Putting a value on virtue

That’s far more sensible. It suggests a plausible scenario. As an investment proposition, a company might tick many boxes, but – if only for reasons of self interest – you might reject it because the company’s lack of transparency meant you did not trust it. You thought there was a greater-than-normal chance of something really nasty crawling out of the woodwork.

If the second scenario is realistic, then it means that there is a cost for companies that fail to report fully on sensitive issues, such as their donations to political parties, their corporate policy on accepting gifts from would-be suppliers or making so-called ‘facilitation payments’ – ie, bribes – to potential customers.

The cost is not so much in lost customers as in lost investors. But that’s real enough, too. Lost investors means a share price that’s lower than it could be. The consequence of that is a cost of capital that’s higher than it would be otherwise. Further effects follow. Projects that would otherwise be profitable have to be rejected because the financing is too expensive. So growth is constrained. Possibly, dividends are cut. As a result, the share price falls further, the cost of capital ratchets up more and so it goes. What could have been a corporate success story drifts into corporate torpor, or worse. And all because the bosses failed to cultivate a good corporate culture.

If this seems too dramatic, then you only have to look at what’s happening to Petrobras (NYSE:PBR.A). When its chief executive, Maria das Graçias Foster, resigned last week, the surprise was not that she had quit but that it had taken her so long to do so. The Brazilian state-controlled oil major, whose shares are listed on the New York Stock Exchange as well as Sao Paulo’s Bovespa exchange, has been mired in a corruption scandal that surfaced a year ago but which relates to events stretching back at least to 2006.

At its peak in 2008, the stock-market value of the company’s equity was over $300bn (£157bn using 2008’s exchange rate). Now it’s 86 per cent lower at $42bn. Not just that, but Petrobras is sinking beneath its own debt, which has quadrupled in the past four years. At $95bn net of cash, debt now dwarfs the value of the company’s equity and, rumour has it, that the company – 64 per cent owned by the state – may seek government help to meet debt repayments falling due. To make matters worse, Petrobras also faces class actions from disgruntled shareholders in the US.

The cause of all this loss? True, the drop in the oil price is a big factor, but the self-inflicted one is a scam in which Petrobras awarded construction contracts at inflated prices on the understanding that suppliers would cream off 3 per cent into slush funds that greased – amongst others – political fixers. The cost of these bribes was ‘just’ $3.7bn, which is not to minimise the scale of Petrobras’s offence, but to highlight the insignificance of the gain in relation to what has now been lost.

Still, that’s how it is with corruption – the consequences of a little can go a long way. Ask GlaxoSmithKline (GSK), whose stock-market value lost £16.3bn, or 20 per cent, over the course of last summer as the company reeled from successive scandals. First, the UK’s Serious Fraud Office launched an investigation into the drugs giant’s selling practices, then in China Glaxo was accused of – and subsequently confessed to – “massive and systemic” corruption. In the end – and with the help of a grovelling apology – Glaxo got off lightly in China – it was fined £297m. Luckier still was the boss of its Chinese operation, Mark Reilly. At one stage, Mr Reilly was staring at a 20-year prison sentence, according to China watchers. As it was, he received three years suspended and deportation.

Petrobras and Glaxo are two high-profile cases where global companies have been hit by scandals relating to the ethics of their business conduct. However, there is a linked question: does lack of transparency in the way that some companies operate extract a more subtle cost?

Examining that question is the function of the table, whose main source is an inquiry into the way that the world’s 124 biggest companies, as measured by their stock-market value, conduct their business. The inquiry, Transparency in Corporate Reporting, was produced by Transparency International, a Berlin-based organisation that calls itself “the global coalition against corruption”. It focuses on three areas of a company’s activities: first, whether the company has clearly defined “anti-corruption programmes”; second, whether it has “organisational transparency”; third, the extent to which it fully reports its activities on a country-by-country basis.

Our table comprises the 16 UK-based companies among the top 124 (including the two Anglo-Dutch outfits) plus some high-profile global greats, such as PepsiCo (NYSE:PEP) and Google (NASDAQ:GOOGL) from the US and Switzerland’s Nestlé (SWX:NESN), and some key representatives from the world’s developing nations – not just Petrobras, but also Russia’s Rosneft (LSE:ROSN) and China’s Bank of China (SEHK:3988).

As Petrobras and Glaxo demonstrate, there can be a big difference between a company having a comprehensive anti-corruption programme and being free from corruption. On paper, both these companies take corruption very seriously. In its 40-page ethics code – and in a faltering translation to English from Portuguese – Petrobras says that, in its dealing with the government, it will “refuse any corrupt and bribery practices, keeping formal procedures for control and consequences for any transgressions”.

Similarly, in a 29-page booklet from 2010, Living our Values, which outlines the “GSK Anti-Bribery and Corruption Programme”, Glaxo’s chief executive, Andrew Witty is unequivocal: “Nowhere is our commitment to ethical conduct more evident than in the area of corruption prevention and detection. At GSK, our attitude towards corruption in all its forms is simple: it is one of zero tolerance.” As a result, for example, Glaxo operates a whistle-blowers’ charter in which it guarantees that employees can report suspect activities without fear of retaliation.

For clearly stating such principles, Glaxo scores highly in Transparency International’s report. Out of a maximum 13 points in response to the same number of questions about a company’s anti-corruption procedures, Glaxo scored 12.5. From the 124 companies assessed, only two – BP (BP.) and Vodafone (VOD) – performed better. Both had a perfect score.

