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Devastating Reputation Failures: Full paper

Devastating Reputation Failures: Full paper

1. Executive Summary

1.1 Overview

Our firm has been working on this paper for the past five months, sparked by the revelations from a variety of significant investigations recently, including the Financial Services Royal Commission.

We seek to understand why these catastrophic reputation-damaging events have happened to major companies over many years, and what boards can do to ensure they do not happen in the future to the same extent.

We have read all the relevant material on these topics from experts around the world, and spoken to a large number of influential Chairs, directors and other knowledgeable people on these topics.

We have also drawn from the extensive research our firm has undertaken over the past five years on the topic of how the best boards in the world go about their work.

We wrote a paper based on this previous research several years ago titled “Board Focus for Long-term Success” which you can find on our website.

The work we have done over the past five months reinforces what we have learned over the past five years about what boards need to do to build the ingredients of long-term success into their organisations.

The full paper covers the following topics:

  • What is reputation and how important is it?
  • What are the major reputational risks?
  • The impact of the next generation and social media on reputation
  • Examples of the impact of reputational crises
  • Why are these risks not managed effectively?
  • Key areas that boards can focus on to build and maintain a strong reputation
  • The benefits of creating a new, overarching role – the Chief Reputation Officer – that oversees all matters relating to reputation.

This Executive Summary focuses on the last three points.  But first – what do the best boards in the world focus on?

1.2 What Leading Boards Focus on Globally to Deliver Long-term Sustainable Success

In summary, our previous paper outlined that the companies which have thrived over the long term have the following in common:

  • A very strong purpose
  • A long-term perspective
  • A balanced view of who the key stakeholders are
  • Leaders at board and executive levels with the appropriate experience, knowledge, character, values and mindset
  • Leadership that is obsessed with delivering customer value
  • Driving a very strong innovation culture which focuses on customer needs and improving internal systems and processes
  • Leadership that is focused on developing a new generation of leaders
  • An “always on” strategy mindset and process
  • Active management of a very strong culture, underpinned by aligned remuneration and measurement systems.

Boards have a major role to play in all of these points.

It is clear from the recent major investigations, and reinforced by our work, that many major companies do not have all, or in some cases, some, of these ingredients in place today.

One of the reasons for this is that many boards have a narrow view of what their role is.

The conventional view of the role of a board as described on the AICD website is:

  • Overall organisational performance: ensuring the organisation develops and implements strategies and supporting policies to enable it to fulfil its objectives
  • Overall compliance/conformance: ensuring the organisation develops and implements systems, processes, and procedures to enable it to comply with its legal, regulatory and industry obligations – and ensure that the organisation’s assets and operations are not exposed to undue risks.

Boards need to do all of this, but we would add one important additional role for a board based on our research of leading boards:

  • Build and sustain the conditions for long-term success.

This additional area of focus highlights the importance of a board:

  • Establishing a powerful purpose
  • Developing and applying a long-term perspective
  • Balancing the needs of all stakeholders
  • Recruiting and/or developing directors, CEOs and C-Suite executives who have the necessary experience, character and values to build and sustain strong performance levels and cultures, and
  • Injecting a strong input into the strategic direction of the business.

The leading boards in the world do this difficult work in addition to dealing with all the usual day to day activities of most boards.

The balance of this summary focuses on why reputational risks are not managed effectively and highlights the importance of:

  • Long-term focus
  • Considering the needs of all stakeholders
  • Culture, and
  • What boards can do to build and sustain strong reputations.

We will also discuss the benefits of creating a new, overarching role – the Chief Reputation Officer – that oversees all matters relating to reputation.

1.3 Why are these reputational risks not managed effectively?

For decades we’ve trusted the current organisational and reporting structures to ensure that risks are identified, acted upon and communicated to the highest levels of an organisation so that crises are averted.  There are risk divisions, executive-level risk roles and risk committees at board level through which risks are identified and managed. 

The current landscape, which has seen numerous institutions, be they banking, religious, welfare, aged-care, brought to account for unethical practices, is evidence that these systems are not failsafe, and that often a so-called ‘fire’ has got out of control before anyone at board level has noticed or initiated remedial action. 

What is it about the current structures that have prevented boards and executive levels from ‘smelling the smoke’ sooner?

Considerable research has determined that the highest impact issues leading to reputational crises can be classified into the following categories:

  • The singular focus on delivering profit for the shareholder: the focus on profit for shareholders to the detriment of other key stakeholders (customers, regulators, staff, etc.) and the company’s freedom (social licence) to operate
  • Measurement & Reward Systems: measurement and reward systems that focus on short-term profit, or rewards that are out of the direct control of employees and therefore lead to slack behaviour
  • Culture: the withholding of ‘bad’ news for reasons of fear of retribution, or an expectation that the problem and the solution will be presented concurrently (thus, where no solution has been found, the problem is not reported); institutional conformity; a culture of denial or wilful blindness towards risk
  • Siloed organisational structures: lack of communication and information sharing across divisions or business units which prevents identification of complex risks, particularly where there is competition between divisions
  • Lack of capability, knowledge and, experience: boards and executives who lack the qualifications, personal attributes, and experience to carry out the tasks required of their role.

The above list goes some way to explaining how organisations, executive teams, and boards can develop a culture of denial or unwillingness to ‘think the unthinkable.’

