Reputation is the collective perception held by stakeholders of how a company manages its intangible assets. In the 74-member Capital Markets sector, those intangible assets underlying reputation comprise three types of risk management—operational, market and credit. “In a market system based on trust, reputation has a significant economic value,” noted Alan Greenspan, a former chair of the US Federal Reserve Board. In the absence of trust following the loss of reputation, liquidity is at risk. During the 2007-2009 financial crises, stakeholders perceived failures in one or more of those risk management processes and precipitated the liquidity crisis. We look at some exemplary reputation data.





As described in great detail in the forthcoming book, Mission: Intangible. Managing risk and reputation to create enterprise value, the data show that there is a strong association between reputation and long-term economic returns. The rank order of 3-year returns for BlackRock (NYSE:BLK), Goldman Sachs (NYSE:GS), Deutsche Bank (NYSE:DB), and Morgan Stanley (NYSE:MS) shown in the chart above adapted from bigcharts.com correspond to their rank order Steel City Re Corporate Reputation Index metrics and inversely to the volatility value and vector of that metric.



The data also show, as illustrated in the above chart that also shows Morgan Stanley's acute reputation drop, that the Capital Markets sector as a group experienced a reputation rise this past year, but that the variance within this group also increased.

Last, as described previously, the data show that the short term distortions of extraordinary returns following extraordinary losses do not skew the reputation metrics. Firms that have superior reputations are more resilient, will fall more slowly in periods of upheaval, and therefore have less ground to regain. The bright side of this relative lack of short-term upside is that the lower volatility translates to lower cost of capital.

Let's turn briefly to reputation restoration efforts at Goldman Sachs (NYSE:GS). Lloyd Blankfein’s decision to withhold cash bonuses from himself and Goldman Sachs’ 30-person management committee reflects a child rearing philosophy that we share not. This is why. Allowing a child to send himself to bed without supper does not rectify the wrong; nor does it foster desired behavior. To paraphrase, “it is a tale told by Blankfein, full of sound and fury, signifying nothing.

As we have argued repeatedly, and now provide the business case in the Society's new book, Mission: Intangible. Managing risk and reputation to create enterprise value, the path to reputation restoration begins with changes in business processes. Excessive risk taking requiring parental bailout was the transgression. A commitment never to repeat the offense affirmed by evidence of substantive business process changes is the only acceptable penitence. The desired behaviors Mr. Blankfein should demonstrate are (1) institution of policies and procedures to better govern the actors that individually contributed to the collective risk and (2) deployment of methods to foster conformance with them.

Six weeks have passed since the Chairman of the Galleon Group, the hedge fund at the center of a suspected insider trading ring, and several executives, have been charged. Three of the companies caught in this scandal are going concerns. Their executives are accused of divulging confidential non-public information. Those companies are McKinsey & Company, IBM (NYSE:IBM), and Intel Corporation (NASDAQ:INTC).

Of the three, McKinsey & Company has a widely held reputation for discretion – an intangible asset that is essential to their operational effectiveness. Last month, we hypothesized that this reputation would help mitigate McKinsey’s headline risk. Evidence of this mitigation would be fewer articles in the business and legal press relative to the other two firms.

Once again, Society member Jim Singer of the Pepper Hamilton law firm and author of the blog IP Spotlight, helped us with the analysis. Lexis Nexis searches were conducted combining 2 comprehensive databases - Business News Publications and Legal News Publications for the dates 9/3/2009-11/22/2009. The first search was for the pairing of “Galleon OR Rajaratnam.” Jim then searched the resulting articles for the additional terms of McKinsey, IBM, or Intel. 

There were no citations meeting the search criteria prior to the government announcement of allegations. Following the announcement, the data show that McKinsey’s name is less frequently associated than the other two firms with the disgraced hedge fund. This observation is statistically significant for the first three weeks of the alleged scandal.



While the findings are not conclusive—McKinsey is privately-held whereas the other two are public—these data are consistent with our general observation that companies with strong reputations based on rigorous business processes make for sympathetic actors that are treated as victims rather than culpable agents when adverse events occur. In short, reputations arising from superior intangible asset stewardship help mitigate headline risk.

NB: Statistical analysis using the Chi Square test for the five weeks of data yields a p<.03, p<.001, p<.01, for the first three weeks, respectively, and then not statistically significant differences thereafter.

Today’s MISSION:INTANGIBLE note was prompted by my colleague Robert Liscouski, COO with Steel City Re and a former Assistant Secretary in the Department of Homeland Security. Bob is yielding his IAFS position to the incoming Chair of the Security Committee, Scott Childers from The Walt Disney Company.

