Join our community of smart investors

Making a fresh start

Corporate scandals can shake share prices and put a painful dent in your portfolio – but when should investors be prepared to forgive and forget?
Making a fresh start

In Ben Affleck's recent film, The Accountant, he plays a number-cruncher who audits a robotics company’s books and discovers that over $60m (£47m) has gone missing. The revelation leads to the deaths of several directors and culminates in a siege on the chief executive’s stately home. In reality, accounting errors and corporate frauds rarely escalate to assassinations and armed combat. But the film shows how a business problem can snowball into a scandal that threatens people’s jobs, reputations and livelihoods.

When a well-known company recalls a dangerous product or admits to cooking the books, widespread outrage, threats of boycotts and calls for prison sentences tend to follow. Public humiliation and castigation can alienate investors, partners and customers and permanently damage a company’s brand and growth prospects. However, executives who correctly handle a corporate scandal can recover some of their losses, gradually regain the public’s trust and restore their former prestige. Given the frequency of mistakes and unethical behaviour in the business world – Rolls-Royce (RR.), Rio Tinto (RIO) and GlaxoSmithKline (GSK) most recently come to mind – our readers are likely invested in one or more companies that will face the long road to redemption in the coming years. Using both cautionary tales and success stories, we outline the strategic steps to expect when disaster strikes.

Damage assessment

After news of a scandal breaks, “businesses are exposed to media attack, low morale, ethical confusion, falling share prices, reduced sales and contracts and conflictual relations with the state”, writes William De Maria, an ethics professor at the University of Queensland. Management’s first move should be taking a step back to assess the situation. It should work out what went wrong, how quickly it can be fixed or contained, and its immediate implications for the business.

Executives should also consider who has been hurt and how badly, as the fallout tends to be much greater if many ordinary people are affected rather than a few wealthy individuals. Media tycoon Martha Stewart was sentenced to prison for making false statements and obstructing a government investigation, but her actions didn’t ostensibly harm the general public. As a result, she was able to re-use her brand upon her release, even running adverts about her experience learning to make Crème Brulee in a prison microwave. In contrast, US healthcare start-up Theranos – valued north of $9bn in 2014 – faces a federal investigation and a raft of lawsuits for allegedly jeopardising the health and safety of patients, who made healthcare decisions based on the results of its unreliable blood tests.

Identifying the root causes of a crisis is key. Take the admission by Volkswagen (GE:VOW3) that it fitted 11m of its vehicles with “defeat devices” to help them cheat on emissions tests. The Economist argues the German auto giant was driven by an overwhelming desire to scale up and overtake Toyota, avoid the trade-off between fuel efficiency, power and cost, and capitalise on lax regulation of car makers. When Toshiba (JP:6502) overstated its earnings by nearly $2bn over seven years, investigators pointed to a culture where the electronics titan’s management couldn’t be challenged and employees were pushed to postpone the release of loss reports and move costs to future years. And Wells Fargo (US:WFC) pressured employees into meeting hyper-aggressive sales targets at any cost, leading to them opening around 2m accounts for customers without their knowledge. Under-fire boards’ top priority should be pinpointing the problem’s root cause to ensure there isn’t an encore.

Open books

Once executives identify a mistake or fraud, they should be transparent about it and publish a clear plan of action as soon as possible. Investors value honesty and integrity in management teams, and will want to know the situation is under control and how it will be rectified. “Forthrightness in communications and substantive credible responses are most likely to restore trust and rescue a brand in crisis,” writes Stephen Greyser, a marketing and communications professor at Harvard Business School.

Keeping quiet about a problem risks worsening the backlash if it’s discovered. For example, Yahoo (US:YHOO) chief Marissa Mayer knew about a cyber attack on the internet giant – which resulted in unauthorised access to 500m user accounts – but neglected to inform Verizon (US:VZ) before accepting the telecoms giant’s $4.8bn takeover bid. Verizon is reportedly seeking a discount now.

Mea culpa

When something goes wrong on their watch, directors should take responsibility and apologise profusely. Attempts to pass the buck are anathema to shareholders: they expect to hold management accountable for abusing their trust and losing their money. Failing to own up can make things worse: Australian grain marketer AWB (ASX:AWB) denied paying $222m in “transportation costs” to ship humanitarian supplies into Iraq, which in reality were kickbacks for Saddam Hussein’s regime. Its mismanagement escalated the scandal, embarrassed the company and exposed the inadequacy of its clean-up strategy, according to an analysis by an Australian think-tank.

By contrast, Johnson & Johnson’s (US:JNJ) response to its Tylenol-tampering debacle set a new standard for remediation. In 1982, after seven people died from ingesting cyanide-laced capsules of its best-selling painkiller, the healthcare giant recalled 31m bottles from store shelves and offered safe replacements for free, at a time when product recalls weren’t the norm. It also rolled out tamper-proof packaging and launched a media campaign in which it expressed concern and care for its customers, rather than defending itself or avoiding blame. Its share of the analgesic market slumped from 37 per cent to 7 per cent, but rallied to 30 per cent a year later. And its shares returned to pre-crisis highs after just two months.

