Once upon a time you could go to your local bank branch and get investment proposals that had a realistic chance of generating a positive return. You could pay several decades into your life insurance knowing that you would receive your money back plus a nice capital gain. And when you bought products from big corporations you could be confident that they would not cheat you outright. Admittedly, not everything was perfect in the past but the good times are certainly over.
Being a successful top manager is not easy these days. With global debt at record levels and a growing number of zombie companies that sell their products below cost it has become increasingly difficult for companies to generate a decent profit. Additional pressure on top management is exerted by the shareholder value approach that emerged in the 1980s. It stipulates that the primary goal of a company is to increase the wealth of its shareholders. In former times a company had to deliver satisfactory net earnings at the end of the year and a clear vision on how to grow profitably in the future. Nowadays investors expect excellent quarterly results and follow stock prices on a daily basis. Instead of taking a long-term view and making sound investments for the future, management is forced to increase current shareholder value at the cost of other stakeholders (such as employees and customers) as well as the long-term outlook of the company itself.
Top management is not only facing increased pressure but also a different incentive structure. In the old days, managers were paid a good base salary and some bonus usually based on sales growth and profit. Nowadays the importance of the fixed salary has decreased and instead bonuses and stock options that depend on the stock price and Earnings per Share (EPS) are the main driver for compensation. This has generated a strong incentive for executives to have companies buy back their own shares even if it means borrowing money to do so. In the event that net earnings of a company stay flat, a reduction in the number of shares means that EPS go up and consequently the stock price. A higher stock price increases the value of stock options. This is great for top management but not necessarily good for the company as it will not only face higher management remunerations but also higher interest payments and higher risk in the future.
Apart from the incentive structure there is another aspect that has changed. Executives used to face a jail sentence if they did something wrong. This risk has diminished substantially in the last 20 years. Today there is not only “too big to fail” but also “too big to jail”. In the U.S. it started in 1999 when a memorandum of then Deputy Attorney General Holder requested that collateral consequences from prosecutions such as corporate instability or collapse should be considered before prosecuting a financial institution. This has not only led to less prosecutions but also to the Justice Department seeking settlements instead of prison sentences. Whereas in the savings-and-loan scandal of the 1980s over 800 managers were convicted, only one Wall Street executive was sent to jail following the Great Financial Crisis (GFC) which was certainly a magnitude larger. And this one executive was not even the managing director of a big corporation but only a senior trader at Credit Suisse. The situation in the USA might be special, but political pressure will probably also prevent the CEO of a big bank in Germany, Australia or Canada from being prosecuted.
Today top managers face a big asymmetry between risk and reward. If they do something unlawful to increase their bonus and it goes wrong, the company faces the losses and might have to pay a (comparatively) small fine to the authorities. But if the offense is not detected the reward will be huge. Losses go to the shareholders or other stakeholders, profits go to the top management. You could not describe a moral hazard situation better.
JP Morgan Chase is an example of top management being rewarded even though their companies have to pay heavy fines. In November 2013 the U.S. Justice Department reached a USD 13 billion settlement with the bank related to its selling of toxic mortgage-backed securities to investors before the Great Financial Crisis in 2006 – 2008. During that time Mr. Jamie Dimon was CEO of the Bank. In January 2014 the Board of Directors of JP Morgan Chase stunned the public with the announcement that Mr. Dimon’s compensation for 2013 was set at USD 20 million (USD 1.5 million fixed, the rest variable), an increase of USD 8.5 million over the previous year. I leave the interpretation to you.
There is enough material available to write a book (or rather a series of books) about unethical and unlawful behavior of big corporations. Let me just briefly give a few examples of the last 20 years. I will start with the Great Financial Crisis that was caused by a combination of deregulation, failed regulation, ill-conceived central bank policies, weak or even fraudulent underwriting standards, undisclosed conflicts of interests, high risk taking and outright fraud. At the heart of the market collapse were U.S. Mortage Backed Securities (MBS) and Collateralized Loan Obligations (CDO). The latter were complex financial products that hardly anyone fully understood. Wall Street firms that wanted to sell such products had to get a rating first. Therefore, they paid credit rating agencies to provide them with a rating. In the years leading up to the GFC the big rating agencies Moody’s and Standard & Poor’s assessed thousands of MBS and CDO and gave them AAA ratings as anything below would have put them out of business. When many high-risk loans started to default in 2006 the agencies maintained the AAA ranking and it was only much later that the ratings were lowered. 90% of AAA ratings given to subprime MBS securities were eventually downgraded to junk status. As a side note it is shocking that credit agencies are selected and paid by the company that wants the credit rating done. Please keep that in mind the next time you hear from your financial advisor “This is a triple A rated security”.
