We adore best practice. It’s now vogue to see CEOs perched on stage at internal leadership conferences cascade best-management practices. Their public broadcasts are typically followed by a burst of scripted communications. Good habits are recorded: for example, they’re logged in appraisals. They’re also adopted company-wide. High standards have paper trails that span offices across the globe.
But what of bad practices, how do they spread? And moreover, what can we do to stop their insidious infiltration into decision-making offices? In search of answers, Aharon Mohliver, Assistant Professor of Strategy and Entrepreneurship at London Business School, studied a pervasive practice: stock-option backdating in the US.
Backdating was prevalent before March 2006, when two Wall Street Journal (WSJ) journalists outed six corporations for their supposed luck with stock-option awards. Through its ‘Perfect Payday’ series, WSJ demonstrated that CEOs at that scale can’t be that lucky.
The practice involved fudging the date to fudge the numbers. CEOs would report to the Securities and Exchange Commission (SEC) that stock-option grants were received on a date when the stock price was lower. By lying and falsifying financial records, they would be rewarded with a healthier sum when they sold the stock.
Between 1996 and 2006 almost one-third of US public firms engaged in the practice. Just weeks after the story broke the SEC ruled that backdating was explicitly illegal. It’s hard to imagine now that it was ever so pervasive.
In October 2006, Linda Chatman Thomsen, the SEC’s director of division of enforcement, addressed industry leaders , some of whom had succumbed to backdating. She said: “If you are ever in doubt about whether a practice is right, imagine explaining it to your family, especially your children.” They should have listened to their mothers, she finger-wagged. “Just because your best friend jumps off a bridge doesn't mean you should too. If the only reason that can be offered as a justification for backdating is that ‘everyone else was doing it,’ that's a poor excuse.”
Chatman Thomsen blamed CEOs for the spread of the practice. “Corporate character matters,” she said. “Employees take their cues from the top. If a CEO is known for integrity, integrity becomes the corporate norm.” Her argument was logical, but Dr Mohliver’s research traces a different story. Ethically questionable practices that aren’t explicitly outlawed – called “liminal” in his research – can spring from unexpected places.
Feeling impossibly lucky?
Reporting fraud was widespread among American firms, providing Dr Mohliver a rich dataset: 56,761 stock-option grants given to executives in 5,616 companies over the nine-year period before 2006.
Dr Mohliver sifted through extensive data, including share prices, the identity of the firms’ auditors, the locations of stock awards and more.
“Because much of the misconduct we observe in the world is based on who gets caught, it’s hard to gain true sight of everyone who cheats,” explains Dr Mohliver. “Who gets caught is down to the process of catching, not the process of cheating. The notion that a cheat isn’t a cheat until they’re caught is wrong. Worse, if the process of catching is skewed, and we only single out the cheats we can see, we never find out who is cheating and simply getting away with it.”
To paint a representative picture of backdating, he used luck as a measure. “Backdating is difficult to prove beyond reasonable doubt, because there’s always a chance that a CEO was extremely lucky. But whether or not you’re lucky should have nothing to do with who you are or who your auditor is.”
Using luck as a proxy for backdating, Dr Mohliver looked at people who were very lucky, over time, and asked, “What explains your luck today?” He found that the luck of an auditor yesterday was a strong predictor that their client would be lucky today. “You can’t learn to be lucky, but luck with stock-option awards was contagious. It spread through information networks.” Dr Mohliver simply replaced luck with backdating. “It’s not that luck spread through information networks, it’s that backdating was passed from firm to firm and from local auditors to their clients”.
So, how did it spread?
“In part, backdating spread across companies through direct contacts between firms,” says Dr Mohliver. Information also flowed through trusted decision-makers. Professional advisors made their own judgements about whether or not a practice would reward or cost their client.
So, do we blame the globally acclaimed big accounting firms? “People think there’s an ‘Arthur Andersen effect’, but there isn’t. The organisational structure of the auditor really matters. The big accounting firms have hundreds of local offices across the globe. If you're an auditor in London you're hired by the London office, you're promoted within the London office and your clients are mostly in London.
“These local offices can either spread or curtail backdating.” Through his analysis, Dr Mohliver was able to map activity at an almost Google Street-View level.
So backdating was widespread: did everyone know everyone else was doing it, just as Chatman Thomsen said in her speech? “That’s the tension. If there’s very little evidence that the practice was discussed – no paper trails, no records – how would you know about it? Without paper trails, the only way the practice could spread was through close-proximity untraceable networks.” The legitimising effect, therefore, ran through the professional experts in their local offices.
This is reassuring: professional experts are highly responsive to the institutional environment.
The good news
After slicing and dicing the data, Dr Mohliver found that the same professional experts responsible for spreading bad practice were instrumental in curbing it.
Interestingly, backdating was wrong but not explicitly outlawed for a long time. The practice was most prevalent in the 1990s and early 2000s. After the passage of the Sarbanes-Oxley Act (SOX) in 2002, professional experts started extinguishing the practice in their local client pool, while local networks of peer firms continued to diffuse it.
Here’s the important silver lining,” says Dr Mohliver. “Pre-Sarbanes-Oxley was a world where backdating seemed okay, but after the act was passed it became quite clear that regulators would probably not view backdating favourably. Even though the practice itself didn’t change, the response of auditors did.”
This is reassuring: professional experts are highly responsive to the institutional environment. “Signal the boundaries of acceptable behaviour, and auditors will start adjusting their clients’ practices accordingly.”
Experts don’t need long lists of dos and don’ts, they can take a hint. SOX is about transparent financial reporting and internal auditing processes, not backdating. Yet local experts reacted sharply to the fact that backdating might become punishable with severe consequences four years before it was deemed illegal.
Read Dr Mohliver’s full research here: http://journals.sagepub.com/doi/full/10.1177/0001839218763595
Practical tips for managers
There’s good reason for deferring to expert opinion. Some knowledge is niche. Dr Mohliver says: “Asking all managers not to engage in any liminal practice is unrealistic. Instead, we need to provide managers with the tools to assess whether a liminal practice is likely to be outlawed or legitimised over time.”
So, what can you do to ensure you uphold high standards in grey – or liminal – areas?
1. If a practice seems liminal ask for a second opinion. When you do, make sure you tap a wider, preferably international, advice network.
2. Consider the long-term effects. Ethical decision-making is sometimes about stopping and reflecting on the benefit of a practice and weighing it against its cost.
3. Keep an eye on regulation. Local auditors began extinguishing backdating after SOX, while peer-to-peer diffusion between firms continued.
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