The returns from a best practices compliance programme

May 2022  |  SPECIAL REPORT: BUSINESS STRATEGY & OPERATIONS

Financier Worldwide Magazine

May 2022 Issue

What is the ‘Holy Grail’ of compliance? It is to show a positive return on investment for your compliance programme? Most executives feel that compliance functions and compliance programmes are cost centres which, at best, do not contribute to overall corporate profitability and, at worst, are centres of business denial. However, recent academic research has begun to show there are positive financial benefits for robust compliance programmes.

In an article by Paul Healy and George Serafeim entitled ‘An Analysis of Firms’ Self-Reported Anticorruption Efforts’, published in The Accounting Review, the authors looked at the issue of not simply profitability of companies which had more robust compliance programmes, but also what was the direct effect on the companies’ return on equity (ROE) in countries which were perceived to have a high incidence of corruption under the Transparency International Corruption Perceptions Index.

According to the article, companies with good governance tended to have more robust compliance programmes. 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 that “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 programme.

Unsurprisingly, in countries with a low risk of corruption there was not much difference in the sales growth for companies with robust anti-corruption compliance programmes and those businesses which fell into the authors’ ‘cheap talk’ category. However, when it came to growth in countries which 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, whereas a 10 percent increase in sales in high corruption segments decreases ROE by 7 basis points. 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 minus 24 basis points”.

This means that there is a negative relation between investments and a company’s return on that investment in high-risk countries where the company did not have an effective compliance programme. This is true even in the face of increased sales growth. For firms which had as high as 10 percent growth in high-risk countries, if they did not have a robust compliance programme in place the negative ROE was between 24 to 30 percent. 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”.

These findings are equally large and important for the chief compliance officer (CCO) or compliance practitioner. The authors conclude by making several observations. First, companies which have more robust compliance programmes are from countries which have more robust enforcement and monitoring. Second, the more robust your compliance programme 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 programme sales will drop off dramatically and may well lead to negative ROE.

Dr Kyle Welch took this analysis a step further in his paper ‘Evidence on the Use and Efficacy of Internal Whistleblowing Systems’, where he reviewed some 15 years of anonymised data from Navex Global, an international hotline provider. This data was from the company’s hotline reporting systems. Some of the key findings included that companies with a robust whistleblower and reporting system had greater profitability and workforce productivity as measured by return on assets (ROA) and there were fewer material lawsuits brought against the company overall and there were lower settlement costs if a lawsuit did occur.

All of this led to a finding of reduction in material litigation cost – and this is not simply civil litigation but all reportable proceedings against a company, including regulatory enforcement actions, criminal sanctions sought by the Department of Justice (DOJ) and all other court proceedings. A material proceeding would have to be 5 percent of a company’s gross margin, so the amount would be quite high. Companies with robust whistleblower reporting systems had 4 percent fewer pending lawsuits the year after increased hotline activity, improving to 6.9 percent fewer material lawsuits over the next three years. Further overall litigation settlements of non-material matters dropped almost 20 percent over three years as well.

All this points to companies which are on the Ethisphere list of the ‘World’s Most Ethical Companies’ and their financial performance. According to Ethisphere, the listed 2022 ‘World’s Most Ethical Companies’ honourees outperformed a comparable index of large cap companies by 24.6 percentage points from January 2017 to January 2022. They have better than average financial performance because they are better run. These companies are on this list largely because they have robust finance internal controls which 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.

Healy and Serafeim demonstrated that spikes in sales in high-risk countries do not translate into sustained growth and without an effective compliance programme in place, a company may lose money. Welch showed that having a robust whistleblower reporting system can bring not only material cost savings, but the positive benefits are significant.

 

Thomas R. Fox is a principal at Tom Fox Law. He can be contacted on +1 (832) 744 0264 or by email: tfox@tfoxlaw.com.

© Financier Worldwide

BY

Thomas R. Fox

Tom Fox Law

©2001-2024 Financier Worldwide Ltd. All rights reserved. Any statements expressed on this website are understood to be general opinions and should not be relied upon as legal, financial or any other form of professional advice. Opinions expressed do not necessarily represent the views of the authors’ current or previous employers, or clients. The publisher, authors and authors' firms are not responsible for any loss third parties may suffer in connection with information or materials presented on this website, or use of any such information or materials by any third parties.