How to find companies that come clean quickly

In an age when corporate blunders have devastated many a portfolio, few things worry investors as much as companies that hide errors and misdeeds until the damage created is beyond repair.

Fostering a corporate culture where hard truths readily come to light, however, is often a daunting task. American companies lost an estimated $660 billion to fraud in 2003, says the Association of Certified Fraud Examiners.

Faced with such high stakes, investors need to know how to identify companies where errors - ethical and otherwise - are likely to be addressed early on. Not only is that possible, researchers say, but shareholders can even help shape an environment where key people feel safe to share corporate missteps.

"Pick your favorite corporate scandal - WorldCom, Enron, go down the litany," says Harold Tinkler, chief ethics and compliance officer for Deloitte & Touche USA. "There were people in the organizations who knew what was going on and they didn't say anything. They didn't go anywhere with it. Why didn't they?... They felt they were in personal danger if they did that."

Creating a culture where mistakes are acknowledged is easier in some industries than others, according to Rod Fralicx, global employee research director at Mercer Human Resource Consulting in St. Louis. Firms that generate lots of new products through innovation tend to expect a certain margin of error. In this environment, systems usually exist to analyze mistakes as a regular part of doing business, and that attitude can help prevent elaborate coverups across departments.

But even in industries with a low tolerance for mistakes, such as banking or nuclear power, some companies are far more likely to learn about errors than others are. It's not unusual for 30 percent of employees at one company to say they would feel comfortable reporting a violation, while just 15 percent at another company in the same industry would say the same, according to Mercer survey research. The difference, Mr. Fralicx says, is cultural - and sometimes changeable.

Given this picture, investors can protect their interests by finding and encouraging corporate cultures that routinely succeed in bringing errors to the attention of management and even the public, according to Joel Levey, founder of InnerWork Technologies, an independent consultancy in Seattle. But sifting out the posers can be daunting, he adds. "Everything that the public sees and investors see without penetrating too deeply has been so sanitized and polished in today's world that it's really hard to glean a well-informed understanding of how ethical principles are actually operating within an organization."

Even so, say Mr. Levey and others, telling signs are there for those who can read them.

In one approach, investors can explore whether corporate structures exist to bring mistakes to light. In this, Tyco International has become a model in the aftermath of scandals that led to the ouster of top executives, according to Marjorie Kelly, editor of Business Ethics magazine. By awarding bonuses for displays of "ethical courage" and training employees in how to question directives from bosses, for instance, the company fosters a climate of forthrightness that Ms. Kelly says is too often lacking in corporate America.

"Ethics is often talked about as though it's a question of, 'Here's an ethical dilemma. How do you decide what to do?' It's taught as a kind of a rational exercise," Kelly says. "There is a piece of that, but the real meat of ethics is, you've got to push back when you feel pressure, and those pressures are probably coming from your boss. So you have to display courage, which is a completely different quality of character than good rational analysis." Investors, therefore, need to discern whether such courage from underlings is encouraged or discouraged.

To that end, investors might probe news reports to identify corporate cultures that are prone to coverups. But it's a tricky business.

Take Boeing. The aircraft company has been stung by ethics problems in recent years, including a January report that it overcharged the United States Air Force by more than $10 million and a federal probe involving documents it illegally obtained from a competitor. For Eric Fernald of KLD Research & Analytics, which analyzes corporations according to social benchmarks, these point to a systemic problem.

"Is there a culture of allowing employees to point [misdeeds] out?" Mr. Fernald asks. "You know there's not because the government has to be pretty aggressive in uncovering that stuff. You see that [hiding of misdeeds] in the companies that have these contract controversies."

Boeing strongly disputes that notion. "We really don't believe we have a culture that punishes bringing things to light," says spokeswoman Anne Eisele. "All of our high-profile ethics cases [of recent years] have been self-reported, self-discovered, [and] turned over to the government."

The federal investigation, for example, occurred at Boeing's initiative, she says.

Investors can push companies to raise standards, experts say. They might urge boards of directors, for instance, to adopt written codes that spell out expectations of employees, differentiate between forgivable and unforgivable missteps, and codify procedures that can be expected when a breach is reported, Mr. Tinkler says.

Fralicx adds that investors could also agitate - perhaps through letters or at shareholder meetings - for structural changes in the organization in order to encourage more disclosure.

"Major violations of [ethical] compliance can make a company go bankrupt," Fralicx says. "I think investors, to the extent that they could get together on the issue, could demand a compliance office.... The board of directors could certainly do that as well. That's a programmatic approach to influencing the organization around how to prevent ethical violations, or at least get them reported."

In terms of reporting, Fralicx doubts that any incentives will lead people to own up to their own errors. Still, investors can track what's being done to elicit reports of someone else's wrongdoing.

Some companies, including Mellon Financial Corp., are working with third parties that take calls about questionable company behavior while guaranteeing a reporter's anonymity. Thanks in part to a new law requiring public companies to establish reporting procedures, one such third party, EthicsPoint in Portland, Ore., has seen its client list grow by 30 to 45 per month. On average, slightly more than 1 percent of a participating company's employees will call with questions or violations to report, says David Childers, EthicsPoint's chief executive.

Multiple systems might not do much good, however, unless managers and employees see that those who bring mistakes to light don't pay a hefty personal price for their forthrightness, Mr. Childers says.