Insights from Reputability

A Question For Our Times

noreply@blogger.com (Reputability) — Fri, 03 Apr 2020 10:01:00 +0000

Andrew Grove

Thirty-five years ago, Andrew Grove found himself “wandering in the valley of death”, leading Intel’s huge but floundering memory chip business. Eventually he asked his chairman, Gordon Moore (of Moore’s Law) an empowering question. “If we got kicked out and the board brought in a new CEO, what would he do?”

Moore replied without hesitation: “He would get us out of [memory chips].[1]” They did just that, overcoming pain to transform Intel into the world’s leading micro-processor company.

Intel succeeded because Grove’s question tapped into deep knowledge. It helped to overcome groupthink, status quo bias, loss aversion and a host of other well-understood social and psychological behaviours that usually leave us unable even to discuss big problems especially when change is needed. And he was blessed with an environment in which his question could be asked and answered in safety.

Most businesses face an existential crisis framed by Covid-19 and the Climate Emergency. Moore's deep knowledge was of the IT world and that was enough to see the new opportunity within it. Had the opportunity been outside his experience, he would not have found a solution even though he was asked an excellent question.

To use words I dislike, he had deep knowledge of the IT 'paradigm' and was able to move Intel within it. But had the problem needed a paradigm shift, he might well have lacked the experience and perspectives to see it.

Some will solve the current crisis within the current paradigm. But many will need to shift outside their current paradigms, for example the travel, leisure and energy sectors. To achieve this, leaderships will need people who think and know things that current leaders do not know and may never have thought about - or even openly despised.

So to my question. What if leaders were to create the conditions to empower their boards and other internal fora to answer Grove's question safely, before listening - with care and respect - to no-holds-barred answers and discussing their implications?

Or can you devise a more penetrating question for our times?

Humility and Self-confidence in Leaders

noreply@blogger.com (Reputability) — Mon, 24 Feb 2020 14:37:00 +0000

One wet, windy winter’s day, I took refuge in the 11^th Century fortified Basilica of Valère, high above the city of Sion in Switzerland. It’s a national treasure. The visit revealed a gem in its Treasury. A long-forgotten cleric from the Middle-Ages had left a Latin graffito on the wall: translated it means: “Humility is the pinnacle of wisdom and the mother of virtue”.

Humility has been out of fashion for a while. It’s partly the cult of celebrity, with superficial appearances - assertiveness, drive, social graces and apparent success - eclipsing evaluation of skills, experience, character and the role of luck in track records. It doesn’t help that those who choose leaders often lack self-awareness of their psychological biases, and an understanding of the pivotal role of character in decision-making, let alone the analytical skills and the experience needed to make good leadership choices.

When I first praised humility in leaders, my audience’s initial reaction was gently mocking. ‘Leaders need self-confidence’, they said, implying that humility and self-confidence are incompatible.

The truth is that leaders do need self-confidence, but self-confidence comes in different flavours.

One that seems widespread among high profile leaders in business and especially in politics is the robust, even hubristic leader whose self-confidence is like a lobster’s carapace: tough armour that protects a vulnerable interior. These often egotistical, hubristic and insecure individuals see high pay as an endorsement of their fragile self-worth.

They can feel their very identity is at risk if their thinking is questioned, let alone if they are given news that things are not going according to plan. It isn’t that they lack intelligence but rather that to accept they may have made an error undermines their self-esteem. So they attack. They sack dissenters and surround themselves with sycophantic acolytes. This drives unwelcome news and insights underground so they don’t learn about problems until it is too late. They and their organisations, whether commercial or political, become brittle, vulnerable to failure for reasons that subordinates and outsiders can often see coming years ahead.

But there is a deeper kind of self-confidence. There are equally bright and ambitious leaders who know and accept that they will sometimes get things wrong. They understand and credit the role of luck in their successes. Echoing the Tao Te Ching's telling of Lao Tzu's wisdom from 600BC, they “consider those who point out [their] faults as [their] most benevolent teachers.” More recently Jim Collins observed that these often self-effacing yet successful individuals deflect adulation and channel any egotistical needs away from themselves and into making their organisations great.

Their self-confidence is not a mask to camouflage insecurity but a strong edifice built on acceptance of their strengths, their limits and their weaknesses. While few welcome being wrong, these leaders are receptive of contradiction and keen to use the insights of others to remedy weaknesses and correct errors before harm is caused. They thank their ‘teachers’ before analysing whether things are on a good track. They surround themselves with people who have different perspectives and encourage all around them to say what they really think. The result is colleagues and subordinates who promptly pass on unwelcome news and are both competent and willing to challenge what may be errors.

Their organisations are intrinsically resilient because, through their openness to different perspectives, challenge and bad news, they gain early warning of things that may be going wrong in time to avoid or mitigate bad consequences.

The reason that graffito grabbed my attention was a recent Financial Times job advertisement by Russel Reynolds. It described the successful candidate as one who exemplifies, amongst other traits, humility and integrity. One swallow does not make a summer, but this is a powerful pair of character traits in a leader. Boards - and investment managers’ governance teams - would do well to develop that line of thinking.

Anthony Fitzsimmons

Author of "Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You"
Reputability

London

www.reputability.co.uk

'Why We Get the Wrong Politicians' - Book Review

noreply@blogger.com (Reputability) — Tue, 18 Jun 2019 19:32:00 +0000

When the UK Parliament's select committees dig to discover why a large organisation has failed, they regularly find systemic weaknesses that have been there for years, widely recognised but not by leaders, a time-bomb ticking ’til luck runs out. These canny committees expose leaders who, unchallenged, managed those systems whilst lacking the skill, knowledge and experience required, often pin-pointing character weaknesses, culture and incentives as deeper causes of failure.

When the bomb explodes, most leaders are stunned to discover what outsiders had long been expecting. They don’t miss the warning signs because they are bad but because we humans are wired that way. Cognitive biases lead us to believe that we are better than we really are and cognitive dissonance leaves us unreceptive to news that contradicts our world view.

The UK's politicians seem stuck in that cognitive limbo. We are experiencing the worst failure of government and opposition in living memory. This is not like the departmental disasters described by the Public Accounts Committee. It is far worse. It is the failure of our political system.

In Why We Get the Wrong Politicians, political journalist Isabel Hardman corrals evidence of what is going wrong in a book that should be compulsory reading for every aspiring and elected politician and civil servant. It is eerie to find so many parallels with my own research into corporate failures. But this is no surprise because all organisational systems are ultimately run by humans.

Analysing MPs’ backgrounds, Hardman finds that few have the knowledge or expertise they need to be effective: “The place is weirdly full of career politicians”. Far fewer have been educated in law, a bizarre weakness in a legislature. Fewer still are well educated in the science and technology that drives the modern world. MPs receive no training on how to navigate the byzantine parliamentary system and its processes. The huge cost of becoming an MP must also reduce diversity of background and perspective.

Hardman describes parliament as “unprofessional”; one MP she interviewed called it “dysfunctional”. She quotes a 2004 pamphlet by Andrew Tyrie: “The executive has succeeded in frustrating parliament… Executive obstructionism and parliamentary weakness threaten to erode trust in politics and politicians, leaving our system of government the biggest casualty.”These traits ensure a blinkered world view and functional incompetence even before the mind-warping Westminster bubble.

Everyone knows that MPs bawl at each other across the floor of the Commons but I was surprised to learn how actively this hubbub is orchestrated. MPs who do not demonstrate unquestioning support for their party find paths towards prestige and power blocked. As to “troublemakers”, the whips reportedly “seek dirt on backbenchers in order to compile as weighty a dossier as possible” against them.

Keeping MPs ignorant, powerless and afraid suits ministers because it shields them from effective challenge. But it is disastrous for democracy and the country.

Just as banks became attractive to people who were driven by the love of money, a culture like this is likely to attract and advance arrogant, amoral egotists with a primal thirst for power more than those with an ethos of diligent public service.

Competence determines what we can do, but character determines what we will do. With MPs selected and rewarded for character traits and behaviour that make them slippery, sycophantic and self-centred, it is no surprise that the public trusts politicians’ truthfulness less than anyone else bar advertising executives. Tyrie’s prediction is now the electorate’s perception.

There is no select committee to force politicians to see their competence, culture, behaviour and mores as others do. The question is: do politicians have the self-awareness to reform themselves before reform is thrust upon them?

Anthony Fitzsimmons is Chairman of Reputability LLP and author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You”

This piece was first published in Civil Service World

Ben Graham's Insights into Audit

noreply@blogger.com (Reputability) — Thu, 28 Mar 2019 16:15:00 +0000

The first edition of Benjamin Graham’s ‘The Intelligent Investor’ devoted 30 pages to “The Investor as Business Owner”. Two insights remain relevant today.

Graham contrasted the theory of shareholder rights with reality. Shareholders are notionally “king”, he wrote, with the power to “hire and fire managements and bend them completely to their will”. In practice Graham saw them as “a complete washout”. “As a class they show neither intelligence nor alertness. They vote in sheep-like fashion for whatever management recommends and no matter how poor the management’s record of accomplishment may be. ”

The ability of ultimate shareholders to influence management has diminished. Most individually owned shares are held through nominee accounts that, in practice, disenfranchise shareholders. Managers of collective investments provide patchy stewardship.

Private shareholders could easily be re-enfranchised by legislation and technology. A resurgence of individual shareholders at AGMs would help boards to focus on public perceptions and the penetrating questions that astute shareholders ask.

As to collective investments, the UK Stewardship Code is inadequate because it is voluntary and has limited scope. The Financial Conduct Authority should develop robust rules that force institutional investors’ incentives and behaviour into alignment with the interests of their ultimate clients, such as retail investors and future pensioners most of whom seek steady long-term growth. To support this, legislation, not just the UK Corporate Governance Code, should make it the unambiguous primary duty of directors to promote long term sustainable success. With this as a national policy, there is logic in aligning voting power with duration of shareholding, giving full voting power only to long term investors.

But that leaves a fundamental question: how can good stewards get the information they need to do their job properly?

The answer ought to be informative company reports. The FRC has made good progress on company reporting requirements but the scope and quality of information provided in Annual Reports depends on management openness. These often seem to be in proportion to management competence.

Extending the scope of audit to the whole annual report will help ensure the accuracy of information provided. But it will not solve the problem of inadequate or absent information.

For those who can see through corporate spin and market groupthink, it is not difficult to identify companies from which more information is needed. Graham suggested investigating those whose return or profit margin has persistently lagged their peers and those who have lost market share. He also highlighted the importance of management competence. This is a crucial tell-tale of future failure, along with leadership characteristics such as CEO arrogance, hubris and dominance and boards that are inadequate to appoint and manage a CEO.

Graham’s second insight is relevant here. He proposed that shareholders of “underperforming” companies should be able to “call in outside business engineers to pass upon the policies and competence of the management”. These outside experts would be “selected by an independent committee of stockholders” with the report “submitted directly to stockholders” and the cost borne by the company.

Auditors could fill much of this role. The Big Four’s move away from calling the firms they audit 'clients' is a start but cosmetic because their appointment and tenure depend on the auditee’s board. They have powerful incentives not to rock the board’s boat. The parallel move, away from providing other services to audit clients, is helpful but too modest. We should follow the direction recommended by Graham.

The auditor’s relationship with larger and quoted companies should become arm’s length. Legislation should create independent Shareholders’ Committees to appoint the auditor, to direct the audit and the investigation of any murky corners (including leadership competence), and to receive reports on behalf of shareholders. Boards will still prepare the accounts and annual report but they will be audited by an entity that owes allegiance only to shareholders.

This will remove the perverse incentives under which the audit profession has laboured for too long, allowing auditors to use their professional skills and judgement to the full. It should also help stem the steady stream of predictable, avoidable corporate failures.

Anthony Fitzsimmons is Chairman of Reputability LLP and author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You”

Why great leaders seek uncomfortable truths

noreply@blogger.com (Reputability) — Thu, 04 Oct 2018 16:02:00 +0000

TSB’s leaders did not expect their IT upgrade to become a reputational disaster. No-one was more surprised than the trustees of the Presidents Club when it imploded. Philip Green was preparing an upbeat message to markets only five days before announcing Carillion’s £845m profit warning. Bell Pottinger’s leaders seemed blind to their firm's impending disintegration.

The pattern repeats endlessly. In ‘Deconstructing failure’, we found that in over 80% of the crises we analysed, the board seemed to be taken by surprise. What is going on?

Anthropologists have observed that social groups develop shared mental maps. These aren’t just a common world view. They define who is a group ‘insider’ and who is not. They influence how the outside world is perceived, what is discussed and what is not - leaving what group ‘outsiders’ see as crucial subjects undiscussed. As Gillian Tett, a Financial Times commentator and trained social anthropologist, put it, these topics “become labelled as dull, taboo, obvious or impolite”. The result is that a social group - such as a board or leadership team - can’t or won’t see, let alone discuss, things that well-informed outsiders - such as their subordinates - know are important.

If we feel we know little, we can learn easily. But when we are presented with information that contradicts our world view, we face what psychologists call ‘cognitive dissonance’. This is stressful. I have pinned to my wall words from the Tao Te Ching: “A [leader] considers those who point out his faults/ as his most benevolent teachers.” Yet I still feel discomfort when someone is considerate enough to tell me I may be wrong.

Most people become defensive when faced with cognitive dissonance. They turn over the page. They hear but do not listen. They bully the bearer of bad news. So doing, leaders lose the opportunity to discover that something is not as they hoped or believed. In failing to assimilate dissonant information, we deprive ourselves of the opportunity to fix incubating, often systemic, weaknesses before they cause crises.

Shutting our eyes, blocking our ears and shouting are not our only responses to uncomfortable truths. We tend to seek information to confirm our world view, rather than to challenge it, because of our confirmation bias. Faced with information that a particular weakness probably affects ‘us’, overconfidence and our egocentric bias lead us to believe we are immune. Optimistic bias leaves us believing that bad things are less likely to afflict us. The Ikea Effect makes us disproportionately proud of what we have produced.

Biases like these and more make it harder to accept the idea that even ubiquitous weaknesses, such as leaders’ blindness to important information - which obviously apply to ‘them’ - also apply to ‘us’. As Daniel Kahneman put it, “We’re blind to our blindness. We have very little idea of how little we know. We're not designed to know how little we know.”

Behaviours and biases such as these leave us predictably vulnerable. The phenomenon is so widespread that we named it the “unknown knowns” problem: There are things leaders need to know, that are widely known to others in the organisation, that they cannot discover until it is too late. Many can be seen by analytical outsiders, including investors, who are able to see through corporate PR, market groupthink and their own psychological biases.

Zen philosophy has an answer to the problem: the cultivation of ‘Beginner’s Mind’. Shunryu Suzuki summarised it as “Wisdom which is seeking for wisdom”. The challenge for a leader is to be as open-minded and inquisitive as a novice with no vested interest in the way things are. Few achieve this state of mind.

Most of us need outsiders to our group with access to corporate knowledge to uncover these uncomfortable truths. Once found, bringing truth to power needs courage and social skills: courage because powerful leaders forced to confront dissonant information can be aggressive; social skills because unwelcome news needs to be presented in a way that helps leaders to change their world view, overcoming dissonance and their cognitive biases.

Research shows that leaders should expect to face a major crisis during a period as short as five years. By overcoming social and behavioural tendencies that affect everyone, including themselves, leaders can search for and fix unknown knowns before they cause trouble. Prevention comfortably beats having to deal with a reputational crisis and face public vilification.

Anthony Fitzsimmons is Chairman of Reputability LLP and, with the late Derek Atkins, author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin YourBusiness, Your Reputation and You”

This article was first published in Management Today in September 2018.

New FRC Code and Guidance: The Headlines

noreply@blogger.com (Reputability) — Wed, 18 Jul 2018 12:17:00 +0000

The Financial Reporting Council has delivered radical revisions of the UK Corporate Governance Code and of the Guidance on Board Effectiveness. The purpose of this note is to bring you the most important headlines.

NED Teams

One of the lessons of the Banking Crisis was that companies that failed frequently had non-executive teams that lacked sufficient know-how, curiosity or character to ask penetrating questions of the executives who were leading them towards a cliff. As Andrew Bailey, now Chief Executive of the Financial Conduct Authority once put it, “Healthy scepticism channelled into intelligent and forceful questioning of the self-confident can be a good thing.”

The FRC has given a strong, systematic emphasis to NED teams having the skills knowledge and experience to understand everything of importance that is going on in their company. It has focused on the importance of so-called 'soft' skills. Crucially it has put ‘Courage’ at the top of a list of desirable personal attributes of NEDs and steered boards towards actively seeking good candidates who are outside the (social) circles of classical head-hunters.

