Compliance Isn’t Going Away (and neither should you) – Part II

Thomas Fox

“A couple of numbers from Leon.”

With that single one-line opening, George Harrison announced Leon Russell was going to play a medley of Jumpin’ Jack Flash/Youngblood at the 1971 Concert for Bangladesh. The album, and later DVD, was one of the greatest live albums from the 1970s and Leon Russell was one of its star players. He had come into the national music scene through leading the Mad Dogs and Englishmen tour with Joe Cocker and a host of others in 1971. While it may appear that Russell had literally burst on the rock and roll scene, he had been toiling in the trenches of Oklahoma honkytonks and grindhouses since the early 1950s.

He moved to Los Angeles in 1958 and according to his obituary, in the New York Times (NYT), he became “one of the top studio musicians in Los Angeles. He was in Phil Spector’s Wall of Sound Orchestra, and he played sessions for Frank Sinatra, Sam Cooke, Aretha Franklin, the Ventures and the Monkees, among many others. His piano playing is heard on “Mr. Tambourine Man” by The Byrds, “A Taste of Honey” by Herb Alpert, “Live With Me” by the Rolling Stones and all of the Beach Boys’ early albums, including “Pet Sounds.”” For some of my favorite Russell playlists, see the end of this blog post.

I am writing a series on why compliance is not going away under a Trump administration and why you should not either. Today, I want to focus on the most bottom line of all business reasons, that being that compliance is good for business profitability. This is made clear each year, when Ethisphere announces the companies that are on the list of the World’s Most Ethical Companies. The key thing about this list is not that they are more ethical, it is that they have put financial and compliance controls in place to make them run. And, because they are better run, they perform better on average than the S&P 500 for each year. Companies are on this list because they have robust finance internal controls that include compliance internal controls. Robust internal controls around compliance do not slow you down but allow you to go faster and move more safely into high-risk countries.

This was aptly proven by Paul M. Healy and George Serafeim, in a paper they issued in the Accounting Review, entitled “An Analysis of Firms’ Self-Reported Anticorruption Efforts”. In this paper, the authors looked at the issue of not simply profitability of companies, which had more robust anti-corruption compliance programs, but also what was the direct effect on the their return on equity (ROE) in countries that were perceived to have a high incidence of corruption, under the Transparency International – Corruption Perceptions Index (TI-CPI). Although the piece was very math heavy, it yielded some very interesting results.

The first finding was that companies with good governance tended to have more robust compliance programs. The authors noted, “Managers of firms with independent and engaged board oversight may take anticorruption laws and enforcement seriously and adopt/enforce policies to deter corruption.” Conversely, they noted, “some investors, boards, and managers may jointly view corruption as an unavoidable cost of doing business in certain parts of the world, yet engage in cheap talk in an effort to reduce regulatory costs.” This good governance was more than simply tone at the top. It was also measured by board independence and board oversight of a company’s compliance program.

Not surprisingly, in countries where there is a low risk for corruption, there was not much difference in the sales growth for companies with robust anti-corruption compliance programs and those businesses feature in the authors’ ‘cheap talk’ category. However, when it came to growth in countries that had a high propensity of corruption, there was a dramatic difference.

While it was laid out in table form, the authors’ explained, “Using the across-firm segment classification, the estimates imply that for the median sample company, a 10 percent increase in sales in low corruption geographic segments increases ROE by 17 basis points (0.10 * 1.738), whereas a 10 percent increase in sales in high corruption segments decreases ROE by 7 basis points (0.10 * 0.733). Using the within firm geographic segment classification, the estimates imply that a 10 percent increase in sales in low corruption geographic segments increases ROE by 14 basis points, whereas a comparable sales increase in high corruption segments decreases ROE by 10 basis points. Therefore, the effect on company ROE from increasing sales in high versus low corruption segments is -24 basis points.”

So, translating that into a language for the lawyer or compliance practitioner, it means there is a negative relation between investments and a company’s return on that investment in high countries where the company did not have an effective compliance program. This is true even in the face of increased sales growth. For firms that had as high as 10% growth in high-risk countries, if they did not have a robust compliance program in place, the negative ROE was between 24 to 30%. As the authors stated, “for firms with high residual anticorruption ratings and sales growth in corrupt geographic segments is positive and significant… Firms with high residual ratings that grow sales in high corruption geographic segments, therefore, do so without lowering their ROE”.

Having been raised in an academic household, when quantitative types say the following, “The magnitudes of the estimated coefficients are economically interesting”; it is a HUGE deal. These findings are equally large and important for the compliance profession going forward. First, the authors demonstrate companies with more robust compliance programs are from countries that have more robust enforcement and monitoring by government authorities and regulators. Second, the more robust your compliance program is the lower your sales growth may be but the higher your overall return in a high-risk country will be going forward. Finally, even if a company sustains high sales grow in a high-risk country, if it does not have a robust compliance program, the sales will drop off dramatically and may well lead to negative ROE.

If you are worried that the Trump administration will gut compliance, I would point you and any such person to this paper. The evidence documented in this paper and the authors conclusions not only prove that doing compliance does not hurt business; they prove that it makes companies more profitable. I have long advocated that compliance programs are business solutions to legal problems. Ethisphere has demonstrated year after year, that companies which are actually doing compliance are more profitable on average than S&P 500 companies. Now Healy and Serafeim have done the research to show that companies, which are domiciled in countries which have robust anti-corruption laws in place and which have robust compliance programs, obtain a higher ROE.

The bottom line is that compliance is good for business. That is another reason that compliance is not going away and neither should you.

Tom’s Top Five:

  1. A Song for You;
  2. Jumpin’ Jack Flash/Youngblood;
  3. Delta Lady;
  4. Tightrope; and
  5. Masquerade.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Thomas Fox, Compliance Evangelist | Attorney Advertising

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Thomas Fox

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