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Saturday, October 29, 2016

Skepticism about Business Ethics

By Roy C. Smith

I have just finished teaching a required MBA course on business ethics, called “Professional Responsibility.” During the six-week duration of the course, we had the lingering effects of the Volkswagen, Valeant, and Panama Papers scandals, and a new one from Wells Fargo to discuss.

My approach to teaching this subject is to set aside most of the philosophy and sociology of ethical conduct to focus on the pragmatic aspects of setting and enforcing standards for such conduct in one’s own business for the betterment of all. It’s about how managers such as they will soon be should act in business.

We begin with observations of how varied and selectively applied ethical standards are in today’s society, how competitive pressures from the marketplace encourage continuous testing of their outer limits, and how elected officials and legal systems operate (not always fairly or effectively) to uphold the public’s interest. Today there are more checks and balances affecting corporate actions than at any time in history. On the other hand, tolerance of sloppy ethical conduct in other parts of society, including in the personal histories of our presidential candidates, may be higher than ever.

Against this dual-standard backdrop, my students were divided into groups to select an example of ethical failure in business, and to report on it in depth. Key to their reports is their analysis of why the failure occurred, and what might have been done to prevent it.

Their reports covered different industries: autos, big pharma, banking, and private banking for the wealthy. What they had in common was that the companies involved were large and publicly traded, and their industries were very competitive, global, affected by sometimes contradictory public polices and highly regulated. All of the companies were under considerable pressure from their boards and managers to increase sales, lower costs and, in general, do what was necessary to increase the stock price. The companies the groups studied, they believed, were typical of others in these and other industries.

The groups reported on their incidents based on data available to them from court filings and other public sources. The groups did not discuss their findings with the other groups, yet, their analyses of why the ethical failings occurred were surprisingly similar.

Several pointed to aggressive business models coldly engineered to maximize profits, without much regard to the impact of their actions on public perceptions beyond those of business success.

These business models were executed and reinforced by top management, sometimes (but but not usually) to a point of obsession. Management used compensation and promotion to reward those that went along, and to discipline those who didn’t. In their enthusiasm to succeed under these arrangements, subordinate and middle managers tended to amplify the need for results throughout the organization.

Also our groups believed that internal control systems to detect abuses were inadequate, underfunded or didn’t cover certain key areas of the business. And there was little evidence of any internal training for middle managers on detection and prevention of ethical misconduct before it could occur.

Most of the groups said they believed that dissenting managers would have had little room to change things at Volkswagen, Valeant, Wells Fargo or any of the other dozen or so banks that have recently settled misconduct cases with the US Justice Department for amounts totaling more than $150 billion.

That is a discouraging conclusion, suggesting, among other things, that teaching Professional Responsibility may be a waste of time – what does it matter if you have an ethical sensibility if the big guys don’t want to hear about it?

I understand why the groups concluded as they did, based on the documents and press coverage that they reviewed. And, they may be right in some or all of the cases they studied, but I don’t believe they are right as a general matter. Boards and senior managers of most large corporations want their junior and middle managers to be aware of ethical infractions that could bring serious financial or reputational consequences, and to speak out when they encounter them. If they don’t want to hear from them – as is always true in these discussions -  then the managers should look for another job.

But without a doubt, many large corporations do little to train or equip middle managers with the knowledge, resources or procedures for reporting and defusing ethical misconduct. One of the arguments against big banks that is brought up periodically is that they are “too big to manage.” Either top management loses control of what goes on below, or what goes on is not protected by strong internal controls and middle managers who are rewarded for defensive play as well as offensive.

What the students appear to agree on is that if they had their own businesses, employing, say, a hundred or more people, the task of setting and enforcing ethical standards would be up to them, and they, as owners of the business, would take the task seriously. Of course, this is equally true if the company grows and becomes publicly traded – it still needs its owners (now represented by the board of directors) to take the task seriously.

For many companies this task gets lost in the mix with their other mission of meeting performance standards.  Too many take their boilerplate statements about ethical standards for granted; by now they should have learned from the examples we studied and others that the consequences of losing track of ethical standards can be ruinous. Being in denial about this can be very dangerous.

But, it is also fair to say that examples of ethical failure have to be kept in perspective. Of the approximately 10,000 public companies listed on major stock exchanges around the world, only a very small percentage are involved in examples of ethical failure. And of these, only a very small number are involved in criminal infractions though of course these get most of the attention.  The ethical performance of large corporations is certainly far better than it was 40 years ago when price-fixing, bribery, market rigging and illegal political contributions were not uncommon. Then transparency was less, enforcement weaker and cynicism by top managers greater; today these things are reversed but, like everything else, the price of good behavior is constant vigilance – by middle managers especially.

Friday, October 14, 2016

John Stumpf, RIP

by Roy C. Smith
The Wells Fargo case broke in mid September with the announcement of its $185 million settlement with the City of Los Angeles and banking regulators, just after my MBA course in Markets, Ethics and Law had begun.
We discussed the case extensively in class and quickly came to realize that (1) because of a seriously flawed bonus plan for branch employees, (2) a surprisingly large number of these employees had gamed the system over several years, opening 2 million or so unauthorized accounts, most of which were either closed or unused. (3) The bank earned very little from all this, and (4) customers who lost money were compensated so no real harm was done, but (5) it took the bank several years to clean up the problem, (6) which only came to light after an article in the Los Angeles Times that triggered the subsequent investigation by enforcement officials. The amount of the settlement was (7) quite modest compared to several multi-billion dollar settlements announced by other large banks for misconduct by employees that were inadequately supervised.
These facts were not enough to prevent the Wells Fargo case to go volcanic.
My students were able to observe that In just a few weeks of unrelenting pressure from politicians inspired by Sen. Elizabeth Warren and the public media, Wells Fargo’s CEO for the past decade, John Stumpf, has been forced to resign in disgrace, surrendering many millions of dollars of compensation and benefits to clawbacks and other penalties assessed by the bank’s board of directors.
Several other large bank CEOs have resigned since the 2008 crisis, none however as a direct result of a media avalanche following a settlement announcement. And none of the others, almost all of which presided over much more serious management failings than Stumpf, was clawed back and subject to other penalties by the board of directors.
Indeed, prior to the announcement of the settlement, Wells Fargo was the world’s most valuable bank (by market capitalization) despite being considerably smaller in total assets than its runner up, JP Morgan Chase. Wells’ stock traded at about 1.7 times book value when JP Morgan’s was at 1.0. Wells Fargo survived the 2008 crisis with no help from the Federal Reserve, and was the rescuing acquirer (without government assistance) of the failing Wachovia Bank, the fourth largest bank holding company in the US.
Arguably, at a time when the largest players in the global banking system have been seriously weakened by an increased regulatory burden, slow economic growth and government interference in markets (to the point of being unviable as continuing businesses -- see my previous posts on this subject) Wells Fargo was the only truly healthy bank among our largest players.
Clearly eight years after the crisis, American Bank Rage driven by politicians looking for headlines has not subsided at all. It has gone too far.