Short-termism

There has been growing political criticism of short-termism and covert asset stripping by those who lead and invest in UK companies. This has been supported by criticism from economists and long term investors. This behaviour is in part a result of Milton Friedman’s ‘Shareholder Value’ philosophy, which has put anything other than shareholder perspectives into ‘second class’ category.

Encouraged by a strong political steer, and despite seemingly coordinated resistance from large corporates, the FRC has now brought “long term sustainable success” to the core of the Code. This philosophy has been reinforced throughout the Code and the Guidance, in which “long term” appears no less than 40 times.

Workforces

Friedman-ism has been dealt a second blow by forcing boards to listen to the workforce. Political pressure arising from the increasing disparity between C-suite and worker pay is one driver. The second is the recognition that workers often won’t give leaders unwelcome news because they fear the consequences – what we call the ‘Unknown known’ problem.

As regards the unknown known’ problem, the FRC has given renewed emphasis on going beyond ‘whistleblowing’ programmes towards systematising a culture which makes it both routine and safe for the workforce to ‘speak up’ if they feel anything is amiss.

The pay disparity issue has been tackled by a variety of measures. One is to force boards to institutionalise an ‘employee voice’ whether via an employee director, a director designated to listen to and bring workforce views to the board; or a formal workforce advisory panel. Boards are expected to explain to the workforce the relationship between executive pay and wider company pay policies and corporate culture.

Bonuses and other incentives

Finally, the FRC made a promising and well-thought-through attempt to de-risk bonuses and other incentives. Among other measures, the FRC is encouraging simplicity and clarity in their structure and the thinking through of potential unintended consequences.

But they have also taken a stand against the risk of a CEO burnishing present profits (and thus bonuses) by increasing risks ‘after I have gone’. It is often easy, and given the wrong bonus architecture can be tempting, to boost profits (and bonuses) today by cutting back on, for example, maintenance or innovation. Cut maintenance regularly causes costly disasters. And many suspect that investment foregone is an important cause of lacklustre performance at UK companies.

The FRC has tackled this through the best method of which we are aware: by encouraging boards to require executive bonus share awards to be held for “two or three years after leaving the company”. That way retiring CEOs have a huge incentive to leave their company in excellent shape. For if one thing is certain, it is that their successor will have a thorough look for skeletons left by their predecessor before setting the starting point for their own bonus scheme.

You will find the rationale behind most of the FRC's main changes fully explained in "Rethinking Reputational Risk - How to Manage the Risks that can Ruin Your Business, Your Reputation and You" by Anthony Fitzsimmons and the late Derek Atkins.

We have written a more detailed note on this, which you will find here.

Anthony Fitzsimmons

Reputability LLP

London

www.reputability.co.uk

Radical Revisions to FRC Corporate Governance Code and Guidance on Board Effectiveness

noreply@blogger.com (Reputability) — Tue, 17 Jul 2018 21:48:00 +0000

The Financial Reporting Council has delivered radical revisions of the UK Corporate Governance Code and of the Guidance on Board Effectiveness (the Code and the Guidance respectively).

The Code and Guidance have been substantially recast, with a focus on making 'tick-box' approaches and boilerplate reporting much more difficult. To this end the Guidance is laced with over eighty penetrating open-ended questions for boards to consider. The new rules come into force as regards accounting periods beginning on or after 1 January 2019.

Our note concentrates on four important themes involving change:

Long term sustainable success
Board skills knowledge and experience
Interacting with the workforce and
Remuneration issues

Long Term Sustainable Success

For years there has been trenchant criticism of short-termism and opportunism among UK company leaders and their shareholders at the expense of sustainable growth. Recent examples include utilities accused of asset stripping that will leave their companies vulnerable when interest rates rise. But examples go back many years.

The Code now begins:

"A successful company is led by an effective and entrepreneurial board, whose role is to promote the long-term sustainable success of the company, generating value for shareholders and contributing to wider society." (Code Principle A)

"The board should ensure that workforce policies and practices are consistent with the company’s values and support its long-term sustainable success." (Code Principle E)

Boards have to report on this. The Provisions that elaborate Code Principles A to E provide:

The board should assess the basis on which the company generates and preserves value over the long-term. It should describe in the annual report how opportunities and risks to the future success of the business have been considered and addressed, the sustainability of the company’s business model and how its governance contributes to the delivery of its strategy." (Code Provision 1)

This approach is underpinned by the Guidance, which begins by describing an effective board.

"An effective board defines the company’s purpose and then sets a strategy to deliver it, underpinned by the values and behaviours that shape its culture and the way it conducts its business. It will be able to explain the main trends and factors affecting the long-term success and future viability of the company – for example technological change or environmental impacts – and how these and the company’s principal risks and uncertainties have been addressed." (Guidance 1)

Whilst this respects the formal wording of s172 of the Companies Act 2006 with all its ambiguities, boards subject to the FRC will either have to comply with the Code on this or explain that, and why, they will not.

What remains is the potential for major shareholders to drive undesirable short-termism in the board. The FRC intends to consult on revisions on the Stewardship Code. In our view this problem cannot be resolved without drawing in the FCA to regulate issues between investment professionals and their ultimate clients, particularly as regards the disparity between the often short bonus-driven time horizons of investment professionals and the far longer horizons of retail investors saving for the long term to retirement. Some have suggested more draconian measures such as the Loi Florange.

Board Skills Knowledge and Experience

The history of corporate disasters, including the 2007/8 Banking Crisis, is littered with boards that lacked key skills, knowledge or experience, a pattern that persists. In an attempt to stem this steady flow, the FRC has tackled board composition. They have three aims: to encourage NED teams that have an adequate combined skill-set; to encourage diversity of perspective; and to increase strength of NED character. The Code now provides:

"...Both appointments and succession plans should be based on merit and objective criteria and, within this context, should promote diversity of gender, social and ethnic backgrounds, cognitive and personal strengths." (Code Principle J)

"The board and its committees should have a combination of skills, experience and knowledge. ... " (Code Principle K)

These dry anodyne principles are reinforced in the Guidance, which includes a new emphasis on character - with courage heading the list.

The boardroom is not supposed to be a comfortable place:

"The boardroom should be a place for robust debate where challenge, support, diversity of thought and teamwork are essential features. Diversity of skills, background and personal strengths is an important driver of a board’s effectiveness, creating different perspectives among directors, and breaking down a tendency towards ‘group think’." (Guidance 16).

Directors should be chosen to add value and effectiveness:

"Appointing directors who are able to make a positive contribution is one of the key elements of board effectiveness. Directors will be more likely to make good decisions and maximise the opportunities for the company’s success if the right skillsets and a breadth of perspectives are present in the boardroom. Non-executive directors should possess a range of critical skills of value to the board and relevant to the challenges and opportunities facing the company." (Guidance 87)

Diversity, soft skills and character matter:

"Diversity of personal attributes is equally important. The nomination committee will want to ensure the board is comprised of individuals who display a range of softer skills, such as [sources of intellect, critical assessment and judgement, courage, openness, honesty, tact, ability to listen, ability to forge relationships, ability to develop trust and strength of character]" (Guidance, 91 combined with Figure 7)

The Nomination Committee should be systematic in working out what the board needs, then set out to find them. Competent boards will also create a person description setting out the personal attributes they seek.

"... The nomination committee should evaluate the skills, experience and knowledge on the board, and the future challenges affecting the business, and, in the light of this evaluation, prepare a description of the role and capabilities required for a particular appointment. .... It is important to build a proper assessment of values and expected behaviours into the recruitment process." (Guidance, 92)

"Skills matrices that map the existing skill-set against that required to execute strategy and meet future challenges can be an effective way of identifying skills gaps. They are a useful tool for role evaluation and succession planning." (Guidance 93)

Boards should make efforts to attract recruits beyond the 'usual suspects':

"Publicly advertising board appointments and working with recruitment consultants who have made a commitment to promote diversity are examples of ways in which the nomination committee can access a more diverse pool of candidates from which to appoint. Attention also needs to be paid to how the interview process is conducted so that candidates with diverse backgrounds are not disadvantaged." (Guidance 94)

The Nomination Committee is asked four questions

"Have we assessed what skillset is required for the board and its committees?

Do we reassess the make-up of the board as a result of emerging trends?

Do we take account of the technical skills and knowledge required by the committees when recruiting members?

How often is a skills audit undertaken and are we keeping up with the pace of change?" (Guidance before 92)

Interacting with the Workforce

The back story to these reforms includes public and political debate around how boards take account of relationships with stakeholders other than shareholders, and the workforce in particular. Separately we have long raised the 'unknown known' problem - the all too common situation where the workforce knows important things that, for a variety of reasons, they will not, or dare not, tell their leaders. The FRC has tackled both issues.

The Code provides:

"The board should ensure that workforce policies and practices are consistent with the company’s values and support its long-term sustainable success. The workforce should be able to raise any matters of concern." (Code Principle E)

"... The annual report should explain ... the company’s approach to investing in and rewarding its workforce." (Code Provision 2)

The board's engagement with the workforce is expected to include one or more of a director appointed from the workforce; a formal workforce advisory panel and/or a designated non-executive director (Code Provision 5).

"There should be a means for the workforce to raise concerns in confidence and – if they wish – anonymously. The board should routinely review this and the reports arising from its operation. It should ensure that arrangements are in place for the proportionate and independent investigation of such matters and for follow-up action." (Code Provision 6)

Boards are encouraged to draw the workforce into a collaboration when setting values because "Ownership of the values will be stronger if a collaborative approach is taken and both the leadership and the workforce are involved in a two-way process to define the company’s values (Guidance 18). Similarly the Guidance advocates using "multiple qualitative and quantitative sources" to avoid gaining an incomplete picture of culture. "The workforce will be a vital source of insight into the culture of the company" (Guidance 23).

The FRC echoes our longstanding concern that boards are commonly in the dark about important things that the workforce knows but will not tell them - what we call the 'Unknown known' problem. The FRC exhorts boards to make both whistle-blowing and more routine 'speaking up' safe for those with information to impart.

"Having policies in place that encourage individuals to raise concerns is a core part of an ethical and supportive business culture. Whistleblowing policies that offer effective protection from retaliation ... are essential components of this. ..." (Guidance 57)

"Companies need to create an environment in which the workforce feels it is safe to raise concerns. Common fears include being negatively labelled, sidelined for promotion or bonuses, and even loss of employment. Leaders need to ensure there are no negative repercussions as a result of doing so." (Guidance 58)

"It is equally important to encourage individuals to speak up. Speak-up arrangements help build trust, act as an early warning system and help to manage risk. It is critical for success that leaders actively listen and feedback how the matter raised has been considered, including any action taken. Companies may want to consider the benefits of extending such arrangements beyond the workforce to external parties, like customers and suppliers. (Guidance 59)

One of the questions for boards to consider in this area is:

"What evidence do we have that the chief executive is willing to listen, take criticism and let others make decisions?" (Guidance below 26)

Remuneration issues

A crucial issue for behavioural risk specialists such as ourselves is the risk that executive reward systems to create incentives that encourage behaviour that is against organisation's best interests and that encourage treating the organisation's interests as pawns in a bigger game: the gaming of incentive schemes. A long-running sore with the public and with politicians is the divergence between C-suite pay and workforce pay. The FRC has tackled both.

As usual the FRC's approach begins with the Code.

"Remuneration policies and practices should be designed to support strategy and promote long-term sustainable success. Executive remuneration should be aligned to company purpose and values, and be clearly linked to the successful delivery of the company’s long-term strategy." (Code Principle P)

Remuneration Committee chairs are required to have had at least 12 months' service on a Remuneration Committee. (Code Provision 32). The Committee should "review workforce remuneration and related policies and the alignment of incentives and rewards with culture, taking these into account when setting the policy for executive director remuneration." (Code Provision 22)

FRC Guidance on executive pay is now robust, encouraging rules that require the holding of shares awarded for long periods. Foreshadowing the holding of shares well into retirement:

"Remuneration schemes should promote long-term shareholdings by executive directors that support alignment with long-term shareholder interests. Share awards granted for this purpose should be released for sale on a phased basis and be subject to a total vesting and holding period of five years or more. The remuneration committee should develop a formal policy for post-employment shareholding requirements encompassing both unvested and vested shares." (Code Provision 36)

The Code steers Remco towards clarity, simplicity, risk awareness and alignment with culture:

"When determining executive director remuneration policy and practices, the remuneration committee should address the following:

clarity – remuneration arrangements should be transparent and promote effective engagement with shareholders and the workforce;

simplicity – remuneration structures should avoid complexity and their rationale and operation should be easy to understand;

risk – remuneration arrangements should ensure reputational and other risks from excessive rewards, and behavioural risks that can arise from target-based incentive plans, are identified and mitigated;

alignment to culture – incentive schemes should drive behaviours consistent with company purpose, values and strategy. ..." (Code Provisions 40)

Remco is expected to supervise all aspects of reward, including the relationshiop between workforce pay and executive pay.

"The remuneration committee is also tasked with reviewing workforce remuneration and related policies. The purpose of this review is to:

ensure the reward, incentives and conditions available to the company’s workforce are taken into account when deciding the pay of executive directors and senior management;

enable the remuneration committee to explain to the workforce each year how decisions on executive pay reflect wider company pay policy; and

enable the remuneration committee to feedback to the board on workforce reward, incentives and conditions, and support the latter’s monitoring of whether company policies and practices support culture and strategy." (Guidance 130)

In setting executive pay, Remcos are expected to "focus on the strategic rationale for executive pay and the links between remuneration, strategy and long-term sustainable success", avoiding "pay structures based solely on benchmarking to the market, or the advice of remuneration consultants, as there is a risk this could encourage an upward ratcheting effect on executive pay." (Guidance 133 and 134)

Once again, the theme of long term success reappears, with what is probably the most effective way of ending the gaming of incentives: forcing executives to hold shares until well after they leave. New leaders tend to search for time bombs bequeathed by their predecessors.

"It is important that the remuneration committee takes steps to counteract the risk of incentives that are detrimental to the long-term success of the company. Packages that are structured to ensure exposure to the long-term share value, including for two to three years after leaving the company, can support alignment with shareholders and encourage executive directors to focus on the impact of their decisions over the long-term." (Guidance 135)

The FRC has asked Remcos to consider a suite of questions that probe:

alignment of executive pay with wider company pay policy

the extent to which workforce incentives support culture and encourage desirable behaviour?

How Remco has explained to the workforce the relationship between executive pay and wider company pay policies

whether their pay policy strengthens long-term thinking

how they have addressed Provision 40 of the Code

how performance measures support long-term thinking

whether the choice of any measure may encourage negative behaviour and if so, what steps have been taken to manage the risks (Guidance after 132, 136 and 37)

If you wish to understand the rationale behind most of these changes, you will find it explained in "Rethinking Reputational Risk - How to Manage the Risks that can Ruin Your Business, Your Reputation and You" by Anthony Fitzsimmons and the late Derek Atkins.

Should you wish for an external board evaluation focused on helping your board to avoid the pitfalls that bring down companies and their boards time after time, please get in touch.

Anthony Fitzsimmons
Reputablity LLP
London

www.reputability.co.uk
www.reputabilityblog.com

Helping NEDs see through CEO charm

noreply@blogger.com (Reputability) — Thu, 07 Jun 2018 08:02:00 +0000

Leaders found to be dominant or hubristic regularly unleash unpleasant surprises after years of charming behaviour that camouflaged the vulnerabilities. Can investment managers reduce such risks?

Once upon a time, a bright young accountant called Fred Goodwin impressed John Connolly, then UK managing partner of Touche Ross. He became their youngest partner before moving on to be chief executive of Clydesdale Bank. Ian Fraser’s book Shredded relates how Goodwin shocked staff by his delight in “shredding” people in front of colleagues.

George Mathewson, then chief executive of Royal Bank of Scotland, was charmed by Goodwin, who arrived at RBS as chief financial officer and Mathewson’s heir apparent. He became confrontational, though charming when it suited him, leaving staff unwilling to speak up.

Weeks before becoming chief executive, Goodwin had a “contretemps” with Amyas Morse, PwC’s audit partner, who would not approve Goodwin’s accounting treatment of the NatWest acquisition.

Goodwin reportedly “unilaterally fired” PwC and “appointed” his old firm, by now called Deloitte and led by Connolly, only later seeking audit committee backing. If Fraser’s narrative is right, the alarm bells should have been deafening.

An effective board needs a non-executive director team with the skills, knowledge and experience to understand every aspect of the business, including its people, and especially the chief executive. NEDs need courage and social skills if they are to challenge executives. Most failures have their roots in board weakness.

The Ivey Business School “Leadership on Trial” research group, forged in the aftermath of the banking crisis, provides insights for boards into the role of character in leadership.

