Fraud: investor priorities and attitudes

Luigi Zingales has been involved in some interesting work on fraud. In this paper he and co-authors look at who detects and exposes fraud, and they find some perhaps surprising results. Employees are the whistle-blowers most often (and, as such, the suggestion is made that further incentives are provided to encourage more of it) followed by regulators and the media. But auditors, analysts and short-sellers are further behind, external shareholders barely get a look in. There is nuance to the picture, if you read the paper they do find that short-sellers are quicker at exposing fraud (9 months versus 21 months for employees), but they expose less of them.

Zingales has also done research into the prevalence of fraud. He and his co-authors estimate that, in any one year, there is a 14.5% probability of a company engaging in fraud. In his book on crony capitalism, Zingales says that 5% to 10% of public companies are affected by fraud every year, though some of this may not be significant in scale. He also argues that one of the reasons it may be so prevalent is because it's not really anyone's job to find it. And notably he goes on to draw a link between the failure to root out unethical behaviour like fraud and the nature of board appointments (i.e. directors are selected by existing board members).

Corporate corruption and fraud occur when controls are weak, and controls are weak when the people in charge have no incentive to challenge the CEO. Yes, there are many serious board members who do their jobs well – but they do so despite the incentives… [C]orporate board members care less about their reputation with shareholders than their reputation with CEOs

So what do we make of all that? A few things suggest themselves. First, investors should probably assume that there is fraud happening somewhere in their portfolio. It may not be a significant risk (though Zingales et al say: average corporate fraud costs investors 22 percent of enterprise value in fraud-committing firms and 3 percent of enterprise value across all firms) but it's probably there.

Second, they should support moves that increase the incentives to expose fraud and decrease/remove the incentives to hide/ignore it. Taking the latter first, this surely means trying to make the auditor as independent as possible, for example by banning or strictly limiting non-audit work. It also seems to strengthen the case for making board members more accountable to others than simply those that appointed them. And it suggests that investors might want to find ways of encouraging employees to speak out.

Finally, in my own corner of the world, I would argue that these findings also mean that corp gov people in particular ought to adopt a sceptical/suspicious approach. Financial (and other) wrongdoing may be much more prevalent than we tend to think, and the incentives for companies to tell investors the truth are... ahem... not straightforward. I can think of a couple of companies I've engaged with that were subject to controversy of one form or another where what we were told initially proved to be wildly inaccurate - and that's if I'm being charitable and assuming they believed what they were saying. It was only because we stuck with it, and probed a bit, that the stories unravelled. And as we saw with News Corp / News International, even major corporations will issue public statements that bear little relation to the truth.

It can be difficult, embarrassing, career-limiting and so on to challenge senior people like board directors when you aren't confident in what they are telling you. But, if you accept Zingales' point that no-one really has the job of exposing wrongdoing, then I think we have a duty (and not just a fiduciary one) to ask the awkward questions.

Risk

There's an interesting article in the Economist about the 'on-demand' economy.  As you would expect, they are very positive about the rise of things like Uber, but even they recognise that this isn't a pain-free future. Here are the final few paras:

Consumers are clear winners; so are Western workers who value flexibility over security, such as women who want to combine work with child-rearing. Taxpayers stand to gain if on-demand labour is used to improve efficiency in the provision of public services. But workers who value security over flexibility, including a lot of middle-aged lawyers, doctors and taxi drivers, feel justifiably threatened. And the on-demand economy certainly produces unfairnesses: taxpayers will also end up supporting many contract workers who have never built up pensions.
...Many European tax systems treat freelances as second-class citizens, while American states have different rules for “contract workers” that could be tidied up. Too much of the welfare state is delivered through employers, especially pensions and health care: both should be tied to the individual and made portable, one area where Obamacare was a big step forward.
But even if governments adjust their policies to a more individualistic age, the on-demand economy clearly imposes more risk on individuals. People will have to master multiple skills if they are to survive in such a world—and keep those skills up to date. Professional sorts in big service firms will have to take more responsibility for educating themselves. People will also have to learn how to sell themselves, through personal networking and social media or, if they are really ambitious, turning themselves into brands. In a more fluid world, everybody will need to learn how to manage You Inc.