To my query of what is hot in security business processes and reputation that will interest our IAFS members, Bob said this: data security. This is why. The new poster child for data security is Heartland Payment Systems, (NYSE:HPY). Heartland, the sixth-largest payments processor of credit and debit card transactions in the U.S., announced in January that its records were hacked. A recently apprehended cyber-gang, according to the Justice Department, compromised 130 million Heartland accounts.

What are the lessons of interest for IAFS members? There are two lessons covering, respectively, the costs of reputation loss and the potential for reputation restoration.

The first lesson is that this was an expensive breach with growing costs. Heartland reported in May that the breach had cost it $12. 6 million so far, which included legal costs and fines from Visa and MasterCard, who said the company was not compliant with payment-card–industry rules. Then, In filings for the Securities and Exchange Commission, Heartland said the 2008 data security breach cost it $32 million as of June 30. Most recently, as of 30 Sept in the 10-Q filing, the Company recorded pre-tax expenses of $105.3 million or about $1.74 per share, associated with the security breach, aka, the Processing System Intrusion.

The majority of these charges, or approximately $90.8 million, related to: (i) assessments imposed in April 2009 by MasterCard and VISA against us and our sponsor banks, (ii) settlement offers we made to certain card brands in an attempt to resolve certain of the claims asserted against our sponsor banks (who have asserted rights to indemnification from us pursuant to our agreements with them), and (iii) expected costs of settling with certain claimants with whom settlement discussions are underway.

There is more. The Heartland breach – which has so far resulted in 28 class-action lawsuits filed against the company precipitated a near-immediate 50 percent drop in Heartland's share price (shown in red). Total equity value lost, rebased against the S&P500 Index (shown in blue) as of today, is about $300 million. Data source: Big Charts.com.



The second lesson is that following its near-death experience, Heartland is now committed to building reputation resilience by establishing the new standard for data security processes. Heartland is raising the bar in retail payments security by bringing end-to-end encryption to its network. It will be expensive and a big logistical challenge to execute. However, as long as it's accompanied by good policy and process, Heartland's encryption initiative will plug a definite security gap in the payments system.

In turning to processes to cure the defects that led to the reputation loss, and by creating a new standard for best practices, Heartland is following the model established by Johnson and Johnson with their product security issue, and El-Al Israel Airlines with their hijacking-related security issues. It is a best practice that examplifies the values of the IAFS and its members. Won't you consider joining us?

Heads up: IAM magazine, the official publication partner of the Society, will feature a reputation-focused case study on Johnnson & Johnson (NYSE:JNJ) in the January 2010 issue, #40.

In the Society’s pantheon of intangible assets that create enterprise value, one has defied efforts to build for it a universally compelling business case. Sustainability, unlike ethics, innovation, quality, safety and security, is not a practice that in our experience reliably has created enterprise value for its practitioners. Further, if one subscribes to the theory that there is wisdom in crowds, than the murkiness surrounding the value of sustainability persists. This is why. According to a recent survey of 1,400 CFOs from a stratified random sample of U.S. companies with 20 or more employees, two-thirds of CFOs don't expect to boost sustainability efforts in next 12 months.

When asked whether they expect their companies’ emphasis on green initiatives to increase, decrease or remain the same in the next 12 months, 68 percent of chief financial officers (CFOs) interviewed said they anticipate no changes. More than a quarter (28 percent), however, said they expect an increased focus on the issue.

When we first saw this report, we assumed that those expecting to increase their focus would be companies that distributed product through Wal-Mart (NYSE:WMT). More generally, we expected retailers and and their supply chains would be investing in green to conform with Wal-Mart’s sustainability requirements – or at least remain competitive.

We were not wrong. Looking horizontally at the data, while overall 28% expected to increase investments, 33% of the CFOs from companies in the retail sector expected to do so. Furthermore, while overall 5.15% expected to increase investments significantly, 6.3% of the CFOs from the retail sector were gearing up for bigger green initiatives.

However, we were surprised by some of the findings. First, the sector from which a plurality of CFOs expected to increase investments the most was finance – nearly 36%. At the other end of the spectrum was transportation – only 19%. However, nearly half of those in the transportation sector expected to make significant increases.

Growth and/or maintaining the status quo were not on everyone’s agenda. Sectors planning to cutback, according to the CFOs surveyed, include business services, construction and – ready for this – retail at 5.2, 4.8, and 3.8% respectively.