Two stand out. The notion that competencies determine what leaders can do, whereas character determines what they will do, is obvious. Less so is the conclusion on seemingly paradoxical traits. A leader with balanced characteristics — confidence with humility, drive with patience, candour with compassion — will be a better leader than one with unalloyed self-confidence, aggression or bluntness: and they will be less risky, too.

One of NEDs’ most important responsibilities is to select chief executives and the non-executive teams that should support and challenge them. Research from the London School of Economics, “Head-hunter methods for CEO selection” by Max Steuer and colleagues, suggests that outsourcing the recruitment of a chief executive to headhunters is a sign of widespread, fundamental board weakness.

Reputability’s research note, “Designing better boards”, confirms the weakness. It found FTSE 100 NED teams overwhelmed by board and financial experience and starved of NEDs with a deep understanding of people. A tiny proportion professed proficiency in fields such as social sciences, anthropology, psychology or HR, skills needed to evaluate character, behaviour and competence.

This makes it no surprise that so many boards seek seeming safety by outsourcing board appointments and pay to headhunters and consultants. The truth is that delegating any task without know-how is risky. The LSE report vividly illustrates the danger. In contrast, it seems no coincidence that at Weir — which recently devised a compensation structure beyond long-term incentive plans — Clare Chapman, an HR professional, chairs the remuneration committee.

Beyond recruitment and pay, it takes skill, know-how, self-awareness and effort to overcome deep-rooted biases and behaviours. Charm blinds us. We believe our own PR. Self-serving bias, the halo effect and overconfidence lead us to see ourselves, and those we have appointed, as better than we are. Social silences lead us to ignore subjects considered impolite, dull or taboo. NEDs who get past such issues need courage as well as social skills to overcome the social norms that shepherd us towards conformity.

The basic weakness is the lack of NEDs’ skills, knowledge and experience in recruiting people at and around board level. Responding to the Financial Reporting Council’s recent consultation on board effectiveness, we recommended putting a top-class people specialist in charge of the nomination and remuneration committees. In time, this will reduce the risk of unpleasant surprises. Investment managers, too, can encourage boards to follow suit.

Anthony Fitzsimmons
Reputability LLP
London
www.reputability.co.uk

Anthony Fitzsimmons is Chairman of Reputability LLP and, with the late Derek Atkins, author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You”

This piece, published here by the Financial Times, has its origins in an article written for Financial World, the London Institute of Banking & Finance magazine.

Myths of Management

noreply@blogger.com (Reputability) — Wed, 04 Apr 2018 14:21:00 +0000

Twitter and Facebook are much discussed ‘echo chambers’ that reinforce existing ideas, closing our minds to new ones and polarising opinion. This is not their purpose: they make money by keeping us glued to their sites so we see as many advertisements as possible.

Daniel Kahneman and Amos Tversky concluded you can think of our brains as having two systems. System 1 is a machine designed to jump to conclusions: that shadow might be a tiger: Hide! Slow, laborious System 2 is in charge of doubting and unbelieving. It has limited thinking power and is energy intensive, so it becomes less effective if it is preoccupied, tired or lazy.

System 2 has another fundamental weakness. Its default method is to search for memories that confirm what it is trying to test. This is our ‘confirmation bias’. As every scientist knows, a far better way to test a theory is to try to break it: but that takes far more energy, knowledge, thought and time.

Twitter and Facebook keep us on their pages by analysing our data and feeding us information that we will like – material that fits our world view. Many newspapers retain readers in a similar way. This likeable material also feeds confirmation bias and lacks perspectives that challenge our world view as they see it. The collateral damage is that they reinforce and entrench our existing attitudes whether these are a harmless obsession with cream coloured cats or pernicious political perspectives. Unless we make considerable efforts to find contradictory information, we are easily, unwittingly, confined to our comfortable bubble.

Mental bubbles are neither new nor confined to the media. Many myths, though widely believed, lack good foundations. Webs of self-reinforcing sticky stories help them persist long after they have been debunked. Management myths are no different. Superficially plausible, many appeal to System 1’s tendency to jump to conclusions. System 2 struggles to disbelieve them. What we need is memorable myth-busting material to feed System 2 even on its dozy days.

One widespread myth is that our rational minds will overcome our emotions, leaving us to make logical decisions. The Brexit vote and the election of Donald Trump will have convinced many that people are not always strictly rational, but most of us still believe that we (as opposed to “they”) make our decisions rationally.

This is where “The Myths of Management” by Stefan Stern and Cary Cooper can play a valuable role. Myth 22 is “The business case will always prove persuasive”. They explain that we are not rational creatures but rationalisers: we feel before we think. This seems to be one reason why the Trump and Brexit campaigns prevailed over their rivals. And it explains why politicians are addicted to policy-based evidence rather than evidence based policy.

Another popular myth is that problems that hit headlines are caused by bad people - rotten apples in a fine barrel. Stern and Cary debunk this idea in Myth 33: “There’s nothing wrong with the business, there’s just a few rotten apples”. It is rarely bad people that are the real problem: a bad system will bring out the worst in most people. There may have been bad apples at HBOS but a rotten system was an important cause of the crisis there.

This book debunks 43 myths of management, including gems such as “It is important not to show vulnerability or doubt” (Myth 4), “You need to be the smartest person in the room” (Myth 6) and “psychology is psychobabble and there’s no need or place for it” (Myth 22), adding nine interviews with well-known management sages such as Margaret Heffernan and Tom Peters. They conclude by debunking Myth 44: “There are only 44 things to get wrong.”

We all live in bubbles, and that includes leaders and managers. It is easy for us to be attracted to alluring management slogans like “Keep your distance if you want respect” (Myth 27) but these need closer examination. This readable book does us all a service by capturing and demolishing persistent, myths that mislead. By giving their critiques snappy titles and flowing prose, Stern and Cooper provide a memorable source of stories we can turn to when System 1 likes a management idea but System 2 hasn’t got the time or energy to test it. When you have read it, keep this book handy. It will help you to test ideas that emerge from the management fad echo chamber.

Anthony Fitzsimmons
Reputability LLP
London

Anthony Fitzsimmons is Chairman of Reputability LLP and, with the late Derek Atkins, author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin YourBusiness, Your Reputation and You”

Blindsided Boards

noreply@blogger.com (Reputability) — Wed, 07 Mar 2018 08:56:00 +0000

Board “blindsided” said the FT headline . Volkswagen’s board is one of an endless stream that did not realise they were sitting on a time bomb with a dodgy fuse. Others unwittingly presided over the incubation of the LIBOR and PPI scandals, bribery cases, most profit overstatements and countless other crises. BP’s Deepwater Horizon, G4S’s Olympics problem, Volkswagen's emissions scandal and the implosions of financial institutions such as Lehman, RBS, HBOS, AIG, Equitable Life and Independent Insurance are tiny sample from my bulging library. These scandals exposed unrecognised reputational risks and the behavioural and organisational risks that underlay them.

Five days before Carillion’s £845 million write down, its chairman Philip Green was working towards an “upbeat announcement” to the City. Yet the new new Finance Director had already sounded the alarm.

Two weeks before Tesco’s £250m profit warning, Terry Smith lucidly explained why he refused to invest in Tesco: it had, he wrote, been massaging its results for more than a decade to create growth in earnings per share, whilst return on capital had almost halved. Even the firm’s auditors had insisted on public warning as to the difficulties in accounting for Tesco’s commercial arrangements.

Independent Insurance was a stock market darling that reported stunning results. Its charismatic chief executive, Michael Bright, was the FT’s “Entrepreneur of the Year” for 1998. Yet the company collapsed two years later and Bright, and two colleagues were jailed for fraud: they had been hiding over £100m of liability claim reserves.

Boards at Airbus, BAe, Rolls Royce, Glaxo and many more found their companies embroiled in bribery allegations, confirming long-running rumours of corruption in their sectors.

The role of NEDs is to challenge and support executives but why don’t they see trouble coming? Having studied scores of scandals, it is clear that insufficient intelligence is rarely the problem. But patterns of board weakness recur time and again.

There are NEDSs who lack understanding of the business. None of the NEDs at Tesco had retail experience so it would not be surprising if they didn’t have enough insight into the Byzantine structure of ‘commercial arrangements’ between supermarkets and large suppliers.

It was the same at Independent Insurance. The main fraud was a scam I was taught about on day one of my reinsurance education. There is always an element of estimation in the kind of liability claims the Independent underwrote, which makes it tempting to cook the books and gull the ignorant. Months before the collapse, a friend and I, armed with no more than their published regulatory returns, found the hole the board had missed. Unfortunately it seems the NED team lacked the skill, knowledge and experience to do this even with access to inside information.

Back at VW, renowned for its technical skills, the truth about the emissions scandal seems to have eluded leaders, who appear not to have questioned how their company was achieving results others thought impossible. Elsewhere, many boards seem to have believed that corruption, rife in their industry, did not encompass their firm.

Competent NEDs worry about how and why their firm is successful, including the relative roles of skill and luck in success. They know it is hard for unpalatable truths to reach leaders. Taboos, loyalty to colleagues, and fear fracture frank communication channels to the top. So do social bubbles, norms and silences. Chinese whispers can transform messages as they rise up hierarchies. Incentives and perceptions of leaders’ attitudes can discourage those with unwelcome news or views from bringing them to leaders. Without curiosity and persistence, dissonances remain unexplored.

One reason for this is NEDs who do not recognise their humanity. We are all affected by cognitive biases. As Daniel Kahneman once wrote,

"We're blind to our blindness. We have very little idea of how little we know. We're not designed to."

The optimistic bias leaves us thinking that bad things are less likely to happen to us. Confirmation bias leaves us seeking to confirm, rather than disprove what we feel or believe. Overconfidence leaves us believing we are better than an outsider would conclude. Hubris overwhelms us. Groupthink undermines our capacity for independent thought. We are less rational and more deluded than our overconfidence leads us to suppose.

The greatest delusion is probably that an intelligent, well-meaning board is enough to lead a company to success. An effective board needs a NED team with the skills, knowledge and experience to understand every aspect of the company’s systems and activities, including its people. It takes NED self-awareness and courage plus forensic and social skills constructively to challenge charismatic or dominant leaders.

Being blindsided is bad for your company and its reputation and for your board members and their reputations. The questions are whether the board wants to remove its blinkers; and who will take the lead.

Anthony Fitzsimmons

Reputability LLP

London

www.reputability.co.uk

Reputational risks, and the behavioural, organisational risks that underlie them, are discussed in more detail in Rethinking Reputational Risk - How to Manage the Risks that can Ruin Your Business, Your Reputation and You You can get a 20% discount hrough this link by using the code RRRF20

Introducing the New FRC Governance Proposals

noreply@blogger.com (Reputability) — Tue, 02 Jan 2018 19:08:00 +0000

This popular post, dating back to January 2018, has been superseded by the FRC's new corporate governance Code and Guidance on Board Effectiveness. You can find out what the FRC decided here

The Financial Reporting Council (FRC) is consulting on revisions its Corporate Governance Code (the Code) and Guidance on Board Effectiveness (the Guidance). The changes proposed by the FRC reflect their increasingly deep understanding of the root causes of company failures. These changes develop the FRC's leadership on governance thinking to reflect the FRC's groundbreaking Guidance on Risk. Our survey of Annual Reports shows that most companies have made poor progress towards meeting the FRC's guidance. And board composition still has far to go.

The FRC's has put 'long term success' of the company at the heart of its thinking. Their approach has two strands. The first confronts the historic priority given to shareholders. It begins to tackle the undesirable drivers of short-termism, including weak design of incentives granted to C-Suites. And it recognises the pressure from investment managers whose own incentives are, reportedly, very short term.

You can think of the second strand as the result of reverse stress testing for risks to 'long term success'. Exploring answers to the question 'what risks our long term success?' will take you in many directions. Some will be specific to your organisation: changing markets, evolving consumer tastes, new sources of supply, increased competition and much more. But others will flow from the fact that, whatever your organisation does and however it is structured, its fate ultimately depends on the actions and inactions of people. Most major failures are, at their root causes, system failures. Since leaders are the ultimate deliberate or inadvertent creators or drivers of all the systems in their organisation, it follows that leaders really matter.

This is why the FRC's renewed focus on leaders and people-systems is so desirable.

The FRC's proposals respond to almost all the types of corporate vulnerabilities we catalogued and illustrated in our book "Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You". The revisions are thus also apt to encourage boards to strengthen their reputational resilience. This makes it a double pleasure to be able to echo Sir Win Bischoff's own praise for "Rethinking Reputational Risk”. We much endorse the FRC's recommendations to business leaders. It is instructive to see the FRC handle the subject with such conviction and clarity.

In our more detailed note here we explain the FRC's new approach under six headings:

Long term success for the benefit of all stakeholders
Board composition, diversity, skills and challenge
Leadership, Values, Culture and Behaviour
Interacting with the workforce and other stakeholders
Setting Pay
Reporting

To give you some flavour, the FRC laces its proposals with over seventy perceptive questions for boards to consider. Examples include:

How have [our] values and behavioural expectations been reinforced in our recruitment, induction, performance management, incentives and reward policies, processes and practices?
How are we testing this with new recruits and the existing workforce?
What behaviours are being driven when setting strategy and financial targets?
Is management using root cause analysis when things go wrong? (Examining not just what went wrong but why.) For example, were incentives/rewards, social or power dynamics a contributing factor?
Is the company holding exit interviews with leavers and are we considering how the feedback reflects on the company’s culture?
What evidence do we have that the chief executive is willing to listen, take criticism and let others make decisions?
How does the ‘tone in the middle’ resonate with the workforce?
What action do we take against senior people or star performers who do not uphold the company’s values?

In the same spirit, the FRC lists a selection of 'warning signs' for NEDs that things might be going wrong on culture:

"Silo thinking
Dominant chief executive
Leadership arrogance
Pressure to meet the numbers/overambitious targets
Lack of access to information
Low levels of engagement between leadership and employees
Lack of openness to challenge
Poor succession planning
Misaligned incentives and flawed executive remuneration practices
Tolerance of regulatory or code of ethics breaches, e.g. by star employees
A lack of diversity
Hierarchical attitudes"

These signs are all too familiar.

Regular readers will have at least a general understanding of the issues the FRC is tackling. For readers who wish to gain a deeper understanding of the issues, we recommend two influential publications. 'Roads to Ruin" is the seminal (2011) Cass Business School report for Airmic. Based on twenty case studies it lays the ground for the field A further six years' research made it possible for our book “Rethinking Reputational Risk” to take a more systematic approach and address the needs of both leaders and risk professionals. They provide complementary perspectives on the insights that inform the FRC's approach.

We have also written a more detailed analysis of the FRC proposals which you will find here.

Anthony Fitzsimmons
Reputability LLP
London

Anthony Fitzsimmons is Chairman of Reputability LLP and, with the late Derek Atkins, author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You”

Deconstructing the FRC's new Governance Proposals

noreply@blogger.com (Reputability) — Tue, 02 Jan 2018 12:00:00 +0000

This popular post, dating back to January 2018, has been superseded by the FRC's new corporate governance Code and Guidance on Board Effectiveness. You can find out what the FRC decided here.

Introduction

With strong encouragement from Parliamentarians, and drawing on its Culture Project, the Financial Reporting Council (FRC) is consulting on revisions its Corporate Governance Code (the Code) and Guidance on Board Effectiveness (the Guidance). These drafts tackle two related families of issues afflicting publicly quoted UK firms:

UK companies' record of "eating themselves," as Andy Haldene called it, by over-distributing dividends at the expense of long term investment; and
the unabated stream of unnecessary, predictable corporate failures of recent years and decades.

The FRC's proposals respond to almost all the types of corporate vulnerabilities catalogued and illustrated in our book "Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You". The revisions are thus also apt to encourage boards to strengthen their reputational resilience. This makes it a double pleasure to be able to echo Sir Win Bischoff's own praise for "Rethinking Reputational Risk”. We much endorse the FRC's recommendations to business leaders. Whilst we shall recommend refinements in our response to their Consultation, it is instructive to see the FRC handle the subject with such conviction and clarity.

The Code Introduction summarises the FRC's aim:

"At the heart of this Code is an updated set of Principles that emphasises the value of good corporate governance to long-term success in this wider context. By applying the Principles, following the more detailed Provisions and using the associated guidance, companies are able to demonstrate throughout their reporting how the governance of the company contributes to its long-term success and achieves wider objectives."