To be honest, the last bit about people having to develop their own personal brand sounds to me like the perfect background to some sci-fi dystopia. But the point about the individualisation of risk is what I find most interesting. This is actually part of a broader process. For example, it is undoubtedly happening in the pensions world in the UK as DB disappears and is replaced by DC. Companies made this switch precisely because they didn't want to shoulder investment risk, and their investors tend to agree. It's notable that there was a very positive response when Tesco announced, along with other moves, that it was considering planning to close its pension scheme. Similarly, labour market practices like zero hours contracts and self-employment promoted in terms of how 'flexible' they are, but again it is the individual who bears the risk. 

Often you get told that employees like this flexibility too, but I do wonder if this is in part because the risk is difficult to grasp. Certainly the DB to DC shift was accomplished in the private with little resistance, which I think was only possible because people didn't really get what was going on (maybe also because initially it only affected new employees). The same may be true of other forms of flexibility. It seems that quite a few of the Citylink drivers were self-employed, and it's when the company runs into trouble that the nature of risk becomes very real, and flexibility more double-edged.

The outcome of these processes is that actual living human beings are expected to shoulder more risk in their working lives (even if they don't quite understand it) in order that risks within companies are controlled. And this is welcomed and encouraged by market participants, who are often investment intermediaries for the same people onto whose shoulders risk is being shifted, on the basis that this is good for the company and its investors. There seems to be a disconnect between between this being a good thing at an aggregate and/or abstract level (i.e. what does it mean to say offloading risk is a good thing for companies, who specifically is benefitting?) whilst being potentially very damaging in real individuals' lives. 

FWIW I don't think the directors of the companies offloading such risk like it in their own lives. As PwC have pointed out, many directors don't like variable pay very much and, they argue, the total scale of executive reward probably partly reflects an attempt to address this. However, they seem quite comfortable making others with significantly lower incomes and less wealth take more risk.        

A few New Years thoughts on corporate governance

When I was at the TUC, we once got Brendan Barber on Newsnight as part of a slot on executive pay. I think this was around the time of the GlaxoSmithkline pay defeat in 2003, and I can remember Brendan arguing that shareholder votes on remuneration should be binding and Peter Montagnon, then at the ABI, arguing that we should give the then new system of advisory votes time to bed down to see if it works.

Ten years or so later and we've just been through the first season of binding votes on remuneration policy. Surprisingly, this has not led to a swift reduction in levels of executive pay... Nonetheless, this got me thinking about some of the other policy positions we were advocating on institutional investment issues back then. Along with binding votes, we also said institutional investors should disclose their voting records, that abstentions were pointless on pay (given the vote was only advisory anyway) and we encouraged trustees to get the ISC principles on responsibilities of shareholders into their schemes' SIPs. (This last bit is basically a greatly watered down version of the Myners Review recommendation that there should be a legal duty on shareholders to intervene.)

At the time, these were all seen as pretty hardline positions, and, as such, were opposed by the large majority of people in the asset management industry (with the honourable exception of what was Co-operative Asset Management). I got used to being told that unions didn't really understand how this stuff really worked, and what we were proposing was nonsense. In particular I fondly remember a very angry man from Newton telling me how wrong we were to campaign for public voting disclosure, and a compliance person from Insight telling me it was legally impossible to make voting records public. 

To state the obvious, these positions that we, and others, were advocating back then are now mainstream. Most large asset managers disclose their voting records, some of the big ones (i.e. Legal and General) now don't abstain on anything - a position also promoted by the NAPF, and we have the Stewardship Code, which is written into many pension schemes' SIPs. It was even a Conservative-led government that introduced binding votes on pay, and a Tory Prime Minister who fronted the policy on TV (on Andrew Marr I think). And, if anything, corporate governance 'reform' has actually gone a bit further. The Stewardship Code expects a lot more than the old ISC principles, we also have annual elections of directors and so on. 

There are two things I take from this. First, and most importantly, the asset management industry talks a lot of crap. Lots of things that were claimed to be dangerous, or even impossible, to enact have been put in place. The sky has not fallen in. To the best of my knowledge, asset managers have not been threatened by shadowy single issue groups (unless you include Barclays under this label...) because of how they have voted or intend to vote. Yet this was an argument that was regularly wheeled out against voting disclosure. Companies have not spent millions unpicking directors' contracts because of the introduction of a binding vote on rem policy. Entire boards have not been voted out because shareholders misused the annual vote on director elections to gain control of companies by stealth. Asset managers haven't been sued for failing to intervene in companies. 

In short, an entire wave of industry lobbying effluent crashed on the rocks of reality. Those of us who still see the need for change should remember this, because they will do it again.