1.4 Long-term versus Short-term

As noted above, one of the key reasons for these major reputational damaging events is a corporate focus on short-term profitability. One of the ironies of this is that this short-term focus actually damages the financial performance of the business in the longer-term.

McKinsey analysis suggests that the difference in economic profit generated is 81% over 15 years – between those companies who focus long-term and those that don’t.  

Other factors amplify many boards’ short-term focus:

  • CEO tenure is short – around four years globally – and many CEOs tend to focus short-term, often with the aim of maximising their personal remuneration, through:
    • Cost cutting
    • M&A deals – where a minority of deals add value to shareholders
  • The overall system – the market and the media, measurement and remuneration systems typically drive a short-term view as well – more often than not focused on short-term profitability.

This short-term focus colours everything in the organisation and filters through every level of the business.

Businesses live in the short-term and need to drive results tomorrow, next month and the end of the next reporting period – but they must do all of these in the context of a long-term plan.  Balance is important.

The data as outlined in our previous paper supports the view that boards that focus on the long-term produce a higher level of both profit and wealth creation than those that don’t.

1.5 Focus on all Stakeholders and not just Shareholders

Focusing solely on the shareholder is a corrosive force, and has been identified as one of the key reasons causing major reputation damaging events.  This focus is usually combined with a short-term focus on profitability.

This primary focus on the shareholder, and on profit, was popularised nearly 50 years ago by influential thinkers like Milton Friedman who argued that a board’s primary responsibility is to the shareholder. Milton Friedman outlined his views in a paper titled “The Social Responsibility of Business is to Increase its Profits” printed in the New York Times on September 13, 1970.

That may have been an appropriate view 50 years ago – but it doesn’t cut it today.

There is now a mountain of evidence of damage done in a pursuit of profit that neglects or damages other key stakeholders – examples of these are set out in Section 6 of our full paper.

There needs to be a balanced focus on all key stakeholders for the following simple reasons:

  • You can only create shareholder value in the long-term by creating value for customers
  • Since most businesses today are service businesses, you can only create long-term customer value through your people
  • You can only create long-term shareholder value if you sustain your right to operate – and minimise regulatory burdens – if you treat the regulators as an important stakeholder in the business
  • You can only survive in the long-term if you behave socially in a manner that people:
    • Want to buy your products and services
    • Want to work for you
    • Want to buy your shares and
    • Are happy for you to be part of the broader community.

The evidence is clear that doing all of these things well delivers significantly more profit in the longer-term.

1.6 The Importance of Culture

There is a vast mass of data available that shows that cultures are formed by the values and behaviours of the leaders – including the board, and especially the CEO and senior management – of the organisation and reinforced down throughout the entire business by its organisation structures, measurement and reward systems.

I have much experience in assessing CEO and other senior candidates.  An observation I would make from doing this work for 15 years is that many boards are very focused on the person’s track record and historical performance, and less focused on their character.

The lessons in recent years are that boards need to have much more focus on the character and values of the key people in the business.

This is very important since culture flows directly from:

  • The tone set by the board’s focus – purpose, long-term, all stakeholders, what they spend their time on, measurement and reward systems they build and so on
  • The character and capability of the board – and specifically the Chair
  • The character and capabilities of the senior executives chosen by the board
  • The measurement and reward systems agreed by the board

The turbocharging effect of a weak (or purely profit-based) purpose, short-term focus mainly on profitability, ineffective or self-centred leaders, both at the board and executive levels, and a weak culture reinforced by misaligned or poorly aligned measurement and reward systems, are the root causes of the catastrophic reputation failures we have witnessed in recent times.

1.7 What can Boards do to Build and Sustain Strong Reputations

A key requirement for change is that boards need to refine their role to include board-level responsibility and accountability for building the conditions necessary to deliver long-term sustainable success and a strong reputation. These conditions include:

  • A very strong purpose
  • A long-term perspective
  • A balanced view of who the key stakeholders are (this includes not paying undue attention to the few but large, noisy, short-term investors who perennially push management and the Board for short term gains)
  • Leaders at board and executive levels with the appropriate experience, character, values and mindset
  • Leadership that is obsessed with delivering customer value through driving a very strong innovation culture
  • Leadership that is focused on developing a new generation of leaders
  • An “always on” strategy mindset and process
  • A very strong customer-focussed culture underpinned by aligned remuneration and measurement systems.

Boards need to assess all of these attributes that deliver long-term success, and put in place work programmes that deal with any identified shortfalls.

We have identified that some major companies globally have created a new role – Chief Reputation Officer – who can work directly with the board and C-Suite to implement the changes required to underpin a strong reputation.

Imagine a role that carries the explicit expectation that the incumbent will ask the difficult questions and will put in place systems that reward others for highlighting unpalatable truths – and who has the direct link to both the CEO and the Board.

In short, if we imagine a role that carries the responsibility for building and protecting the culture and reputation of the organisation – would that go some way to ameliorating the structural problems that have prevented many boards from ‘smelling the smoke’ until now?

1.8 Conclusion

Our hope is that this work can stimulate thinking at some of Australia’s major boards, which leads to changes being implemented that reduces the risks of further reputational damaging events.

The following full paper provides a great deal of background information for those interested in reading more on these topics.

