SUSTAINABILITY AND REPUTATION RISK – OCTOBER 22ND, 2014

What’s a Reputation worth?  Certainly Arthur Andersen knows. One of the Big Five accounting firms prior to their public acknowledgement of shredding documents related to Enron in 2002, Arthur Andersen vanished following the Enron scandal. Also lost were nearly 100,000 jobs and clients associated with Arthur Andersen suffered nearly $10 billion in stock market losses in the 3 day window following the breaking of this news.  Last month, former partners with Arthur Andersen announced they are resurrecting the Arthur Andersen name.  Those involved clearly believe some good can be salvaged.  The name, which was established in 1918, spent 70+ years building a celebrated reputation but was forever tarnished by one illegal act.  Clearly the cost to employees, shareholders, and the public has already been realized.

As an advisor, I often encounter situations with companies that involve accidents, misbehavior and negligence.  The biggest threat to reputation is seen by a survey of 269 senior executives responsible for managing risk to be a failure to comply with regulatory or legal obligations. The CEO is regarded as the individual with primary responsibility for managing reputational risk in the survey. Companies that have a communications strategy that enables them to respond quickly and effectively to bad news, and which manage issues promptly and openly, often emerge with their reputations enhanced. Still many companies settle by paying a fine and admitting “no wrongdoing”.  The firm pays and it’s business as usual.  Often those companies suffer heavy and, in some cases, irreparable damage.

We all love a comeback story, but redemption is often not as effective when the subject in question accepts little or no responsibility for their actions.  A good example of this is BP.  In the aftermath of the 2005 refinery explosion in Texas which killed 15, obtained email documents revealed that the company’s strategy was to accentuate the positives and downplay the negatives with the expectation that the fallout would subside due to the holiday weekend; a heartless yet not un-expected method of operation. BP proceeded to launch a PR campaign to espouse the virtues of their alternative energy efforts, but failed to address their role in the massive damage to the environment and local economy.

Could we have drawn a conclusion following the 2005 plant explosion given what we knew about the board of directors’ and management teams’ approach to damage control?  After the Texas City explosion, the Occupational Safety and Health Administration fined BP $21 million. The company also agreed to a $50 million plea bargain with the U.S. Department of Justice, in which it promised to comply with the improvements OSHA required. The string of investigations that were conducted after the blast cited cost cutting and poor maintenance as contributing factors. One internal BP report said that BP had a “poor understanding of risk.” Another noted that workers had a “lack of awareness of potential consequences.” A 341-page investigation by the Chemical Safety Board found that “budget cuts and production pressures seriously impacted safe operations at Texas City” and that BP executives “failed to provide effective leadership and oversight to control major accident risk.”

What does it say about a company that chooses to deflect wrongdoing versus taking responsibility for the damage they caused?  I would make the case that the former is an extremely short sighted approach and unsustainable.  Whereas the latter case allows the company to lay everything out on the table, say this is what we did wrong, and going forward we are going to be better.  It may cost more in the short term, but it does more to solidify the company’s operations and reputation going forward.

The larger question is this. Is reputation risk manageable?  And if it is, are the consequences of poor management or decision making foreseeable?  Here are some examples to consider.  Within Costco’s supply chain, it was recently revealed that the contracted company in Thailand that harvests the shrimp sold in Costco’s stores employs slave labor.  Making this decision shows a lack of supply due diligence and the situation has led to considerable negative publicity for the company.  BP’s failure to provide an adequate response to regulators in the wake of the 2005 Texas refinery explosion should have been a warning sign with respect to their handling of other projects.  FedEx made the decision to take on social reputation risk by associating their brand with an ethnic controversy by being a sponsor for the Washington Redskins.  Does such a decision give investors reason to question management’s strategy on brand positioning?

One effective way of managing reputational non-financial risk is for companies to begin strictly monitoring how their operations are being run relative to industry peers.  The Global Reporting Initiative and the Sustainability Accounting Standards Board (SASB) are two organizations working to provide greater transparency and standardization to Sustainability reporting.  Both organizations provide a thorough set of sustainability reporting guidelines that companies can use to evaluate their own operations.  These guidelines provide a standardized method of measuring various non-financial aspects to a company’s operations and together can give an individual firm an idea of where they stand relative to the industry averages.