We have drawn six key themes from the FRC's proposals. These are:

Long term success for the benefit of all stakeholders
Board composition, diversity, skills and challenge
Leadership, Values, Culture and Behaviour
Interacting with the workforce and other stakeholders
Setting Pay
Reporting

We have used the FRC's own words to develop these themes because a synopsis would mask the FRC's tone and the depth of its understanding of the issues. In what follows, references are to paragraph letters/numbers in the proposed revised Code and Guidance except where otherwise indicated.

Long term success for the benefit of all stakeholders

Profits retained by quoted companies for reinvestment fell from 90% in 1970 to about 35% in 2015 leaving firms with far less money for growth-boosting investment and risking "eating themselves". Debt levels increased relative to equity. This is bad for the long term health of UK Plc and its ability to generate wealth.

There are many reasons for this. A deep root is Milton Friedman’s ‘Shareholder Value' thesis which held that a corporate executive's duty was to maximise profits for shareholders, and that anyone arguing for business to show a social conscience was "preaching pure and unadulterated socialism". Despite contemporary ministerial statements to the contrary, the wording of s172 of the UK Companies Act 2006 was widely interpreted as giving shareholder interests primacy over other stakeholders. A prominent example is in the Preface to the current (2016) version of the Code, which concludes:

"While in law the company is primarily accountable to its shareholders, and the relationship between the company and its shareholders is also the main focus of the Code, companies are encouraged to recognise the contribution made by other providers of capital and to confirm the board’s interest in listening to the views of such providers insofar as these are relevant to the company’s overall approach to governance."

In a world where C-suites and institutional investors are rewarded on short term measures of profitability, the natural result is strong pressure to deliver short term profits to shareholders at any cost - including foregoing investment and other routes to longer term success. As Professor John Kay wrote in in his Review of UK Equity Markets that:

"short-termism is a problem in UK equity markets, and that the principal causes are the decline of trust and the misalignment of incentives throughout the equity investment chain."

Reinforced by parliamentarians of all parties, the FRC has changed its emphasis, declaring that the function of a board is:

"to promote the long-term sustainable success of the company, generate value for shareholders and contribute to wider society." (Code Principle A)

The Guidance recommends boards to:

"consider input from the workforce and other stakeholders and be able to explain how this was taken into account and the impact it had on the decision." (Guidance19)

The FRC confronts the clash with investment managers whose time horizons are measured in quarters rather than years or decades. Having stated that boards are responsible for the company’s health and need to take a longer-term view, the FRC observes:

“This can be in contrast with some investors or potential investors who may focus on short-term returns." (Guidance 37)

This clash needs further remedial work. Investment managers are regularly chastised for, among other sins, being ferociously focused by very short term bonuses. Revising the Stewardship Code is a first step. However we suspect that the Financial Conduct Authority will have to develop robust rules to force investment manager incentives and behaviour into alignment with the interests of their ultimate clients, most of whom will usually be retail investors and pensioners seeking steady long-term growth.

Board composition, diversity, skills and challenge

Few boards lack honesty or ample intelligence. The vulnerabilities identified in "Rethinking Reputational Risk" were hitherto unrecognised gaps in NED skill sets, unrecognised biases, heuristics and social behaviours, insufficient diversity of thought and perspectives, cloistered world views and a reluctance to challenge. These present huge systemic risks to long term success.

These tendencies should be no surprise. It is normal for we humans to surround ourselves with self-perpetuating "people like us". In the UK there also seems to be a widespread, persistent but deeply mistaken notion that what matters most for boards is a combination of intelligence, financial literacy and an aptitude for 'strategy'. Execution and systems, and the skills and knowledge relevant to
them, are too often looked down upon by, and absent from, boards.

Whilst gender diversity has improved somewhat, our research shows that there is much to improve in UK boards. We found ethnic diversity largely absent, with boards dominated by accountants, investment bankers and people with experience in and around the C-Suite. Given that all companies' systems depend on a combination of people and IT, it is astonishing that people with a deep understanding of IT and human behaviour rarely found on boards.

The FRC has taken substantial steps towards tackling these weaknesses. The revised Code reiterates the Chair’s responsibility for the board’s effectiveness and for promoting a culture of openness and debate by facilitating constructive relations between directors, with particular attention to ensuring that NEDs make effective contributions. Non-executive directors are expected to provide specialist advice and strategic guidance as well as holding management to account through constructive challenge. (Code Introduction and G)

The Code sets out to force boards to recruit beyond their, and their recruiters’, social sets, circles and comfort zones: "Both appointments and succession plans should be based on merit and objective criteria, and promote diversity of gender, social and ethnic backgrounds, cognitive and personal strengths." (Code J) To reinforce this, “Regular evaluation of the board should consider the balance of skills, experience, independence and knowledge, its diversity ..." (Code K)

"Open advertising or an external search consultancy should generally be used for the appointment of the chair and non-executive directors. " (Code 20)

The Guidance develops the theme:

"The boardroom should not necessarily be a comfortable place. Challenge, as well as teamwork, is an essential feature. Diversity in board composition is an important driver of a board’s effectiveness, creating a breadth of perspective among directors, and breaking down a tendency towards ‘group think’.." (Guidance 13)

The Guidance tackles the tendency of some CEOs to bounce boards into new projects.

"Some chairs favour a series of separate discussions for important decisions; for example, concept, proposal for discussion, proposal for decision. This gives executive directors more opportunity to put the case at the earlier stages, and all directors the opportunity to share concerns or challenge assumptions well in advance of the point of decision." (Guidance 17)

The FRC recognises that humanity's ubiquitous psychological weaknesses are found in boardrooms as well as elsewhere when it recommends:

"putting in place additional safeguards to reduce the risk of distorted judgements by, for example, commissioning an independent report, seeking advice from an expert, introducing a devil’s advocate to provide challenge." (Guidance 20)

Turning to the practicalities of recruitment, the FRC recommends that when preparing to recruit a new director the nomination committee should "evaluate the balance of skills, experience, knowledge and diversity on the board and, in the light of this evaluation, prepare a description of the role and capabilities required for a particular appointment." (Guidance 76)

As to skills and perspectives:

"Appointing directors who are able to make a positive contribution is one of the key elements of board effectiveness. Directors will be more likely to make good decisions and maximise the opportunities for the company’s success in the longer term if the right skill-sets and a breadth of perspectives are present in the boardroom. This includes independence of mind, diversity and a range of skills, experience and knowledge. Non-executive directors should all possess critical skills of value to the board and relevant to the challenges and opportunities facing the company." (Guidance 79)

As to character and intellect:

"It is important to consider a diversity of personal attributes among board candidates, including intellect, critical assessment and judgement, courage, openness, honesty and tact; and the ability to listen, forge relationships and develop trust. Diversity of psychological type, background, gender and ethnicity is important to ensure that a board is not composed solely of like-minded individuals. A board requires directors who have the intellectual capability to suggest change to a proposed strategy, and to promulgate alternatives." (Guidance 82)

As the FRC observes, a board with diversity in all its dimensions is more likely to make better decisions as well as avoiding ‘group think’. (Guidance 89)

As to board evaluations, the FRC has retained its valuable, but under-used, suggestion that external board evaluations are particularly helpful to a newly appointed new Chair:

"External facilitation .... may also be useful in particular circumstances, such as when there is a new chair, if there is a known problem around the board table requiring tactful handling; or there is an external perception that the board is, or has been, ineffective." (Guidance 94)

Leadership, Values, Culture and Behaviour

Code Principles set the tone.

"… The board should establish the company’s purpose, strategy and values, and satisfy itself that these and its culture are aligned." (Code A)

"The chair … should … promote a culture of openness and debate by facilitating constructive relations between directors; in particular, the chair should ensure the effective contribution of all non-executive directors." (Code E)

Developing these principles, the Code continues:

"Directors should embody and promote the desired culture of the company. The board should monitor and assess the culture to satisfy itself that behaviour throughout the business is aligned with the company’s values. Where it finds misalignment it should take corrective action. " (Code 2)

"...alignment to culture: incentives should drive behaviours consistent with company purpose, strategy and values." (Code 40)

This is supported by recommendations in the Guidance:

"[Boards should ask questions such as... ] How do we obtain assurance that the culture we are leading is open, accountable and aligned to purpose, strategy and values?" (Guidance 13, Box)

"... The board should consider the potential impact of [decisions] on the company’s culture, for example the behaviour it could drive or the message it might send. The board should ensure its decisions are consistent with its values and what the company says it stands for." (Guidance 18)

"Having policies in place that encourage individuals to raise concerns is a core part of a supportive ethical business culture. Whistleblowing policies that offer effective protection from retaliation, as well as policies that support bribery and corruption legislation are essential components of this. Such policies are important, for example when attempts to resolve things internally have not worked." (Guidance 32)

"It is equally important to create an environment that encourages individuals to raise concerns or ask questions about a wide range of issues. Speak up arrangements help build trust, and can act as an early warning system and help to manage risk. Some companies even extend such arrangements beyond the workforce to external parties, like customers and suppliers." (Guidance 33)

"The board sets the framework within which a healthy corporate culture can develop, that underpins the way in which the company operates. It then satisfies itself that the culture throughout the organisation is consistent with that framework, leading by example and taking action where it spots misalignment." (Guidance 39)

The FRC list a selection of tell-tale signs of a cultural problem:

• "Silo thinking
• Dominant chief executive
• Leadership arrogance
• Pressure to meet the numbers/overambitious targets
• Lack of access to information
• Low levels of engagement between leadership and employees
• Lack of openness to challenge
• Poor succession planning
• Misaligned incentives and flawed executive remuneration practices
• Tolerance of regulatory or code of ethics breaches, e.g. by star employees
• A lack of diversity
• Hierarchical attitudes" (Guidance 40, Figure 2)

The FRC directs attention to the influence of recruitment and reward systems on behaviour.

"Boards should seek assurance that management has put appropriate mechanisms in place to implement and embed the company purpose, strategy and values. In particular, incentives and rewards, promotion and development decisions should be aligned to these. Boards should satisfy themselves that this is clear in company policies and is applied in practice, challenging themselves and management on how effective they are at shaping and embedding culture, for example in the areas suggested below.”

Examples include:

• “How are we demonstrating ethical leadership, displaying and promoting throughout the company, behaviours we expect from others? (sic)
• What steps have we taken to address any negative trends or misalignment between values and behaviours?
• How have the values and behavioural expectations been reinforced in our recruitment, induction, performance management, incentives and reward policies, processes and practices?
• How are we testing this with new recruits and the existing workforce?
• What behaviours are being driven when setting strategy and financial targets?
• Is company tax policy consistent with stated values?
• What steps has management taken to ensure that suppliers meet expected standards of behaviour?" (Guidance 42)

The Guidance points towards ending siloed thought and action on the corresponding risks:

"The board should engage different parts of the business, for example HR, internal audit, risk and compliance, in its assessment of culture and encourage an integrated approach. It should make use of technology to access and analyse information in order to develop a more sophisticated view of culture-associated risk and develop its understanding of how culture and behaviours impact performance." (Guidance 44)

The FRC points boards towards sources of insight such as turnover and absenteeism rates, grievance and ‘speak up’ data, promptness of payments to suppliers and attitudes to regulators, internal audit and employees" (Guidance 45). These are reinforced with a raft of suggested questions such as:

• "Is management using root cause analysis when things go wrong? (Examining not just what went wrong but why.) For example, were incentives/rewards, social or power dynamics a contributing factor?
• Is the company holding exit interviews with leavers and are we considering how the feedback reflects on the company’s culture?
• What evidence is there that the way the company conducts business in practice is consistent with what it claims to stand for?
• Do employees feel that customers and suppliers are treated fairly and that the company cares about its impact on the environment and community?
• What evidence do we have that the chief executive is willing to listen, take criticism and let others make decisions?
• How does the ‘tone in the middle’ resonate with the workforce?
• What action do we take against senior people or star performers who do not uphold the company’s values?
• What do examples of communications from leadership and middle management tell us about the commitment to values, openness and accountability?" (Guidance 46)

More generally, boards are encouraged to ask how well their values and expected behaviours are embedded in their HR system from recruitment to exit interviews and how the company structures remuneration and other forms of reward to produce appropriate incentives. (Guidance106)

Turning to Remuneration Committees (Remcos), it encourages asking questions such as:

• "How effective are the financial and non-financial performance measures at supporting values and culture?
• Are incentives across the organisation aligned to our culture and encouraging the desired behaviours?
• Have we considered negative behaviour which the choice of any particular metric may encourage and what steps have we taken to manage such risks?" (Guidance 113)

Interacting with the workforce and other stakeholders

The FRC defines 'workforce' in broad terms, including remote workers, agency workers and contractors and recognises them as both stakeholders and important sources of information for boards before stating:

"The workforce should be able to raise concerns in relation to management and colleagues where they consider that conduct is not consistent with the company’s values and responsibilities. ... "(Code D)

Turning to how workforce views can be brought to the boardroom, the FRC recommends:

"The board should establish a method for gathering the views of the workforce. This would normally be a director appointed from the workforce, a formal workforce advisory panel or a designated non-executive director. There should also be a means for the workforce to raise concerns in confidence and (if they wish) anonymously. The board should review this and ensure that arrangements are in place for the proportionate and independent investigation of such matters and for follow-up action." (Code 3)

Again the Guidance helpfully suggests questions for boards to consider. For example, reaching beyond the workforce:

"How do we make sure the voice of the workforce, customers and wider stakeholders is heard at board-level and what impact has this had on our decisions?" (Guidance 13)

"[Before major decisions] the board should consider input from the workforce and other stakeholders and be able to explain how this was taken into account and the impact it had on the decision." (Guidance 19)

The Guidance emphasises the importance of speaking up and challenging authority becoming a part of normality. Having identified the value of ‘speak-up’ and whistleblowing systems (Guidance 32) the Code continues:

"Engagement through a range of formal and informal channels helps the workforce to share ideas and concerns with senior management and the board, provides leaders with useful feedback about business practices from those delivering them and can help empower colleagues. Companies need to create an environment in which the workforce feel it is safe to voice their views. Common fears include being negatively labelled for speaking up, which might result in being side-lined for promotion, pay increases and bonuses. To be successful, leaders must actively listen, encourage the workforce to speak up and ensure there are no negative repercussions as a result of doing so.” (Guidance 34)

The FRC suggests questions for boards to consider, such as:

• "Does management provide feedback to colleagues on how complaints and concerns have been dealt with?
• How comfortable do the workforce say they are with challenging and reporting issues of concern and is there any evidence that they are doing this?
• Do employees report that leaders and managers live the company’s values?” (Guidance 36)

NEDs are expected to listen to all stakeholders including outsiders:

"To fulfil their duties, non-executive directors should take into account the views of shareholders, the workforce and other stakeholders, because these views may provide different perspectives on the company and its performance. They should avail themselves of opportunities to meet major shareholders, key customers and members of the workforce from all levels of the organisation." (Guidance 68)

This includes discovering how stakeholders view the board’s performance to achieve a 360 degree perspective:

"The chair should consider how to obtain input from the workforce and other stakeholders on the board’s performance.” (Guidance 91)

Setting Pay

The starting point on pay is Code Principle O:

"The board should satisfy itself that company remuneration and workforce policies and practices promote its long-term success and are aligned with its strategy and values." (Code O)

The Guidance gives the board ultimate responsibility for ensuring that all workforce remuneration, incentives and other workforce policies support the long-term success of the company and promote its values. (Guidance 102)

The Code recommends that the chair of the Remuneration Committee (Remco) "should have served on a remuneration committee for at least 12 months" before appointment.” (Code 32) continuing:

"The remuneration committee should have delegated responsibility for determining the policy for director remuneration and setting remuneration for the board and senior management. It should oversee remuneration and workforce policies and practices, taking these into account when setting the policy for director remuneration.” (Code 33)

The Code exhorts Remcos to use its independent judgement both when evaluating the advice of remuneration consultants and when they are hearing Executives’ views on pay. (Code 35) This implies that Remco should have a sufficient skill and experience in understanding human behaviour to be capable of making such a judgement.

The FRC has recognised that incentive schemes can be gamed. With strong Parliamentary encouragement it has recommended both longer vesting periods and that executives should continue to hold shares after they leave.

"Remuneration schemes should promote long-term shareholdings by executive directors that support alignment with long-term shareholder interests. In normal circumstances, shares granted or other forms of long-term incentives should be subject to a vesting and holding period of at least five years. Longer periods, including post-employment periods, may be appropriate." (Code 36)

The FRC recommends that Remcos address six aspects of remuneration that have caused trouble in the past.

"Clarity – remuneration arrangements should be transparent and facilitate effective engagement;

Simplicity – remuneration structures should avoid complexity; their rationale and operation should be easy to understand;

Predictability – the range of possible values of rewards to individual directors should be identified and explained at the time of approving the policy;

Proportionality and reward for individual performance – there should be a demonstrable link between individual awards and the long-term performance of the company.

