Is it possible to manage an ethical company and be successful? Logically, most people would agree that, yes, ethics and success are not mutually exclusive conditions of sound governance. Yet the Securities and Exchange Commission has found that private equity firms are more likely than not to break the law or have material conflicts of interests. Has the principle of fiduciary responsibility, the “Prudent Man” rule, been relegated to the dustbin of financial market ethos?
Recently, Blackstone Group, the world’s most profitable fund manager, was ordered to repay fund investors $28.9 million and assessed a $10 million fine by the SEC for failure to disclose the collection and handling of fees that should have been used to benefit investors. Blackstone, to its credit, reported that its internal audit group uncovered the problem and reported its findings to investors. However, senior executives within the firm had to conceive the idea and present the proposal to a governing board for approval. What is the cause of a lapse in ethical judgment?
Blackstone is not alone; in the same article several incidents were cited of regulatory violations related to fee disclosure by fund managers. Blackstone Group has $330 billion under investment and close to $3 trillion dollars under administration, so what causes successful firms to cut corners? How does governance break down? A spokesperson for Blackstone Group responded to the violation by explaining, “our Limited Partner Advisory Committee did not exercise its right to object.”
One of the hottest topics in financial services is a new concept called conduct risk. The term comprises a wide variety of activities and types of behavior which fall outside the other main categories of risk, such as market, credit, liquidity and operational risk. In essence, it refers to risks attached to the way in which a firm and its staff conduct themselves. There is no clear definition for conduct risk, so it is more like pornography, right? You know it when you see it! But that is not exactly correct. The reason conduct risk is hard to define is because we are misled by the frequency of certain events, leading to errors in judging when bad ideas become bad behavior. These incidents beg the question of whether the unethical behavior by private equity firms is any different from Volkswagen’s emissions scandal?
The public outrage and media attention attributed to Volkswagen pales in comparison to reports of financial services firm misbehavior. Why is this the case? The answer is found in the field of cognitive science. Our views of events are shaped in large part by the frequency of news reports on a variety of risks we face. Shark attacks are a great example of this phenomenon. We believe that more humans are killed or maimed by sharks than cows. We know, empirically, that humans are killed or maimed by cows more frequently because farm workers encounter more cows than beach-goers do sharks. Local news accounts of “death-by-cow” events just don’t draw the same attention as a shark attack leading us to misdiagnose the risk.
The same can be said to explain how we view misbehavior of financial services firms. The frequency of regulatory and financial misbehavior has become almost invisible and is often relegated to the second or third page of news. The shock factor has worn out and we are no longer surprised to find that some fund manager has over charged or failed to follow the rules.
So how do we in risk management, audit, compliance and ethics address conduct risk? What defense can be used when the argument is, “everyone else is doing it why can’t we?” This is the riddle of ethical dilemmas. There is no risk framework or internal control to deal with conduct risk. It represents 98 percent of all operational risk failures, according to a recent study. For the largest firms, regulatory fines are no longer a deterrent and the costs of compliance, risk and audit have already been absorbed as a cost of doing business. The public is no longer outraged about being fleeced. In fact, car buyers will return to Volkswagen and investors will, undoubtedly, return to Blackstone Group. Solving the riddle of ethical dilemmas is the biggest challenge faced by risk professionals who are ill equipped to adequately mitigate this risk.
It is possible to run an ethical company and be successful. But it is also possible for unethical behavior to creep into the boardroom and C-Suite because the costs no longer exceed the benefits.