Archive for July, 2011

Directors Hazard and the New Rules of Governance

July 20th

The Murdoch hearings before Parliament gained a global audience and once again served to focus attention on the governance issues that now seem to arise at every turn.  Or, at least, when something goes wrong and we look back to determine who was responsible? or who should have been responsible? we seem to be confronted repeatedly with issues of governance and questions of moral hazard.

Where you responsible Mr. Murdoch?  No, he answered the people he trusted were responsible and the people that they trusted.

Unfortunately, since there had plainly been wrongdoing in the interest of selling more newspapers, Mr. Murdoch’s answer became the centerpiece of much of the coverage that followed.  Should he have assumed greater responsibility?  Was it even true that he didn’t know what was happening?

For directors who are responsible for protecting the well being of their companies, this answer raised troubling questions (once again) about the nature of moral hazard.  Economists talk about moral hazard (a condition that occurs when a party that is insulated from risk behaves differently than they would if they were exposed to the risk) as a case of information asymmetry.  Insurers need to be protected, according to the theory, from cases where the insured do not behave as they would if they had no insurance, if they were themselves subject to the full risks of their behavior.

In the 17th Century when insurance companies were first grappling with the concept of risk, they sought to understand whether the people that they insured would behave in a riskier manner as a result of the insurance.  In the case of health insurance today, there is ongoing debate over whether insurance encourages an overconsumption of health care and then there is a debate over whether that’s a bad thing.  Co-payments and other devices are used to encourage the consumer to assume part of the risk.

But in recent years, especially after the financial crises of 2008, the question of risk to the taxpayer became clear as institutions were protected, at taxpayer cost, from behaviors in which they had assumed too much risk.  Directors and national leaders, it was reasoned, would be better able to protect shareholders and taxpayers if the actions of CEOs were less protected and if their decisions were required to be transparent.

Michael Anteby, an associate professor of organizational behavior at Harvard Business School, writes in Working Knowledge, an HBS blog that “many companies today operate like Russian nesting dolls, relying heavily on other companies or external individuals to conduct many of their activities”.  (“Rupert Murdoch and the Seeds of Moral Hazard”)  Anteby expands the concept of agency and moral hazard by looking more broadly at the implications of the interconnectedness of our society.  He is concerned that when companies interconnect the “associated moral hazard often goes unnoticed.  Such risk can prove even greater when the various elements of the ‘delegation chain’ obey different standards.”

Whether or not the Murdochs knew about the phone hacking at the News of the World they were plainly in a situation of “plausible deniability”.  In the food and apparel industries, Anteby argues, there is a need to “secure” all elements of the production chain.  Whether they have in fact recognized this and whether there is a similar requirement in other industries is a debatable point.  But certainly one of the most interesting consequences of Rupert Murdoch’s denial of responsibility for the actions of his agents was to raise once again the question:  If not you, then who is responsible for the actions of your employees?

Future directors will have to think carefully about what these emerging concepts of “responsibility” will mean for them.  Will transparency be sufficient to protect the shareholders and the public?

We have reached a time when every company is an IT company.  Some Boards are beginning to see this and to grapple with the risks associated with information.  They may not yet have reached the point where they are grappling with the risks of information asymmetry and, if transparency is an antidote to the problem of the Russian nesting dolls, the consequences that this form of insurance will convey.

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UK’s Watergate

July 19th

The Parliamentary Hearing into the actions of News Corp broke new ground and the whole matter has opened a new requirement for business analysts everywhere.

First, the questioning of Rupert Murdoch and his son on live international television was an extraordinary spectacle worthy of, say…Rupert Murdoch.

The opportunity to inquire into the most intimate details of corporate governance of one of the most powerful men in the world is extraordinary theater.

And, in this case, there was an element of human drama that would have been difficult to miss.  Here was Murdoch being asked “what did you know and when did you know it?”  He was given the choice that always dominates discussions like this one – what did you know about this scandal?  What steps did you take?  Obviously, the witness cannot say that he was fully informed and took actions to make things better for his company.  Now that the dam has broken and there is a formal, legal inquiry, any actions taken that were protective have the taint of being conspiratorial.

So what could he say?  He could say that he was a bad manager.  Or he could say that he was foolish or stupid.  Or he could say that he did not know.

But if he didn’t know and if he was a competent manager, then his son must have known.   So there was a human drama of potentially throwing his son under the bus.  Of course, his son was the Chief Executive and perhaps should have taken steps long ago.

Finally, there should be little question that this is not a “UK” problem as much as the Murdocks might have wished that it were.  US law – foreign corrupt practices and licensing before the FCC – make this inquiry a US inquiry as well.

The new ground?  In their answers the Murdochs referred frequently to their reform of the corporate governance committee.   Clearly it would have been better to have had a Management and Standards Committee that reported to the independent directors.   The corporate governance process would have been better protected and that decision may turn out to have been a multibillion dollar decision.

In the end, it’s hard to predict how extensive the damage will turn out to be.  Business analysts everywhere will have to be even better at being able to assess events and processes like this one.

New ground at a minimum, indeed.

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