Outcomes should not reward poor performance and total rewards available should not be excessive; and

Alignment to culture – incentives should drive behaviours consistent with company purpose, strategy and values. (Code 40)

This responsibility for remuneration extends beyond mere money but includes areas such as culture and incentives:

"This means overseeing not only pay, conditions and incentives but also other policies that have an impact on the experience of the workforce and drive behaviours. This includes policies around recruitment and retention, promotion and progression, performance management, training and development, re-skilling and flexible working." (Guidance 103)

The FRC suggests that boards should set principles for pay and reward across the enterprise, listening to the workforce and joining up thinking. (Guidance 105 and 106) Once again the FRC suggests questions for boards to consider, such as:

• “Can we articulate our approach to investing in and rewarding our workforce?
• Have we taken workforce views and priorities into account in developing our approach?
• Does the balance between financial and non-financial incentives support the desired culture?
• Are behavioural objectives included in leadership and employee goals and are behaviours formally assessed as part of performance review activity?
• Have we considered whether executive pay incentives or those of other employees could undermine culture?”(Guidance 106)

Remcos are expected to engage with the workforce to explain how executive remuneration aligns with wider company pay policy and promotes long-term value generation. (Guidance 113) On this score too Remco is encouraged to ask itself questions such as:

"How is executive remuneration aligned with wider company pay policy?

How is corporate reputational risk considered in the setting of incentive pay?

What is the maximum award we think is reasonable for our executive directors and what will we do in the event the application of the formula produces an outcome in excess of that award?

How effective are the financial and non-financial performance measures at supporting values and culture?

Are incentives across the organisation aligned to our culture and encouraging the desired behaviours?

Have we considered negative behaviour which the choice of any particular metric may encourage and what steps have we taken to manage such risks?

Do employees feel that they are treated well and fairly in the workplace and that they are supported in developing themselves and fulfilling their potential?

What have we done to explain executive pay arrangements in comparison with those of the workforce? (Guidance 113)

Reporting

The overarching principle here is that more reporting, both internally and externally, will help boards better to listen and respond to to challenge as the workforce and other stakeholders learn what they do, how and why.

Setting the tone, the Code begins:

“At the heart of this Code is an updated set of Principles that emphasises the value of good corporate governance to long-term success in this wider context. By applying the Principles, following the more detailed Provisions and using the associated guidance, companies are able to demonstrate throughout their reporting how the governance of the company contributes to its long-term success and achieves wider objectives." (Code Introduction)

Moving to content:

"The board … should describe in the annual report how opportunities and risks to the future success of the business have been considered and addressed, the sustainability of the company’s business model and how its governance contributes to the delivery of its strategy." (Code 1)

"The annual report should explain the board’s activities and any action taken [in relation to culture]." (Code 2)

"The board should explain in the annual report how it has engaged with the workforce and other stakeholders, and how their interests and the matters set out in section 172 of the Companies Act 2006 influenced the board’s decision-making." (Code 4)

"There should be a description of the work of the remuneration committee in the annual report which should include:
• an explanation of the strategic rationale for executive directors’ remuneration policies, structures and performance metrics;
• reasons why the remuneration is appropriate using internal and external measures;
• whether the remuneration policy operated as intended in terms of company performance and quantum, and, if not, what changes are necessary;
• what engagement has taken place with shareholders and the impact this has had on remuneration policy and outcomes;
• an explanation of the company’s approach to investing in, developing and rewarding the workforce, and what engagement with the workforce has taken place to explain how executive remuneration aligns with wider company policy; and
• to what extent remuneration outcomes have been affected by board discretion. (Code 41)

"Directors should ... explain... their decisions and how they have taken account of the interests of different stakeholders. This will include being able to explain how the benefits in terms of the long-term success of the company outweigh any negative impacts, and any action the company plans to take to mitigate those impacts." (Guidance 30)

Conclusion

The changes proposed by the FRC are radical, reflecting an increasingly deep understanding of the root causes of company failures. They have strong support from both Government and the Parliamentary Inquiry into Corporate Governance.

Regular readers will have at least a general understanding of the issues the FRC is tackling. For readers who wish to gain a deeper understanding of the issues, we recommend two influential publications. 'Roads to Ruin" is the seminal (2011) Cass Business School report for Airmic. Based on twenty case studies it lays the ground for the field A further six years' research made it possible for our book “Rethinking Reputational Risk” to take a more systematic approach and address the needs of both leaders and risk professionals. They provide complementary perspectives on the insights that inform the FRC's approach. Of course we can provide practical education tailored to the needs of your board and your risk team.

Anthony Fitzsimmons
Reputability LLP
London

Anthony Fitzsimmons is Chairman of Reputability LLP and, with the late Derek Atkins, author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You”

Designing Better Boards

noreply@blogger.com (Reputability) — Mon, 27 Nov 2017 12:25:00 +0000

At a recent seminar, Tom Peters tackled board composition. His prescription for a perfectly composed [non-executive] board team of ten?

Two under-25s - they will have a different experience from their "elderly - 35 year old - peers"
At least three or four women
One data/IT 'superstar' - a "certified goddess or god from the likes of Google"
A brace of entrepreneurial or VC types
One person of stature who seems weird - Peters suggested artists, rappers, rock musicians and shamen because they look askance at the world.
A design guru
No more than two over-60s
No more than three MBAs

That spec, one of many gems to be taken taken from his latest book "The Excellence Dividend", provides ample ingredients for vigorous discussion about board composition. We would add three more categories to the cauldron:

At least one non-executive director (NED) with a deep understanding of how the business's markets work;
At least one NED who understands how people work: a graduate in psychology, sociology or social anthropology, preferably a strategic HR 'superstar' too; and
At least two highly analytical NEDs with the detachment to see outsider views and the character and social skills to deliver constructive challenge. Good lawyers, academics and journalists should have skill and curiosity needed. But they also need both the strength of character to challenge and persist; and the social skills to ensure their critiques are internalised by those who need to hear them.

How do these characteristics compare with real boards? We have extended our recent survey of mainly FTSE100 companies to include Non-Executive Director (NED) board composition as described in Annual Reports. We thought it would be interesting to include regulators too. Using website information we have similarly analysed the boards of the UK's main financial regulators, the FCA, FRC and PRA; and three non-financial regulators, the IPCC (police), the SRA (solicitors) and the CQC (healthcare).

Here is a snapshot of our results. Bear in mind that they represent what these companies and regulators have decided to say about themselves and that the figures are not about Executives but NEDs.

UK Boards	Large UK Companies	Financial Regulators	Non-financial Regulators	Population Baseline
Females %	31%	27%	32%	51%
BAME %	3%	0%	16%	14%
CEO or MD experience?	46%	48%	26%
C-Suite experience	94%	61%	48%
Relevant trade?	52%	52%	29%
HR experience	2%	0%	3%
Psychology, behavioural economics and social sciences	1%	3%	10%
IT and Data experience?	9%	0%	3%
Journalist, Academic or Lawyer	7%	9%	35%

Beginning with social justice, it is well known that women still trail men; Black, Asian, and Minority Ethnic (BAME) populations are even more under-represented in all except our sample of non-financial regulators.

It is reassuring that about half of FTSE board members have experience of their trade. But it is disturbing that over half of financial regulator boards appear to be drawn from people of the kind they regulate. The same is true of the SRA which is dominated by solicitors. The problem is only slightly less acute as regards our other non-financial regulators.

People with experience in and around the C-suite overwhelm FTSE boards and are a major presence elsewhere. Such people, with their years of experience of leading large organisations, are an essential part of any board. But their dominating presence is risky because it limits board perspectives, attitudes and horizons. Most of the real world lies beyond the C-suite's knowledge horizon. Shared perspectives and attitudes are as dangerous as they are comfortable.

Not all Annual Reports in our cohort provide age data, but for the seventeen companies where age data was provided, the youngest NED was 44, the oldest 80 and the average 60. 7% were under 50 and 55% were over 60. This probably reflects the predilection for people with CEO and C-suite experience. For comparison, Facebook's youngest was 41, its oldest 72 with the average at 54; though at Alphabet, Google's owner, ages ranged from 57 to 71 with the average at 65.

All organisations, even Tech giants, are still dominated and led by people, but NEDs with deep knowledge and skill in understanding how people really tick are rare. Such people have degrees in subjects such as psychology, organisational behaviour, behavioural economics, sociology and anthropology. Some may have been HR stars. We found virtually no such NEDs. Our non-financial regulators did slightly better though the sample size was tiny.

It is the same with IT and data. Organisations no longer use IT and use data. They depend on IT and data just as life depends on water; but boards lack Peters' IT superstars. 9% of NEDs with IT experience looks reasonable. But a third of those in our sample were in just four companies in the IT, media and telecoms sector - essential trade skills. Of the balance, over 70% of our cohort, had no board member with declared expertise in this field.

Those with obvious professionally honed challenging skills were also rare. Less than 25% of companies had a lawyer on their board. Of six academics on boards, three were medical or pharmaceutical professors on pharma boards. We found no journalists.

Our research, highlighted in 'Rethinking Reputational Risk - How to Manage the Risks that can Ruin Your Business, Your Reputation and You' shows that inadequate board skills - not just IT and people skills - and ineffective challenge were among the most frequent causes of failure in almost all our 40+ case studies.

Adapted from 'Rethinking Reputational Risk' Fig 14.1 © the authors

These criteria for well-constructed boards do not pretend to be a perfect, universally applicable set of rules. Neither are they comprehensive: for example they barely touch on personal attributes such as NED character. But they do provide a useful set of attributes against which to compare your organisation's NEDs. So I shall leave you with five questions:

How does your NED team compare to these criteria?
Where are the gaps and what are their consequences?
What do you believe is wrong with or missing from these criteria, and why?
What do you believe is wrong with or missing from your own board's NED team, and why?
How would you change your own board's composition to make it more effective?

Anthony Fitzsimmons
Reputability LLP
London
www.reputability.co.uk
@Reputability

The research behind this post is explained in greater detail in Rethinking Reputational Risk - How to Manage the Risks that can Ruin Your Business, Your Reputation and You You can get a 20% discount through this link by using the code RRRF20

Do Boards Understand Behavioural Risks to Reputation?

noreply@blogger.com (Reputability) — Sun, 12 Nov 2017 12:06:00 +0000

As regular readers know, we have analysed the annual reports of about 40 FTSE100 companies. Our aim is to ascertain the extent to which boards and their companies demonstrate a good understanding of reputational risk, behavioural risk, organisational risk and cultural risk together with the extent to which the companies show an understanding of learning from errors and experience. This approach is derived from our research insights, which are explained in more detail in "Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You"**

We have extracted their performance using five criteria.

Regular readers will recall our scoring system:

These disappointing results will represent a combination of accurate reporting of reality and poor reporting of better quality work. We believe the former is much more likely than the latter: boards that understand these areas and their importance are unlikely to hide their company's strengths.

The least disappointing results emerge from 'cultural risk' with an average score of 2.8 and median of 2.5. Given the strong emphasis given to culture by politicians and regulators, it is perhaps not surprising that culture has produced the least bad performance. There is considerable room for improvement.

The worst results, sharing a disappointing average score of 1.7, were 'reputational risk' and 'learning from errors and experience'. Their medians were 1.5 and 2 respectively.

'Learning from errors and experience' was highly skewed: eleven companies scored zero whilst two scored 4 and three scored 3.5. This kind of learning is critical to long term success and stability. A company has to get many underlying behavioural, organisational and cultural factors right to achieve a justified high score. That makes this measure a particularly powerful pointer that regulators, investors and D&O insurers can use to differentiate between fragile companies and those that are systemically resilient.

These results also suggest widespread board skill gaps in this risk area. The FRC anticipated this when it added behavioural, organisational and reputational risks to boards' explicit responsibilities. The Risk Guidance provides that boards should consider:

“whether it, and any committee or management group to which it delegates activities, has the necessary skills, knowledge, experience, authority and support to enable it to assess the risks the company faces and exercise its responsibilities effectively. Boards should consider specifically assessing this as part of their regular evaluations of their effectiveness”

These include the explicitly added areas of behavioural, organisational and reputational risk.

The FRC also recommends that the board should:

"satisfy itself that [its] sources of assurance [on risk] have sufficient authority, independence and expertise to enable them to provide objective information and advice to the board."

Where shortcomings are found, the remedy is clear: arrange board education from people with "authority, independence and expertise".

In the meantime, we are extending our cohort to include regulators while we watch for correlations between bad scores and disastrous performance. We shall report on results as they emerge.

Anthony Fitzsimmons

Reputability LLP

London

www.reputability.co.uk

@reputability

** You can claim a 20% discount code on a purchase of 'Rethinking Reputational Risk' through this link using code RRRF20.

Finding Future Failures

noreply@blogger.com (Reputability) — Tue, 31 Oct 2017 10:05:00 +0000

Our research, summarised in 'Rethinking Reputational Risk', shows that behavioural, organisational and board risks are the root causes of most major crises. These systemic risks typically lie latent for years encouraging complacency before they trigger a major reputational crisis that typically takes leaders by surprise, shreds shareholder value and often damages careers.

We have long known that it is possible to identify, in advance, organisations that have systemic weaknesses that make them more likely to fail in this way. Preliminary findings from our latest research provide indications of a new analytical approach.

Regular readers will recall that recent rules from the UK Financial Reporting Council require companies it regulates to report clearly on important reputational, behavioural and organisational risks. [Note: since this was written, the FRC has published new Guidance on Board Effectiveness which recommends greater focus on these areas at board level. We have written about it here. Our recommendations to the FRC on this are here.] We have analysed the Annual Reports of about half of the FTSE 100 constituents to discover how they were getting on.

We used a simple scale to score their reporting performance on five axes

The scoring system awarded from 0 to 5 points on this scale.

The five (inevitably overlapping) axes we chose were:

Behavioural risk
Organisational risk
Cultural risk
Reputational risk
Learning from errors and experience

We added these scores to produce an averaged composite score for each company, also with a maximum of 5.

By way of example our cohort included seven financial services companies. Plotting their results on a chart reveals the picture below.

This picture is revealing even without more information. You can separate financial services (FS) companies that talk about learning from mistakes from those that do not; evidence of the Financial Conduct Authority and Prudential Reguation Authority campaigns to improve culture is ubiquitous; and two seeming weaklings emerge: FS6 and FS7 with averaged composite scores of 1.6 and 1.1.

To give a little perspective, FS2 was the top scoring company across our entire survey with a composite score of 3.6 that leaves plenty of room for improvement. The bottom company managed to score a zero on all five dimensions.

Annual Reports may portray a company as better or worse than it actually is. A poor score may reflect poor risk management or inadequate reporting by the board. Contrariwise a higher score may represent better risk management or exaggeration by the board. At present we suspect the former more than the latter.

This analysis provides a new and solid starting point for identifying UK companies that are particularly vulnerable to unpleasant surprises. Huge volumes of differentiating information exist in the public domain. Our experience is that, with a suitable analytical framework and methodology, this yields revealing and predictive insights into the extent of a company's vulnerability to crises and the nature of its fault lines. The framework can equally be used to compare and rank companies, identifying both which companies are more and less accident-prone and which are more, or less, likely to survive a reputational crisis.

Our methodology is obviously relevant to leaders of companies both in reducing the risk of being held responsible for the unexpected sudden collapse of their company and to ensure that outsiders gain a fair perspective on risk management in these areas. With access to inside information the analysis can be made far more granular, robust and revealing, supporting improvements in both risk management risk reporting. We are talking to a number of companies about this.

Our research insights and methodology are also relevant to:

Investors who wish to avoid unpleasant surprises;
D&O insurers ranking board risks;
General liability insurers ranking operational risks;
Banks assessing credit risks.

These groups have access to public information. Armed with a suitable analytical framework, they can ask questions to probe areas that they regard as particularly important.

We plan to report further on our findings in the coming months.

In the meantime you can learn more about reputational, behavioural and organisational risks, and how they destroy seemingly sound organisations, in "Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You" written by the late Professor Derek Atkins and me. Publishers Kogan Page offer a 20% discount using code BBLRRR20 to our readers.

Anthony Fitzsimmons
Reputability LLP
London
www.reputability.co.uk
@reputability

Learning from mistakes: the key to flying high

noreply@blogger.com (Reputability) — Fri, 29 Sep 2017 11:11:00 +0000

“He hit me first,” whines the indignant two-year-old. We learn the ‘blame game’ young. With luck it develops into asking “why (did he hit me/take my sweets…etc.)?”

