objectives. That is why incentives are so important. The individual with valuable local knowledge should be incentivised to act as if the objectives of the organisation are his or her own.