2. Introduction

Global studies show that trust in companies to ‘do the right thing’ is declining both in Australia and worldwide. 

This finding is hardly surprising considering the recent exposure of a veritable torrent of companies both in Australia and overseas that have been shown to have deliberately flouted the rules, acted unlawfully or treated some of their customers and staff badly.

Collectively, these companies ignored the law and their regulatory responsibilities, breached privacy on a major scale, or set performance targets and designed remuneration systems that rewarded unethical behaviour. 

In Australia, we need only think of the recent evidence presented to the Financial Services Royal Commission to be:

  • Overwhelmed by the enormity of the legal, behavioural and compliance breaches, and
  • Dismayed by the realisation that many of those at the very top of the organisations were complicit in condoning unethical practices.

“It suggests an abiding blindness to the seriousness of the underlying conduct.” Commissioner Kenneth Hayne, commenting on one of the banks’ inability to remedy serious customer breaches.

With the largest listed companies having considerable resources allocated to identifying and managing risk – including committees at board level – how is it that companies are still facing crises that they either didn’t foresee or, chose to ignore? 

Also, how is it that some companies have not learned the lessons of the past, and over twenty years are repeat offenders of significant reputation damaging events?

This paper seeks to answer these questions, and also offers a series of ideas as to how boards can avoid these crises in the future.

In this paper we’ll explore:

  • What is reputation and how important is it?
  • What are the major reputational risks?
  • The impact of the next generation and social media on reputation
  • Examples of the impact of reputational crises
  • Why are these risks not managed effectively?
  • Key areas that boards can focus on to build and maintain a strong reputation
  • The benefits of creating a new, overarching role – the Chief Reputation Officer – that oversees all matters relating to reputation to:

Provide boards with the comfort that all major reputational risks have been identified, and that mitigation plans are in place.

With reputation accounting for up to 25% of a company’s market value, boards and senior executives need to apply greater focus on protecting this significant asset of the business.

3. What is reputation and how important is it?

“It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.”  Warren Buffett

The Reputation Institute, a research and advisory firm which aims to increase corporate reputation measurement and knowledge, defines reputation as

“the emotional bond between a company and its stakeholders.”

which can be further broken down into components such as:

  • Customers want to buy your products and services and recommend you to others;
  • You become an employer of choice, with an engaged workforce;
  • Investors want to buy shares in your company; and
  • You are seen favourably by regulators, other important stakeholders, and policy-makers.

In 2014, Deloitte released a report that found that 87% of executives surveyed rate reputation risk as the most important strategic business risk; and found that reputation risk is viewed as a board and C-Suite issue.

The World Economic Forum’s 2012 report found that more than 25% of a company’s market value is directly attributable to its reputation. 

With so much of a company’s value linked to how it is viewed by all stakeholders, it is easy to conceive that some of Australia’s largest and most ‘trusted’ institutions are facing a reputation crisis and the subsequent share value backlash that accompanies it. 

Melanie LoBue, of the Reputation Institute, sees reputation as a vital focus for organisations, and argues that reputation impacts business ROI in five ways:

  • Reputation enhances company value – a strong reputation yields 2.5 times better stock performance when compared to the overall market
  • Reputation underscores stakeholder support – that is, the emotional connection a stakeholder (employee, customer, government official, shareholder) has with a company
  • Reputation elevates growth – higher purchase consideration, sales and loyalty, including customer recommendations
  • Reputation influences existing and potential employees – especially among Millennials and Gen Z
  • Reputation mitigates corporate risk – 63% of the general public give companies with excellent reputations the benefit of the doubt in times of crisis

 “If the executives who participated in our study on reputation risk are right, a company’s reputation should be managed like a priceless asset and protected as if it’s a matter of life and death, because from a business and career perspective, that’s exactly what it is. (Deloitte)

4. What are the major reputational risks?

There are many factors which influence a company’s reputation – and therefore, there are equally as many threats – customers, shareholders, employees, culture, supply chain, market forces, regulatory, cyber (including social media), corporate social responsibility, OH&S, misconduct at executive and board level, as well as global events such as the GFC, war, major accidents or even natural disasters. 

How a company manages its reputation and the risks to that reputation, particularly in the face of a crisis, is crucial.

In 2017, Norton Rose Fulbright released the results of a survey of board members and C-level executives in Australia that found that the risks that are most likely to have an impact on a company’s reputation are:

