This article was first published in the October 2011 of Accountancy Futures journal
Stories of corruption, fraud or wider business ethics issues are rarely out of the news. Every year has its crop of unwelcome headline scandals, often implicating household corporate names or their staff in practices that damage reputations and send share prices plummeting.
The US’s Foreign Corrupt Practices Act and most recently the UK Bribery Act aim to combat corruption, and their powers extend across the globe to companies that do business in the US and UK.
While it is a near certainty that some companies will end up in the headlines, identifying and evaluating the risk that corruption or fraud will have an impact on a given company, represents a real challenge for investors. At the extreme, such issues can have a catastrophic impact on share prices, as the failures at Enron, WorldCom and Parmalat demonstrate, and recent regulatory action and litigation in the US and Germany have resulted in fines in the hundreds of millions of dollars.
Corruption – that is, the ‘abuse of entrusted power for private gain’ – is an area of specific concern for UK companies in 2011, as the UK Bribery Act came into force on 1 July. The provisions of the act are also expected to be keenly applied by the Serious Fraud Office.
Collateral long-term damage to brand and competitive edge also extends beyond the core issues of fraud and corruption and into wider business ethics issues. In recent years, companies shown to have unscrupulous business practices, poor working conditions for employees or suppliers and/or poor environmental practices have found that their broader reputation has suffered, undermining their share price in the short term and their ability to outperform their peers over the longer term by discouraging talented staff, customers and suppliers from working with them.
If anything, the response of financial markets to business ethics issues is likely to become more pronounced, as governments continue to reinforce sanctions on businesses guilty of poor ethical practices.
The problem facing investors is not so much whether or not these issues matter, but how they can spot companies that are particularly vulnerable to unethical practices and adopt investment strategies that ensure that they are not negatively affected. Addressing this problem was the focus of a research project undertaken by Henderson Global Investors and PwC.
The hypothesis adopted was that while unethical business practices are by their nature difficult to spot, there are nonetheless certain characteristics of businesses that make them more vulnerable. PwC’s forensic services division has, over many years, built up a library of case studies of businesses that have suffered from major business ethics controversies. Using this database, a list of ‘red flag’ characteristics that make businesses particularly vulnerable to fraud, corruption or wider business ethics malpractice was developed.
These red flags, which fall into one of five broad categories – type of industry; country of operation; company structure and business model; management integrity and supervision; and high-level financial indicators – are routinely in evidence at companies where business ethics later becomes a critical issue.
Of course, just because a company has a significant number of red flags does not necessarily mean that it is corrupt. It just means that a business’s characteristics and operating environment expose it to greater business ethics risk. In order to determine whether a company is indeed more likely to be subject to business ethics malpractice, direct analysis and engagement with the company’s management is required to understand the quality of its internal control systems.
Such engagement can be highly revealing about a company. In some cases, the way the company responded to a request for a meeting to discuss these issues gave away a lot. In one instance, repeated requests for a meeting were only answered once a major accounting fraud had become public knowledge.
In other cases, companies were able not just to articulate and share high-level policies and procedures governing the management of critical areas of their business, but also the additional detail of how the policies had been implemented, what they had learnt and how they had subsequently refined these policies.
Similarly, other companies were able to tell a compelling ‘story’ of risk management backed up by data, for example, on how often business ethics hotlines had been used and/or how training on ethical business practices is implemented within the organisation.
Quality and extent of reporting was a key differentiator. For example, the most advanced companies were able to provide both detailed anecdotes as well as quantitative data on the performance of their internal control systems. In some cases, companies were also reporting this publicly either through their annual or corporate responsibility reports.
However companies choose to manage and report on their approach to business ethics issues, there is no doubt that changes in businesses’ operating environments are increasing risk in the area of business ethics to companies and therefore to their investors. Indeed, a 2010 survey conducted by PwC on business ethics and ‘tone-from-the-top’ activity within companies, found that 70% of respondents agreed or strongly agreed that ethical risks were identified but only 34% reported they were adequately measured or evaluated, while 27% confirmed that their business had recently terminated a business relationship as a response to unethical behaviour.
The red-flag tool has already helped to identify one company that subsequently suffered a serious business ethics issue. However, it is too early to comment on its overall effectiveness.
While many of the red flags are themselves not new to portfolio managers, incorporating them into a disciplined and structured framework to help assess business ethics risks is. This structured approach is of particular value at both the portfolio level and also in undertaking a stock-by-stock analysis, for example, at initial public offerings.
Ultimately, it is clearly not possible to know definitively where the next corporate corruption scandal is going to come from. What is definite, however, is that there will be corporate scandals. Prudent investors need to respond to this increased risk by developing and applying tools and frameworks like the one described here.
This is an abridged version of Avoiding Bear-traps: An Investor Tool for Identifying and Managing Business Ethics Risks by Seb Beloe and Mark Anderson, published in Risk and Reward: Shared Perspectives, which can be found at on the ACCA website.
Seb Beloe is head of sustainable and responsible investment (SRI) research at Henderson Global Investors. He is responsible for the identification and analysis of critical sustainability and responsibility issues with investment relevance for the SRI funds. In addition, Beloe guides and oversees the research team’s communication and engagement with companies, the investment community, government and civil society to promote understanding of sustainability, corporate responsibility and SRI matters.