Inadequate investigations

“Why?” is a powerful question. Inexpertly used it leads to quick but superficial attribution of causes: “Why did the rogue trader emerge?” “Because he was bad.” In times past, air accident investigations often concluded that the tragedy was caused by ‘pilot error’. But as Stanley Roscoe, a pioneering aviation psychologist of the 1980s pithily put it, blaming an accident on ‘pilot error’ was “the substitution of one mystery for another”.

At the time air accidents remained uncomfortably frequent with deaths running at around a thousand per year. Roscoe’s insight was a key to transforming aviation from the somewhat hazardous to an activity so safe that the prospect of an aircraft crashing onto London as it approaches Heathrow has barely featured in the debate over a new runway for London’s airports. Terrorism apart, air accidents on western-built aircraft globally killed about 300 people per year in the decade to 2015, by which time the number of flights had more than doubled. For comparison, over 1800 were killed on UK roads in 2013 alone (over 34,000 on US roads).

Aviators learnt to learn better

The transformation was no accident. The airline industry foresaw that growth in flying might lead to a monthly air disaster featured on all front pages if they could not improve safety. As aviation investigators and academics dug deeper into the causes of accidents, asking “why?”, significant themes emerged.

Digging deeper uncovers system failures

One concerned communication failures. High workloads played a part but some were due to hierarchies. A co-pilot needed to tell his commander (in those days pilots were always men) something was going wrong but the difference in status led him to mince words in a way that masked the message; or the message was clear but his commander was unable to absorb information that did not fit his expectations. Sometimes the co-pilot said nothing at all because a challenge was socially unthinkable even when the alternative was imminent death.

The Kegworth crash

The problem grew worse as the gap in status increased, with an even higher barrier between the flight deck crew and the cabin crew even though the latter might have really important information. When the commander of the aircraft that crashed at Kegworth in 1989 announced to all that there was a problem with the right engine, which he was shutting down, many in the cabin could see that it was the left, not right, engine that was on fire. Whilst some cabin crew were too pre-occupied with their emergency duties notice the announcement, there was no attempt to tell the flight crew that the left, not right engine seemed to be on fire. The aircraft crashed just short of the runway when the functioning right engine was shut down; and the left engine’s fire was made worse when extra fuel was pumped into it. 47 died and of 79 survivors, 74 suffered serious injuries.

The pilot who was sucked out of the cockpit

Another theme was system failures. When accidents are investigated there is of course an immediate cause. Soon after a BAC 1-11 aircraft took off from Birmingham airport in 1990, there was a loud bang as a newly installed cockpit windscreen disappeared at 17,000 feet. The co-pilot, who had undone his safety harness, was sucked out of the aircraft and left hanging on by his knees. He was saved by cabin crew holding his legs as the pilot regained control of the aircraft and landed it safely.

The immediate cause was that the windscreen had been installed using bolts that were a mixture of too small in diameter and too short. The next deeper level of causes included a fundamental design error in the windscreen and a mechanic deprived of sleep. But even this was not enough for the investigators who identified fundamental system failings, including that “the number of errors perpetrated on the night of this job came about because procedures were abused, 'short-cuts' employed and mandatory instructions ignored. Even when doubt existed about the correct size of bolt to use, the authoritative documents were not consulted.”

The airline had failed to detect the slipped standards because they did not monitor more senior mechanics. It did not help that their procedure for gathering feedback about the effectiveness of the maintenance system was not working properly: the AAIB estimated that the ratio of near misses to serious accidents might be as high as 600 to one so successful detection of system failures depends on reporting a substantial proportion of near misses.

What aviators learnt

The success of commercial aviation in flight safety is built on two pillars:

Analysis of accidents and near misses to their root causes, including system failures including effects of human psychology and behaviour at all levels;
Remedying systemic weaknesses and managing behavioural and psychological issues uncovered.

These systemic issues include systemic weaknesses caused by human behaviour: aviators have overcome the idea, common elsewhere, that systems just means processes. Systems do include processes, but recognising that humans are an integral part of their systems, aviators treat normal, predictable human behaviour as an integral part of the flight safety problem and integrate lessons about human behaviour into flight safety.

Practical lessons for all

Thus even the most experienced pilots are taught to listen to subordinates and welcome challenge. Everyone is trained to challenge whenever necessary and ensure they are heard. All are trained to listen to each other and to cooperate, especially under stress. And through what is known as “just culture” the whole commercial aviation system encourages even self-reporting of near-misses and errors as well as accidents so they can be analysed to root causes and the lessons fed back to all. The deal is spelt out on the CAA website:

“Just culture is a culture that is fair and encourages open reporting of accidents and incidents. However, deliberate harm and wilful damaging behaviour is not tolerated. Everyone is supported in the reporting of accidents and incidents.”

This is not whistleblowing to bypass belligerent bosses: it is a routine system that applies to everyone, every day and at whatever level. It applies to all directly involved in flight operations including leaders on aircraft and those who lead the manufacture, maintenance and support of aircraft and the systems that keep them flying. No-one in the system is above it; and the CAA statement of the just culture is endorsement of the flight safety culture from aviation’s highest level: its regulator.

Everyone in the system now accepts it, though it was initially resisted just as Professor Atul Gawende’s surgery checklists were initially resisted by some surgeons. It was no surprise to psychologists that most of the minority who resisted Gawende’s checklists thought that, though they did not need to use checklists, any surgeon operating on them should use one.

The story of flight safety illustrates how carefully thought through culture change has brought about a system so safe that few even think about flight safety. Aviation has achieved this despite the system’s complexity, which includes legions of organisations, huge and small, worldwide.

Applying the lessons beyond aviation

Can it be replicated elsewhere? The fact that airlines – such as British Airways’ recent IT failure – can have serious failures beyond flight safety confirms that the cultural transition between flight safety and the rest of the business is not automatic – even where the group chief executive was once a pilot.

There can be no doubt that senior UK financial regulators understand that cultural, management and leadership failures in and around finance are among the root causes of the 2007/8 financial crisis. Some of these roots – such as the accumulation and promotion of undesirable character traits among staff hired primarily for greed and aggression – go deep. But many, even if not transient, are less deep-rooted.

A better culture, and the incentives and other drivers to support it, can be designed and launched surprisingly fast though embedding it will take longer. Incorporating a culture of learning from errors, near-misses as well as the serious failings in conduct, will help identify systemic weak spots so they can be remedied.

But just as it was crucial that even the most senior pilots learned to welcome analysis and challenge of their actions, so too must business leaders. Their perceived character, culture, incentives and behaviour are crucial models for their subordinates. And just as the CAA overtly underpins aviation’s culture of learning from error, so regulators, and their political masters, must embrace the importance of an open, analytical - and forgiving - attitude to honest mistakes.

Anthony Fitzsimmons
Reputability LLP
London

Anthony Fitzsimmons is Chairman of Reputability LLP and, with the late Derek Atkins, author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You”

This article was first published in the August/September 2017 edition of Financial World.

What is wrong with “efficiency”? Plenty.

noreply@blogger.com (Reputability) — Thu, 27 Jul 2017 13:42:00 +0000

We are delighted to welcome a guest post from Professor Henry Mintzberg, a prolific writer on management issues including The Rise and Fall of Strategic Planning and Managers Not MBAs which outlines what he believes to be wrong with modern management education.

Efficiency is like motherhood. It gets us the greatest bang for the buck, to use an old military expression. Herbert Simon, winner of one of those non-Nobel prizes in economics, called efficiency a value-free, completely neutral concept. You decide what benefits you want; efficiency gets you them at the least possible cost. Who could possibly argue with that?

Me, for one.

I list below a couple of things that are efficient. Ask yourself what am I referring to—the first words that pop into your head.

A restaurant is efficient.

Did you think about speed of service? Most people do. Few think about the quality of the food. Is that the way you chose your restaurants?

My house is efficient.

Energy consumption always comes out way ahead. Tell me: who ever bought a house for its energy consumption, compared with, say, its design, or its location?

What’s going on here? It’s quite obvious as soon as we realize it. When we hear the word efficiency we zero in―subconsciously―on the most measurable criteria, like speed of service or consumption of energy. Efficiency means measurable efficiency. That’s not neutral at all, since it favors what can best be measured. And herein lies the problem, in three respects:

1. Because costs are usually easier to measure than benefits, efficiency often reduces to economy: cutting measurable costs at the expense of less measurable benefits. Think of all those governments that have cut the costs of health care or education while the quality of those services have deteriorated. (I defy anyone to come up with an adequate measure of what a child really learns in a classroom.) How about those CEOs who cut budgets for research so that they can earn bigger bonuses right away, or the student who found all sorts of ways to make an orchestra more efficient.

2. Because economic costs are typically easier to measure than social costs, efficiency can actually result in an escalation of social costs. Making a factory or a school more efficient is easy, so long as you don’t care about the air polluted or the minds turned off learning. I’ll bet the factory that collapsed in Bangladesh was very efficient.

3. Because economic benefits are typically easier to measure than social benefits, efficiency drives us toward an economic mindset that can result in social degradation. In a nutshell, we are efficient when we eat fast food instead of good food.

So beware of efficiency, and of efficiency experts, as well as of efficient education, heath care, and music, even efficient factories. Be careful too of balanced scorecards, because, while inclusion of all kinds of factors may be well intentioned, the dice are loaded in favor of those that can most easily be measured.

By the way, twitter is efficient. Only 140 characters! This blog is less so.

References

Herbert A. Simon Administrative Behavior: Second Edition (Macmillan, 1957, page 14).

This TWOG derives from my article “A Note on the Dirty Word Efficiency”, Interfaces (October, 1982: 101-105)

This blog was first published by Henry Mintberg's own blog at http://www.mintzberg.org

Intelligent Dissent

noreply@blogger.com (Reputability) — Mon, 10 Jul 2017 10:09:00 +0000

On 13 May, 1940, Sergeant Walther Rubarth was in the vanguard of the German army invading France. His company had survived a hail of French machine gun fire as it crossed the River Meuse and fought through French defences.

Having reached his objective his orders were to dig in, but he was surprised to find that a key part of the battlefield was undefended – for the time being. He saw a golden opportunity to further the army’s overall goal and advance, but to exploit it he had to disobey his orders. As he pondered the options, an officer arrived and ordered him to dig in. Rubarth challenged the order and won the argument. His subsequent actions went on to create “such destructive chaos that it unlocked the heart of the French defences and had decisive operational significance”.

This was not extraordinary. For decades, the German army had cultivated a culture of “intellectual development through curiosity, critical thinking, imagination and openmindedness”, according to Professor Lloyd Clark,(1) that permitted and encouraged considered dissent underpinned by a clear articulation of overall objectives. It was an essential element of what the Germans call auftragstaktik (mission-orientated command).

Adopted by the German army in the nineteenth century, it is widely used in the British and US armies today. To work, it requires a clear culture shared across the organisation, well-defined goals and mutual trust. Execution is delegated to subordinates, working within the ethos and culture they have been trained to share. Intelligent dissent is encouraged.

Provided you have a good enough reason, and stay within the cultural rules, you can disobey orders to achieve the overall goal. Culture is, therefore, a central pillar supporting leaders as they exert control over their military machine. The feedback provided by intelligent dissent is essential to keeping it in good working order and using its innate intelligence to the full.

Fast forward 76 years to the City of London in 2016. Andrew Bailey, then leading the Prudential Regulation Authority and now chief executive of the Financial Conduct Authority (FCA), recognised the crucial effect of culture on outcomes that matter to regulators. His assessment (2) of recent failures was damning of management and leadership. He said:

“There has not been a case of a major prudential or conduct failing in a firm which did not have among its root causes a failure of culture as manifested in governance, remuneration, risk management or tone from the top.”

So culture sowed the seeds of disasters,

“for instance where management are so convinced of their rightness that they hurtle for the cliff without questioning the direction of travel”.

People find it easy to discuss the familiar, such as market, credit, liquidity or conduct risk, but are reluctant to talk about risks from individual behaviour, let alone the behaviour of their leaders. Most people find it embarrassing, dangerous, or both, to raise such subjects. Bailey did not mince his words, continuing:

“You can add to that [list], hubris risk, the risk of blinding over-confidence. If Imay say so, it is a risk that can be magnified by broader social attitudes. Ten years ago, there was considerable reverence towards, and little questioning of, the ability of banks and bankers to make money or of whether boards demonstrated a sufficient diversity of view and outlook to sustain challenge.How things have changed. Healthy scepticism channelled into intelligent and forceful questioning of the self-confident can be a good thing.”

A central aim of the FCA is to drive fair treatment of customers through a culture that puts customers first and a system that allocates responsibility unambiguously. Who can argue with its requirement that managers communicate that aim to staff? Or with the responsibility placed on managers, via the senior managers regime, to put customers at the heart of strategy, staff training, reward or controls? (3) But is that enough?

The FCA’s themes are sound. Allocating responsibility clearly ensures that all know who is in charge of what. The FCA understands that culture is rooted in history and can take years to change. It recognises that bad cultures from the past leave toxic legacies that endure. A company or industry that has recruited, rewarded and promoted on aggression, self-confidence and greed for decades has a problem that will take decades, or a cull, to fix. Antony Jenkins, the former chief executive of Barclays, saw the enormity of the problem he faced when he wrote:

“There might be some who don’t feel they can fully buy into an approach which so squarely links performance to the upholding of our values. My message to those people is simple: Barclays is not the place for you.” (4)

The FCA emphasises tone from the top. How you behave matters even more than what you say. But in an industry that, for years or decades, has recruited and promoted for what are now seen as undesirable character and behavioural traits, where do you find leaders who combine technical competence with the traits, attitudes and values now required?

The answer is in the question. Desirable character traits should become an explicit part of the specification of every leader and potential leader and be given at least equal weight with skills, knowledge and experience in recruitment and promotion. As Canada’s respected Ivey Business School explained, good leaders balance confidence with humility; aggressiveness with patience; analysis with intuition; principle with pragmatism; deliberation with decisiveness; candour with compassion. (5) Organisations that dig more deeply may be pleasantly surprised to discover seams of people who were previously overlooked as potential leaders, including women and minorities of many kinds, with both technical skills and desirable character traits.

Any potentially risky aspects of leaders’ characters should be discussed openly by boards and regulators. Those of senior leaders should feature prominently on the risk register. There are advantages in an enthusiastic, forceful or charismatic chief executive, but the corresponding risks should be recognised and managed. I was surprised when I first heard of a chief executive whose “dominant” character featured in the company’s risk register; but its presence there made it possible for his dominant tendencies to be managed in normal polite discussion.

Another aspect of tone is the company’s strategy and how it is expressed: not just what you are trying to achieve but also how you manage clashes between objectives and principles and with what consequences. This feeds through to reward patterns.

Of course bonuses matter because you can expect to get more of what you reward – although you should take care what you wish for. Bonuses drove payment protection insurance sales that produced pain. The same applies to other kinds of reward, from a pat on the back through public praise to promotion. These patterns determine who leaves, who stays and who rises as particular character traits are encouraged and a culture built and reinforced.

Most telling is how you respond when objectives clash with principles. How do you deal with someone who gets the right result by crossing your red lines? And what about someone who forgoes a deal because they would not cross them?

But let us move into your office, today. What do you do when faced with a rule that does not work in your real world of work? Do you shrug, obey the rule and achieve the wrong result? Do you “work around” or disregard the rule, perhaps after discussing the problem with colleagues? Or do you tell your superiors that the rule needs to change and why? My experience suggests that more people take the first two options than the third. These undermine the ground rules – risking serious breaches – whereas feedback from intelligent dissent reinforces and improves them.

Another question: what happens if something goes wrong? Not so badly that it is obvious to your boss, but bad enough to need fast or fancy footwork. Do you tell your superiors? Analyse what went wrong and why? Make sure weaknesses are fixed and lessons learned widely? More likely the problem is discussed locally, if at all, then buried; yet mishaps without bad consequences provide valuable feedback as to how well the system is working, or not. They are often symptoms of systemic weaknesses where a bad outcome has been prevented by a mixture of luck and crisis management. When luck runs out, something far nastier happens. Consequences can be personal, painful and protracted.

Part of the reason for the persistence of risk areas is that leaders have not created psychologically safe spaces where subordinates, let alone leaders, can admit to mistakes and deal with them. Some leaders lack the humility and selfconfidence to cope with contradiction, let alone regular intelligent dissent. The penal aspects of the UK senior managers regime, imposed on financial regulators may play a part, by causing leaders to see admitting errors as a weakness rather than a strength and an opportunity to learn from mistakes. Whatever the cause, the result is that rules are undermined and organisations fail to learn, leaving systemic weaknesses unresolved until something blows up.

Putting your customers first will please the FCA. But a more comprehensive route to sustainable success is to adapt auftragstaktik and intelligent dissent to achieve a culture that learns and repairs itself. It will also put your trusted team’s expensively bought brainpower to more productive use.

