Organizational Culture: An Overlooked Internal Risk

Companies that encourage and support open communications outperform their peers, according to research from the Corporate Executive Board

Nearly half of executive teams lack the information they need to manage effectively because employees withhold vital input out of fear that doing otherwise will reflect poorly on them. This restricted information flow can cripple a company's ability to identify and respond to internal and external threats. A recent survey by the Corporate Executive Board of more than 400,000 employees across various industries reveals that companies that break down two key barriers to honest feedback not only reduce fraud and misconduct, but also deliver peer-beating shareholder returns by a substantial margin.

Imagine that the chief executive of your company recently launched a strategy aimed at taking advantage of a megatrend affecting customers: environmentally friendly widgets. You're a senior executive tasked with communicating to your largest shareholders how this strategy will drive better corporate performance. You believe in this strategy, and of course you want the meeting to go well. You go to Boston and New York to meet with your five largest shareholders. The first three meetings go great, but the last two portfolio managers you meet with are not convinced. They don't come right out and say so, but you sense that they believe environmentally friendly widgets are a fad and thus they are skeptical of the long-term viability of your strategy. When you get back to the office, you bump into your CEO, who asks how the meetings went. What do you tell her? Do you mention the skepticism?

There is no right or wrong answer. Many individuals, however, will instinctively emphasize the positive (e.g., "The meetings went very well; there is some genuine excitement about the direction we are taking"). There are a number of reasons for this: 1) It affirms your preexisting emotions (you wanted the meetings to go well and believe in the strategy); 2) it reflects well on your own performance (it's your job to communicate in a compelling way); 3) it is not incorrect (generally speaking, the meetings went very well); and 4) perhaps you don't believe your CEO is interested in hearing contrary feedback.

You can imagine scenarios like this playing out across the organization in conversations with customers, employees, and suppliers as important information about the business is relayed to key decision-makers. The problem this creates is that the "weak signal" (skepticism over a key assumption underpinning the company's strategy) becomes increasingly filtered out as information travels from the bottom of the organization to the top. Like the emperor whose nakedness is long ignored as he parades in front of his subjects, the CEO doesn't receive any contrary feedback until it is too late.

Multiply Your Competitive Advantage

If you are not among those who (consciously or unconsciously) tend to put a positive spin on results you are accountable for, you might find the prevalence of this behavior surprising. A recent CEB poll found that:

• Nearly half of executive teams fail to receive negative news that is material to company performance in a timely manner because employees are afraid of being tainted by being the bearer of bad news.

• Only 19 percent of executive teams are always promptly informed of bad news material to company performance.

Of course, you might be saying, "this is not news to me." The belief that CEOs and senior leaders are insulated from facts on the ground is widespread. This is the reason we get out of our offices and meet with employees, customers, and investors. But imagine if you worked at a company where you didn't need to seek such information outside your office. How much more effective would your company be if honest feedback flowed more freely?

CEB research suggests that a significant advantage accrues to companies that know where and how to break down barriers to honest feedback. Such companies appear to outperform their peers in terms of long-term total shareholder return (TSR) by a significant margin.

For years, CEB's Compliance and Ethics Leadership Council has surveyed hundreds of thousands of employees on behalf of CEB clients to help the clients understand the extent to which they have an ethical culture and to identify hot spots for unethical conduct that require attention. As a by-product of that work, CEB identified a surprising relationship: Companies where employees provide honest feedback substantially outperformed their peers in terms of 10-year TSR from 1998 to 2008. Two factors stood out in particular:

• Openness of Communication

Employee perceptions of the extent to which management encourages two-way dialogue matters. According to CEB research, companies rated by their employees in the top quartile in terms of openness of communication have delivered TSR (10-year TSR 1998–2008) of 7.9 percent compared with 2.1 percent at other companies. In addition, they also had materially lower levels of observed fraud and misconduct.

• Fear of Retaliation (and Willingness to Speak Up)

Among the 12 key indicators we track in our cultural diagnostic, the one that is most strongly correlated with 10-year TSR is employee comfort speaking up. The most important driver of this comfort is a lack of fear of retaliation. As with openness of communication, we found that companies that excel on this factor also had materially lower levels of observed fraud and misconduct.

Fear is a particularly powerful inhibitor. CEB recently surveyed more than 100 clients and asked them to estimate the amount of harm that would have to be present to share honest (negative) feedback if they thought it would put their careers at risk:

• Fifty-nine percent estimated that more than $1 million worth of harm to the company would have to be at stake for employees to share honest (negative) feedback.

• Twenty-nine percent estimated that more than $10 million would have to be at stake.

Worse During the Recession

Not only are these barriers to honest feedback significant; they have also increased during the past two years at most organizations. CEB data from 400,000 employees suggest that perceptions of openness of communication, as well as overall perceptions of corporate integrity, fell close to 4 percent during the recession in 2008 and remained depressed in 2009. Although 4 percent may seem small, a 1 percent drop in perceptions of corporate integrity equates to approximately a 1 percent increase in observed misconduct. Assuming the average company has 10,000 employees, that equates to approximately 400 additional instances of observed misconduct.

At precisely the time that employees sought more clarity and direction from their leaders to deal with a volatile environment, they believed they were receiving less guidance and felt less inclined to share Information that could have been useful to their managers.

Corporate Executive Board has worked with hundreds of organizations to help them establish and improve their approach to risk management. In conversations with senior executives, CEB found that risk management programs at large companies tend to be finely tuned to financial and compliance risks but rarely focus on cultural sources of risk like the ones described above. Indeed, we believe this is a risk blind spot for many organizations.

Organizations should take a number of steps to manage cultural risks better.

First, to reduce fear of speaking up, dispel employee myths about retaliation:

• Remove barriers to speaking up by targeting underlying employee perceptions, which are often incorrect.

• Address employee perceptions through credible education and communications.

Second, reinforce the importance of speaking up:

• Establish escalation criteria and create employee and manager speaking-up expectations.

• Roll out speaking-up policy and supporting materials to all employees.

Third, educate employees how and when to escalate issues:

• Provide employees with tools and processes to remove uncertainty about when and how to report compliance and ethics concerns.

The best companies also recognize the critical role managers play in defining their culture and climate. For example, one company we've highlighted in our research translates key aspects of its culture into simple and targeted guidelines for managers. The managers then provide simple suggestions for translating those guidelines into day-to-day behaviors for their staff.

By measuring and managing cultural risks, leading companies not only reduce the probability of internal threats from misconduct but they also boost productivity and performance.

Paul Edelman, Srikanth Seshadri and Randeep Rathindran also contributed to this article.

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