Which leads on to point two: in fact, despite all the reform, not a lot has changed. Shareholders (which in practice means mainly asset managers) have been given more power and more information, and been prodded repeatedly to encourage them to act more like owners. But I remain to be convinced that actual behaviour has shifted considerably. I think the FRC has kind of hinted at this in its work on the Stewardship Code. In at least one report it suggested that companies haven't noticed a change in the nature of engagement since the Code came in. 

This leaves us in an interesting position, since I don't see a lot more that can be ticked off on a shareholder-focused corporate governance program. We could make it easier to file shareholder resolutions, we could introduce a vote on business reviews, and maybe we could improve company disclosure. But essentially this would be 'more of the same', and I don't think anyone would expect much change from a list like that. The UK already has a very pro-shareholder governance regime. The problem continues to be that shareholders don't seem to keen on their responsibilities. Sooner or later this seems likely to lead to a shift in direction.

All this hasn't quite worked itself through the system yet. But I am pretty sure it's in the post. For example, as I blogged quite a lot in the past, I don't think shareholder primacy exists any longer in a meaningful sense in systemically important financial institutions. I think regulators have too little faith in shareholder oversight to see investors playing any serious quasi-regulatory role. I actually think, to the extent they are interested in shareholder activity, they probably care more about trading decisions than engagement. Shorting activity in particular gives you a sense of practical market sentiment, and may help identify problems, but the ability of shareholders to actually fix such problems is unproven. I suspect the FCA knows that big asset managers are too uninterested and conflicted to act as real guardians. (The comments from banker-turned-finance-academic Peter Hahn here are interesting in this respect.)

In my opinion, this means that for banks, and maybe other bits of the finance sector, we actually have a regulatory governance model while formally retaining the fig leaf of shareholder primacy. John Thurso may have lost his battle, via the PCBS, to explicitly remove shareholder primacy at the banks. But I think the point he was trying to make has already been accepted by some important people, even if it isn't explicitly acknowledged.

This is certainly a shift in direction, but isn't a big win for opponents of financialisation or whatever you might call it. The net result is a strengthening of regulators, but their own role is drawn pretty narrowly and this represents what I think is a desire amongst many politicians for a technocratic response. e.g. Let's get some 'experts' to make sure the banks are doing what we think they ought to be doing. What those experts in turn propose and enact will be framed in terms of economic efficiency, with other broader questions not getting a look in. Unfortunately this seems to be a good example of what Peter Mair was getting at in his comments about the 'regulatory state'.

That said, there are some interesting emerging contradictions in all this. Remember, the idea of shareholder oversight is that investors/owners have the strongest incentives to intervene, and, under shareholder primacy, have the legitimacy and power to act. So much for the theory, but it is found wanting in practice. First, the increasing interest amongst some investors in 'public policy engagement' is a recognition that they need some things doing for them (like requiring disclosure of certain types of information). Second, the existence of the Stewardship Code similarly acknowledges that market participants need to be pushed to get them to behave in the way that is supposed to be in their own interests. So the state is required both to compel companies to do things (provide certain information) that their owners can't get them to do, and to get the owners to behave like they are expected to. Both sides of the company-shareholder relationship are being structured by state power to deliver outcomes that are supposed to be market driven. So even in financial markets laissez-faire has to be planned...

On similar turf, I think the failure of shareholders to address the growing gap within companies between executives and the rest (because most asset managers don't have any interest - in either sense - doing so) will become significant. If shareholders can't/won't tackle the aspect of pay that causes the political problem - the size of it! - then either we give up, or we look elsewhere. I don't underestimate the unwillingness of a lot of people to really tackle this one, so the executive class can probably keep asking for more for a few years yet. But at some point I think the political pressure to intervene will be too great, and I think whoever is in government will have to do something quite different. And given that executive pay is the area of most shareholder engagement, if this does happen it will be quite a big knock to the whole shareholder primacy idea.

All this opens up the possibility of a more interesting change of direction, though not much more than that. I think redrawing directors' duties and introducing significant employee representation and ownership in the governance of companies are some of the things the Left should be properly exploring now (I also like the IPPR profit sharing idea). This could form the core of an alternative regime. Shareholders will always be an important component of the governance of public companies, and that will continue. But in the UK we have plenty of experience now of trying to rely on them alone to address a whole range of issues. It doesn't seem to work very well. And, as the executive pay example shows, sometimes their interests pull in a different direction to those of other stakeholders so they may be incapable of doing what is expected. So it makes sense to look at the role others can play, and the failures of recent years provide the opportunity. I think you can see the first signs of a shift in things like the interest in B Corporations, and the increasingly wide range of people who criticise shareholder-centred governance.

