Dinosaur attitudes to governance in private equity

I have a report from a recent round-table discussion on making non-executive directors effective which was led by a director of one of the UK's major private equity firms. It was fascinating and horrifying for its old fashioned attitudes that are surely, to borrow a cliche, not fit for purpose.

Asked about where directors nominated by private equity firms owe their allegiance he seemed to imagine there was no issue to worry about here. Well.....Later asked about board diversity he merely trotted out the old mantra that if women have other priorities and don't get to board positions then that automatically means there is an inadequate pool of qualified women to serve as non-executive directors. And of course he opposes quotas for female participation at board level. No idea of making changes to make it easier for women's careers to advance to board level. No concept that aspects of approved career progression paths in the UK are too conservative. Needless to say this chap's executive team colleagues comprise just 12% women and not a single coloured face. He accepts that diversity improves corporate performance but, of course, that applies to others and cannot conceive how he could sensibly change the status quo. I too worry that quotas avoid the difficult questions but I think they are inevitable when such young fogeys are so common in this country.

A wonderful remark remark reported by my informants was to the effect that there was, however, a big demand for female non-execs in specific industries, such as cosmetics. What a ******!

Talking about finding senior people for companies he spoke about installing CEO's and Finance Directors: very revealing - no concept that HR is a key discipline that should improve the bottom line, as are engineering skills in many cases.

Where are the open and enquiring minds? Such attitudes as reported here are all too common, to the detriment of our nation's corporate performance; and they are most damaging when they are found in finance businesses such as banks and private equity because there they infect the companies these guys finance, so the virus is spread and reinforced.

Aviva shareholders revolt on board pay

It must be worth noting that there has been a 54% vote against the remuneration committee report at Aviva's annual meeting. This follows votes at other major companies indicating shareholder dissatisfaction over executive pay - not least rising pay in the face of falling performance. This groundswell of opinion seems to be an international phenomenon, with shareholders complaining in the USA and elsewhere. About time too! Next I'd like to see such votes having the power to compel management to withdraw their proposals. If that does not happen then I think we will see the rise of votes to remove directors from office. See Guardian article.

Damning Business Ethics Report from the USA

I am grateful to Norman Marks in his blog for bringing this latest annual report from the Ethics Resource Center to my attention. The team surveyed nearly 5,000 people across the USA.

Consider some disturbing headlines;

• 42% of respondents described their companies as having a 'weak ethics culture'
• 45% have witnessed misconduct. And we are not talking about pinching the odd pen
• 13% Health & Safety violations
• 12% Stealing
• 11% Sexual Harrassment
• 11% Substance abuse
• 65% reported the misconduct
• 22% suffered retribution as a result, including;
• 64% excluded from decisions or work activity by supervisor or manager
• 62% verbal abuse by supervisor or manager
• 55% not given promotion or pay rise
• 32% demoted
• 31% experienced physical harm to self or property 
• 29% harrassed at home

62% still have confidence in senior maanagement but 34% do not believe their line managers display ethical behaviour

So we have two worlds; the significant number of wrongdoers on one side and a substantial number of people who are outraged by it and will act to denounce it, regardless of the very real consequences.

Although this survey was conducted in the USA I very much doubt that things are much different in the UK. It is not news that whistleblowers often suffer for their ethical stand but I am cheered to learn that nearly 80% did not suffer consequences.

Financial Reporting Council paper on "Comply or Explain"

In February 2012 the UK's Financial Reporting Council published a report on the "Comply or Explain" approach applied to its Corporate Governance Code. Compliance with the Code is a statutory requirement for listed companies and the report considers two discussion groups, involving representatives of investors and listed companies, that met to discuss the workings of "Comply or Explain".

There are two reasons for producing this report; the first is that the European Commission has asked for views on a proposal that regulators and not shareholders should decide if explanations of non compliance are adequate; the second is that a review of a sample of UK annual reports found a minority of those that had not complied on one or more principles had given only a 'perfunctory' (i.e. inadequate) explanation.

I offer two contrasting thoughts; firstly, that there is a risk that yet more regulation and bureaucracy will simply make declarations even more legalistic and unhelpful (defeating the object of the change); the second, that it is astonishing that company bosses can be so inept and so arrogant as to resist giving proper explanations in the first place. It reminds me of the unhelpful legal boilerplate approach that has been adopted by companies in response to requirements that they disclose the principle risks facing their business. GSK, as I have written before, provides a particularly risible example of this.  I wonder whether the company secretarial staff who produced the 'perfunctory' explanations attended the discussions hosted by the FRC - I bet not.

Baroness Hogg, who chairs the FRC, might ponder whether the answer is for her organisation to adopt a more assertive approach - how about giving those companies whose explanations are inadequate a right kick up the arse? Hauling them in and admonishing them would be a useful first step, followed - if they don't release an adequate statement - by a public shaming. Try that for a while before laying on the dead hand of bureaucracy.

Maybe customers don't care about ethics at Goldman Sachs

I wonder whether my strictures against Goldman Sachs ethical standards are mere self-righteousness on my part. The thought arises from the evidence: a tidal wave of criticism and bad publicity after Greg Smith resigned from the bank and published a valedictory letter in the New York Times shifted the share price not one jot. See here.

It has long been an article of faith with me that dedication to the well being of your customers is what leads to success. Of course you worry about your own profitability but you put your faith into building a loyal customer base that does business with you because they trust you and because you deliver what they want at a good price. But why do they not desert Goldman? They probably believe the tenor of the letter, that they are described disparagingly as 'muppets' and that Goldman Sachs focuses exclusively on what can be earned from them. After all there has been plenty of previous publicity given to Goldman Sachs selling securities that the bank analysts thought were a very bad deal. Maybe customers believe it is only other customers who are patsies. Maybe they believe all Wall Street firms are the same. Frank Partnoy writes in the FT that clients you deal with through the markets are a very different thing from those you advise and to whom you have a fiduciary duty.