Anthony Fitzsimmons
Chairman,
Reputability LLP
@Reputability
London

Endnotes

1. Clark L (2017), ‘The Intelligently Disobedient Soldier’. Centre for Army Leadership. Available at www.army.mod.uk/documents/general/Centre_For_Army_Leadership_Leadership_Insight_No_1.pdf.
2. Bailey A (2016), ‘Culture in Financial Services – a regulator’s perspective’. Bank of England speech. Available at: www.bankofengland.co.uk/publications/Pages/speeches/2016/901.aspx.
3. Davidson J (2016), ‘Getting Culture and Conduct Right - the role of the regulator’. FCA speech. Available at: www.fca.org.uk/news/speeches/getting-culture-and-conduct-right-role-regulator.
4. ‘Antony Jenkins to staff: adopt new values or leave Barclays’, The Daily Telegraph, 27 January, 2017. Available at: www.telegraph.co.uk/finance/newsbysector/banksandfinance/9808042/Antony-Jenkins-to-staff-adopt-new-values-or-leave-Barclays.html.
5. Gandz J at al. (2010), Leadership on Trial: a manifesto for leadership development. Ivey School of Business

Anthony Fitzsimmons is joint author, with the late Professor Derek Atkins, of "Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You"

This article was first published in the June/July 2017 edition of Financial World.

WanaCrypt0r 2.0 Virus infects NHS and more

noreply@blogger.com (Reputability) — Fri, 12 May 2017 22:45:00 +0000

Large sections of the UK's National Health Service (NHS) were hit by a ransomware attack as were many other organisations worldwide.

According to the Financial Times, the virus was a weaponised development of the US National Security Agency's 'Eternal Blue' tool, part of a "highly classified NSA arsenal of digital weapons leaked online last year by a group called the Shadowbrokers".

WanaCrypt0r seems to have been distributed by the common route of an attachment to emails which were opened by numerous recipients who did not identify the attachments as suspicious.

The Guardian reported

"Many NHS trusts still use Windows XP, a version of Microsoft’s operating system that has not received publicly available security updates for half a decade, and even well-patched operating systems cannot help users who are tricked into running software deliberately."

and later:

"It’s our governments, via the intelligence agencies, that share a responsibility for creating vulnerabilities in our communication networks, surveilling our smart phones and televisions and exploiting loopholes in our operating systems,” said Dr Simon Moores, chair of the International eCrime Congress."

In an interview with Andrew Marr,

"Michael Fallon [was] forced to defend the Government's decision not to fund crucial updates for NHS computer systems, leaving them vulnerable to a global cyber attack which caused chaos at hospitals across the country."

The cost saving was apparently a £5.5m saving by Central Government that could have been spent on keeping in place national support for XP in the NHS. Apparently there had been repeated warnings of the risks of running systems on an unsupported XP operating system, including a warning by Microsoft two months ago.

Brad Smith, President and Chief Legal Officer of Microsoft wrote:

"Repeatedly, exploits in the hands of governments have leaked into the public domain and caused widespread damage. An equivalent scenario with conventional weapons would be the U.S. military having some of its Tomahawk missiles stolen. And this most recent attack represents a completely unintended but disconcerting link between the two most serious forms of cybersecurity threats in the world today – nation-state action and organized criminal action."

According to Keren Elazari, the sectors where unsupported software systems are most prevalent are those where safety matters:

"healthcare, energy and transport; as well as finance and other industries where computer systems provide the foundations for modern functionality."

Assuming early reports are broadly correct, this attack raises behavioural, organisational, leadership and reputational risk issues.

Why are parts of the NHS using outdated, unsupported Windows XP?

The obvious answer is cost-cutting by people who do not understand the consequences, in this case the risks of running out-dated, unsupported operating systems. This now seems to include a Government minister who did not listen to advice on a subject he did not understand.

If so this is a classic case of cost-cutting to produce a short term gain at the cost of a systemic weakness that goes on to cause great pain when the risk eventually manifests. Cost-cutting in ignorance of the consequences is a risk that typically emanates from the highest levels of leadership anbd it regularly causes failures.

Why do NHS staff lack the training needed to operate an outdated, unsupported operating system?

It seems that NHS staff lacked the training manually to identify suspicious emails. Candidates as causes of this state of affairs include:

Ignorant leaders did not realise that cost-cutting on operating systems created cyber risks to which training might provide a partial solution.
Leaders who recognised the risks but would not provide training, for example because it would cost money they were not prepared to spend;
That no amount of training would be sufficient - but leaders either did not know this or did not care.

Leadership ignorance is an organisaitonal and leadership risk that regularly causes failure.

Who else is using unsupported software in systemically important systems?

These include supply chains for cash, food, power, water and the internet itself. What potential consequences might there be for the public?

Intelligence agencies

The UK intelligence agency GCHQ, backed by the UK Home Office under Theresa May, have already inserted backdoors into many encryption systems and recently gained statutory authority to demand backdoors into encryption and other systems including computers, phones and TVs and anything else containing sortware. It has statutory authority to hack into computers and other devices worldwide and there can be little doubt that they, like the NSA, developed tools to achieve this years ago. They also stockpile vulnerabilities in operating systems, preventing companies like Microsoft from dealing with them. As Brad Smith, Microsoft president’s and chief legal officer, said,

“An equivalent scenario with conventional weapons would be the US military having some of its Tomahawk missiles stolen.”

No organisation can guarantee the security of valuable tools such as these against a determined external attacker or internal leaker. These risks will always be greater than zero.

If surveillance and cyber-warfare tools escape into the hands of criminals or hostile state actors, the potential for harm will broadly be in proportion to the versatility of the tools and the creativity and motivation of users. There can be no doubt that a determined, skilled and motivated group of hackers could design an event to cause great harm and outrage, just as Al Quaeda did with its carefully designed and planned "9/11" attack on the USA. These are perfect weapons for the weak.

Given that there is a finite risk of cyber-warfare tools 'escaping', the question is whether intelligence agencies, and the politicians who ultimately control them, have considered the risks and consequences of the tools they develop being turned against their own countries and allies. Even if the probability of theft of the tools is thought very low, a foolhardy assumption, the potential for harm to the public is unknowably great.

This is yet another example of the risks of balancing short term gains against the long term consequences of systemic weaknesses. The problem with this balancing act is that it is rarely possible to quantify the consequences of systemic weaknesses, especially where deliberately caused harm is involved. History shows that it is easy to overlook or underestimate them. The problem is exacerbated by leaders' tendency to give more weight to imminent than to distant consequences.

As to the security services, the likelihood is that current cyber attack will come to be seen as small beer. When that happens, the reputation, and licence to operate, of the security agency concerned whose software has been turned against its own state or a friendly state, will be balanced on a knife edge. Other security agencies will be at risk of collateral damage.

As to the NHS, a series of scandals of incompetence, catalogued by Richard Bacon in his book "Conundrum", has left the NHS and its leaders with a poor reputation for competence when it comes to IT. If it eventually emerges that the NHS IT system had weaknesses that left it vulnerable to this attack, its reputation for competence will be damaged further. Evidence emerging suggests that it will also leave the reputation of the minister who cancelled the IT support contract in tatters.

Background reading: You can read more about how behavioual, organisational and leadership risks cause immense harm to seemingly solid organisations in 'Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You". Lord David Owen wrote of it:

"An exceptional book for learning at every level – whether you are a business school student or a chief executive; Prime Minister or a new recruit into the civil service."

You can read reviews of the book here.

Anthony Fitzsimmons
Reputability LLP
London

www.reputability.co.uk
www.rethinkingreputationalrisk.com
@Reputability

Financial Times reviews 'Rethinking Reputational Risk'

noreply@blogger.com (Reputability) — Wed, 04 Jan 2017 12:10:00 +0000

Stefan Stern has reviewed 'Rethinking Reputational Risk' for the Financial Times.

Introducing his review, Stern wrote:

"Th[is] book offers a thorough analysis of the many ways in which apparently unexpected crises can destroy businesses and reputations. Boards, chief executives and their managers may believe they have a firm grip on the risks they face. They should think again."

He continued:

"The book contains a series of detailed case studies of some of the best-known corporate crises of recent years .... The authors draw more than 30 lessons from their schadenfreude-free research."

before concluding:

"Businesses and executives are therefore vulnerable on a number of levels. They would do well to reflect on the serious messages contained in this well-argued book."

You can read more reviews here.

You can read more about 'Rethinking Reputational Risk' here.

You can buy copies from the publishers here.

Rethinking Reputational Risk

noreply@blogger.com (Reputability) — Thu, 03 Nov 2016 22:02:00 +0000

For too long, there has been an unspoken assumption in traditional risk management and regulation that organisations are quasi-mechanical and that decision making is essentially rational. The implication is that you if can devise the right rules, risks will disappear because people will respond to them logically.

In truth, all organisations consist of real people who exhibit the range of normal human feelings, emotions and behaviours and have individual characters. These, and well-understood mental short-cuts and biases, are as important as strict logic in making decisions in the real world. Real people constantly react to real life in ways that, whilst predictable, are not strictly rational. It is those who lack these feelings and emotions who are unusual, not those who exhibit them.

You visit the baker to be faced with an aromatic array of fresh bread. Do you rigorously compare the nutritional content of each loaf, run quality tests and carry out a price and product comparison with other bakers in the vicinity (not forgetting transport and opportunity costs) that, if you are strictly rational, you ought to consider?

Of course you don’t. You follow your eyes, nose and feelings rapidly to choose what you feel is the best choice: today a bag of bagels; tomorrow scented spelt scones; and if you like sweet things you may scoff the scrummy sugared doughnut you know you should shun. If you stuck to strict logic, the baker’s shelves would be empty by the time you made your decision.

Feelings and emotions are an important element in normal decision-making, and this is true of all normal people in all contexts – including the most intelligent and respected business leaders in their work. Unfortunately the emphasis on ‘homo economicus’, economists’ rational, benefit-maximising model of man leads many leaders to assume this crude model represents reality, a double danger if they do not realise the extent to which their own decision-making depends on feelings and emotions.

Real people use what behavioural economists and psychologists call heuristics and biases in making decisions.

Heuristics are mental short cuts that we all use to simplify decision-making. There are dozens of them, working beneath our consciousness. For example there is evidence that where we recognize one of a number of choices but have no better information, we are likely to put a lower store on the option we do not recognize. That is the recognition heuristic.

Then there are biases. An important bias is the ‘optimistic bias’. As healthy humans we tend to delude ourselves that bad events are less likely to happen than good ones. And we tend to attribute positive events to our skill and adverse ones to ‘them’ or bad luck: the ‘self-serving bias’.

Many more heuristics and biases provide the numerous unrecognised assumptions and short-cuts that make the life of a normal person – well normal.

This matters. People and the way they behave is what can make organisations great. But one of the insights to emerge from our work on “Roads to Ruin” the 2011 Cass Business School report for Airmic (we were two of the report’s four authors), is that people are almost always at the root of why organisations are derailed. They are implicated twice over: first because individual and collective human behaviour, most of it perfectly normal and predictable, lies at the root cause of most crises; and then because it regularly tips potentially manageable crises in to unmanageable reputational calamities.

We have since established that seniority amplifies the consequences of behaviour for good or ill, so that other things being equal, behavioural and organisational risks related to leaders typically have far more serious consequences than an analogous errors lower down the hierarchy.

Unfortunately this area of risk is not systematically recognised by classical risk management. Some areas of people risk are captured by looking at process safety, but this leaves huge gaps. And a restricted view of reputational risk has left large areas of risks to reputation doubly unprotected. Leaders and risk professionals have a structural blind spot that leaves the organisation – and its leaders – predictably vulnerable.

We have solved the problem by rethinking reputation and reputational risk – and so can you. The Financial Times lexicon defines reputation as: “Observers’ collective judgments of a corporation based on assessments of financial, social and environmental impacts attributed to the corporation over time”; and there is much bickering over the nature of reputational risk.

Whilst the FT definition is good in parts, it is too narrow. We prefer the deceptively simple:

“Your reputation is the sum total of how your stakeholders perceive you.”

Think about it and you will find its hidden depths. One is that you lose your reputation when stakeholders come to believe, rightly or wrongly, that you are not as good as, or are worse than, they previously believed you to be. That leads to our definition of reputational risk:

“Reputational risk is the risk of failure to fulfil the expectations

of your stakeholders in terms of performance and behaviour”

Many ‘performance’ failures are caught by enterprise risk management; but few risks from behaviour or organisation are captured. The result is that risks that both cause crises and destroy reputations are not captured, so they remain unmanaged. Worse, the research shows that behavioural and organisational risks can take many years to emerge. In the meantime, leaders think all is well when, helped by the self-serving bias, they have been fooled into complacency by what is, in truth, a run of good luck; and they have lost the opportunity to deal with potentially lethal unrecognised risks before they cause harm.

And as Richard Feynman, the late lamented Nobel laureate who uncovered the people risks that caused NASA’s Challenger disaster, said: “The first principle is that you must not fool yourself; and you are the easiest person to fool.”

Professor Derek Atkins

Anthony Fitzsimmons

www.reputability.co.uk

“Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You” will be published on 3 January. You can read reviews of the book at www.koganpage.com/reputational-risk For a limited time you can (pre-)order the book there at a 20% discount: use code ABLRRR20

This blog is based on an article first published in Management Today.

Blind Reliance on Models: a Recipe for Trouble

noreply@blogger.com (Reputability) — Fri, 18 Dec 2015 17:42:00 +0000

We are delighted that Professor John Kay has allowed us to reprint this column, on the dangers of relying on models to predict what is beyond their power to predict.

As the global financial crisis began to break in 2007, David Viniar, then chief financial officer of Goldman Sachs, reported in astonishment that his firm had experienced “25 standard deviation events, several days in a row”. Mr Viniar’s successor, Harvey Schwartz, has been similarly surprised. When the Swiss franc was unpegged last month, he described Goldman Sachs’ experience as a “20-plus standard deviation” occurrence.

Assume these experiences were drawn from the bell-shaped normal distribution on which such claims are generally based. If I were to write down as a percentage the probability that Goldman Sachs would encounter three 25 standard deviation events followed by a 20 standard deviation event, the next 15 lines of this column would be occupied by zeros. Such things simply do not occur. So what did?

The Swiss franc was pegged to the euro from 2011 to January 2015. Shorting the Swiss currency during that period was the epitome of what I call a “tailgating strategy”, from my experience of driving on European motorways. Tailgating strategies return regular small profits with a low probability of substantial loss. While no one can predict when a tailgating motorist will crash, any perceptive observer knows that such a crash is one day likely.

Some banks were using “risk models” in which volatility was drawn from past daily movements in the Swiss franc. Some even employed data from the period during which the value of the currency was pegged. The replacement of common sense by quantitative risk models was a contributor to the global financial crisis. And nothing much, it seems, has changed.

It is true that risk managers now pay more attention to “long-tail” events. But such low-probability outcomes take many forms. The Swiss franc revaluation is at one end of the spectrum — a predictable improbability. Like the tailgater’s accident this is, on any particular day, unlikely. Like the tailgater’s accident, it has not been observed in the historical data set — but over time the cumulative probability that it will occur becomes extremely high. At the other end of the spectrum of low-probability outcomes is Nassim Taleb’s “black swan” — the event to which you cannot attach a probability because you have not imagined the event. There can be no such thing as a probability that someone will invent the wheel because to conceive of such a probability is to have invented the wheel.

But most of what is contingent in the world falls somewhere in between. We can describe scenarios for developments in the stand-off between Greece and the eurozone, or for the resolution of the crisis in Ukraine, but rarely with such precision that we can assign numerical probabilities to these scenarios. And there is almost zero probability that any particular scenario we might imagine will actually occur.

What Mr Viniar and Mr Schwartz meant — or should have meant — is that events had occurred that fell outside the scope of their models. When the “off-model” event was the breakdown of parts of the wholesale money market in 2007, their surprise was just about forgivable: in the case of the Swiss revaluation, to have failed to visualise the possibility is rank incompetence.

Extremes among observed outcomes are much more often the product of “off-model” events than the result of vanishingly small probabilities. Sometimes the modellers left out something that plainly should have been included. On other occasions they left out something no one could have anticipated. The implication, however, is that most risk models — even if they have uses in everyday liquidity management — are unsuitable for the principal purpose for which they are devised: protecting financial institutions against severe embarrassment or catastrophic failure.

First published in the Financial Times.

The Rise and Fall of BP

noreply@blogger.com (Reputability) — Tue, 17 Nov 2015 17:20:00 +0000

The tale of BP is a story of a sleepy British corporate, transformed by Lord Browne into one of the world's largest and apparently most successful oil companies, only to be cut down to size by a series of tragedies.

