11 Signs to Avoid Management Meltdowns

Knowing some common yellow and red flags can help us side-step the risk of permanent loss of capital

“Tolstoy wrote that all happy families are alike and all unhappy families are unhappy in their own ways. The inverse appears to be true when it comes to ethics in organizations. All unethical organizations are alike, their cultures are identical, and their collapses become predictable.” - Marianne Jennings

Twitter has been abuzz with the Sam Bankman-Fried (SBF) trial, in which the former cryptocurrency magnate was recently found guilty of fraud. How SBF charmed many otherwise thoughtful businesspeople and media personalities are legitimate questions.

But should we be surprised?

I’m not an expert on SBF or FTX. I haven’t read Michael Lewis’s book, nor have I stayed up-to-date on the trial. However, this strikes me as the latest example in a long line of mass delusions and crushing ethical failures in the business world.

To be sure, it will happen again.

And we’re all susceptible. Indeed, some of my biggest investing mistakes have been misreading the character of certain companies’ management teams. I’ll discuss some of my learned warning signs in a moment.

Fortunately, most management meltdowns don’t end in fraud or bankruptcy. More often, the result is moat erosion and permanent impairment of capital. As such, we must learn to recognize the warning signs.

Author’s photo

To improve my judgment, I recently finished reading The Seven Signs of Ethical Collapse: How to Spot Moral Meltdowns in Companies…Before It’s Too Late by Marianne Jennings, a business school professor focused on legal and ethical studies.  

The book was published in 2006 on the heels of numerous high-profile corporate ethical collapses like Enron, Worldcom, and HealthSouth. Jennings uses these examples throughout the book, showing how common patterns emerge.

Jennings’ seven signs of ethical collapse are:

• Pressure to maintain those numbers

• Fear and silence

• “Young’uns” and bigger-than-life CEOs

• Weak board

• Conflicts

• Innovation like no other

• Goodness in some areas atoning for evil in others.

Let’s take a look at each of those seven signs. I’ll add four of mine at the end.

Pressure to maintain those numbers

Anyone who's made it to the C-suite understands that missing Wall Street estimates can result in a stock price drop. There's natural pressure to satisfy investors, particularly when the stock price drives a big part of employee compensation.

Some of that pressure can be good, but it can also lead to unethical decisions when a company can't achieve those numbers in the ordinary course of business. A company may, for example, stuff a channel with inventory to pull forward demand. That can work for a while, but eventually, all the customers' warehouses are full.

Photo by Mauricio Gutiérrez on Unsplash

Companies might also make an acquisition, alter segment reporting, or take some type of restructuring initiative to reset investor expectations. These moves should be viewed with skepticism.

Fear and silence

The 19^th-century Danish author Hans Christian Andersen wrote “The Emperor’s New Clothes,” a fable about two swindlers who convince a thickheaded, clothes-loving emperor that they can weave for him a new suit of clothes.

As an added bonus, they tell the emperor, the suit of clothes would appear invisible to people ill-suited for their jobs. As the swindlers mimed weaving the emperor's clothes, the sycophants in the emperor's court, afraid for their jobs, exclaimed how beautiful the clothes were.

Noblemen followed the emperor, now parading down the street, pretending to hold up the train of his cloak. No one – save a small child who didn't understand the social implications – dared to tell the emperor he was naked.

Jennings writes that "Sycophants are the enablers of ethical collapse. Fear and silence are the enemies of an ethical culture." If you believe a company's employees cannot speak truth to power, run – don't walk – to the nearest exit.

Young’uns and bigger-than-life CEOs

An iconic CEO who surrounds themselves with young, ambitious employees can be a warning sign. Jennings argues that’s because:

“These young’uns don’t have enough experience or wisdom to challenge the CEO, and the CEO has roped them in with executive success. They are hooked on the cash and its trappings and cannot speak up about obvious ethical and legal issues because they might lose the homes, the boats, the cars, and, yes, the prestige that comes with astronomical financial success at a young age.”

Photo by Obi - @pixel8propix on Unsplash

In contrast, when a CEO has an experienced team who – critically – have financial and professional options other than working at the company, it's far less likely (though not impossible) for misbehavior to persist for long.

Weak board

The purpose of a board of directors is to represent shareholders, advise executives on strategic initiatives, and hire and fire C-level executives. How the board is selected and organized and how it works together behind closed doors can either enable or prevent bad behavior.

Jennings suggests that, among other things, the ideal board member is independent and conflict-free and has unquestionable integrity. The ideal independent board member does not have family or business ties with the company or management, isn’t reliant on their income as a board member, and has shown themselves to be principled in other settings.

We can all think of companies that had weak boards and enabled shenanigans. This topic is worthy of a separate post. Jennings astutely observes that boards "should be doubly diligent when performance exceeds expectations" and not allow a "Yeehaw" culture to develop at the company where lavish perks and profligate spending become the norm.

Conflicts

"We are sophisticated in a technological sense," Jennings writes; however, "ethics have not changed with technology. Old-fashioned back-scratching and erudite quid pro quo still exist."

Consequently, investors should take note of various conflicts of interest between the board and management, as well as within the company.

Jennings advises companies to either disclose potential conflicts or get rid of them altogether.

Once, while researching a company with substantial family influence, I found that an immediate family member was in a sensitive position regarding financial reporting. It was disclosed, but it was easy to miss. I was already concerned with other things I saw, so the research ended there.

