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The Board Role In Ethics And Compliance

For compliance programs, "tone at the top" is a frequently used (but little examined) term.  Just how does a board of directors determine and establish a practical system of ethics that will reach throughout the corporate structure?  What elements are needed?  How can the board gauge the effectiveness of its efforts?  What approaches work best-and which lead to failure?

Historically, the main responsibility of a board of directors has been to protect and maximize shareholder return.  Depending on the company charter and bylaws, this usually meant establishing proper governance systems, approving executive pay, and voting on important business decisions such as mergers or divestitures.  However, we have entered a new era of transparency and interdependence.  The public perception of organization's integrity, accountability and social value are key drivers of its reputation, marketing position, and ultimately its value to all its stakeholders.  For example, in the United Kingdom, the newly revised Companies Act of 2006 defines the responsibilities of directors as promoting "the success of the company for the benefit of its members as a whole" through consideration of the following six factors:

  1. The likely consequences of any decision in the long term.
  2. The interests of the company's employees.
  3. The need to foster the company's business relationships with suppliers, customers and others.
  4. The impact of the company's operations on the community and the environment.
  5. The desirability of the company maintaining a reputation for high standards of business conduct.
  6. The need to act fairly as between members of a company.

Clearly, each of these factors individually requires a values-based (as opposed to rules-based) approach.  If everyone in an organization shared these priorities, it would almost certainly have a robust ethics and compliance program, and what could objectively be described as an ethical culture.  Indeed, in the U.S., the Federal Sentencing Guidelines for Organizations (FSGO) define an effective ethics and compliance program as one that "promote(s) an organizational culture that encourages ethical conduct and a commitment to compliance with the law."

There are a number of pragmatic, concrete steps that boards can insist on to create and foster a humanistic, sustainable culture of corporate values.

Boards have seen more and more examples of the growing cost of corporate misconduct, the risk of losing market share to companies with more perceived integrity and social value, and the proven increase in long-term performance for organizations that encourage values-based decisions.  Establishing a clear set of humanistic, sustainable corporate values and emphasizing to management that corporate behavior must reflect those values is now one of the most important steps in maximizing value for all stakeholders.  There are a number of pragmatic, concrete steps that boards can insist on to create and foster such a culture. 

  1. Board Power
    Board power is both statutory (by law, the fundamental right and obligation to manage the company often resides with the board) and practical.  Because they oversee the decisions and compensation of management, boards are in a powerful position to act as guides of company culture and to shape the fundamental relationships between their companies and every stakeholder.  Research has shown that consistently and publicly rewarding managers for delivering ethical corporate outcomes or personally embodying sustainable company values, rather than simply financial return, is crucial to the most effective ethics and compliance programs.  This applies to relations between the board and management as much as between management and everyone else.  Management usually responds quickly to the tone and focus set by the board, whether it is one of "profits at any cost" or responsible corporate citizenship.  When boards hold management accountable for creating, shaping, and fostering an ethical culture, proper governance inevitably follows.

  2. Society and Corporations
    What has changed to make ethical culture and governance newly connected to shareholder returns?  Nothing.  Companies that have developed reputations for integrity and good corporate citizenship, whether in healthcare (Johnson & Johnson), manufacturing (Deere&Co.), or consumer goods (Warby Parker) have consistently beaten the competition over time.  What has changed is the speed with which such reputations can be destroyed-and at a slower pace, built.  This past March, Elon Musk, CEO of Tesla Motors, tweeted that a new software update was about to "end range anxiety" for electric car purchasers.  Musk's announcement caused the share price of the relevant Tesla subsidiary to jump 3.7 percent.  Almost immediately, Musk had to follow up with another set of tweets, responding to critics who accused him of share manipulation.  In the space of hours, the CEO of a major corporation had moved the market for his company by over a billion dollars, been accused of unethical and potentially illegal behavior, and been forced to defend his actions to the public.  All this was done using communication channels that were unimagined ten years ago.  These technologies have exponentially increased the ability of the public to see and respond to the inner workings of businesses and to the behaviors of their employees.  The public has not been shy about using this new-found information to criticize, shame or even boycott companies that act in ways it feels lack integrity or violate ethical standards.  The risk presented by falling in corporate citizenship is real, and should be of significant concern for those entrusted with protecting shareholder return. 