  • Regulatory investigations – for example, following an APRA investigation into governance, culture and accountability at CBA due to a money-laundering scandal, CBA was forced to add an additional $1 billion in regulatory capital and conduct remedial action
  • Cyber risk, including data privacy breaches – for example, in April 2018, Facebook notified 87 million members of its platform that their data had been improperly shared with Cambridge Analytica
  • Intellectual property/brand management – for example, Volkswagen’s spectacular fall from grace in the wake of the emissions fraud scandal, which saw it lose an estimated $10 billion in brand value
  • Corporate governance and whistleblowing – for example, the governance failure of insider trading by Enron management, which led to the loss of confidence in stock investments. When the Enron stock price dropped sharply in November 2000, management sold large amounts of personally held stocks at a profit.  Then, the chairman and finance director also sold their own stocks at a profit, which led to the crash of the Enron stock price.
  • Conduct/ethical risk, including directors’ and officers’ liability – for example, when United Airlines staff chose to forcibly eject a customer from an overbooked flight, showing complete disregard for and injuring the passenger in the process, the company lost $1.4 billion on its stock price in a single day after news of the incident went viral.
  • Community and social impact – for example, companies including Mars, Hershey, PepsiCo, Unilever and Nestle, who have suffered reputational damage and faced boycotts of their products due to their use of unsustainable palm oil derived from plantations linked with the destruction of habitat for Orangutans, whose species is now considered critically endangered.
  • Tax and financial liabilities – for example, the tax avoidance scandals faced by many global companies. “In the UK, companies like Apple, Starbucks, and Amazon were vilified and boycotted as a result of their tax policies. Tax avoidance can make a company vulnerable to accusations of greed and selfishness, damaging its reputation and destroying the public’s trust.”

Looking to the future, Norton Rose Fulbright’s survey found the top four future trends expected to have the largest impact on reputation risk are:

  • Ethics and conduct in the workplace
  • Social media in the age of post-truth
  • Disruption of regulation
  • Disruptive technology.

5. The next generation, social media and the impact on reputation

The power of social media to supercharge the negative effects of any major crisis is of critical importance to organisations, today and increasingly in the future.

Information travels with lightning speed in the digital environment, and hence reputational damage to a company can rise exponentially in the face of a crisis. And this can occur very quickly.

Boards need to consider that the main users of social media – the younger generations (Millennials and Gen Z) who are the key consumers, employees, and shareholders of the future – have a different set of values by which they measure companies.

“…the next generation is watching, learning, impatient, and does not like much of what it sees.”

Millennials and Gen Z are the most digitally savvy among us, and their opinion about an organisation, be it positive or negative, can be shared on social media, which can have immediate and far-reaching effects. 

They are also motivated by different values when judging whether a company is trustworthy and ‘good.’  They now require evidence, not just that a company is doing the right thing in its field, but that it has a global mindset towards bettering the world (environment, global politics, human rights issues).

Reputation Lighthouse, a marketing firm that works with companies globally to elevate and protect their reputations, suggests that while all stakeholders these days expect more transparency than ever before from companies, Millennials, and Gen Z are becoming more demanding of the companies with which they deal. 

For example, where Millennials have said that a company needs to be corporately responsible, Generation Z, by comparison, is seeking tangible evidence that companies are ‘good,’ in order to earn their trust and loyalty.

“Gen Z does not like companies who think about themselves and not others.  … Acting with integrity has become the only standard. If companies pollute, cause cancer, use unethical labour, etc., this information will spread and tarnish the brand image.”

6. Examples of the impact of reputational crises

Edelman, a global public relations company that undertakes research and analytics, recently published their 2018 Trust Barometer, which reported that in Australia, trust in institutions (Business, NGO’s, Government and Media) to ‘do the right thing’ had dropped an aggregate of 10% between 2017 and 2018.

A detailed summary of the following examples of recent reputational crises can be found in Appendix 1, but the effects of crises are summarised below:

  • Share price drop following revelations of scandals
    • AMP shares drop from 2018 high of $5.47 to $2.31 in the space of six months, and the wealth management division reports a net outflow of $1.5 billion in response to the Royal Commission
    • Aged Care providers Estia Health, Japara Healthcare and Regis Healthcare all suffered share price drops between 30-40% flollwing announcement of Royal Commission into Aged Care
    • Facebook share price drops 19% (a loss of $119 billion) and analyst downgrade following Cambridge Analytica scandal
  • Financial penalty due to breaching of regulations
    • CBA given $700 million penalty for breaching anti-money laundering and counter-terrorism laws – CBA failed to introduce daily deposit limits on Intelligent Deposit Machines, and failed to submit ‘Suspicious Matter Reports’ to AUSTRAC, which would have identified criminals engaged in money laundering
  • 25% loss of market value, departure of CEO, financial penalties and loss of confidence in brand following failure to deal with leak causing environmental disaster
    • BP – Deepwater Horizon spill results in 25% loss of market value between 2010-11; the largest marine oil spill in history – 11 killed, 1,700 km coastline polluted, massive harm to wildlife, up to 12,000 left temporarily unemployed, $40 billion spent in clean—up and recovery and $65 billion in compensation to people impacted by the spill
  • Custodial Sentence, Financial Penalty, Environmental damage and ‘Loss of confidence in Brand’ due to deliberate actions to deceive regulators in quest for competitive advantage
    • Volkswagen admits to fitting 11 million cars worldwide with technology to cheat emissions tests, resulting in a 7 year custodial sentence for former VW executive, Oliver Schmidt for Conspiring to commit fraud and violating the US Clean Air Act; more than $30 billion in fines, settlements and remediation, resignation of CEO Martin Winterkorn, and a 30% share price drop following the scandal
  • Culture of greed, and disregard for the rights of the customer contributes to resignation of CEO and Chairman
    • NAB delays remediating superannuation customers who were charged adviser service fees by subsidiaries in 2008/09, despite the issue being brought to attention of board in 2014. It took until September 2018 to start remediating customers, and this was only after substantial pressure from ASIC. These and other issues contributed to the recent resignation of both the CEO and the Chairman of NAB.
  • Culture of secrecy, entitlement and protection leads to abuses of power, cover-ups and world-wide reputation failure of Catholic Church
    • Royal Commission exposes long-term denial and cover ups of abuse towards vulnerable children within the care of the church. Catholic Church now facing revelations of abuse by clergy in epidemic proportions worldwide, with allegations now reaching those closest to the Pope (2 cardinals in the Council of Cardinals), whilst in a recent speech, the Pope admits that priests and bishops have also sexually abused nuns, resulting in some cases in forced terminations of pregnancies
  • Financial penalty, resignation of CEO, loss of confidence in brand due to culture of greed, singular focus on the shareholder, measurement system focused on short-term profit, and condoning of unethical behaviour
    • Wells Fargo’s stable reputation tarnished by account fraud scandal after regulators fine Wells Fargo $185 million in 2016 for creating an estimated 3.5 million fake customer accounts. Investigations found that unrealistic targets for performance and reward led to a bank-wide culture that endorsed fraudulent and unethical behaviour. 
    • Share price dropped 11% in one month following exposure of scandal and subsequent fine
    • CEO resigns and forfeits $41 million in stock options, and was stripped of a further $28 million by use of a clawback option.
  • Shareholder backlash due to outrage at Remuneration and Reward despite Underperformance
    • NAB Remuneration Report rejected by 88% of shareholders at AGM on 19 December 2018, with representatives from the ASA suggesting that no bonuses should be paid in light of the negative TRS and revelations made by the Financial Services Royal Commission
  • Loss of funding and trust due to unethical behaviours driven by unrealistic targets
    • Victoria Police loses $4 million of funding and must implement ‘ethics training for staff’ following investigation into faked breath tests, which were driven by unrealistic targets set by management
  • ‘Win at all costs’ culture destroys reputation of Cricket Australia, financial penalty through loss of sponsorship, and harms the ‘brand’ of ‘Australia’ as a consequence
    • The recent ball tampering scandal during the third test in South Africa in 2018 has far-reaching effects.
    • Two cricketers banned from playing for 12 months and one for 9 months
    • Cricket Australia and players involved lose major sponsors Magellan Financial Group ($20 million contract), Asics, Sanitarium, LG, Commonwealth Bank
    • The scandal is widely reported as having damaged the Australian psyche – with PM Malcolm Turnbull noting that the captain of the Australian Cricket Team is viewed as being as important (if not more) than the role of Prime Minister
    • Ethics Centre investigation finds that CA has failed to create a culture that values and teaches moral courage and ethics. "In our opinion, CA's fault is not that it established a culture of 'win at all costs'. Rather, it made the fateful mistake of enacting a program that would lead to 'winning without counting the costs.”
    • Resignations due to scandal – CEO, Chairman, Coach, 2 Board Directors.

We could have filled another 10 pages of stories like this. However, the point has been made.

Even organisations whose entire purpose is to act morally – churches, the police, banks and so on – have failed in their core duties.

There is a widespread need for boards to recognise that we have a serious social problem affecting much of the world, and something needs to be done about it.

Responsibility for solving this problem lies with the boards of our major institutions – our biggest companies need to lead these changes and set an example for the rest of society.

7. Why are these reputational risks not managed effectively?

“Failings of organisational culture, governance arrangements and remuneration systems lie at the heart of much of the misconduct examined in this Commission.” Kenneth Hayne

For years we’ve trusted the current organisational and reporting structures to ensure that risks are identified, acted upon and communicated to the highest levels of an organisation so that crises are averted.  There are risk divisions, executive-level risk roles and risk committees at board level through which risks are identified and managed. 

The current landscape, which has seen numerous institutions, be they banking, religious, welfare, aged-care, brought to account for unethical practices, is evidence that these systems are not failsafe, and that often a so-called ‘fire’ has got out of control before anyone at board level has noticed. 

What is it about the current structures that have prevented boards and executive levels from ‘smelling the smoke’ sooner?

In a recent interim report titled, Thinking the Unthinkable, international broadcaster Nik Gowing and Chris Langdon, former Managing Director of the Oxford Research Group, set out to understand how major crises failed to be identified as risks by those in positions of responsibility. 

In 2015, throughout in-depth interviews with 60 top-level executives from the public and private sectors around why it remains difficult to ‘think the unthinkable,’ they identified some issues that were commonly repeated.

These issues may go some way to explaining the current reputation crises faced by some of Australia’s largest and most ’trusted’ institutions.

The highest impact issues leading to reputational crises can be classified into the following categories:

  • The singular focus on delivering profit for the shareholder: the focus on profit for shareholders to the detriment of other key stakeholders (customers, regulators, staff, etc.)
  • Measurement & Reward Systems: measurement and reward systems that focus on short-term profit
  • Culture: the withholding of ‘bad’ news for reasons of fear of retribution (either financial or exclusion from promotion, a so-called ‘career limiting move’); institutional conformity; a culture of denial or wilful blindness towards risk
  • Siloed organisational structures: lack of communication and information sharing across divisions or business units which prevents identification of risks, particularly where there is competition between divisions
  • Lack of capability, knowledge and, experience: boards and executives who lack the qualifications, personal attributes, and experience to carry out the tasks required of their role

The above list goes some way to explaining how organisations, executive teams, and boards can develop a culture of denial or unwillingness to ‘think the unthinkable.’