While the company hasn't collapsed - it would have been a big winner – the risk was clear, and I couldn't in good conscience back the business.

Family ownership can be a strong positive signal that the company is acting with a stewardship mentality and has intrinsic motivation for the work. In some cases, however, family entanglements can be yellow or even red flags. Employees are generally reluctant to be a whistleblower to begin with, and even more so if the person in question will be at Thanksgiving dinner.

Innovation like no other

As technological advances accelerate, we’re more frequently dazzled by their potential impacts. Jennings warns that companies behind these technologies may consider themselves “as being above the fray, below the radar, and generally not subject to the laws of either economics or gravity.”

Founders and executives of tremendously successful companies often receive accolades from the business and financial media, as well as their local communities. In turn, this feedback can create an inflated sense of self-importance.

To illustrate, here’s a clip from a December 2000 press release announcing that Fortune magazine named Enron one of the 100 best companies to work for in America.

Enron adds the “100 Best Companies to Work For in America” distinction to its “Most Innovative Company in America” accolade, which it has received from Fortune magazine for the past five years. The magazine also has named Enron the top company for “Quality of Management and the second best company for “Employee Talent.”

When a company gets this type of public reinforcement, it can provide mental cover for justifying other actions.

As an antidote to this red flag, Jennings suggests being on the lookout for how management responds to external questions about the company, its performance, or its tremendous growth. If rather than thoughtfully respond to a tough question, management launches an ad hominem attack against the questioner, be on your guard.

Goodness in some areas atoning for evil in others

When Jennings wrote the book in 2006, most public companies subscribed to the Friedman Doctrine.

Based on the writings of the economist Milton Friedman, the Friedman Doctrine states that business ethics is solely concerned with creating shareholder value. As such, the company itself has no moral or ethical grounds to be concerned with social responsibility. That should be left up to individuals and other groups to determine.

That approach has clearly changed in the last decade. Today, companies publicly promote their ESG efforts and stakeholder relationships. Consequently, it’s harder today to spot companies attempting to hide wrongdoing under the veil of altruism.

That doesn’t mean the sign is irrelevant.

Science fiction writer Robert Heinlein once wrote that “Man is not a rational animal; he is a rationalizing animal.” We live through our narratives and that can include rationalizing our flaws by emphasizing our virtues.

SBF, for instance, widely proclaimed to be an adherent of “effective altruism,” whereby he wanted to make as much money as possible so he could give more of it away to society. What could be wrong with that?

In such circumstances, the public might conflate, as Jennings notes, “that so much external effort for good was the measure of goodness in all areas of life.” Indeed, questioning the motives for such individual or corporate altruism can be perceived as unsympathetic or in bad taste, so they’re usually not raised.

Jennings adds:

“As cynical as it seems, skepticism about social responsibility and philanthropy may be one of the most certain determinants of a Yeehaw Culture. If you find these present in a company, check for the other factors of ethical collapse because the generosity and service may be a cover for a troubled soul and even more troubled books.”

Whether you agree with it or not, advertising corporate social responsibility is now table stakes for publicly traded businesses. The signal Jennings described in 2006 is more challenging to identify today, but it’s still important to investigate.

Additional signs

I mentioned at the top of this post that some of my biggest mistakes have been misjudging management character, which led to the deterioration of business fundamentals and, consequently, the stock price.

The deterioration primarily resulted in misguided transformational M&A and poorly considered capital allocation decisions rather than fraud or bankruptcy. Still, they were similarly born of compromised situations that management or the board could have prevented and investors like me should have identified.

This book helped me recognize how I might have rationalized otherwise concerning behavior and provided a blueprint for future evaluations.

What I’ve come to appreciate is that most of the above signs are yellow flags on a standalone basis. When more than one is present, however, it’s a red flag and a signal to exit the position.

Here are four more signs worth considering when evaluating management’s ability to make rational, ethical, and thoughtful decisions:

• Egregious Leverage: The pressure of mounting financial obligations in a downturn can create motivation to cut corners in the hope that it will get the company through the other side.

• Bread and Circus: To distract or appease its citizenry, Roman emperors would distribute copious amounts of food and provide entertainment that included gladiatorial combat, races, and theater performances. Similarly, companies that provide lavish perks to various stakeholders may also hope to distract or appease that group.

• Complexity: Companies with complex or frequently-changing financial reporting worry me because they might be counting on investors to not do the necessary digging to get at the heart of the matter.

• Obsession with short sellers: If the company has been the target of a well-distributed short thesis, there are two appropriate responses for the types of companies we want to own. One is ignore it and focus on the business. In 1992, when Fastenal founder Bob Kierlin was asked about the huge short interest in his stock, he replied: "I've got nothing against short sellers…They have a role in the market place, too. My own portfolio has a couple of short positions. In the long run, the truth will always come out." The second is to calmly and thoughtfully respond to short seller concerns like Netflix’s Reed Hastings did in reply to Whitney Tilson. Any other type of response - particularly when it’s driven by emotion - is a warning sign.

The best strategy is to avoid the above eleven situations altogether. I've found, however, that most companies have some behavioral yellow flags if you dig deep enough. As with any investment, it is about balancing risk with the potential reward. Investors can manage this in part through position sizing.

Minimizing unforced errors goes a long way to producing satisfactory long-term returns. If your gut tells you something isn’t right with a company, start asking questions or move onto a new investment idea.

What are some of your yellow flags? Please let me know in the comments below.

Stay patient, stay focused.

Todd

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