To reiterate what I've said before, there is nothing inevitable about such change taking hold. While the existing corporate governance regime looks like it has some big holes in it, if we want something different we need a clear idea of what it is, and what the evidence is for it (and we might have some interesting allies). In addition, as we can see from the response to relatively minor reforms - within the shareholder-centred model - vested interests will claim that such change is a threat to capitalism/wealth creation/small children and fluffy animals. There's a lot to play for, but a lot of work to do.

Salience and priorities in responsible investment

I've written a couple of bits recently to point up what I think is a bit of a lop-sided approach in the responsible investment world. Specifically, in the UK at least (thought I expect elsewhere too), there is a lot more emphasis on environmental and governance issues than 'social' ones. And given my interests, obviously I'm particularly concerned about the lack of focus on employment issues. I want to be constructive about this, but also be clear that there is a disconnect between much RI activity and where beneficiaries are.

Let's take a detour into Capital P Politics for a minute. Lord Ashcroft (yes, him) has become a source of very useful polling. Not only has he undertaken constituency-level polling in addition to national polls, he has also done some really interesting research on salience. This recent piece is worth a read. He makes the point that issues like 'economic competence' or 'leadership' are actually not necessarily as important as our politico commentators assume. If they were the Tories would be home and dry, as they easily lead on them versus Labour. But because these issues do not have the same salience as 'being on the side of people like me' or 'wanting to help ordinary people' where Labour has a lead, the election is still wide open. (Interesting, too, that Labour's advantages are about values/intentions rather than particular policies. Usually lefties are on the wrong side of this - quoting tractor production stats rather than projecting values.)

And there are issues that have very little salience at all. On these ones you can have a significant lead and it won't really affect the punters' views at all. This is exactly where Labour is with the environment. It has a clear advantage over the Tories on this issue, and has held this advantage over the last two years. But its salience with voters is well below average.

This, to me, shows why it was an obvious move for David Cameron to get rid of the 'green crap' to try and respond to Labour's policy on energy prices. They don't really risk anything given the low salience of the environment, but potentially gain by being able to say "we'll bring bills down" by getting rid of green taxes and thus cutting away at Labour's lead on 'wanting to help ordinary people'.

Actually you see something very similar in the polling that the NAPF undertook of pension scheme members I blogged previously. When asked what they thought asset managers should focus on it was pretty much bread & butter topics - the financial performance of the companies and the pay and conditions of employees were the top two. Environmental issues weren't even close. Again, low salience. (Of course, some will argue that actually a lot of the activity the RI sector undertakes IS focused on the financial performance of companies. But I think, if we're honest, we know this is a limited explanation for a lot of it.) But if we look at the activity undertaken in the RI world these positions are reversed. Environmental issues, climate change in particular, dominate whereas pay and conditions of employees is a long way down the list.

I can't help feeling that this is part of the reason that RI still feels like a bit of an add-on rather than an integral part of what pension funds do. Scheme members probably think it's broadly a good thing that people engage with companies over climate change, but it's not something many see themselves having a personal interest in. And because of its low salience at best it's pretty irrelevant in terms of building beneficiary support for RI activity (making it easy for opponents to scrap the investment industry's "green crap"). At worst there could be a significant gap between what pension scheme members want and what the RI sector undertakes on their behalf. It could look a bit like the legitimacy problem politicians now face.

I think it would be useful for all us in this field if there were a tighter link between what beneficiaries seem to want, and the activity undertaken on their behalf. Reorienting RI a bit so that bread and butter issues are given more prominence could do a lot to bolster credibility, and make it harder for opponents to challange. But then I would say that, wouldn't I?

PS. if I were working at an asset manager I would be looking at some of this polling a little bit nervously. There has already been a bidding war between the parties on pension charges. There is also growing interest in hidden investment costs. It's easy to see how a "lower costs"/"value for money" campaign could quickly gain ground, rooted in some simple values (like sticking up for scheme members), and I've little doubt that is something punters would be interested in.  

