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Do Directors Have an Oversight Responsibility for Workplace Culture?

Recent legislative, enforcement and compliance trends all suggest that corporate directors should focus on workplace culture and corporate compliance. Shareholder activists have shown increasing willingness to pursue actions to hold directors responsible when corporate scandal and executive misconduct impair shareholder value. Further, with the Dodd-Frank Wall Street Reform and

Consumer Protection Act’s bounty program promising million-dollar incentives for whistleblowers who report corporate misconduct to the SEC and employee mistrust of management at an all-time high, those charged with steering the corporate ship cannot afford to ignore employee perceptions and on-the-ground effectiveness of compliance resources.

It is widely accepted that directors oversee the organization’s strategy. To do so, directors must understand how corporate culture and strategy interact in ways that affect organizational performance. To illustrate, Bain & Company’s 2011 Great Repeatable Model Study highlighted one way in which culture can impact the implementation of strategic goals: executives

charge that managers are too risk averse. Yet, the executives do not know or appreciate that the managers’ risk aversion is often born of mistrust or the perception that support is lacking from those very executives. As part of their responsibility to oversee the CEO and organizational strategy, directors must address such impediments to achieving corporate goals.

By Earl “Chip” Jones and Amy Mendenhall

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Cultural Value is Shareholder ValueOn January 25, 2012, shareholders of Health Management

Associates, Inc. (HMA), a company operating acute care hospitals

and other healthcare facilities, filed a class action alleging that the

company, its executives and directors defrauded shareholders.

Specifically, the lawsuit alleges that HMA withheld material

information regarding a Medicare fraud investigation by the

U.S. Department of Health and Human Services and a whistleblower

lawsuit filed by the company’s former compliance director. The

investigation, lawsuit and later resignation of the company’s

general counsel each brought swift and significant drops in stock

price – 9%, 8% and 13%, respectively. On August 5, 2013 yet another

whistleblower lawsuit against the company was unsealed and, on

August 13, 2013, a majority of the company’s shareholders voted to

elect a new Board of Directors.

The shareholder class action against HMA and drops

in its stock price show the extent to which the fallout from

an allegation of misconduct and government investigation

can be dramatically compounded by the perception of a corrupt corporate culture and

retaliation against employees who blow the whistle on fraud. In other words, shareholders

may view the actions of company employees, particularly those tasked with compliance

and counseling functions, as corroborative evidence of misconduct, evidence of a

corrupt culture and a basis to seek recovery of investment losses. Because of this,

creating an ethical corporate culture and a workforce that trusts its managers’ commitments

to ethics must be a part of any board’s plan to build and protect shareholder value. Indeed, a

survey by Corporate Executive Board showed that companies rated highly by their employees

in terms of their openness of communication had an average total shareholder return of 7.9%

in the previous 10-year period, compared to a 2.1% average return for companies ranked in the

bottom three quartiles.

In the wake of well-publicized corporate scandals, investors who fear that any company

could be one investigation or lawsuit away from a tarnished reputation and plummeting stock

price may begin to care more about a company’s commitment to ethical business conduct and the

extent to which those ethics permeate the corporate culture. Further, opportunistic shareholders

and plaintiffs’ attorneys in search of potential lawsuits will likely pay increased attention to

companies’ representations regarding ethical business practices and workplace culture. In

this light, a corporation’s public statements regarding the company’s openness, transparency,

inclusiveness and levels of employee engagement take on a new cast. No longer mere puffery,

these statements in Codes of Ethics or Corporate Social Responsibility Reports will likely face

additional scrutiny on several fronts. The old adage (while hardly a legal term of art) – “mean

what you say and say what you mean” – has new emphasis.

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Employee Mistrust and the Fate of Internal Compliance

So, what does it mean to have an ethical workplace culture?

Among other things, it means that an employee who suspects

misconduct believes three things: (1) the conduct the employee

has witnessed is not consistent with the company’s values and

commitments; (2) the company wants the employee to report

his or her concerns, and the employee is aware of one or more

safe, accessible ways to do so; and (3) the company will not tolerate

any retaliation in response to the employee’s report. Directors who are

well-versed in a company’s code of conduct and complaint hotlines

may be surprised to learn just how few employees in today’s

workforce actually hold these beliefs about their employers.