Also, the following analyses demonstrate that risk management is not managed effectively in the majority of companies:

  • Norton Rose Fulbright’s survey found that 59% of respondents do not use risk scenarios regularly to estimate the potential impact of incidents
  • Deloitte’s 2014 report found that only 19% of respondents rated their capabilities at managing reputation risk as ‘A’ grade
  • Companies are least prepared for risks beyond their direct control, for example, those brought through actions of a third party or within their supply chain.

Organisations need to create structures that allow for early identification of the ‘unthinkables,’ they need to create a culture that is willing to hear the ‘unpalatable’ truths, and they need to ensure that their people have the experience, capability, and support to carry out their duties.

“There is a core need to embed with confidence a new, accepted role for constructive challenge within institutions.” (Gowing & Langdon)

8. What should boards do about this?

“The companies that survive longest are the ones that work out what they uniquely can give to the world – not just growth or money but their excellence, their respect for others, or their ability to make people happy.  Some call those things a soul.”  Charles Handy

The previous section outlined the major reasons why reputational crises occur.  These reasons have been identified through various studies and through our research.  The Financial Services Royal Commission also identified most of these factors as contributing to these crises.

The most impacting issues creating reputational crises can be broken down into the following categories:

  • The singular focus on delivering profit for the shareholder
  • Measurement systems and reward systems that focus on short-term profit
  • A poor culture created by ineffective leadership at board and executive levels and underpinned by unaligned measurement and reward systems
  • Lack of communication and information sharing across divisions or business units
  • Boards and executives who lack the qualifications, personal attributes and values, and experience to carry out the tasks required of their role

The following sections focus on each of these areas.

8.1 Summary of what boards should do to address reputational issues

A key requirement for change is that boards need to refine their role to include board-level responsibility and accountability for building the conditions necessary to deliver long-term sustainable success and a strong reputation. These conditions include:

  • A very strong purpose
  • A long-term perspective
  • A balanced view of who the key stakeholders are
  • Leaders at board and executive levels with the appropriate experience, character, values and mindset
  • Leadership that is obsessed with delivering customer value through driving a very strong innovation culture
  • Leadership that is focussed on developing a new generation of leaders
  • An “always on” strategy mindset and process
  • A very strong culture underpinned by aligned remuneration and measurement systems.

We have also identified a potential new role for major companies – Chief Reputation Officer – who can work directly with the board to implement the changes required to underpin a strong reputation.

8.2 Shareholder focus

“Let us be clear, profits – and good profits – are always essential, and not just in business.  But the myth dies hard, the myth that profit is the purpose.”  Charles Handy

Our firm has worked with KBA to review the economic performance over the past 20 years of the top 100 companies in the US, UK, and Australian markets.

This analysis shows the following:

  • The highest performing companies tend not to outperform short-term financial performance expectations over a given measurement period. Instead, they create wealth almost entirely by establishing new economic profit expectations to be delivered beyond the measurement period.  This is done through a strong innovation engine which is driven by a powerful focus on customer needs
    • These high performing companies generate strong organic growth
  • On the other hand, under-performing companies typically destroy value:
    • During the measurement period, and
    • By failing to innovate and deliver new products or services to the market that connect with customers
    • These companies tend to focus on short term cost cutting and M&A transactions – and most M&A transactions do not create shareholder value.

The economic data from around the world is totally clear – if you want to create sustainable shareholder value, you need to have leadership that is obsessed with delivering customer value.

In addition, since most companies are services-based, and therefore the customer delivery system is often through your people – you can only create customer value if you have an engaged and quality work-force that is attracted to work for the business.

“Is a business in business solely for profits – or maximizing shareholder value through the reallocation of profits through dividends and share buybacks – or is it in business to serve all stakeholders?”

This is a question posed by Dan Pontefract, writing for Forbes, who goes on to suggest that for a business to be in business solely to deliver profit to shareholders runs counter to the needs of the fast-changing and complex world in which we currently live.

In our opinion, boards need to focus on delivering value to all legitimate stakeholders in the business.

8.3 Measurement

Most boards use a small number of key financial metrics to determine the performance of the business. Some of these measures are either flawed or incomplete – and therefore not appropriate for the use to which they are put.  One metric that provides an incomplete picture of management performance is EPS growth.

Figure 1 shows clearly that, for the ASX 500 over the past 10 years:

  • 39 ‘EP dominant’ companies (which, on average, had ‘economic profit per share’ growth much greater than their ‘earnings per share’ growth) produced an annualised TSR more than 9% higher than the 159 EPS dominant companies (whose EPS growth was much greater than their EP per share growth)
  • The wealth creation outcome (TSR less the Cost of Equity Capital [Ke]) experienced by the shareholders of companies in the ‘EP dominant group’ was nearly 10% per year higher than for the ‘EPS dominant’ group.