Ruling the Void

Ruling the Void, a posthumous sort of finished book by Peter Mair, is one of the most interesting things I have read recently. It covers similar issues to Colin Crouch's Post-Democracy but with a) some analysis of electoral behaviour to underpin the argument and b) a focus on the EU as an example. If you don't know about it, the book is basically about the hollowing out of Western democracies, with declining political participation and loyalty leading to more volatility on the one hand but less accountability on the other.

Particularly interesting to me area the comments about the state becoming primarily a regulator rather than an instrument of politics. This is exacerbated by the tendency of governments to seek to demonstrate the ideology-free nature of their offer by appointing third parties to develop and oversee policy. In practice this means that often only corporate interests get a look in since only they have the resources to devote to such work. Therefore, in my opinion, you should shudder when someone suggests that we need to "take the politics out of" a given issue, as this will likely mean hand it over to industry interests to do as they see fit with little accountability.

Anyhow, well worth a read. Below are a few good snippets.

[P]ublic policy is no longer so often decided by the party, or even under its direct control. Instead, with the rise of the regulatory state, decisions are increasingly passed to non-partisan bodies that operate at arms length from party leaders... [T]he officials who work within these delegated bodies are less often recruited directly through the party organisation, and are increasingly held accountable by means of judiciary and regulatory controls. And since this broad network of agencies forms an ever larger part of a dispersed and pluriform executive, operating both nationally and supra nationally, the very notion of of accountability being exercised through parties, or of the executive being held accountable to voters (as distinct from citizens or stakeholders) becomes problematic.

....

[T]raditional politics in seen less and less as something that belongs to the citizens or to the society, and more and more as something done by politicians. There is a world of citizens - or a host of particular worlds of them - and a world of politicians and parties, and the interaction between them steadily decreases. Citizens change from participants into spectators, while the elites win more and more space in which to pursue their own particular interests.

....

[I]t is possible to speak of a growing divide in European party systems between parties which claim to represent, but don't deliver, and those which deliver but are no longer seen to represent.   

Neo-liberalism

This is a few months old, but well worth a read - an interview with Will Davies (parts 1 and 2). Some choice quotes below that I particularly like/ agree with.

Ultimately what neoliberalism is doing is paradoxical.  It is asserting the political legitimacy of certain anti-political forms of technocracy, measurements and economics.  But when those forms of technocracy, measurements, economics and so on reach some massive crisis, as they have done in recent years, then the paradox becomes visible because the only things that can happen is for the state to use all its power to prop everything up and in a sense assert it all back into being.   And so the illusion that we can have a capitalism without power, without politics, and without sovereign bodies, comes crashing down – a project of power comes again to the fore.

xxxx

[O]nce the state’s job is measuring outcomes and measuring efficiency, the legitimacy of the state looks very different from if its job is seen in a much more normative, legal-constitutional way of imposing a particular market order....
[T]here is an emptying out of the capacity of judges, lawyers and regulators to mobilise arguments on the grounds of principle.  And this is deeply problematic because right now we live in a situation where most people would like to reduce the powers of banks and the main way in which that could be done is through regulation.  But the problem is that the banks are now involved in activities which are so complex and require such expertise, that they can always turn around to the regulator and say: you don’t know or understand what we are doing as well as we do and if you were to intervene that would have a drastic impact on certain economic indicators – growth or whatever.  And the regulator has no counter-argument to that.  What’s interesting about neoliberalism, I think, which has brought us to a state of crisis which we seem unable to get out of, is that it has gutted the very bodies which might traditionally have had the authority to restore certain areas of our economy to a state of legitimacy.  It has made it impossible for anyone to come along and claim that certain practices are simply illegitimate, because the only argument about legitimacy with any force is one based on economic evidence. 

ESG - where are the workers?

There's an interesting PRI report just published on investor engagement on public policy. It is worth a read. But I thought I'd carry out a little experiment to see the relative emphasis put on different issues as measured by mentions.

Here's the scores on the doors -

Sustainable+sustainability - 56 (37+19)
Climate - 53
Environment - 34
Governance - 31
Social - 19

Employee - 5 (of which 3 are part of the name of an investment institution)

Employment - 2

Union - 2 (including 1 in 'European Union')

Inequality - 1
Labour - 1
Worker - 0

To be clear, this is not a criticism of this particular report, it's a general point, and this is a very simplistic measure. But I wonder if anyone in this world would be surprised? Personally I think it's pretty indicative of where the RI community is at currently. The people whose money is being organised, and used to engage with corporates, don't get much of a look in. Attention is very much focused on environmental issues, and climate change in particular.