The survey was developed by Robert Half Management Resources.

Thirteen days have now passed since the Chairman of the Galleon Group, the hedge fund at the center of a suspected insider trading ring, and several executives, have been charged. The fund has liquidated about 90 percent of its nearly $3.7 billion portfolio of technology stocks and other securities and will be consigned to history, shortly. 

Three of the companies caught in this scandal are going concerns. Their executives are accused of divulging confidential non-public information. Those companies are McKinsey & Company, IBM (NYSE:IBM), and Intel Corporation (NASDAQ:INTC). Of the three, McKinsey & Company has a widely held reputation for discretion – an intangible asset that is essential to their operational effectiveness.

We hypothesized that this reputation would help mitigate McKinsey’s headline risk. Evidence of this mitigation would be fewer articles in the business and legal press relative to the other two firms.

Society member Jim Singer of the Pepper Hamilton law firm, and author of the blog IP Spotlight, helped us with the analysis. Lexis Nexis searches were conducted combining 2 comprehensive databases - Business News Publications and Legal News Publications for the dates 10/1/2009-10/29/2009. The first search was for the pairing of “Galleon and Rajaratnam.” Jim then searched the resulting 112 articles for the additional terms of McKinsey, IBM, or Intel.



The data show that McKinsey’s name is less frequently associated than the other two firms with the disgraced hedge fund. This observation is statistically significant. It is consistent with our general contention that companies with strong reputations based on rigorous business processes make for sympathetic actors that are treated as victims rather than culpable agents when adverse events occur. In short, reputations arising from superior intangible asset stewardship help mitigate headline risk.

NB: Statistical analysis using the Chi Square test yields a p<.03 (statistically significant).

Of the various companies caught up in the Galleon Hedge Fund matter, the headline that caught our attention was from Reuters and exclaimed, “McKinsey shocked by insider-trading allegations.” It has a whiff of Claude Rains, in the role of Captain Renault, expressing shock at the gambling in Casablanca. This is why.

One one hand, McKinsey has strict standards barring its consultants from trading stocks or funds that relate to the companies they are advising, a source close to the company said. The company's partners sign off each year on the policies. On the other hand, according to the Reuter’s story, McKinsey was aggressively recruiting college graduates by offering them new investment options, including getting a stake in a pool of McKinsey clients that gave the firm equity instead of cash for their consulting services. “A slippery slope,” says Lawrence White, a professor at the New York University's Stern School of Business.

McKinsey is looking at headline risk. The Financial Times' Newssift sentiment index reports that for the past week, the 9 article in the business press on McKinsey that included the word reputation were evenly divided at 33% each positive, negative, and neutral giving a positive/negative ratio of 1.0. For the month before the scandal broke, of the 11 articles, four were positive and two were negative for a p/n ratio of 2.0. (For comparison, Johnson & Johnson (NYSE:JNJ), the reputation leader for early 2009, had a one-year p/n ratio of 8.3)

Ironically, earlier this year, consultants from McKinsey authored an article on the importance of reputation management. The article called for substantive business process controls, and highlighted the limitations of public relations. Perhaps this is why McKinsey, so far, has been tight lipped?

Former Fed Chairman Greenspan noted last year that in a market system based upon the intangible asset of trust, reputation has significant value. Madoff aside, trust is having a hard time on Wall Street. We share two recent stories of reputation malignment (vilification?) in the Financial services sector.
 
The first, reported by the Financial Times last Thursday, is that one in five hedge fund managers misrepresents their fund or its performance to investors during formal due diligence investigations, according to research from New York University's Stern School of Business. Researchers found that the most common misrepresentations by hedge fund managers was the amount of money they had entrusted to their funds; Performance and regulatory and legal histories are also often misrepresented.
 
The second, which broke widely on Friday, involves allegations of trading on insider information at the hedge fund, Galleon Group. According to prosecutors, co-conspirators of fund founder Raj Rajaratnam include a McKinsey & Co. consultant, an IBM (NYSE:IBM) senior vice president, an Intel Corp. (NASDAQ:INTC) treasury manager and two executives from the New Castle hedge fund group of the defunct Bear Stearns.

The reputation angle obviously interests the Society. But there is more. What really interests us is how McKinsey, IBM, and Intel will manage the headline risk. Will their intangible asset risk management systems allow them to characterize the malfeasance as the product of rogue actors? Or will they be held culpable for the non-compliance of their employees?

Stay tuned.