Prodrome of a governance crisis - behaviour

Volkswagen’s Dieselgate scam about fraudulent emission testing was revealed in 2015. Earlier in 2009, the Financial Times had reported about the company “having the worst corporate governance structure among Germany’s blue-chip companies.” There had been much water cooler talk as well, yet all advance signals were missed — the prodromes were missed!

In 2019, the European Securities and Market Authority criticised German regulators for ignoring the red flags over Wirecard’s financial reporting for years. News reports carried the headline, “German regulator should have heeded Financial Times on the Wirecard fraud.” Implicitly, the role of the independent directors was also doubted. Here again, the prodromes were missed.

Regulators and board directors should be sensitive to advance signals, usually manifested through behavioural aberrations before the failure. Behavioural corporate governance — an inspiration from Amos Tversky and Daniel Kahneman — is an idea whose time has arrived.

All business inevitably entails understandable risk, but honest failure should not be punished. What is an honest failure? Honest failure is a contained failure, without devastating consequences for stakeholders. Failure which is implosive (ill-conceived and executed) or fraudulent (premeditated deceit) shatters shareholders, lenders and employees. Fraud is often born when risky bets go wrong. A risk that bets the whole institution irretrievably is dangerous. Since every failure is not a fraud, we should consider the vichaar  (intent) and the aachar (conduct). 

A failure is often preceded by a failure of aachar before ill-directed vichaar manifests. Aachar or conduct is easier to observe as compared to judging the vichaar or intent. Is there good governance? Does the entrepreneur resource the enterprise with competent management and effective board processes like risk review, audit committee and so on? Is there constructive dissent in board meetings? Does the entrepreneur or promoter display huge personal greed, which is a precursor of malintent and fraudulent thinking? Greed blinds a person to divert funds, so do risky trades and the like.

Prodromal test

Prodromal signals are the advance signals that precede a mishap; they do not accurately predict a mishap but they point to the possibility of a failure. I designed an easy-to-administer and imperfect test to judge prodromal signals. The test result is cautionary about the quality of alertness called for; it has been validated by fitting it to 15 established failures. No single answer is meaningful, but, taken in aggregate, the results are meaningful.

The test assigns 1 point for Yes and 0 for no to each question below.

1. The firm(s) is portrayed as being the handiwork of a single genius, who is highly profiled.

2. The entrepreneur and his firm(s) work at maintaining a high public prominence.

3. The entrepreneur appears to possess access to people in high places, and those connections are leveraged.

4. The firm(s) consistently delivers unbelievably good results, out of line compared to others in similar business.

5. The entrepreneur seems adept at exploiting weaknesses in the law or in the implementation of regulations.

6. The entrepreneur demonstrates excessive impatience for growth and appears to be greedy for personal wealth accumulation.

7. The firm(s) of the entrepreneur borrow heavily, often running up unwieldy and ballooning debt obligations.

8. Even intelligent investors find it difficult to understand the inter-connected web of subsidiaries and associates, and the consequent accounts of the firm (s).

9. The firm(s) are not acclaimed for great practices, for example, an effective whistle-blower scheme. The governance is opaque and independent directors appear friendly/grateful to the entrepreneur/chairman.

10. The auditor is either an unknown entity or a well-known firm, which strives to maintain good relations with the company.

11. There is persistent “water-cooler” talk about the use of unusual means, though, in the absence of proof, everyone maintains silence.

12. The entrepreneur and/or his family display ostentatious living styles,for example, hobnobbing with celebrities — these attract media reportage.

13. The line between firm’s wealth and personal wealth seems to be thin.

14. In interviews, the entrepreneur displays personal panache and bravado, while also quoting modest family origins, or spirituality or do-good for society and community.

15. If there is negative reportage, the entrepreneur displays shock and hurt, exhibiting a severe denial syndrome.

The scores mean:10-15 (Dangerous and dodgy governance, please reconsider board position if you are a director), 6-9 (Average like others, but be observant and cautious) and finally 1-5 (There are some imperfections, but within acceptable limits).

Try the test on companies that you know or care for.

Email: rgopal@themindworks.me

The writer is an author and corporate advisor. He is distinguished professor of IIT Kharagpur. He was director of Tata Sons and vice chairman of Hindustan Unilever