Markkula Center of Applied Ethics

Ethical Risk Assessment: Crisis-prone or Crisis-prepared

by Anne Federwisch

Management, investors, and the public at large have become increasingly interested in evaluating companies for ethical performance and risk in the wake of Sarbanes-Oxley, the NYSE standards, the updated U.S. sentencing guidelines, and the Department of Justice principles of prosecution.

"It's not just this explicit regulatory push, but there's also this heightened awareness in society that these things matter," said Shawn L. Berman, assistant professor of management at Santa Clara University. And once fraud taints an organization, it's costly to make amends in terms of both image and finances. The key is to proactively determine where risks lie and either eliminate the source or mitigate the risk before it reaches headline proportions.

To address this need in the industry, Berman and Kirk O. Hanson, executive director of the Markkula Center for Applied Ethics, presented a preliminary draft of the ethics assessment tool they are developing, dubbed the Santa Clara Alternative. They unveiled their work in progress at the June 13, 2006, meeting of the Business and Organizational Ethics Partnership. The tool builds on a presentation Hanson gave at an earlier BOEP meeting entitled "Crisis-Prone or Crisis-Prepared."

Other measures

In developing their tool, the pair looked at two existing measures of ethical risk that were ultimately found lacking: the Global Reporting Initiative (GRI) and the Ethics Resource Center Ethics Quick Test.

The GRI takes a broad look at social performance measures, looking at how a company adhered to multinational codes and standards in the past, Berman explained. "It's really backward-looking. It really says what we've done, and not what kinds of risks we have and how do we manage them. It doesn't help us manage the risk going forward, so unfortunately, we didn't find it super helpful."

The Ethics Quick Test focuses on 12 areas of an organization's commitment to ethics, such as how ethics factors into its organizational values, strategies, goals, objectives, policies and procedures. It looks at organizational incentives, decision-making, and tone at the top, as well as ethics evaluation, education, and training. But the major downfall of the Quick Test, Berman noted, was that it focuses on organizational dynamics as ethical risk factors, without really getting at individual or industrial-level factors.

So in developing the Santa Clara Alternative, Berman and Hanson tried to create a forward-looking tool that addresses ethical risk factors inherent in the industry, the company, and in the employees themselves. By asking probing questions that cover all three potential aspects of ethical pitfalls, the tool allows a company to calculate a numerical value of its ethical risk based on the identified factors, weighted for importance. The quantitative nature of the tool allows a company to determine whether or not it has successfully decreased its ethical risk over time. But the qualitative aspect of the tool allows the organization to identify and address specific risk-prone areas by minimizing risks that can be controlled and by instigating effective measures to counteract unavoidable risks.

The industry

The first part of the tool asks a series of questions designed to analyze where ethical risk may arise from the industry itself. How intense is the competition? The more the competition, the more risk for ethical lapses. How important are a few large customers? The more important, the higher the risk. Some of the other questions look at product differentiation, overcapacity in the industry, and trade regulations.

Attendees had several suggestions for this section, such as addressing the track record of the particular industry, the placement of the industry on the supply chain (the closer to the end-user, the more likely it is to face scrutiny), how global the industry is, and the special set of risks inherent in dealing with government contracts.

The company

The section of the Santa Clara Alternative dealing with the company itself focuses on three separate aspects: structure or strategy; the ethics system, and the culture.

Under structure or strategy, questions delve into how hierarchical the company is (the more hierarchical, the greater the risk), how flexible it is in adjusting goals to changing conditions, and how much the company deals with "problematic" countries, industries, suppliers, and business partners (the more dealings, the higher the risk).

Recommendations from the BOEP included breaking out a section on communication, considering how rapidly a company has grown, and asking about the proximity and independence of the board of directors. As attendees presented suggestions and examples, Hanson observed, "What we're doing is drawing on the collective wisdom here of scandals we have known. What were the pathologies that led to the scandals? That's a pretty good way of looking at risk, of identifying sources of risk."

The ethics system section asks about a company's code of ethics and values. Does the company conduct meaningful ethics training? Does it incorporate ethical and value-oriented behavior formally into the performance evaluation system and reward ethical behavior? Does the company ever punish senior executives for unethical conduct?

One listener expressed concern that the measure may not fully reflect that in ethics, it is not what you say, but what you do that matters. One unethical act that is viewed by employees and is not reprimanded or punished is worth about 12 codes of conduct.

Hanson agreed. "Do the employees perceive that the company has a serious code of conduct? Do the employees perceive that there is a values statement-and that it means something? Credibility of each of these would be important."


Questions in the company culture section try to focus on how the tone at the top trickles down to ethical behavior throughout the company, including: How approachable and open to communication are the leaders of the company? How transparent is the company leadership about decisions made? How strong is leadership's reputation for honesty and integrity? Are there units of the company known to be ethical outliers?

"I find that in a lot of organizations, the fact that a particular division is let to remain as an ethical outlier has a contamination effect on the whole organization," Hanson noted.

The individual

The tool's last section centers on how the company deals with individual employees. Questions in this section include: Does the company's ethics program credibly emphasize that ethics is every employee's business? Does the company seek to rein in arrogance and hubris? How decisive is the company in dealing with ethical violations that arise? How effective is the employee assistance program in helping employees with personal or financial problems?

One listener suggested that the questions in this section should scrutinize more closely how individuals understand, trust, and use the systems in place to aid in ethical conduct-not just whether or not the company offers them. Another recommendation was to ask how employees perceive the fairness of company policies.

Putting it all together

Hanson and Berman are still modifying the tool, but eventually it will be used to measure total risk. It will also allow a company to determine whether its risk is going up or down over time.

"The bottom line," Hanson said, "is that the crisis-prepared organization understands its risk profile, minimizes risks by lowering risks that can be controlled, minimizes risks by creating countermeasures to risks that cannot be avoided, reevaluates its risk profile frequently, considers the impact on ethical risk of new strategies, structures, policies, etc."

As he and Berman continue to shape and change the Santa Clara Alternative, Hanson said they hope to fashion a tool that is not only useful for analyzing and managing ethical risks, but one that also underscores the importance of ethics as an essential part of a company's fiber, not just as a superfluous overlay on top of its underlying business structure.

Slides From This Presentation

Anne Federwisch is a freelance writer.