    People who successfully think in terms of values as opposed to rules not only exhibit the right behavior, but enter a "virtuous cycle" of trust.

  3. Rules vs. Values
    What can boards do to maximize shareholder return in the face of this risk?  Traditionally, that question has been viewed through a narrow legal and regulatory lens.  Clearly, compliance with laws and regulations is fundamental to any reputable organization that wishes to keep its license to operate.  However, a strictly rules-based approach to ethics and compliance typically fails.  Laws are complex and prescriptive, focusing on what can or cannot be done, leaving a tremendous amount of white space when it comes to what should have been.  In fact, given the inevitability of "loophole thinking," approaching ethics and compliance from a strictly rules-based perspective is itself a risk that could potentially cause irreversible harm.  A set of living, humanistic and sustainable values, on the other hand, truly lessens risk because values are not situational.  They are sustainable guides that enable people to come to a correct conclusion based on any set of facts at hand.   People who successfully think in terms of values as opposed to rules not only exhibit the right behavior, but they enter a "virtuous cycle" of trust.  Being asked to use their own judgement makes them feel more trusted and valued, which in turn encourages them to be more trustworthy. 

    Managers are much more likely to think their ethics programs are highly effective than the employees who are supposed to exhibit the required behaviors. 

  4. Culture Assessment
    Once boards and directors recognize the value of ethical culture, how can they know where their companies stand compared to where they wish to be?  As a starting point, boards need to be fully aware of the health of their organizations' ethical culture.  One reason that building a values-based culture is so challenging is that without assistance, companies are usually unable to benchmark their culture's resilience or susceptibility to misconduct.  Another reason is that senior managers often have very different perceptions of their governance and leadership systems than the rest of the organization.  They are much more likely to think that their programs are highly effective than the employees who are supposed to exhibit the required behaviors day after day. 

    LRN surveyed more than 900 C-suite executives and found that they were three to eight times more likely to believe that their organizations were highly values-based than the more than 35,000 less-senior employees taking part in the same study.  Boards can use a growing array of tools, such as LRN's Governance, Culture and Leadership Assessment, to provide measurement and benchmarking of the current state of employee behavior and corporate culture in their organizations.  These data allow boards and senior management teams to become much more intentional and deliberate about shaping behaviors that strengthen their company's desired culture and behaviors, and to identify and minimize risky and non-compliant behaviors. 

    Without regular ethics program assessments, directors will find it difficult to "exercise reasonable oversight" of their value. 

  5. Risk Assessment
    In addition to a culture assessment, boards also need to conduct traditional company-wide risk assessment.  Every organization faces different risks, and the 2010 update to the Federal Sentencing Guidelines now requires ongoing risk assessments.  Risk assessments have been a fundamental part of ethics and compliance program management for years, but one element that boards should analyze is the variety and quality of metrics used in the assessment design.  Risk assessments work best when closely tailored to the operation and realities of the company.  This makes the use of appropriate metrics crucial to effective evaluation.  The 2014 LRN Program Effectiveness Report noted that the use of appropriate metrics actually correlates with better ethics and compliance programs-more effective programs use many more inputs in their risk assessments than do less effective programs.  Companies who run highly effective programs are two to four times more likely to believe that the metrics they are using are selected on the basis of their validity, impact, practicality, and value. 

    Continuous assessments and revisions to ethics and compliance programs, under the oversight of the board, also differentiate the most effective programs.  In an LRN survey of more than 130 programs, every company whose program was found "most effective" conducted frequent formal program assessments.  More than 70 percent of those companies did so either annually (43 percent) or every other year (27 percent).  The programs we found "least effective" rarely adhered to any particular schedule, or in a few instances did not conduct any formal assessments.  The lesson for boards is clear-without regular ethics programs assessments, directors will find it difficult to "exercise reasonable oversight" per the U.S. Federal Sentencing Guidelines.  The cadence of these assessments should be at least annual.  If the risk profile of a company has changed due to external factors, or due to its own activities (such as geographical expansion, new lines of business, M&A, etc.), they may need to be even more frequent.

