Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday, 22 May 2018

A rotten corporate culture


Reports by select committees of MPs after some scandal should be treated with care. There is nothing MPs like more than to take the moral high ground and heap blame on others in front of TV cameras, whether their victims deserve it or not. But in the case of the collapse of Carillion, their condemnation of the senior management, the board and the auditor seem fully justified. When the Institute of Directors say that “effective governance was lacking at Carillion” you know things were very wrong.

Think of the company as a ship. The captain has steered the ship too close to the rocks, and seeing the impending disaster has flown off in the ship’s helicopter and with all the cash he could find. After the boat hit the rocks no lives were lost, but many of the passengers had a terrifying ordeal in the water and many lost possessions, and the crew lost their jobs. Now if this had happened to a real ship you would expect the captain to be in jail stripped of any ill gotten gains. But because this ship is a corporation its captains are free and keep all their salary and bonuses. The Board and auditors which should have done something to correct the ship’s disastrous course also suffer no loss.

To say this reflects everything that is wrong with neoliberalism is I think too imprecise. [1] I also think focusing on the fact that Carillion was a company built around public sector contracts misses the point. (I discussed this aspect in an earlier post.) To say, as the MPs do, that the collapse of Carillion is the result of recklessness, hubris and greed tells us nothing, because many people are bound to be those things if the system provides no incentives for better behaviour. The problem is that the senior managers, the auditors and the Board are not in prison and have not even suffered any financial loss.

In theory the incentive for better behaviour is that everyone except the auditors have lost their job and are unlikely to get another. But executive salaries are now so high that this penalty, if it is applied, is just not strong enough. The former chief executive, who resigned in 2017, earned £1.5m in 2016. (A third of that was in the form of a bonus that could have been clawed back until the remuneration committee made that more difficult in 2016.) Few people would think that never being able to captain a ship again was a sufficient disincentive for the imaginary captain who steered his boat too close to the rocks.

The idea from Econ 101 that CEOs are paid their marginal product is now laughable. Their pay is so high in part because it is set by cosy remuneration committees, but mainly because CEOs have considerable bargaining power over the firm that employs them. This power is intrinsic, so greater oversight by shareholders will do little to change this situation. I wrote some time back that perhaps economists should think about the benefits of a maximum wage, or a return to punitive taxation on CEO type salaries and bonuses. [2] That idea normally provokes shock and horror, but have economists come up with a better idea to offset this market failure at the centre of modern corporations?

As far as auditors are concerned, there is much talk of breaking up the big four. The idea is that in a more competitive auditor environment there would be more opportunity for firms to establish a reputation, and for those that failed to do so to go out of business. I suspect the issues go deeper than that. It would be interesting to know if existing auditors after a high profile failure like Carillion lost market share. It may be that shareholders have insufficient power to ensure the selection of auditors useful for them. If that is the case, there may be a case for giving regulators greater power to act on shareholders behalf.

Ultimately corporate failures are a reflection of how companies are governed. I tend to agree with Will Hutton that the model where the shareholder and more particularly the share price are king is deeply flawed. The term financialisation is a bit like neoliberalism in that it is used by different people to mean different things, but I think it does describe how corporate culture has changed in the UK and US (at least) over the last few decades. We must never forget that the largest disaster in recent times reflecting a rotten corporate culture was the Global Financial Crisis.

Will writes
“My contention is that limited-liability companies, having certain formal privileges and status, should not be the private playthings of transient owners interested only in their own immediate self-enrichment, without any concern for how their profits are made. They should be organisational structures that allow humanity to innovate and then produce to meet the great challenges of any era: in this context profits are made by delivering a noble, moral business purpose, integral to the wider legitimacy of the enterprise.”

The big challenge is to work out the most efficient way of achieving that goal.

[1] What I think is fair to say is that a neoliberal culture is why attempts to address these problems have been ignored for so long. Ed Miliband talked about predatory corporate practices, and the overwhelming reaction was that this made him ‘anti-business’ and ‘too left wing’.

[2] The idea currently being embraced by politicians is to publish firm pay ratios: the ratio of the CEO’s pay to the average employee in that firm. You could cap that as a policy, although it is not obvious to me why CEO’s in firms (in sectors like finance) that have highly paid employees should be allowed to expropriate more from the firm than those with lowly paid employees. However as this is not my area, I am happy to see analysis on the optimal way of removing this distortion within corporations.