Wheat and chaff

When a scandal breaks, wronged investors often clamour for heads to roll. A firing spree doesn’t just punish the perpetrators; it signals to the market that the company is proactively tackling a problem and serious about reform. Moreover, while investigations into dodgy executives can be distracting and dog a business, there’s the risk the accused will resume their illicit behaviour if they aren’t removed, and appointing new management can help to bring customers back into the fold and salvage the group’s reputation.

Volkswagen has subscribed to this philosophy: its chief executive resigned within days of the ‘Dieselgate’ scandal breaking, and the group replaced seven of its 10 senior executives. Similarly, after Tesco (TSCO) revealed it had inflated supplier payments and overestimated full-year profit by £263m, the supermarket rejigged its board. The Serious Fraud Office has since charged three former executives.

In some cases, an executive is so unsavoury and incorrigible that he or she tarnishes the entire company. The boss of teen clothing retailer American Apparel reportedly held meetings wearing only a sock – not on his feet – while the head of peer Abercrombie & Fitch (US:ANF) allowed his partner, who had no official position at the company, to review internal documents and conduct spot checks on how employees were dressed. And following his resignation, the president director of Asia Resource Minerals barricaded himself in the international miner’s offices and barred the finance and mining directors from entering, meaning the board had “only very limited visibility of current bank account information”.

The list goes on: the chief executive and finance director of Tyco stole $150m from the Swiss security systems group through bonuses, benefits, unapproved loans and fraudulent stock sales; Martin Shkreli became public enemy number one after the pharmaceuticals boss hiked the price of a 62-year-old HIV drug by 5,000 per cent to $750 a pill, and was later arrested for stock fraud; and retail tycoon Philip Green was excoriated for racking up a £571m pension deficit at BHS, then selling the department-store chain for a pound to someone who bankrupted the business in a year, putting the savings of 20,000 pension-holders at risk. Badly behaved bosses are often more trouble than they’re worth.

Checks and balances

Few investors will back a business that’s been mired in scandal unless they’re confident another problem isn’t around the corner. Boards have to take meaningful action to prevent future incidents and regain their trust. For example, after internal auditors blew the whistle on WorldCom for inflating revenue and capitalising billions in expenses to mask falling profit, new boss Michael Capellas introduced corporate governance standards at every level of the telecoms titan. He also penned a new code of conduct, mandated ethics training for all 50,000 employees and established a corporate ethics office – complete with a chief ethics officer and a confidential hotline. Rebranded as MCI, the company was purchased by Verizon in 2006 and counted the American Red Cross among its clients this year.

Redcentric (RCN) will hope to emulate WorldCom’s turnaround. The managed IT services provider recently announced it had overstated its financial results in recent years, crediting its internal audit committee for raising the red flag. In a bid to shore up market confidence, it has recruited audit and legal firms to conduct independent forensic investigations and appointed a new finance director. And Facebook (US:FB), recently criticised for allowing the spread of fake news on its social media platform during the US election, as well as providing misleading viewing metrics to advertisers, has taken steps to address those issues.

Strict corporate governance and appropriate incentive schemes for executives are key to preventing bad behaviour. Scandals are more likely to occur at large companies with insiders on their boards, and where managers receive sizeable options, according to a study of corporate scandals between 1993 and 2011 by four University of Sussex researchers.

Government regulations can also play a role in discouraging and punishing corporate malfeasance. In the US, the Sarbanes-Oxley Act of 2002 holds executives personally liable for accounting irregularities at their corporations. Moreover, penalties can curb funny business and galvanise reform if they’re big enough: some analysts hope the $14.7bn fine on Volkswagen will prompt it to streamline its sprawling portfolio, scrap lagging divisions and address low productivity. Indeed, management recently announced it would restructure its brand, reduce headcount by 5 per cent and invest the savings in electric cars.

Fresh coat of paint

Scandals can permanently tarnish a business. Blaring headlines about money laundering and fraud at The Bank of Credit and Commerce International in 1991 earned it a new name: The Bank of Cocaine and Criminals International. In severe cases, apologising and cleaning up may not be enough to restore a company’s brand and reputation. Chipotle Mexican Grill (US:CMG) has seen its market valuation roughly halve to below $12bn in the past 18 months, after hundreds of the Mexican fast-food chain’s customers contracted E. coli, salmonella or norovirus. Although Chipotle has overhauled its preparation and serving processes, dangled free burritos and launched marketing campaigns emphasising its commitment to freshness and food safety, continued revenue and profit declines suggest it still has work to do.