In fact, a number of workplace surveys have found dramatically low levels of employee

engagement and trust in their employers. A 2011 survey by Maritz Research found that only 14%

of employees surveyed believe their companies’ leaders are ethical and honest, and only 10%

trust management to make the right decision in times of uncertainty.

Additional workplace surveys suggest that startlingly low numbers of employees

report misconduct, largely because they fear retaliation. The effects of this mistrust and fear

of retaliation are two-fold. First, misconduct that goes unreported may continue unabated and

begin to pervade the workplace, resulting in higher rates of impermissible activity and greater

exposure to civil or criminal liability. Second, employees who fear retaliation by employers may

be more likely to report allegations of misconduct directly to a government agency, without first

making use of a company’s internal compliance procedures.

The latter consequence is particularly acute in light of the whistleblower bounty awards

now available to employees who report misconduct to a government agency. Under the

2010 Dodd-Frank Act, these employees may receive bounty awards of 10-30% of any penalty

recovered, if the sanctions against the corporation total $1 million or greater. When adopting

regulations under Dodd-Frank, the SEC rejected pleas from the business community and

compliance experts to adopt a requirement that, in order to recover an award, whistleblowers

must first avail themselves of a company’s internal reporting mechanisms.

A hallmark of the disengaged, mistrusting workforce is that it experiences, or at least believes

that it will experience, retaliation in response to internal reports of misconduct. In this atmosphere,

those who feel they cannot trust their managers or their companies’ compliance systems will be

strongly motivated to report to the SEC and potentially collect a rich bounty. For this reason, having

thorough, well-constructed ethics and business codes and procedures in corporate manuals is simply

not enough. There must also be a prevalent atmosphere of commitment to the business-defined

ethical values, lawful conduct and freedom from retaliation against whistleblowers in order to ensure

that the compliance system’s reporting and response mechanisms are able to function optimally.

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Efforts to Create an Ethical Workplace Culture Can Cushion the Blow of an Enforcement Action Against the Company

Though the odds are much lower, even companies with the strongest commitment to

ethics and workplace culture may find themselves facing a whistleblower lawsuit or government

investigation. In the event that some misconduct is uncovered and subject to prosecution, the

existence of a rigorous ethics and compliance program may help to lessen the penalties a

company and its executives or directors may face.

In the last two decades, there has been a notable trend toward increasing responsibility

and liability for boards of directors. In the 1990’s, courts began interpreting the directors’ duties

more expansively and imposing individual liability upon directors for breaches of those duties.

In 2002, Congress responded to the public outcry over ENRON and other scandals by passing

the Sarbanes-Oxley Act, which includes provisions requiring that corporate audit committees

raise red flags with the board and that the board adopt a code of ethical conduct.

Many directors have embraced the challenge of this more expansive role, devoting

more time, focus and oversight to the job. Yet, there can remain some uncertainty about just

what the board can and should do to foster ethical and lawful corporate conduct.

The U.S. Sentencing Commission has offered some guidance on this question in the form

of the Federal Sentencing Guidelines Manual. These guidelines establish that an organization,

its directors and executives may seek leniency from prosecution in a case involving allegations

of corporate misconduct, if the corporation had an effective compliance and ethics program.

The guidelines identify certain components of an effective program, including:

• establishment of standards and procedures for preventing and detecting criminal

conduct;

• a board of directors that is knowledgeable about the compliance and ethics program

and exercises reasonable oversight over it;

• actions by high-level personnel that ensure an effective program;

• periodic communication of compliance-related standards and procedures, including

training programs, to employees, boards of directors, and high level personnel;

• monitoring and auditing of the compliance program;

• periodic evaluation of the program’s effectiveness and a publicized system for

anonymous reports of possible misconduct; and

• promotion of the compliance and ethics program throughout the organization by

way of incentives and disciplinary action in response to compliant and non-compliant

conduct, respectively.