As an example, Coke and Pepsi are both large players in the beverage space.  Coke has publicly stated that water scarcity is a major concern for their industry.  They also point to the potential for plastic bottles to be subject to “deposits or certain eco taxes or fees” as well as the continued scrutiny of soft drinks and the negative association with obesity and inactive lifestyle which remains a “significant challenge to our industry”.  Pepsico is aware of water scarcity as a threat, however they make no mention these other two risks in their 10-k.  On the face, should we assume that Pepsico is less concerned or less likely to tackle these two particular issues which Coke has defined as material risks?  The Sustainability reporting guidelines provide areas where both companies can address these issues by auditing their operations on Environmental Materials, Waste, and Product Responsibility.  Participating in this new set of measurements would give stakeholders a more transparent and deeper understanding of how a company run and can provide further insight into potential deficiencies which could impact financial performance.  We can also see how this type of reporting can apply to the previous examples.  Costco would need to address Supplier Assessment for Impacts on Society, BP-Labor and safety Practices, and even Fedex should address Human Rights Grievances.  We definitely see this type of reporting gaining broader acceptance given how much additional depth and value this information provides.

Because reputation is so interconnected with nearly every facet of a company’s business, it’s not surprising that it can come under threat at any time.  Once a reputation is firmly established it is put on the line every second of every business day, and sustaining one’s reputation is just half the battle.  A company also needs to have crisis management processes in place when damaging incidents occur.  This typically entails communicating issues to stakeholders in a timely matter as well as outlining and executing corrective actions.  As we have outlined, reputation risk can vary in degrees with some having more potential to impact financial performance than others.  But for many stakeholders, it is not just about financial performance that makes an investment worthy.  Using new guidelines that help us measure these non-financial aspects to operations provides an extra layer of screening that helps stakeholders make better decisions and the ability to invest in not just what is profitable, but what is right.

Each industry has standards which dictate whether a company is performing above or below expectations.  And while every company strives to excel in profitability it’s an unfortunate fact that some will cut corners in order to achieve their financial objectives and outperform their peers.  This type of decision making, however, if continued may lead to poor results over the long term.  For example, a company that does not compensate its employees fairly or below the industry standard may be more profitable in the short term, but in time they will have difficulty recruiting and retaining talent.  Establishing a reputation as a company that does not pay well directly threatens long term competitiveness.

Reputation is arguably a company’s most valuable asset, and building the most sustainable and successful reputations requires having a management team that understands that business does not operate in a bubble independent from the rest of the world.  The most successful management teams are those that are willing to take responsibility and make decisions that will solidify the company’s existence and good standing within the public’s eye for years into the future.  Advisors should take notice of how management teams handle reputation risk and use these insights as a way of building more sustainable portfolios.

Andrew Friedman, CFP®, SIP
AJF Financial Services, Inc.
708 Third Ave., Suite 2011
New York, NY  10017

212-779-0789
212-686-4590 (fax)
212-779-0851 (fax)

Website:  www.ajffinancial.com

Securities offered through American Portfolios Financial Services, Inc. (APFS) Member FINRA/SIPC. AJF Financial Services, Inc. is not affiliated with APFS.

Information in this illustration has been obtained from sources believed to be reliable and are subject to change without notification. The information presented is provided for informational purposes only and not to be construed as a recommendation or solicitation. Investors must make their own determination as to the appropriateness of an investment or strategy based on their specific investment objectives, financial status and risk tolerance. Past performance is not an indication of future results. Investments involve risk and the possible loss of principal.

SUSTAINABILITY AT AJF FINANCIAL SERVICES

Sustainability is at the core of everything we do on behalf of our clients. Please click below to learn more about what sustainability means to AJF Financial Services

Check the background of your financial professional on FINRA's BrokerCheck.

The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. Some of this material was developed and produced by Advisor Launchpad to provide information on a topic that may be of interest. Advisor Launchpad is not affiliated with the named representative, broker-dealer, state- or SEC-registered investment advisory firm. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.

*Securities offered through American Portfolios Financial Services. Member FINRA and SIPC.