From this, two points arise. First, the UK companies assessed seem to have in place strong anti-corruption programmes. Even Lloyds Banking (LLOY), which had the lowest score of the 16, made nine out of 13. Given that Lloyds has few operations outside the UK, it may feel less need for comprehensive anti-corruption measures than a global player such as Glaxo, or miner Rio Tinto (RIO) and British American Tobacco (BATS), which had the same score as Glaxo.

The existence of these programmes may owe much to the Bribery Act (2010), which is widely labelled “the toughest piece of anti-corruption legislation in the world”. It permits the prosecution in the UK of bribery committed anywhere and has the power to jail an offender for up to 10 years and impose an unlimited fine on a guilty organisation.

Second – and arguably reflected by the gap between the public posture and private performance of Petrobras and Glaxo – it is relatively easy for companies to say the right things about corruption and score well in Transparency International’s assessment. For example, even the Russian oil-and-gas giant, Rosneft, scored 10.5 out of 13.

On the one hand, Rosneft’s Code of Business Ethics talks about “strengthening (the company’s) reputation as a transparent and fair market participant”. On the other hand, it is easy to be cynical about Rosneft. After all, here is a company that, if not actually founded by a corrupt transaction, was built on corruption’s partner in grime, state patronage. That is, Rosneft owes its size to the state-sponsored theft of most of the assets of Yukos, Russia’s biggest oil company until it was broken up when its founder and controller, Mikhail Khodorkovsky, fell foul of the Kremlin in the early 2000s. In 2004, most of Yukos’s assets were sold by the state in an auction in which a shell company controlled by Rosneft was the only bidder. It was a deal that a senior economic adviser to Vladimir Putin described as the “scam of the year”. All this is not to say that Rosneft – 65 per cent owned by the Russian state – fails to take corruption seriously, but its antecedents are damning.

Transparency International reckons that corruption is often related to a company’s structure or, at the very least, that “the use of off-shore companies and their lack of transparency are posing increasing risks for global companies as well as for their shareholders”. This is why it asked the 124 about the extent to which they disclose their structure; in particular, whether they reveal a full list of their subsidiaries, associates and joint ventures.

German companies do well, but that’s because national requirements demand that they disclose such information. On average, however, companies were reluctant to reveal full information. In response to eight questions about subsidiary-company disclosure, the average score was 3.0.

Particularly reticent were technology companies, such as Google and Amazon.com (NASDAQ:AMZN). This is ironic. These companies know a great deal about their customers but want their customers to know little about them. The ultimate expression of this reticence is manifested in what The Wall Street Journal in 2013 dubbed “the incredible vanishing subsidiary”. For example, according to Transparency International, in 2009 Google revealed the existence of 100 subsidiaries, but by 2012 that number had shrank to just two (both of which were in Ireland).

It is no coincidence that this reserve is linked to the growing interest in – and criticism of – companies’ tax affairs. That is why Transparency International also wanted to know the extent to which companies disclose country-by-country reporting of their activities. True, in some areas legislation is in place that will compel this. In both the US and the EU, companies in extractive industries may soon have to report sales and profits country by country. Until it is compulsory, however, companies are unwilling to reveal such sensitive stuff.

Transparency International’s five questions on country-by-country reporting were met with a blank response by more than 50 companies. These would say nothing about revenues and profits per country, let alone more detailed information, such as capital spending or income tax paid per country. The most forthcoming was Norway’s state-controlled oil and gas major, Statoil (OSE:STL), which answered three of the five questions.

Arguably, some of Transparency International’s questions are irrelevant (such as, Does the company disclose its community contributions in country x?). More important, others may demand too much information (such as, Does the company disclose countries of incorporation for each of its non-fully consolidated holdings?). After all, there is a limit to the amount of information about a company that anyone can usefully employ. Beyond that, all that’s induced is ‘data fatigue’.

Not quite. Computer programmes are very good at consolidating information, re-organising it and joining up the dots. So the ‘data fatigue’ argument may function as an excuse for the silence behind which companies hide dodgy deals. Even so, it would be nice to know – and it would help the drive towards more disclosure of sensitive information – whether there is a discernible pattern between a company’s transparency and its cost of equity and/or its share rating; in other words, are companies rewarded for being good just as they are for being profitable?

“Debatable,” is the inconclusive response. If there were a link, you could glance down the columns in our table labelled ‘Implied cost of equity’ and ‘PE ratio’. As the companies with the highest rankings for transparency are at the top, you would see cost of equity rise as you scrolled down the table because, to spell it out, less transparent companies would have to offer investors higher returns to persuade them to part with their capital. By the same logic, PE ratios would fall.

That does not apply in any statistically significant fashion. Sure, there seems to be a link between cost of equity and tarnished reputations – note the cost that Petrobras and Rosneft have to pay. The same applies to the least transparent companies in the table, China Construction Bank (SEHK:939) and Bank of China. Yet in all four cases the stronger link may be between cost of equity and developing-market status. And, in the case of Petrobras and Rosneft, the falling oil price will be a factor. Besides, it’s not as if household-name developed-world companies, such as Google, Amazon.com or Walt Disney (NYSE:DIS), seem to pay a high price for their lack of transparency.

Still, we can’t really call the findings disappointing because, if you like, the lack of predictability was entirely predictable. To expect a nice, neat correlation between something as elusive as ‘transparency’ and simple, perhaps even simplistic, measures of a company’s share rating would be naive.

Which is not to say that such links can’t become firm. It would be desirable if they did. After all, if the important function of financial markets is to allocate capital efficiently –rather than permit lucky punters to make a quick buck, which is often the perception – then it is good that the cheapest capital should go to the companies that include virtue among their merits. And, if the obligation for companies to become more transparent fosters a change in the way that they actually behave – in addition to changes in the way they claim to behave – then so much the better.