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In 2010, the U.S. Sentencing Commission revised the sentencing guidelines in two ways

that are significant here. First, the commission shifted an increasing amount of responsibility

for oversight of ethics and compliance programs to the board by offering sentencing mitigation

where ethics and compliance officers have direct reporting obligations and access to the

board of directors or other governing authority. Second, the amended guidelines provide that

an effective program is one in which an organization promotes “an organization culture that

encourages ethical conduct and a commitment to compliance with the law.”

These developments show that it is incumbent upon a board to exercise reasonable

oversight over an organization’s efforts to promote an ethical organizational culture and one

committed to compliance. Not only will these efforts help prevent misconduct and scandal

up front, but they may also lessen the liability a company faces in the unfortunate event that

wrongdoing is alleged or, worse, found to have occurred.

The importance of these steps became all the more apparent when the Ethics Resource

Center (ERC) issued a report in 2012 recommending a number of changes to the Federal

Sentencing Guidelines. The ERC organized a group of renowned judges, former regulators,

professionals and practitioners (the “Advisory Group”) to examine the Federal Sentencing

Guidelines, “its successes and failures, and to identify possible areas of improvement.”

Among other recommendations for creating strong ethics and compliance programs,

the Advisory Group suggests revisions to the FSGO that will prompt executives and

organizations to conduct “regular assessments of corporate cultures” connected to established

performance standards, thereby prompting boards of directors “to review and reflect on the

results of [ethics and compliance] efforts.” The ERC also wants to encourage executives to

include compliance and ethics professionals in regular business discussions and encourage

organizations to have at least one board member who is familiar with the FSGO and has some

expertise overseeing compliance programs.

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Overseeing Strategy Without Assessing Culture May Be a Big “Swing and a Miss”

In the Bain & Company study cited above, the firm surveyed nearly 400 executives

worldwide and found that only 15% of those executives cited lack of opportunities as the biggest

barrier to growth. Instead, the clear majority found that “the lack of focus, organizational

complexity, and a risk-averse culture [are] to blame.”

It is not difficult to understand why executives have that sentiment in today’s

business climate. Managers and decision-makers are gun shy for several reasons. One

reason is simply the natural reaction to the economic downturn. People are hunkered

down, prepared to weather the storm. Lawyers and corporate watchdogs warn of

employees who may file complaints with the SEC in pursuit of hefty bounties and

suggest that, because of concerns about corruption, attempts to do business

in emerging markets are too risky. There is also the common perception that a

leader/manager cannot “get involved” with a subordinate because the manager

will be accused of favoritism, cronyism, or worse, harassment, discrimination, and/or

invasion of privacy. With all of that head-wind and workforces that distrust executive

management, it is no wonder that executives have identified risk-averse cultures as

an obstacle to growth and success.

Additionally, there is the divide (whether perceived or real) between executive

management and the rest of the organization regarding the values of the organization.

A study conducted by the Legal Research Network, “The How Report: Rethinking the

Source of Resiliency, Innovation and Sustainable Growth,” found that in organizations

where the C-Suite had positive opinions of the culture of the organization, the majority

of the organization did not share the same belief. These results reveal the potential risk

that executives and the teams they manage are disconnected.

Why is this important for directors? An organization will not be able to implement

a CEO’s potentially successful strategy if those responsible for executing the strategy are

disengaged, afraid to take responsibility, unwilling to accept the risks associated with new

ideas, or at worst, actively working to oppose the strategy.

Directors should not assume that employee engagement and workplace culture are

the sole responsibility of executive management. According to the strategy expert Michael

Porter of Harvard University, a successful strategy exists when a “company can outperform

rivals” by establishing a “difference that it can preserve.” That difference is either delivering

greater value to customers or creating comparable value at a lower cost, or both. Porter is also

well-known for his admonition that “operational effectiveness” [i.e., employing more advanced

technology, motivating employees better, producing products more efficiently, etc.] is not a

strategy. Porter contends that while operational effectiveness may provide a temporary

advantage, it is not sustainable because competitors may easily copy the best practices.