7 comments:

  1. On the auditor point.
    I worked in the management consultancy of 2 audit firms, and dealt with auditors of other clients, e.g. when selecting/installing accounting systems.
    The conflicts of interest were manifest:
    1. the demand to up-sell the audit to a consulting client.
    2. Same applied to tax clients, and also the reverse for audit clients. Inevitably, the integrity of advice could be impacted.
    3. the appointment of auditors by the managers, thru a token vote at the AGM - I have never found data on how many reappointments were voted down.
    4. Finance directors are usually trained by audit companies. Again I have yet to find robust data on how many FDs appoint their alma maters.
    5. With vertical integration of consulting services from strategic advice down to programming, audit firms' consulting divisions can be involved in developing/configuring/installing accounting software for their clients.

    Investors have an interest in audited accounts whether or not they hold shares, likewise HMG, and HMRC in particular, neither of whom have any influence over the audit process.

    Large corporations are so complex that auditors require time and effort to familiarise themselves with the practices of the business. However, the audit teams for each client evolve over the years, as new young staff are given experience, and older staff are promoted on and up, or leave to become finance directors.

    FWIW a few ideas on improving the integrity of the audit process:
    Step 1 would be to bar auditors from offering other services to their clients. This has been proposed and resisted since time immemorial, but the argument doesn't go away.
    Step 2 would be to limit the number of years a single auditor could be re-appointed. For global corporations, which employ multiple audit firms, typically from the big 4, some rotation of duties is essential, and should be beneficial, assuming no active cooperation (cartel) between firms at the same client, which could be difficult for the client to detect and prosecute. A variation, which could be applied to all large companies, would be to have more than one auditor, reappointing one at a time, to ensure some continuity, while limiting the scope for, let's call it, over familiarisation.
    Step 3 Getting seriously radical: look at who the clients of the audit report really are. The original purpose of audit was that the shareholders used the auditors to hold the shareholders' appointed managers to account. There are now other parties who have an active interest in the audit process, including potential investors, and the government. It is therefore worth considering restructuring the audit appointment process. Ideally, all clients of the audit process should be involved directly, but that may create too much complexity???
    As a first suggestion, quoted companies could have their auditors appointed by the markets on which the companies are traded; with many global corps traded on multiple markets, the market authorities would have to cooperate; with markets supervised by national governments (including tax authorities), that would have additional benefit of improving international, governmental, cooperative, direct supervision of global corporations. The audit fee could be recovered from corporate market membership fees, and from investor market trading fees.
    For unquoted companies, partnerships, etc., the national tax authority/-ies, HMRC in the UK, could appoint the auditors from a pre-selected panel. The audit fee could be recovered through the taxation system.
    No doubt there are other solutions.
    The increasing sophistication of audit software may yet render current concepts of audit obsolete.
    There will always be incentives for powerful people to game the system. The need for integrity to be enforced will never go away.
    Serious debate on the audit function is long overdue.

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  2. Note: badly-run companies do collapse and change happens.
    Just imagine how bad the situation gets when badly-run institutions are funded with public money (see 'socialism').

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    1. gosh drat that dastardly NHS which provides better outcomes than most health services in the world. we really need some sensible disruptors to remove this stalinist affront to dignity.

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  3. I think the issue is more one of general morality. If you look at the works of Adam Smith he assumes that the capitalist system will only work within a system of morality and he was right. What you call a rotten corporate culture is in effect a condemnation of a general culture.

    The problem within any serious failure like this one is that it casts a shadow over the whole of business and there will be an attempt to "not rock the boat" and cause "too much" criticism. Will Hutton may be right but regulation is unlikely to provide the answer; that is a question of more general morality.

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  4. I was reading a piece in the Guardian about Philip Green and people like him and it made a very good point about running corporations for "wealth extraction" vs. "wealth generation."

    Economists ought to be concerned about promoting the latter and disincentivizing the former. The way that compensation has been disconnected from performance and driven to great heights (although the top execs in Europe seem to be pikers compared to those in the US--you mention ‎£1.5 million salary as if it is significant, for a US CEO that would be a rounding error) is of course a big element of this.

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  5. Surely the problem is that the auditor is chosen by the board, and the board will want to choose the most compliant auditor. The market provides strong selection against good governance.

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  6. In this post you ask "...have economists come up with a better idea to offset this market failure at the centre of modern corporations?" Answer: YES, increase workplace democracy and employee ownership. Why? Because it is the people who work in a corporation who are in a much better position than absentee shareholders to monitor management each and every day; increasing workplace democracy and employee ownership would augment both their means and incentive to do so.
    This could be in the form of codetermination
    https://www.socialeurope.eu/codetermination-enters-the-american-political-debate
    and ultimately by democratizing corporations, so that they become democratic communities of the people who work in them:
    Distribution or Predistribution? http://philsci-archive.pitt.edu/12776/

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