Reputation and the Business Network

It's been a bad few months for almost any business sector where managing reputational risks is important. The headlines were grabbed by ailing financial services firms with the death of Lehman Brothers and the Congressional bailout of the financial industry and (as of press time) the proposed bailout of the automobile industry leading the news. But firms operating in other sectors of the economy have also suffered from reputation-impairing scandals. Firms in the food, pharmaceutical, and legal services sectors have recently experienced crises that have arisen from failures to manage the inherent risks of their business networks.

Business Networks

Complex business networks are the consequence of a new-economy world where flat and lean organizations outsource non-core functions. Companies depend on complex supply chains and other robust business networks such as semi-autonomous globally distributed licensees and franchisees. This form of business-by-network brings with it reduced visibility, impaired awareness and limited control, all of which, in turn, create financial risk. Reputational insults stemming from unethical sourcing, environmentally unsustainable practices, and unsafe products from within the supply chain have recently cost some of the world's largest companies tens of billions of dollars in market capitalization and have tarnished their reputations for years to come.

Recent Butcher's Bill

Lehman Brothers was felled by the same vortex of forces that, a year ago, turned Barbie's accessories into toxic waste and knocked off $2 billion from Mattel's market cap. That vortex was created by the complex forces at play in Mattel's business network, i.e., its supply chain. Mattel depended on offshore suppliers who, in turn, depended on offshore factories. Lehman depended on a global network of banks and other organized sources of capital. That network's crisis of confidence and its resulting failure to supply the required liquidity mortally wounded a storied investment firm.

Scandals linked to outsourcing to Chinese manufacturing firms continued to emerge in the food sector. China's quality watchdog reported in mid-September that 24 batches of milk from Yili, Mengniu and Guangming ' top brands trusted by hundreds of millions of Chinese ' contained up to 8.4 micrograms of melamine per kilogram. The tolerable daily intake for melamine is 0.63 micrograms per kilogram of body weight, putting children most at risk. KFC of fried chicken fame was caught up in the problem; Starbucks ordered its 300 branches in China to switch to soy milk. Cadbury and Mars both recalled a number of chocolate confections. Total damage to date: Four infants have died and more than 53,000 others have been sickened. About 1,300 babies remain hospitalized, with 158 suffering from acute kidney failure.

Ranbaxy and Sandoz looked sheepish after quality problems in their supply chains became public matters. The Food and Drug Administration issued a warning alert regarding the import into the United States of more than 30 different generic drugs made by Ranbaxy in two of its factories in India. The agency highlighted poor compliance with current good manufacturing practices. Likewise, the World Health Organization officials recently advised consumers to stop buying Sandoz products made by its South African generics unit after an inspection revealed more than 40 instances of noncompliance and deviation from that agency's rules on good manufacturing practices.

Meanwhile, here in the United States, in an options backdating case before a federal district court involving the former general counsel of computer security firm McAfee, the lawyers responsible for conducting the internal investigation were thrust into the awkward position of having to explain why they had waited until the eve of trial to produce seven e-mails that should have been produced earlier in the case. When held to account for the omission before the court, the lawyers explained that it was the result of poor supervision over work performed by “contract attorneys,” who were employed for the specific purpose of carrying out document discovery. The lawyers also blamed the mishap on the filtering software the contract attorneys had used to review documents in the case.

Business Networks and Reputational Risk

In today's global markets for both goods and services, almost every form of business enterprise depends on supply chains and other robust business networks. Such networks are the muscles and sinews of enterprise value and reputation. They are also major sources of risk.

Business processes guide the operations of these networks. They marshal the infrastructure and human resources within the networks to deliver goods and services. They also control intangible attributes of the processes and end-products ' environmental sustainability, quality, safety, security and integrity ' that comprise the intangible assets of the enterprises that participate in the network. From these processes flow another intangible asset: reputation. Reputations take shape from the perceptions that stakeholders have about an enterprise's intangible assets.

Thus, intangibles collectively support reputational value. That support, however, is like a Roman arch. The individual values of the intangible assets are highly interdependent, and the loss of any one can cause the entire structure to collapse.

Excellence in Intangibles

Two recent papers published in Intellectual Asset Management magazine quantify the relationship between reputational value and the management of the underlying intangible assets. The first paper, published in the August/September 2008 issue by Peter Gerken et al., shows that firms that are recognized as superior stewards of their intangible assets reward shareholders with above-average returns. The metric used to define the quality of the intangible asset management was Steel City Re's Intangible Asset (Reputation) Financial Performance Index (“the IA Index”).

In the second paper, published in October/November 2008, the authors of this article looked at a more granular level at the day-to-day fluctuations of the IA index. We found that the IA Index could explain, to varying degrees, price volatility for firms across a number of different sectors. Volatility in the Financial Services Sector was most susceptible to explanation by volatility in the IA Index ' a finding that corresponded to the apparent importance the public markets placed on the intangible asset of “integrity” during the time period of the study.