When it emerged that BP's apparent success was built on foundations of charisma, a flawed safety culture, cost-cutting and lost internal expertise, its reputation and its market value, were destroyed. It became a pariah, publicly berated by a US President, downgraded to BBB by Fitch and discussed as a take-over target. It was probably saved from takeover by its toxic litigation legacy, only recently resolved at a cost estimated at more than $50 billion.

Journalists have feasted on stories from the Texas City explosion and the Deepwater Horizon disaster. We deconstructed the root causes from reports internal and external, to extract more lessons from these stories than from almost any other company in crisis.

But to our delight, Professor Andrew Hopkins has done better. He taught the US Chemical Safety and Hazard Investigation Board, charged with investigating the Texas City refinery explosion, about culture, safety cultures and learning cultures. His insider knowledge of the investigation and track record of thinking and teaching about oil industry disasters put him in a good position to write about both disasters. But he also identified, which we had not, a treasure trove of material: depositions and internal BP documents on a US website devoted to the Texas City disaster by Eva Rowe in memory of two of its victims, her parents James and Linda Rowe.

The result is two exceptional books. The first, 'Failure to Learn' takes apart the story of Texas City with a confidence that comes from direct contact with the evidence of witnesses and other primary sources. Based on these sources he devotes a chapter to the failure of BP's top leadership

'Disastrous decisions' the second of this pair of books, deconstructs the Deepwater Horizon disaster. It is worth quoting its opening words, which we endorse:

The blowout in the Gulf of Mexico on the evening of 20 April 2010 caught everyone by surprise although it shouldn't have."

Before the Deepwater Horizon disaster, BP was sufficiently riddled with systemic behavioural and organisational risks and reputational risks that a bad accident was to be expected even it was not possible to predict timing or the precise accident. This is not an uncommon situation: systemic risks typically lie latent for years, sometimes decades, before causing what can be catastrophic damage. In the meantime, the absence of a catastrophe leads insiders, particularly leaders, to be complacent, believing that "it won't happen to us" because it hasn't - yet. Outsiders, and frequently lower level staff, know otherwise. But no-one listens to them until luck takes a day off.

Whereas the special focus of 'Failure to learn' is leadership, Hopkins uses 'Disastrous decisions' to explain and illustrate the power of error management and root cause analysis to find out why accidents happen so that their root causes can be dealt with before they cause harm. He also focuses on decision-making by middle-mangers, using the community of engineers to illustrate his points.

Both books make striking contributions to the literature. Their additional sources have reinforced our analysis with new and strong evidence. Both should be compulsory reading for business leaders, board members and everyone with risk responsibilities.

And unlike most required reading, they tell a captivating story too.

Anthony Fitzsimmons
Reputability LLP
London
www.reputability.co.uk

Anthony Fitzsimmons is Chairman of Reputability LLP and, with the late Derek Atkins, author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You”

Why Government Repeats Mistakes - and What to Do about it

noreply@blogger.com (Reputability) — Fri, 23 Oct 2015 08:55:00 +0000

We are delighted to be able to post, with his permission, an essay by Richard Bacon MP. Richard is Member of Parliament for South Norfolk, Deputy Chairman of the Public Accounts Committee, its most long-serving member and, with Christopher Hope, the author of Conundrum. Richard has probably been involved in the study of more governmental mishaps than any other parliamentarian.

Sir Michael Barber once observed that the “How” question is relatively neglected in the writing of history and politics. A textbook would say of some medieval king that “he gathered an army and hastened north” without pausing to consider just how difficult that was to do. Yet when governments embark on anything new, it is quite normal for things not to turn out as planned – and the problems are nearly always to do with the “How” question.

We have seen an NHS dental contract which left large numbers of people without a dentist; a new system for marking school tests where up to three quarters of the marking was wrong; a pension regulatory body which had no objectives; and an urban regeneration project which had no budget. People have died because flawed hospital computer systems meant they were not told about their next vital check-up until it was too late. Holidays have been ruined because the Passport Office couldn’t issue passports on time. Failed asylum applicants with no right to be in the country – who happened to be murderers, kidnappers and rapists – have been released from jail to wander free in our community because no one could be found to deport them.

Farmers have committed suicide because of the Kafkaesque horrors of the Rural Payments Agency. The NHS mismanaged its recruitment of junior doctors so badly that medics – whose training had been paid for by British taxpayers – were forced to flee abroad in search of work, only to be urged to return soon afterwards, at the highest agency rates, due to a government-induced shortage of doctors. Some failures are so infamous they have become household words – the Child Support Agency or the Criminal Records Bureau (CRB) – even surviving Orwellian rebranding efforts to stamp out memories of a fiasco; no one I know calls the CRB the “Disclosure and Barring Service”.

Ministers routinely enter office with no knowledge of why things have gone wrong so often in the past. Few civil servants are around long enough to tell them. After only eighteen months as an education minister in charge of academies policy, Andrew Adonis found he had been in post longer than any of the officials who were supposed to be advising him. The Department for Transport somehow managed to have four permanent secretaries in two years. Given the track record, one might expect the quality of government spending to be a matter of sustained national concern. One can’t say “Oh, that’s management” and expect someone else to do it. It turns out that the “How” question can seriously affect the “What” question or even “Whether” anything happens at all.

The case for examining much more closely the quality of what we are doing has never been stronger. In a rapidly changing world there is an almost perfect storm of problems. As we get better at keeping people alive longer, we face inexorable rises in the cost of pensions and healthcare systems. As our population gets older and the tax base shrinks, our need to invest in better infrastructure – including better broadband connections, roads, railways and airports – only grows more urgent. We have an ongoing skills crisis. Our people need to be more numerate, literate and IT-savvy. We need to produce more housing but we have a dysfunctional model that fluctuates between near-stasis and a market bubble. Across the globe we face a burgeoning population and the need to produce more food on less land with much less water. We also know that if we can’t help the world’s people in situ they will instead come to us, compounding the pressures we already face. And we grapple with all these problems while struggling under a growing mountain of public debt, because successive governments seem quite unable to live within their means.

Squeezing much more out of the lemon is simply essential. We know that our governments must cost us less while being much more efficient and effective, to help us to deliver the changes we need. All this is probably common ground among most political parties, but the truth is that we are very bad at learning from our mistakes. Many politicians, civil servants and journalists are more interested in getting on with the next policy initiative, the next project or the next story.

Who is responsible for all this failure? Many screw-ups are plainly the result of poor decisions by ministers, who either try to do things too quickly or who won’t listen. Officials advising ministers on the Common Agricultural Policy were explicit that using the “dynamic hybrid” method for calculating single farm payments would be “madness” and a “nightmare” to administer; ministers chose it anyway.

The big regional contracts in the NHS’s National Programme for IT were agreed at indecently high speed – and duly signed before the NHS knew what it wanted to buy and the suppliers knew what was expected of them – because of pressure from Downing Street; the result was an expensive catastrophe. Tax credits still cause misery for thousands of low income families who have been overpaid, because HMRC demands repayments they cannot afford; the policy was Gordon Brown’s from its inception.

But what about civil servants? When managers at the Learning and Skills Council failed to count the money for the FE Colleges building programme while handing it out – thus pledging billions of pounds which they didn’t have – the Innovation and Skills Secretary John Denham said grimly that “there was a group of people that we might have expected to know what was going on who did not themselves have a full grasp of it”. In the InterCity West Coast franchising competition, the officials in charge at the Department for Transport were unaware of advice from external lawyers that the Department’s actions were unlawful. And even in the case of the Rural Payments Agency, where decisions were very ministerially driven, the choice of the “dynamic hybrid” method for determining single farm payments was made – as Dame Helen Ghosh, the Permanent Secretary, eventually told MPs – because “ministers were being told it was possible when it was not in fact possible.”

The reality is that there is more than enough blame to go around. We need to spend less time blaming and more time seeking to understand what is going on. In recent decades there has been a whole string of attempts to reform the Civil Service, including Continuity and Change, the Citizen’s Charter and Taking Forward Continuity and Change. Then came Modernising Government and Civil Service Reform: Delivery and Values. Imaginatively, this was followed by Civil Service Reform: Delivery and Values – One Year on, which in turn was followed by the “Capability Reviews”, then Putting the Frontline First: Smarter Government and The Civil Service Reform Plan. Now we have The Civil Service Reform Plan – One Year on. That’s roughly one white paper or major initiative every two years for twenty years. And eight years after the Capability Reviews – more than the time required to fight the Second World War – the Government launched the Civil Service Capabilities Plan. A year later the new head of the Major Projects Authority identifies that there is “a lack of distributed capability around delivery across Government”. The problem is not a lack of "to do" lists.

For sure, it is down to the Civil Service and its accounting officers to make sure there is a system that works. As Richard Heaton, Head of the Cabinet Office put it: “It is our job, without ministerial pushing, to create a civil service that has the capabilities that the Government need”. But what should a civil servant do when a powerful minister is on the rampage and demanding the impossible? The epic scale of the failures should tell us that the problem is systemic. As the former Head of Tesco Sir Terry Leahy put it: “Management and democratic process are not a good mix”. But we will only solve the problem when we stop looking in the wrong place. As Bill Clinton nearly said: “It’s behaviour, stupid.”

Of course, influencing behaviour is almost a new Holy Grail among policymakers. We are told it will help us reduce crime, tackle obesity, ensure environmental sustainability and make sure people pay their taxes on time. It works – and it’s not that new. Making unleaded petrol cheaper than the leaded stuff sees more people buying it. Making it easier for people to recycle achieves better results than moral hectoring.

But what about the behaviour of civil servants and ministers? And the behaviour of Parliamentarians? What about the behaviour of suppliersto government such as big IT firms, who – unsurprisingly – have a preference for large IT projects regardless of what might actually be best for taxpayers. What if you have a civil servant running an IT project whom no one dares challenge? Or a team of civil servants foisted on a project without the right skills? What should you do when you have a permanent secretary and a Cabinet minister who barely talk to each other for months? Just as in Margaret Atwood’s novel The Handmaid’s Tale, this has all actually happened, somewhere, sometime.

As HM Treasury’s Permanent Secretary, Sir Nicholas Macpherson, has observed: “I have worked under Tory governments where Chancellor and Chief Secretary weren’t really speaking to each other. I have certainly worked under Labour governments where that was the case”. Many billions of pounds have been squandered this way. If we really want better outcomes, then understanding this – and changing it – is much more important even than policymakers’ efforts at “influencing” the behaviour of citizens.

Economics has seen a big shift towards studying how people actually behave, rather than how they are supposed to behave. We need a similar shift inside government and politics. The London 2012 Olympics showed we can get it right. The outstanding feature of the Olympics, as Head of Programme Control David Birch put it, was that “we worked hard to generate and recognise one source of truth”.

The world’s most successful organisations, whether in manufacturing or in services, spend a disproportionate amount of time and effort developing people. Our governments need to do the same. MPs are among the most determined people you will meet – otherwise they would rarely have become MPs – but as a class they need much better preparation for ministerial office. In the British Civil Service we have one of the world’s best talent pools but we don’t get the best out of them. Instead of incessant exhortation, we need to think harder about what makes people tick. Sir Ken Robinson, a teacher renowned worldwide in the development of creativity, wrote that “human resources, like natural resources, are often buried deep. In every organisation there are all sorts of untapped talents andabilities”. Don’t we need every hand on deck in order to get out of the mess we have landed ourselves in? It is always sensible to make the most of what you have. The answer is to look more closely at ourselves and our nature – and to act on what we find.

This essay was first published by Reform in "How to run a country: a collection of essays".

You will find our blog on the competence of civil servants here

First Lessons from Volkswagen

noreply@blogger.com (Reputability) — Wed, 23 Sep 2015 15:12:00 +0000

Volkswagen, scion of German industry, has fallen off its pedestal after revelations that up to 11 million of its diesel cars were fitted with software designed to deceive regulators about levels of toxic NOx emissions.

It all began to unravel last in May 2014 when Virginia University's Center for Alternative Fuels, Engines & Emissions (CAFFE) discovered that NOx emissions from two of three diesel-powered cars it was testing produced between 5 and 35 times more than the official emissions standard, though in laboratory conditions they complied. This was the first whiff of rat.

According to a Californian Air Resources Board (CARB) letter of 18 September, CARB took up the case and pursued investigations. Discussions ensued with VW, who solemnly carried out tests and provided fixes, which did not work when CARB tested them.

As CARB relates in its letter, on 3 September, after a year's prevarication, VW confessed. As the world now knows, large numbers of VW's diesel-powered motor cars were "designed and manufactured with a defeat device to bypass, defeat or render inoperative elements of the vehicle's emission control system" whilst meeting official testing procedures.

When the news became public, on 18 September, it was met with a mixture of incredulity and a drop in the VW share price of about 25%. After defending an almost indefensible position for almost five days, VW's Chief Executive Martin Winterkorn resigned. Some began asking whether VW would survive.

Beyond VW there was collateral damage. The share prices of other car makers dropped, though less than VW's. A discussion began as to whether diesel technology, held responsible for large scale health problems, was a wrong turning that should be abandoned. And questions were asked whether, after a long string of governance failures in Germany, German industry was really the paragon represented by its good reputation.

But the intriguing question is: why did this happen?

We do not yet know what happened but it is not unknown for major corporate scandals to have their genesis in the board room. Think of the Olympus and Toshiba scandals. That said there is no evidence of active boardroom involvement and Mr Winterkorn's protestations of surprise imply that he first learned of the problem very late in the day. But the composition of the supervisory board, which does not seem to have been chosen with skill sets as its primary concern, has echos of the boards at Airbus at the time of the A380 crisis and at the UK's Co-operative Group when it almost collapsed.

If that is so, he must have been in the dark, unaware of what seems to have been a piece of deliberate skulduggery going on under his nose - but without his knowledge.

This sadly is a very common state of affairs. We call it the Unknown Knowns problem. There are things that leaders would dearly love to know - but they cannot find out until it is too late. In our research, 85% of leaders were taken by surprise when a serious crisis engulfed their company. Yet most of these crises were caused by systemic failures that had lain unrecognised for years, sometime decades.

The most telling example is that there have been at least 14 rogue traders, averaging one every eighteen months, since Nick Leeson broke Barings in 1995: most recently the London Whale, who breached in 2012. JP Morgan sustained losses of $6 billion on positions said to amount to about $160 billion. All the rogue traders operated in an environment where risk teams are huge: JP Morgan's risk team ran to thousands but they didn't spot the Whale; nor did the astute Jamie Dimon - until an even more astute hedge fund spotted his problem from the outside and began to trade on his misfortunes.

What seems to happen is that some combination of character, culture, leadership, targets, incentives, corner-cutting, complexity, groupthink - and the slippery slope from gently bending rules to breaking them - leads an individual or team to start doing something that, as Warren Buffett put it, you "wouldn't be happy to have written about on the front page of a national newspaper in an article written by an unfriendly but intelligent reporter." It doesn't help if regulators are not robustly independent.

Once the wrongdoing has begun, it is very hard for participants to confess - doing so will probably lead to unpleasant sanctions - so it continues. The hole gets deeper.

The wrongdoing is rarely known just to the participants. Others usually know, but are unwilling to rock the boat. This may be because the wrongdoer has higher status; or it may be because they are in the same 'tribe', but as time passes unwillingness becomes tacit complicity. Many may know things are wrong but they won't tell anyone above them. Often the root causes are visible to the thoughtful, perceptive outside observer, such as a hedge fund or professional investor. We call these companies 'predictably vulnerable'.

There may be a potential whistle blower; but anyone who researches whistle blowing as an activity will discover that it is commonly terminal if not merely frustrating. It takes courage and determination to blow the whistle; and it takes an exceptional leader to listen and understand what a whistle blower is alleging with an open mind.

This is one of the ways in which leaders find themselves in the dark. Breaking this silence is difficult. It takes an insider-outsider, as anthropologists term it, armed with trustworthiness, skill and understanding of human behaviour to learn what insiders think and know but won't tell. A sensitive investigation should uncover the root cause behavioural and organisational risks that lead to Unknown Knowns so that leaders can fix at least the root causes before they can cause more harm. And as our research also shows, they usually do have some time.

An investigation may uncover things you wouldn't be happy to have written about on the front page of a national newspaper. If so, you should listen and learn; and be grateful for the opportunity to deal with them before they blow up and destroy your personal reputation as well as that of your organisation.

Anthony Fitzsimmons
Reputability LLP
London
www.reputability.co.uk
@Reputability

You can get a 20% discount when you buy Rethinking Reputational Risk - How to Manage the Risks that can Ruin Your Business, Your Reputation and You through this link by using the code RRRF20