Figure 1 Differential Per Share Growth and Total Shareholder Returns in ASX 500 – 10 Years to 30 June 2018

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Source: KBA analysis

Figure 2 shows the results of a similar analysis conducted in the US market covering the ten years to 31 December 2007.  It revealed a similar outcome, in which it was also apparent that:

  • The EP dominant group was made up of companies whose EPS growth was double their growth in book equity per share. This tends to indicate a focus on organic growth, rather than on ‘buying’ earnings through acquisitions for which the price paid is often much higher than book value
  • The EPS dominant group on the other hand, had a growth in book equity per share that was significantly higher than their EPS growth. It is likely these companies were tending to ‘buy’ earnings or earnings per share, either through M&A activity or through ill-disciplined capital expenditure.
  • Acquisitions at fair value are economically breakeven. While they may sometimes be the easiest and the fastest way to achieve a desired level of earnings and EPS growth, it can often be economically unprofitable growth.

Figure 2 - Differential Per Share Growth and Total Shareholder Returns in S&P 500 – Why a Focus on EP is Crucial

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Source: Kontes, Peter, The CEO, Strategy and Shareholder Value – Making the Choices That Maximize Company Performance, John Wiley & Sons, Hoboken NJ, 2010

The measures that the board sets for senior executives then trickles down throughout the organisation.

This data is clear – the best companies produce powerful and sustainable economic performance by obsessing about the customer.  Amazon is a very good case study on a long-term focus on the customer.

8.4 Reward

There are a few key metrics that underpin most executive reward systems throughout Australia – and rTSR – (ranked relative Total Shareholder Return) – is one of the most common measures used for the LTI component of remuneration systems.

We collaborate with KBA on issues around economic profit analyses and the connection to remuneration.

Figure 3 draws on a Monte Carlo Simulation of rTSR vesting outcomes for an ASX 20 company, which was completed by KBA to demonstrate that even when a company produces performance largely in line with market expectations, executives can expect zero vesting 45 per cent of the time, full vesting 30 per cent of the time, and partial vesting 25 per cent of the time.  This looks much more like a lottery than an incentive.

Many executives tell us that LTI’s are a lottery, and are largely dismissed as being of little relevance and an incentive.  Most boards know this to be the case as well.

Figure 3.  Vesting Based on Relative TSR Derived from Monte Carlo Simulation

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Source: KBA analysis

The lottery like nature of incentive plans based around rTSR becomes even more apparent when the vesting outcome is overlaid on the actual capital market outcomes experienced by shareholders.  Figure 4 shows that vesting based on rTSR produces either a false positive (where executives benefit unfairly at the expense of the company and its shareholders) or a false negative (in which the reverse is true), roughly half the time.

Figure 4. Comparing Vesting Outcome with Underlying Capital Market Performance

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The uncomfortable truth is that (in large part because of flaws in most LTI plans), executives and their companies tend to become more and more focused on producing short-term results, delivering profit to shareholders, bonuses to executives and financial rewards to employees for meeting often unreasonable and generally unsustainable targets, to the detriment of the broader stakeholders that the company serves. 

We believe that most companies in Australia feel that the senior executive remuneration systems are dysfunctional and are causing organisational and cultural damage.  Many of these companies are looking for a better way.  We believe there is a better way.

“It is not now, and cannot be, disputed that variable remuneration can pose ‘an unacceptable risk of promoting behaviour that is inconsistent with the interests of customers’.”  Kenneth Hayne

“Remuneration and incentives, especially variable remuneration programs, tell staff what the entity rewards. Hence, remuneration and incentives tell staff what the entity values.”  Kenneth Hayne

“Rewarding misconduct is wrong. Yet incentive, bonus and commission schemes throughout the financial services industry have measured sales and profit, but not compliance with the law and proper standards. Incentives have been offered, and rewards have been paid, regardless of whether the sale was made, or profit derived, in accordance with law. Rewards have been paid regardless of whether the person rewarded should have done what they did.”  Kenneth Hayne

8.5 Culture

“If what has happened in the past is to be avoided in the future, entities have no choice but to grapple with culture, governance and remuneration. All three are related…Remuneration and governance inform and reinforce the culture of the entity.”  Kenneth Hayne

Recommendation 5.6 of the Financial Services Royal Commission – Changing culture and governance

“All financial services entities should, as often as reasonably possible, take proper steps to:

  • Assess the entity’s culture and its governance;
  • Identify any problems with that culture and governance;
  • Deal with those problems, and
  • Determine whether the changes it has made have been effective.”

Commissioner Hayne’s Final Report describes culture as the “shared values and norms that shape behaviours and mindsets within the entity.  It has been described as ‘what people do when no one is watching’”.

It’s increasingly evident that companies need to be driven by moral compass and purpose, rather than merely the drive for profit.  Companies should no longer be asking ‘can we do it?’, their first question should be ‘should we do it?’ 

“Part of this is moral. Training your civil servants, your advisors, your business team, to be intellectually and morally courageous...But it’s also structural. It’s building into the system both events and fora where people can speak their mind openly. And systems for ensuring that dissenting views reach their way to the top...It mustn’t be a career killer.”

“Promoting core values is a way to engage employees and increase their commitment and loyalty to the organisation and at the same time encourage ethical decision making.” Ethical Advocate

Fostering a culture that values and rewards humility and authenticity – from the top down – is also important.

There is no longer room for the ego-driven CEO whose judgement cannot be questioned.  As found by Gowing & Langdon, there is now a strong push for senior executives to show humility – to ask for help and admit when they don’t have all the answers. 