Indeed, 40% of the variance in the price of financial service sector companies could be explained by their IA Index ranking. We do not believe that this is coincidental given the extent to which the earnings (balance sheets) of firms in this sector were under assault during the period of our study. As the balance sheets of the Financials became suspect ' or the actual value became opaque ' investors were forced to turn to intangibles, such as reputation, in order to discover prices. In this context, Bear Stearns and Lehman Brothers are good specific examples. Left with a dearth of reliable quantitative measures of tangible or intangible firm value, investors relied heavily on rumor, guesswork, and fear. Even Goldman Sachs, whose reputation for risk management was probably unparalleled in this sector during this time, was impacted by the overall degradation of confidence in the highly leveraged investment bank business model.

We also looked specifically at intellectual property and reputation for innovation. We identified firms that would be expected to value highly strategic management of intangible assets and asked whether the risk adjusted returns for these firms were any better than what investors could obtain by investing in the overall market in the time period between February and August 2008. The performance of various technology-heavy or intellectual property indices were taken as reasonable surrogates for the performance of such firms. As discussed in the article, such firms fared better than the overall market during this recent time of economic upheaval and provided superior risk-adjusted returns.

Networks, Process, and Intangibles

The business network is the modern day operating business. The old business of making things has been replaced with the business of connecting things. The lower costs associated with connecting things are a trade-off for the higher risk associated with having diminished direct control over quality. Processes that maximize the ability of firms to control quality throughout the business network, therefore, are among the most valuable assets an iconic company can have today. They help firms increase, protect, and restore the value of reputations that are put at risk daily by doing business on a global scale.

Whether the business network from which risks arise is a supply chain or a team of outside contract attorneys, intangibles and the reputations for innovation, integrity, and quality that they support are assets to be managed actively. In fact, reputation is probably a greater driver of value among law firms than almost anything else, because, in the eyes of the majority of the public, their work product is extremely technical and opaque. Thus, as unrelenting competitive pressures compel law firms to outsource functions that were once performed exclusively in-house, the stakes are higher than ever for those firms that care about preserving and enhancing their reputations. All are well-advised to design and implement reasonable business processes that allow them to maintain sufficient control over the quality of their work product throughout their business networks.

Nir Kossovsky, MD, is CEO of Steel City Re, a risk management and assurance company, in Pittsburgh, PA. Dr. Kossovsky also serves as the Executive Secretary of the Intangible Asset Finance Society. He may be contacted at [email protected]. Jorge M. Torres is a patent attorney in New York and a member of the Intangible Asset Finance Society. The opinions expressed in this article are solely those current opinions of the authors and should not be construed to reflect the opinions, policies, or positions of any entity other than the authors.

It's been a bad few months for almost any business sector where managing reputational risks is important. The headlines were grabbed by ailing financial services firms with the death of Lehman Brothers and the Congressional bailout of the financial industry and (as of press time) the proposed bailout of the automobile industry leading the news. But firms operating in other sectors of the economy have also suffered from reputation-impairing scandals. Firms in the food, pharmaceutical, and legal services sectors have recently experienced crises that have arisen from failures to manage the inherent risks of their business networks.

Business Networks

Complex business networks are the consequence of a new-economy world where flat and lean organizations outsource non-core functions. Companies depend on complex supply chains and other robust business networks such as semi-autonomous globally distributed licensees and franchisees. This form of business-by-network brings with it reduced visibility, impaired awareness and limited control, all of which, in turn, create financial risk. Reputational insults stemming from unethical sourcing, environmentally unsustainable practices, and unsafe products from within the supply chain have recently cost some of the world's largest companies tens of billions of dollars in market capitalization and have tarnished their reputations for years to come.

Recent Butcher's Bill

Lehman Brothers was felled by the same vortex of forces that, a year ago, turned Barbie's accessories into toxic waste and knocked off $2 billion from Mattel's market cap. That vortex was created by the complex forces at play in Mattel's business network, i.e., its supply chain. Mattel depended on offshore suppliers who, in turn, depended on offshore factories. Lehman depended on a global network of banks and other organized sources of capital. That network's crisis of confidence and its resulting failure to supply the required liquidity mortally wounded a storied investment firm.

Scandals linked to outsourcing to Chinese manufacturing firms continued to emerge in the food sector. China's quality watchdog reported in mid-September that 24 batches of milk from Yili, Mengniu and Guangming ' top brands trusted by hundreds of millions of Chinese ' contained up to 8.4 micrograms of melamine per kilogram. The tolerable daily intake for melamine is 0.63 micrograms per kilogram of body weight, putting children most at risk. KFC of fried chicken fame was caught up in the problem; Starbucks ordered its 300 branches in China to switch to soy milk. Cadbury and Mars both recalled a number of chocolate confections. Total damage to date: Four infants have died and more than 53,000 others have been sickened. About 1,300 babies remain hospitalized, with 158 suffering from acute kidney failure.

Ranbaxy and Sandoz looked sheepish after quality problems in their supply chains became public matters. The Food and Drug Administration issued a warning alert regarding the import into the United States of more than 30 different generic drugs made by Ranbaxy in two of its factories in India. The agency highlighted poor compliance with current good manufacturing practices. Likewise, the World Health Organization officials recently advised consumers to stop buying Sandoz products made by its South African generics unit after an inspection revealed more than 40 instances of noncompliance and deviation from that agency's rules on good manufacturing practices.