All the big banks were eager to sell MBS and CDO to their customers even though they were aware that something was wrong with the products. Some banks went even further and shorted them while continuing to sell them to their clients. A report by the U.S. Senate Permanent Subcommittee on Investigations mentions one particular example involving (in)famous investment bank Goldman Sachs. It states: “In the case of Hudson 1, Goldman took 100% of the short side of the $2 billion CDO, betting against the assets referenced in the CDO, and sold the Hudson securities to investors without disclosing its short position. When the securities lost value, Goldman made a $1.7 billion gain at the direct expense of the clients to whom it had sold the securities.”
The U.S. Justice Department issued more than USD 100 billion in fines to banks for their role in relation to the GFS. All big players were affected such as Bank of America, JP Morgan Chase, Citigroup, Deutsche Bank, Wells Fargo, RBS, BNP Paribas, Credit Suisse, Morgan Stanley, Goldman Sachs and UBS. However, as already stated above, all those fines represented out-of-court settlements. None of the banks were officially charged and except for one mid-level executive no senior banker went to jail.
Banks have also been very active in rigging interest rates. One popular target was the London Inter-Bank Offered Rate (LIBOR) which is considered to be one of the most crucial interest rates in finance as it affects the price of approximately USD 350 trillion in derivatives. In 2012 it was discovered that banks had for many years colluded in manipulating the LIBOR in order to profit at the expense of their clients and other market participants that lost billions of dollars. Involved in the scandal was once again the “Who’s Who” of the banking industry such as Deutsche Bank, Barclays, UBS, Rabobank, HSBC, Bank of America, Citigroup, JP Morgan Chase, the Bank of Tokyo Mitsubishi, Credit Suisse, Lloyds, West LB, and RBS. About USD 9 billion in fines were levied which is peanuts compared to the damage caused. This time several traders were convicted but again no senior banker ended up in jail.
Money laundering is another highly lucrative business that banks tend to be involved in. Normal citizens have to complete preposterous Know-Your-Customer (KYC) forms, are intensely questioned for larger cash deposits and withdrawals and might even have their accounts frozen following a small international transfer to a bank in an emerging country. For big customers different rules apply, not just in America but also in Europe. In 2017 it emerged that approximately EUR 200 billion of illegal money from Russia and other former Soviet states had been laundered through the Estonian branch of Denmark’s Danske Bank. Other European banks have also been caught facilitating money laundering. Research by anti-money laundering expert Fortytwo Data shows that 18 out of the 20 biggest banks in Europe have been fined for respective offences.
Bank misbehavior in other areas is also rife. Wells Fargo is a good case in point. In 2017 the bank admitted that its employees had opened 3.5 million savings and credit card accounts for customers without their knowledge and consent. Main reasons for this fraud were very high sales incentives as well as strong pressure from higher-level management. The bank was fined USD 185 million by three government organizations, among them the U.S. Consumer Financial Protection Bureau. In the same year Wells Fargo had to admit that it charged 750,000 customers for auto insurance they did not ask for. The case was later settled with a USD 385 million fine. In 2018 Wells Fargo agreed to pay a $2.09 billion fine for issuing mortgage loans it knew contained incorrect income information. And in the same year the bank filed a report with the U.S. Securities and Exchange Commission (SEC) in which it disclosed that a software coding error resulted in 625 customers being incorrectly denied a mortgage for which they were qualified. About 400 of these customers lost their homes. The list of scandals involving Wells Fargo can easily be extended. But certainly, the biggest scandal is that after all the misdeeds committed by the bank it is still able to find customers who are willing to deposit money with it.
Cheating and deceiving is for sure not confined to the financial industry. Big corporations in other business sectors are also willing to compromise ethics and contravene existing laws to obtain commercial benefits. Despite what is written in fancy mission and value statements most companies are readily willing to infringe on environmental protection laws to meet and exceed their budget targets. The Volkswagen “Dieselgate” scandal is a good example. Between 2009 and 2015 Volkswagen installed software in its diesel engines which could detect when the car underwent emission testing. This “defeat device” was then able to reduce the emissions helping the engine to pass the tests. Volkswagen admitted that around 11 million cars worldwide had been equipped with the software. The company had to pay several billion EUR in fines and also spent billions on car recalls.