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However, Porter maintains that operational effectiveness

is “essential to superior performance.” Given recent evidence

and research showing an overwhelming amount of skepticism

about executives and their values, directors should be asking

executive management tough questions to determine whether

the rest of the management team is on board with the strategic

direction of the business. According to Porter, the ability to lead

is a necessary predicate to developing or reestablishing a clear

strategy. Directors should focus on whether the CEO has the

ability to lead and utilize the best research available to assist the

CEO with being an effective leader.

Second, Porter notes that “strategic positionings are

often not obvious, and finding them requires creativity and

insight.” While some aspects of operational effectiveness may

be derived from machines, creativity, insight and innovation are

the province of people. Ensuring that the organization’s strategy

will build a sustainable competitive advantage requires hiring a

CEO who can build a team that has the ability to be creative,

insightful, and innovative. According to LRN’s research in “The How Report,” one of the most

important factors to foster innovation is to build a culture of “trust.”

Modern social research consistently shows that the level of employee trust in the

organization and the extent to which employees are actively engaged with the business are

some of the most material assets an organization can have. Yet, because those assets are not

on a public financial statement, they are typically overlooked, not managed, and not measured.

Directors may, however, help secure a strategic advantage by understanding how culture is

measured and managed and ensuring a connection with the organization’s strategy.

What Directors Can DoIt is true that the amount of time directors have to oversee the business is already

limited. Also, a CEO may perceive questions about workplace culture as crossing the line

between providing oversight (the director’s job) and managing the business (the CEO’s job).

Yet, directors should take the time to inquire how the organization is managing and measuring

culture. The inquiry alone will lead to healthy self-examination by the executive team and is, in

fact, an important aspect of overseeing an organization’s growth and strategy.

The ERC’s proposed revisions to the Federal Sentencing Guidelines suggest that

directors can help protect the organizations they serve by familiarizing themselves with

those guidelines and with compliance issues more generally. Even if not the board’s expert

on overseeing compliance programs, a director who understands the general aim and specific

requirements of the Federal Sentencing Guidelines will be better able to assess risk and set

priorities for compliance initiatives.

In high-trust environments,

employees are more willing

to experiment and take risks.

In contrast, low trust results

in more cautious employees

and less risk-taking. And

without risk-taking, there

is no innovation.

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Directors can also increase their awareness about how culture can be measured and

how executives can be held accountable to meet cultural objectives. While changing corporate

culture typically is a 3 to 5 year project, that is the same amount of time that it takes to

implement many strategic plans and initiatives. Consequently, directors should not be wary of

tackling culture as a strategic objective.

As a final recommendation, directors can help to identify an organization’s core values

and then promote those values in a manner consistent with the overall strategy for growth and

development. Rather than launch a generalized campaign to be perceived as doing and saying

the right things, directors should discourage attempts to overstate an organization’s altruistic

commitments. Instead, directors can work to thoughtfully identify values that connect to the

strategic mission of the business and help the executive management refocus on those values.

For a public corporation, its only mission by law is to focus on building and protecting shareholder

value. So-called “charitable” or “moral” initiatives that do not complement organizational

strategy should be jettisoned to focus on core strategies. Companies with high-profile brands

will have more difficulty deciding which projects are necessary to protect the brand; however,

it is important that any initiative or activity undertaken by the organization assist in building

a sustainable competitive advantage that is necessary to be successful over the long term.

Moreover, managers and employees are more likely to trust a company’s commitment to its

core values when the executives and directors of that organization have a clear idea of what

those values are and set strategic priorities in a manner that is consistent with them. ¢

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Earl “Chip” Jones Shareholder

ejones@littler.com 214.880.8115

Amy Mendenhall Knowledge Management Counsel

amendenhall@littler.com 202.772.2516

ABOUT LITTLER MENDELSON: Littler Mendelson is the world’s largest labor and employment firm exclusively devoted to representing management. With over 950 attorneys and 57 offices throughout the U.S. and globally, Littler has extensive resources to address the needs of U.S.-based and multi-national clients from navigating domestic and international employment laws and labor relations issues to applying corporate policies worldwide. Established in 1942, the firm has litigated, mediated and negotiated some of the most influential employment law cases and labor contracts on record. For more information, visit www.littler.com.