Meanwhile, here in the United States, in an options backdating case before a federal district court involving the former general counsel of computer security firm McAfee, the lawyers responsible for conducting the internal investigation were thrust into the awkward position of having to explain why they had waited until the eve of trial to produce seven e-mails that should have been produced earlier in the case. When held to account for the omission before the court, the lawyers explained that it was the result of poor supervision over work performed by “contract attorneys,” who were employed for the specific purpose of carrying out document discovery. The lawyers also blamed the mishap on the filtering software the contract attorneys had used to review documents in the case.

Business Networks and Reputational Risk

In today's global markets for both goods and services, almost every form of business enterprise depends on supply chains and other robust business networks. Such networks are the muscles and sinews of enterprise value and reputation. They are also major sources of risk.

Business processes guide the operations of these networks. They marshal the infrastructure and human resources within the networks to deliver goods and services. They also control intangible attributes of the processes and end-products ' environmental sustainability, quality, safety, security and integrity ' that comprise the intangible assets of the enterprises that participate in the network. From these processes flow another intangible asset: reputation. Reputations take shape from the perceptions that stakeholders have about an enterprise's intangible assets.

Thus, intangibles collectively support reputational value. That support, however, is like a Roman arch. The individual values of the intangible assets are highly interdependent, and the loss of any one can cause the entire structure to collapse.

Excellence in Intangibles

Two recent papers published in Intellectual Asset Management magazine quantify the relationship between reputational value and the management of the underlying intangible assets. The first paper, published in the August/September 2008 issue by Peter Gerken et al., shows that firms that are recognized as superior stewards of their intangible assets reward shareholders with above-average returns. The metric used to define the quality of the intangible asset management was Steel City Re's Intangible Asset (Reputation) Financial Performance Index (“the IA Index”).

In the second paper, published in October/November 2008, the authors of this article looked at a more granular level at the day-to-day fluctuations of the IA index. We found that the IA Index could explain, to varying degrees, price volatility for firms across a number of different sectors. Volatility in the Financial Services Sector was most susceptible to explanation by volatility in the IA Index ' a finding that corresponded to the apparent importance the public markets placed on the intangible asset of “integrity” during the time period of the study.

Indeed, 40% of the variance in the price of financial service sector companies could be explained by their IA Index ranking. We do not believe that this is coincidental given the extent to which the earnings (balance sheets) of firms in this sector were under assault during the period of our study. As the balance sheets of the Financials became suspect ' or the actual value became opaque ' investors were forced to turn to intangibles, such as reputation, in order to discover prices. In this context, Bear Stearns and Lehman Brothers are good specific examples. Left with a dearth of reliable quantitative measures of tangible or intangible firm value, investors relied heavily on rumor, guesswork, and fear. Even Goldman Sachs, whose reputation for risk management was probably unparalleled in this sector during this time, was impacted by the overall degradation of confidence in the highly leveraged investment bank business model.

We also looked specifically at intellectual property and reputation for innovation. We identified firms that would be expected to value highly strategic management of intangible assets and asked whether the risk adjusted returns for these firms were any better than what investors could obtain by investing in the overall market in the time period between February and August 2008. The performance of various technology-heavy or intellectual property indices were taken as reasonable surrogates for the performance of such firms. As discussed in the article, such firms fared better than the overall market during this recent time of economic upheaval and provided superior risk-adjusted returns.

Networks, Process, and Intangibles

The business network is the modern day operating business. The old business of making things has been replaced with the business of connecting things. The lower costs associated with connecting things are a trade-off for the higher risk associated with having diminished direct control over quality. Processes that maximize the ability of firms to control quality throughout the business network, therefore, are among the most valuable assets an iconic company can have today. They help firms increase, protect, and restore the value of reputations that are put at risk daily by doing business on a global scale.

Whether the business network from which risks arise is a supply chain or a team of outside contract attorneys, intangibles and the reputations for innovation, integrity, and quality that they support are assets to be managed actively. In fact, reputation is probably a greater driver of value among law firms than almost anything else, because, in the eyes of the majority of the public, their work product is extremely technical and opaque. Thus, as unrelenting competitive pressures compel law firms to outsource functions that were once performed exclusively in-house, the stakes are higher than ever for those firms that care about preserving and enhancing their reputations. All are well-advised to design and implement reasonable business processes that allow them to maintain sufficient control over the quality of their work product throughout their business networks.

Nir Kossovsky, MD, is CEO of Steel City Re, a risk management and assurance company, in Pittsburgh, PA. Dr. Kossovsky also serves as the Executive Secretary of the Intangible Asset Finance Society. He may be contacted at [email protected]. Jorge M. Torres is a patent attorney in New York and a member of the Intangible Asset Finance Society. The opinions expressed in this article are solely those current opinions of the authors and should not be construed to reflect the opinions, policies, or positions of any entity other than the authors.