Most companies don’t care about your privacy and the protection of your personal data despite what is written in increasingly lengthy and incomprehensible privacy statements. A very notorious case is Facebook which has a long track record in completely disregarding the privacy of its customers. The biggest scandal emerged in 2018 when it was found out that personal data of 87 million Facebook users had leaked to the political consultancy Cambridge Analytica. Facebook alleged knew that Cambridge Analytica was siphoning off data but did nothing about it. In July 2019 Facebook agreed to pay $5 billion to resolve a U.S. Federal Trade Commission investigation of privacy violations.
Theranos is another example of a Silicon Valley company with a highly questionable business model. This enterprise claimed to have developed a revolutionary technology for blood testing, raised USD 700 million from investors and was at its peak valued at USD 9 billion. In 2018 Theranos was charged by the U.S. Securities and Exchange Commission (SEC) with massive fraud by lying about the extent and quality of its testing technology, revenue, regulatory approval and clinical trials. The firm has since been liquidated. As a delicate side note it needs to be pointed out that the Theranos Board of Directors included two famous former U.S. Secretaries of State, two former U.S. Senators and two former CEOs of big corporations.
Reckless management behavior even puts human lives at risk as the Boeing 737 MAX fiasco shows. In March 2019 aviation regulators around the world grounded the Boeing 737 MAX after two fatal crashes in Indonesia and Ethiopia that killed a total of 346 people. Subsequent investigations uncovered that Boeing was willing to cut corners in order to compete with Airbus in an upcoming American Airlines tender. Instead of developing a completely new aircraft it opted to equip the outdated fuselage of the 737 with much bigger engines then it was originally designed for. To deal with the resulting aerodynamic instability Boeing hastily developed a highly controversial Maneuvering Characteristics Augmentation System (MCAS) that was at the core of the two crashes. It later emerged that Boeing management disregarded internal safety improvement proposals to keep cost down and put tremendous pressure on its development team to speed up work and circumvent necessary but costly design changes. Instead of using available funds to increase safety senior management preferred to invest in stock buybacks to boost their bonuses. During the investigation it became known that the U.S. Federal Aviation Administration (FAA), that must certify each new aircraft type, completely failed in its task. Their inspectors were not only insufficiently trained but also handed over most of the certification work to Boeing. Regarding the fatal MCAS system that relied on a single sensor instead of at least two it turned out that regulators had never independently assessed this system. It is certainly useful to have a cozy relationship with your regulator.
The above examples are only the tip of the iceberg. Most inappropriate or illegal behavior doesn’t even make it to the news. Nonetheless, you increasingly find it everywhere. Companies make inaccurate statements about their products and pay ghostwriters to disseminate false information on the internet. Sales people give incorrect assurances to their customers to get commission (and avoid being fired for not hitting their “stretched” sales targets). Enterprises don’t adhere to business contracts in the hope that the other party will not file a lawsuit to avoid high cost and risk. Subscription businesses reject cancellations or intentionally extend the process to get a few additional payments. Enterprises employ subcontractors that use child or slave labor. Construction companies and producers use substandard materials. Internet firms harvest your data without you even knowing it. The list can be extended almost indefinitely.
In summary, today’s executives are more likely to cook the books, cheat customers or commit other crimes. The reason is that they face high rewards if everything goes as planned and have low risks if someone finds out. This has led to an adverse selection process. Candidates for top positions who are law-abiding and ethical are disadvantaged as they “underperform”. Instead candidates with no scruple and a strong desire to maximize their own bank account are selected. Consequently, it is not surprising that there are more sociopaths running large corporations today than ever before. And as a fish rots from the head down this has a big impact on the whole organization. Middle managers with low moral standards are appointed to apply immediate pressure on lower management and staff. Bad behavior is spreading like a virus from big corporations to medium and even small companies. Decent companies find it more difficult to compete and are increasingly forced out of the market.
Please consider all this the next time you talk to your nice and obliging financial adviser, insurance broker, real estate agent or lawyer.
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