“We are seeing the rise of the new ‘humble CEO’; someone who talks about ‘we’ rather than ‘I.’

“There are now some leaders who admit they do not have all the answers.”

8.6 Structure

Creating an organisational structure that allows for risk identification and communication across all areas and levels

There are two key points for action:

  • Reducing the lack of visibility and communication between silos (or better still, removing silos all together), and
  • Ensuring that communication channels are put in place that allows information to be shared from bottom to top across the organisation and executive/board levels

These points may help argue the case for creating a communication channel that sidesteps the current hierarchical model, for example, through a Chief Reputation Officer role.

8.7 Capability

Do your people have the required skills, experience and personal qualities to confront risk in an ever-changing environment?  Gowing and Langdon argue that this is not the case, based on their interviews. 

They found that many interviewees reported that there a lack of resilience and experience around identifying and dealing with risk throughout all levels of organisations.

“…most agreed that there is an urgent need to develop what was described by one oil executive as a new ‘muscle’ that will help leaders from the top down build their resilience to risk in future.”

There is an identified need to train people at all levels of the organisation to identify and manage risks, and to ensure that the organisation has the agility to adapt to a rapidly changing environment. 

“Resilience has become a fashionable term, not just for individuals, but also creating resilient organisations in a complex world. It is about a company understanding its fast-changing external context with ever-more complex supply chains and its wider risk landscape, and the leadership’s capability and the capacity of the organisation to adapt.”

There is also an identified need to ensure that there is a diversity of experience at the highest levels of the organisation, with a focus on reinforcing the level of knowledge and experience around cyber risk. 

“Faced with the explosion of new technologies and threats like cyber, the main recommendation is to diversify C-suite and top-level executive recruitment by skills, experience, gender, age, and outlook.  Rigorous conformity must be seen as at best a neutral qualification but, in reality, it is more negative.”

In addition to the above, ensuring that there are clear guidelines and expectations around succession planning, and the moral courage to discuss an often ‘difficult’ topic. 

“The succession of both the CEO and the Chair, and the NEDs, must be a ‘discussable thing’...too often people pussyfoot about it. There are many cases of CEOs staying too long in a company. Standing down has to be put to them in a way that doesn’t seem to be a personal attack; how it’s better for the future of the business, how future strategic planning requires a new CEO.”

In summary, when thinking about their organisation, how board members answer the following questions will provide valuable insight into whether the organisation is well prepared for the crisis and protected against reputational damage:

  • Do we have a culture that values and encourages people to ‘do the right thing’?
  • Does the culture support and reward people to challenge and to voice concerns?
  • Does our current organisational structure allow for problems to be identified and communicated across all levels?
  • Do our people have the courage, experience, and ability to listen and act in the face of unpalatable truths?
  • Are we confident that the behaviours and practices within our company are driven by the right intentions – for the good of all stakeholders?
  • Are we confident that the measures we use to determine success and reward people promote good behaviour and ethical decision making? 

9. A potential contributor to solving this problem – Chief Reputation Officer

An additional solution to help prevent these crises is to consider the creation of an executive level role – The Chief Reputation Officer.

This role’s main remit is to ‘think the unthinkable’ and to ‘speak the truth,’ however uncomfortable that ‘truth’ may be. 

If we imagine a role that can influence across all functions across the organisation, including: Communications, stakeholder relations, marketing, risk, compliance, ethics, culture, HR, strategy, products, conduct, cyber.

If we imagine a role that carries the explicit expectation that the incumbent will ask the difficult questions and will put in place systems that reward others for highlighting unpalatable truths – and who has the direct link to both the CEO and the Board.

In short, if we imagine a role that carries the responsibility for building and protecting the culture and reputation of the organisation – would that go some way to ameliorating the structural problems that have prevented many boards from ‘smelling the smoke’ until now?

10. The new role – Chief Reputation Officer

While still a relatively new role at executive level, the argument for creating a Chief Reputation Officer role is gaining momentum. 

Anthony Johndrow, Co-Founder, and CEO of Reputation Economy Advisors, when interviewed in 2016 by Financier Worldwide Magazine, said:

  • “A CRO role with a direct line to the board and empowered to implement and enforce policies and programmes that ensure ongoing, strategic management of reputation is one possible solution.
  • For a true, cross-functional CRO role to be empowered at a company, they would have to have authority beyond that of a function head – second only to a CEO.”

Mike Lawrence, EVP and Chief Reputation Officer at Cone Communications LLC, when interviewed for the same article by Financier Worldwide Magazine, said:

  • “The CRO should be responsible for ensuring an organisation is perceived positively and with trust and respect by its key stakeholders.
  • To be effective, a CRO should report either to the CEO or to the board of directors, and should be a member of the organisation’s executive leadership team.”

“…whoever is chosen, that individual must have the power to influence changes broadly, ensuring your operations aren't letting your reputation down.”

This is a critical role that requires a person with the strongest moral compass.

A person who is able to communicate and engage with people at all levels of the organisation as well as all stakeholders – and who has the courage to speak the truth, to hold individuals and the organisation to account, and thus build and maintain a strong culture and reputation for the firm.

Appendix 2 describes a possible job description for this role.  Obviously, the focus for this role would need to be built for the precise needs of each organisation.

Author(s)

John Colvin, Elizabeth MacGregor

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