    6. Fostering an Ethical Leadership Culture
    Once the baseline risks have been benchmarked, the hard work of fostering a culture of ethical leadership can begin.  First, exceptional boards can directly affect the leadership that will differentiate their companies in all areas, including ethics and compliance, simply by engaging in specific behaviors in the boardroom.

    Ethical leaders exhibit several hallmark behaviors.  These include a desire to have meaningful two-way conversations, the ability to demonstrate moral authority and shape the context of business challenges, and to lead with purpose.  By engaging in these behaviors in each board meeting, boards can begin to set the tone at the top, modeling the kind of leadership they expect from management.  Next, boards need to ensure that management teams mirror those behaviors in their interactions throughout the company, especially with middle management.  Directors can work with top executives in clearly and deliberately communicating a sense of purpose for the company-sharing information early, often and widely, and having two-way conversations bout the trajectory of the company.  These behaviors aim toward the creation of a culture where employees feel trusted to think for themselves, to make decisions that benefit the company and wider society, and to change how they behave for the better.  This is often a difficult adjustment for boards accustomed to practices dating back to the Industrial Age.  However, companies will be better served if they arm their people with a system of sustainable values that can be applied consistently, rather than a rulebook that only applies to certain circumstances.
  1. Tone at the Top and In the Middle
    As noted, successful ethics and compliance programs not only set a clear tone at the top of the organization, but support this tone throughout middle management.  Active, consistent, and sincere board and CEO involvement in these matters makes it clear throughout the company that behavior matters as much as outcomes.  Adherence to fundamental values and culture matters more to long-term organizational success than do short-term metrics.  When Unilever's incoming CEO, Paul Polman, announced that Unilever would stop its practice of providing investors with quarterly earnings guidance, Unilever stock fell within days.  However, this sent a clear message, and with the support of his board, Polman resisted short-term investor pressure.  Four years later, Unilever's stock was up 50 percent from where it was when Polman took office.  As the mantra of long-term value spreads, we can continue to expect more rewards to go to those exhibiting courage in the boardroom.  National Grid, a $50 billion electricity distributor, became the largest FTSE-100 company to announce early in 2015 that it would discontinue quarterly reporting all together, stating that frequent reporting to investors brought "an unnecessary focus on matters of little relevance to a long-term business."

    While such tone and actions from the top are critically important, boards cannot ignore the distance from which the tone at the top is received.  Very few employees have regular interaction with members of the board and C-suite.  Over 80 percent of ethics violation complaints are made to a frontline manager, not to a board member or anonymous hotline.  This means mid-level managers are the first responders on a vast majority of individual ethical challenges.

    It is unsurprising, then, that our data show a supportive tone in the middle is as closely associated with ethics and compliance program effectiveness as is the tone at the top, if not more so.  Middle management that absorbs a message of ethical culture and adherence to corporate values from the top, and which effectively exemplifies that message in their interactions throughout the company, can truly make or break the organization's culture. 

The difference between effective and non-effective ethics and compliance programs is tied to a focus on culture. 

Most ethics and compliance programs have several common components-a code of conduct, education and training programs, a confidential hotline, and the provision of some information and metrics to the board of directors.  All of these are important and necessary elements.  Yet the differences between effective and non-effective programs can be boiled down to one thing-an intentional focus on culture.  Companies which set out to improve their corporate culture and elevate employee behavior receive a greater return on their compliance-related investments than those who focus on "check the box" programs. 

Boards of directors should recognize that a dedication to maximizing shareholder value means it is their responsibility to get serious about culture.  They should also understand that it will be a hard journey, marked by many unknowns and surprising lessons.  Yet by choosing to embrace a purposeful, values-based culture, and by fostering the implementation of metrics, education programs, and communication strategies that support such a culture, they can ultimately create truly compliant companies. 

This article was originally published in the September/October issue of The Corporate Board magazine.




Topics: Ethics & Compliance, Culture, Leadership, Corporate Culture, Values, Tone At The Top