But, despite the evidence, I am unreformed and unrepentent. Even without evidence to support me I believe that unethical attitudes to outsiders (customers, suppliers, competitors and regulators) lead to unethical attitudes to insiders (colleagues, shareholders and the organisation). I believe that governance and performance are damaged in the long-term.

Robert Peston, for the BBC, points out that Goldman Sachs reputation for being a bit too sharp for its own interests has been around for a long time. But he too ends his article by expressing the view that they must mend their ways if they are to survive and prosper. Perhaps, like me, he clings to his moral certainties over the evidence of his eyes.

We will have to wait and see...I'll check that share price daily

PR Disaster at Goldman Sachs

Today a senior executive at Goldman Sachs has resigned and published a damning article in the New York Times explaining his reason; which is that he can no longer stand the culture of screwing the clients. According to him this is not the way it used to be and that the company grew with a culture of "teamwork, integrity, a spirit of humility, and doing right by our clients"

But to see this article as a PR disaster is to miss the real point. This is merely the broadcasting of a long-running corporate governance disaster arising from an inappropriate culture - sometimes referred to as a toxic culture. The writing was on the wall when the financial crisis broke and it was publicised that Goldman Sachs was knowingly offloading poor quality investments on to its clients.

Why is this an issue of governance? Because "governance describes the systems, procedures and behaviours by which an organisation is directed and controlled". Because abusing one set of stakeholders - customers - also implies an attitude to integrity that must permeate the organisation and affect the behaviours of staff and management in other ways.

Three particular quotes from today's Telegraph article are must reads;

"... These days, the most common question I get from junior analysts about derivatives is, 'How much money did we make off the client?' It bothers me every time I hear it, because it is a clear reflection of what they are observing from their leaders about the way they should behave.

"Now project 10 years into the future: You don’t have to be a rocket scientist to figure out that the junior analyst sitting quietly in the corner of the room hearing about 'muppets', 'ripping eyeballs out' and 'getting paid' doesn’t exactly turn into a model citizen."

 Mr Smith believes the decline in the firm’s moral fibre represents the single most serious threat to its long-run survival and see his article as a wake-up call to the board of directors. 

EU Audit Reforms

I may seem a little late responding to the EU Commission's proposed reform of auditing for public companies that was announced on November 2011. However, it often seems best to let the dust settle after the first outpouring of responses, to get a clearer view.

This is an important corporate governance issue, or rather several;

• are boards too close to their auditors, preventing necessary criticism?
• do auditors have conflicts of interest?
• is there sufficient competition for audits?

The Commission is responding to the undeniable fact that banks that collapsed or have had to be rescued as a result of the financial crisis had clean audit reports. They believe those banks had not adequately assessed their risks and nor had their auditors and that SOMETHING MUST BE DONE!

Always beware when there is an outcry that "something must be done": it will usually be the wrong thing aimed at the wrong target. For example, the global financial crisis was not fundamentally a result of poor bank regulation but the result of global trade imbalances - which are the fault of governments (who do not seem to be in the firing line). If it had not been an investment bubble in US mortgages it would have been an investment bubble in dotcom businesses or in something else.

Two little questions I would pose to the Commission;


1  Where were the regulators in all this?
If the banking regulators failed to notice the levels of risk being taken on by banks what makes you think that auditors would do any better?

Oh, and by the way, the banks own executives and risk committees failed to assess the risks correctly.

2  Will the proposals achieve what they hope without unacceptable consequences?
The main proposals, applicable to all listed companies, are to;

1. rotate audits every 6 years
2. forbid auditors from offering consultancy services
3. mandate open tenders for audit work
4. commission supervision of auditors

Auditors argue that it takes some time to get up to speed with a new client and that rotation every six years will add to costs. I am a little dubious about this argument; are they saying that we can't trust an audit in the first year - I hope not? The problem with consultancy services is that they create conflicts of interest and contribute to development of an oligopoly of huge firms. On the other hand, if a firm develops tax expertise, for example, in order to audit a client's tax affairs, how can you reasonably forbid them from offering that expertise in advance? The same argument applies to other consultancy services and, if implemented, must create duplication of work and added cost. Further, you would expect the development of expertise for provision of consultancy services to improve the quality of expertise available for auditing as well; so if you prevent that you are reducing not improving auditors expertise and the probability they will get it right. As for open tenders, how do you deal with simple dislike of a client for the auditor: are they to be forced to take the lowest bid? In practical terms you have to get on with your auditor if the relationship is to work but how do you write that into legislation? And finally to commission supervision of auditors....hmmm....not so sure that's the sort of thing we want the EU to be getting into.

But finally - what about behaviours? The thing is that people change their behaviour when there is legislation. So, in Italy, it is common for an audit team to jump ship to a new audit firm when the audit transfers. How do you stop that in a free society and does the practice not make a nonsense of rotation? And if auditors only offer consultancy to non-audit clients how does that reduce the dominance of the the big four auditors? Or if the cost of consultancy is pushed up due to duplication of expertise how does this help anyone? How else might behaviours change in ways that would thwart the intention of the proposed legislation?

But let us not throw out the baby with the bathwater. As executives, directors and investors we must ask whether any of the proposals could be sensible improvements to governance. Some rotation of audits seems a sound idea and audit committees should keep an eye on whether they are putting so much business with one firm that their independence is compromised. How about requiring audit reports in the annual accounts that report on these issues and that give a genuine assessment of risk rather than legal boilerplate?