One option is a new name: Malaysia Airlines rebranded as MAB after one of its planes went missing and another was shot down over Ukraine, together leaving more than 500 passengers dead or presumed dead. Quindell re-emerged as Watchstone (WTG) after the insurance outsourcer revealed it had overstated its financials. And after multiple press investigations and the sale of its dating websites in late 2014, Cupid became Castle Street Investments, and adopted the moniker Coretx (COR) after investing in two computing companies this year.

Labouring in obscurity

After diagnosing the problem and identifying necessary changes, directors shouldn’t seek the spotlight. Instead, they should keep their heads down and focus on rebuilding the business and restoring value for shareholders. An individual who exemplified this approach was John Profumo, the secretary of state for war who had an affair with a 19-year-old woman and was also romantically involved with the Soviet naval attaché assigned to London. Profumo was branded a liar and adulterer who put national security at risk. He could have lain low then emerged a few years later, repentant and power-hungry, but instead he spent the next 40 years washing dishes, scrubbing toilets and doing other social work. His humility was rewarded with a seat next to the queen at Margaret Thatcher’s 70th birthday party in 1995. “No one in public life ever did more to atone for his sins,” wrote the Daily Telegraph following his death in 2006. “No one behaved with more silent dignity as his name was repeatedly dragged through the mud; and few ended their lives as loved and revered by those who knew him.” Disgraced executives who show genuine remorse and devotion to redemption have the best shot at forgiveness.

Pay the piper

Embattled businesses should make adequate provisions to cover exceptional costs such as redundancy payments and legal and restructuring expenses. Volkswagen has set aside €18.2bn (£15.9bn) to settle fines and penalties, which could prove conservative given the costs of repairing its reputation, replacing non-compliant vehicles and staunching the exodus of customers. Meanwhile, Samsung (SE:005930) has pegged the costs of recalling its exploding Galaxy Note 7 smartphones at $5.3bn, and the damage to its brand and market share may well inflate the bill.

An industrial building materials group, James Hardie, provides an example of what not to do. As public awareness grew of the health risks of asbestos between 2001 and 2007, the company – which used the dangerous substance – set up a purposefully underfunded compensation fund, peddled misinformation and dodged responsibility. Similarly, after Unocal – a US oil company that became part of Chevron in 2005 – spilled up to 20m gallons of petroleum thinner under California’s dunes and into the nearby ocean, management insisted on secrecy and tried to shift the blame, accusing passing ships of pumping bilge.

In some cases, recompense takes the form of hard time: the bosses of Enron and WorldCom were sentenced to more than 20 years in prison. Bernie Madoff, who swindled investors out of $64.8bn through a Ponzi scheme, was sentenced to 150 years in prison and $150bn in restitution.

Atonement

There are multiple ways for maligned companies to regain credibility and rebuild their public reputations. Between 1997 and 2006, researchers at three US universities reviewed the actions of 94 companies trying to repair their reputations after making major accounting restatements, and found that over half were targeted at customers, workers and local communities rather than investors and creditors. They suggest employees of troubled companies could become disillusioned and leave if they think they’re working at a house of cards, and customers could switch to competitors. They also identify ‘reputation capital’ as a true intangible asset: cash flow improves and capital costs fall when stakeholders trust a company will uphold its covenants and commitments.

There are plenty of examples from recent decades. While fighting thousands of lawsuits related to Vioxx – an arthritis drug that may have contributed to nearly 28,000 heart attacks or deaths between 1999 and 2003, according to regulators – Merck (US:MRK) pledged up to $25m to help the World Bank eliminate river blindness in Africa. Similarly, JPMorgan Chase (US:JPM) didn’t just pay out $20bn to settle federal investigations and investor lawsuits related to its sales of questionable mortgages during the financial crisis. The bank also pledged millions to typhoon victims in the Philippines, housing charities and non-profit institutions helping poor communities, and donated $250m in housing to community organisations. TalkTalk Telecom (TALK) took a more direct route after suffering a cyber attack last October: it launched new promotions and offered free upgrades to customers.

Save or sell

The toughest question for executives of a disgraced company is whether it should be scrapped or salvaged. Frauds of a certain magnitude favour the former: Enron could never rebound from its $74bn fraud, and Globo filed for bankruptcy after multiple executives colluded to artificially inflate turnover. Watchstone’s new bosses opted for the latter option, selling the troubled professional services business, returning the proceeds to shareholders, and refocusing the business on telematics.

It’s possible for scandals to have upsides. In a paper titled ‘Better infamous than unknown’, a Swedish master’s student highlights the case of Klarna AB, which gained notoriety in 2014 for charging unjustified fees to customers. She argues the flood of articles about the online payments group boosted awareness of its service, possibly accelerating its growth. However, most businesses prefer to get the word out without attracting public opprobrium.