Barak Orbach - Do Directors and Officers Have a Duty to Monitor Corporate Culture?





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Dec 14, 2019
by Barak Orbach
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Barak Orbach - Do Directors and Officers Have a Duty to Monitor Corporate Culture?

Professor of law reflects on organizational culture and important characteristics of business realities Barak Orbach at Salzburg Global Seminar | Salzburg Questions for Corporate Governance

This article is part of the series, the Salzburg Questions for Corporate Governance by the Salzburg Global Corporate Governance Forum

The Difference Between Formal Policies and Informal Practices

The organizational culture of an entity consists of formal and informal policies, norms, beliefs, and values that the entity insiders understand as “the way we do things around here.” This is an underdeveloped corporate governance theme, although a critically important one. The root cause of many, if not most, costly corporate governance failures is organizational cultures that motivated, accommodated, or neglected patterns of undesirable conduct, such as excessive risk-taking, violations of law, unethical practices, sexual harassment, and hostile attitudes.

More broadly, organizational culture affects the productivity of companies, as well as the well-being of their stakeholders. Consistent with this understanding, companies use aspirational depictions of their corporate culture to boost their image and recruit employees. Outsiders tend to be skeptical of such representations, understanding intuitively that they refer to formal values and principles that do not necessarily govern the company in actuality and may be overshadowed by informal norms and beliefs. Recently, the #MeToo movement powerfully underscored what we have always known: formal values and principles are sometimes platitudes that do not direct corporate insiders.

The mismatch between formal policies and informal practices is undoubtedly challenging and frustrating for boards of directors and management teams. The persistent evaluation of and efforts to address this mismatch ought to be understood as aspects of the fiduciary obligations of directors and officers (D&O). D&O, who assume that the mismatch does not exist or neglect addressing it, are neither informed about nor acting in good faith to advance or oversee the company's operations.

While this point is not an explicit legal standard (yet), it is consistent with the contemporary interpretation of fiduciary duties by the Delaware courts. It is also consistent with the spirit of current enforcement policies that create powerful incentives for companies to implement effective compliance programs. The effectiveness of compliance programs is not in their formal principles, but in their internalization by employees and other relevant stakeholders.

To be sure, a mismatch between formal policies and informal practices always exists, and there should be no expectation that companies would eliminate it. This mismatch sometimes indicates that formal policies are deficient or no longer practical and should be revisited. Accordingly, to discharge their fiduciary obligations, D&O must make good faith efforts to oversee and address the mismatch.

Illustration: Wells Fargo

Consider the Wells Fargo cross-selling fiasco. Wells Fargo set aggressive daily targets for employees that created incentives to maximize the number of accounts that customers held. At the same time, the company’s policies emphasized that the “opening multiple accounts for the purpose of increasing potential incentive compensation is considered a sales integrity violation.” This misalignment between performance and compliance standards created a culture that encouraged the opening of unauthorized accounts. Thus, although Wells Fargo terminated about 5,300 employees who had opened unauthorized accounts for customers, investigations concluded that the company’s leadership failed for creating and neglecting a problematic organizational culture. Wells Fargo settled a derivative lawsuit after a district court ruled that the shareholders sufficiently stated claims of breach of fiduciary duties and securities fraud.

Oversight Responsibilities

The idea that corporate directors and officers may be held accountable for failures to maintain adequate corporate culture is hardly new. The Business Roundtable’s Principles of Corporate Governance provide that the “board’s oversight function encompasses” the responsibility to “set a ‘tone at the top’ that demonstrates the company’s commitment to integrity and legal compliance.” “This tone,” the Principles further provide, “lays the groundwork for a corporate culture that is communicated to personnel at all levels of the organization.” The responsibilities of the CEO and other senior officers for issues concerning corporate culture are more operational. These responsibilities are related to the development and implementation of the company’s vision, policies, risk management function, and business resiliency plans. I read the Business Roundtable’s 2019 Statement on the Purpose of a Corporation as a clarification of the values that should guide the “tone at the top.”

Characteristics of Business Realities

The analysis of organizational culture and, more specifically, gaps between formal policies and informal practices requires attention to three important characteristics of business realities.

(1) Decentralized organizational structures. Decentralization of control and diffusion of responsibilities are inevitable in large companies, although they come with a variety of inefficiencies and agency costs. Some of these inefficiencies and costs set limits on the effectiveness of formal policies. In decentralized organizational structures, the downward communication of goals and policies and the upward communication of challenges and problems are indirect, as information is transmitted through a hierarchy of agents and a network of communication channels. Under such conditions, corporate agents who engaged in unlawful or unethical conduct can be described as “bad apples” or “rogue employees,” while D&O may remain unaware of any illegal or unethical conduct. This pattern is the principal rationale for increased scrutiny of corporate culture. The findings of the independent investigation of Wells Fargo’s sales investigation illustrate how decentralization may contribute to a gap between formal policies and informal practices.

(2) Profitable violations. Many forms of unlawful and unethical conduct may appear profitable ex-ante. It is axiomatic, however, that a fiduciary may not choose to act in an illegal fashion, even if the fiduciary believes that the illegal activity will increase corporate profit and shareholder gain. Tensions between (a) compensation and reward schemes and (b) compliance programs and other formal policies often lead corporate insiders to engage in seemingly profitable conduct in violation of the company’s formal policies. Again, the Wells Fargo cross-selling fiasco illustrates this point.

(3) Changing economic conditions and social norms. The content and understanding of the mismatch between formal policies and informal norms constantly evolve and, among other things, respond to changing economic conditions and social norms. For example, reactions to the #MeToo movement forced all companies to reassess policies and realities of sexual harassment. More broadly, the improved understanding of institutional biases has reshaped attitudes toward diversity, inclusiveness, and the workplace environment. Proper oversight of organizational culture, thus, requires attention to external factors that influence the meaning and understanding of informal norms.

The Duty to Monitor Corporate Culture

To conclude, like it or not, a variety of social, economic, technological, and legal trends have increased the expectations for D&O oversight of corporate culture. Present enforcement policies and liability standards already reflect this development, and their evolution is likely to continue in this direction.

Have an opinion?

We encourage our readers to share your comments by joining in the discussion on LinkedIn.

Barak Orbach is a professor of law at the University of Arizona James E. Rogers College of Law, a member of the American Law Institute, a member of the Executive Committee of the Association of American Law School’s section on Antitrust and Economic Regulation, and a Fellow of the American Bar Foundation. Barak teaches and writes about antitrust, corporate governance, compliance, regulation, and the motion picture industry. Before joining academia, he served as an advisor for Law & Economics to Israel Competition Authority and worked as an associate with Cleary, Gottlieb, Steen & Hamilton, New York. He holds masters and doctorate degrees in law from Harvard Law School and undergraduate degrees in law and economics from Tel Aviv University.

The Salzburg Questions for Corporate Governance is an online discussion series introduced and led by Fellows of the Salzburg Global Corporate Governance Forum. The articles and comments represent opinions of the authors and commenters, and do not necessarily represent the views of their corporations or institutions, nor of Salzburg Global Seminar. Readers are welcome to address any questions about this series to Forum Director, Charles E. Ehrlich: To receive a notification of when the next article is published, follow Salzburg Global Seminar on LinkedIn or sign up for email notifications here:  

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