BP’s Failure to Debias (Page 6 of 6)

In respect to information collection, Heath et al. discuss methods for dealing with availability bias and rare events. They state, “A particularly important form of missing information is the absence of experience with highly unusual events. Bank examiners rarely see a bank fail, nuclear technicians rarely see a meltdown, airline personnel rarely witness a crash.” The analogy of these examples to the explosion of Deepwater Horizon is evident. Heath et al. describe the following cognitive repair. They state, “For example, at the Federal Reserve Bank, which certifies the security of banks, senior bank examiners deliberately recount stories of failed banks to keep junior examiners aware that they should be vigilant. At one bank’s commercial lending department, senior credit officers would hold seminars and informal brown-bag lunches to discuss past lending mistakes, particularly in areas characterized by unusual or rare events (e.g., “problems with highly leveraged companies, real estate, environmental liability on contaminated property”) (p. 14).

As for drawing conclusions, a major challenge for a firm with BP’s culture is to mitigate confirmation bias. Heath et al. suggest that doing so typically requires a formalized structure for devil’s advocacy. In contrast, BP’s culture tends to feature great resistance to the presentation of opposing views. Heath et al. provide an interesting example, “Disney regularly holds “Gong Shows” where personnel (including department secretaries) can pitch ideas to a group of senior executives… The senior executives are careful to give exceptionally frank feedback at the end of the session, highlighting both good and bad aspects of the presentations” (p. 19).

A general repair that firms can use in respect to sharing information involves the choice of sayings and slogans. Hayward’s slogan “Every dollar counts” conveys a powerful message. However, it needs to be counterbalanced by some other slogan that relates to safety, defined sufficiently broadly. Heath et al. discuss another useful saying “There are no bad people, only bad systems,” which is motivated by the military’s saying “There are no bad troops, only bad officers.” The former saying is intended to help mitigate fundamental attribution error, the tendency to attribute outcomes primarily to people instead of to situations. Heath et al. remind us of the claim in Deming (1982) that situations, rather than people, are primary in 94 percent of cases.

Firms with healthy corporate cultures build cognitive repairs into their processes, and integrate those processes. They establish standards consistent with value creation. They engage in planning to establish detailed strategies for achieving those standards. They put incentives in place to reward the entire workforce for achieving standards. And in the course of conducting operations, they share critical information about how actual performance compares to standards and plans, with the purpose of adapting to conditions as necessary.

Shefrin (2008) describes several firms which he suggests have developed healthy corporate cultures in that they have institutionalized cognitive repairs into the processes in order to mitigate psychological pitfalls. Examples include Ford Motor Company, Southwest Airlines, and Whole Foods.28 We suggest that if Dudley is to succeed where Hayward failed, he would do well to investigate the best practices of these firms.

In particular, Dudley could learn important lessons from Ford’s CEO Alan Mulally. When Mulally was appointed in September 2006 for his experience in corporate repair at Boeing, the company was in distress. He very quickly discovered that information sharing at Ford was poor. To turn things around, he established regular weekly meeting with executives. The meetings are meant to share information and to make executives focus on the firm’s standards and business plan. To mitigate aversion to a sure loss (or escalation of commitment), Mulally used praise to induce executives to share negative information with each other. He also instituted techniques to help his managers avoid groupthink.

Mulally’s approach began to yield positive effects in mid-2007. The company eventually returned to profitability in the second half of 2009 after four years of losses. In 2010 the company earned more than it had in any full year since 1999, when it reported income of US$7.24 billion. Ford reported a 70 percent increase in third-quarter earnings, driven by higher sales of vehicles in its core North American market. At that stage, BusinessWeek reported that Ford had become the most profitable automobile manufacturer in the world. Ford indicated that it reduced its debt and was planning for future investments, although it subsequently had a poor fourth quarter.

Among the big three US auto makers, Ford is the only one that did not declare bankruptcy during the global financial crisis, and on July 23, 2010, it reported the best quarterly results in the previous six years. Interestingly, Ford adapted to the 18-month recession in the period December 2007–June 2009 by cutting production. In contrast, GM did not, instead choosing to maintain production rates. We hypothesize that because of poor processes and culture, confirmation bias and aversion to a sure loss both contributed to GM’s value destructive decision. On the other hand, Ford had instituted sound processes, and managed to mitigate these pitfalls.

When Tony Hayward became CEO, BP would have done well to have done something similar to Alan Mulally’s debiasing efforts; but it did not. Analysts, investors, and regulators would have done well to monitor BP’s efforts at debiasing using a pitfalls-process framework; but they did not. We suggest that Bob Dudley needs to initiate sensible debiasing procedures at BP; we hope he does so. We suggest that analysts, investors, and regulators need to monitor BP’s efforts at debiasing in a systematic fashion; we hope they do so.

7. CONCLUSION: LESSONS FOR ACADEMICS AND EVERYONE ELSE

The explosion of Deepwater Horizon is an event offering many lessons. The first lesson is that psychologically induced mistakes can be very expensive. The current estimate attached to BP’s liability for the explosion of Deepwater Horizon is US$40 billion. Indeed, as we complete this article, the US government has joined 80 other litigants in suing BP for damages.

The second lesson is that BP is not an isolated case. Shefrin (2010c) argues that psychological pitfalls at financial firms were also the root cause of the global financial crisis that erupted in 2008. Indeed, a side-by-side comparison of this paper with Shefrin (2010c) reveals that the same psychological issues plaguing these financial firms also plagued BP. In this regard, see also Walter (2010).


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The third lesson is that BP’s corporate culture supported, if not encouraged its high risk profile. In this regard, the National Commission appointed by the US government to investigate the explosion of Deepwater Horizon concludes that the main issue was a “failure of management” especially at BP with inadequate policies for managing risk and sharing information. As a result, decisions intended to save time and increase efficiency created a higher risk exposure.

The fourth lesson, which follows immediately from the third, is that the weaknesses in BP’s risk management culture were already apparent in 2007, after the accidents which occurred at BP’s facilities in Texas and Alaska. Moreover, events after 2008 only served to reinforce this assessment. Yet, analysts, investors, and regulators all missed the signals, and underestimated operational risk at BP.

The fifth lesson is that there is a strong need for a better conceptual framework to judge the quality of corporate culture and risk management before disaster strikes. In this regard, the National Commission states “In the view of the Commission, these findings highlight the importance of organizational culture and a consistent commitment to safety by industry, from the highest management levels on down… The Deepwater Horizon disaster exhibits the costs of a culture of complacency.” (p. ix) To these points, we contend that a useful way of characterizing a firm’s culture is in terms of a process-pitfall framework. Corporate financial judgments pertaining to decisions about capital budgeting, capital structure, valuation, agency contracts, and mergers and acquisition fit naturally into this framework.

The process-pitfall framework provides a convenient way both to diagnose biases in a firm’s culture, and to use cognitive repairs to address those biases. At the same time, debiasing is difficult. Nevertheless, what BP must do to heal its problematic corporate culture is an important issue for the future. This statement applies well beyond BP to other firms with problematic corporate cultures, to the analysts covering those firms, and to regulators and supervisory authorities overseeing these firms.

The sixth and final lesson is that academics need to ramp up the emphasis they attach to the behavioral dimension of corporate finance, both in the classroom and in their research. Admittedly, behavioral corporate finance is still relatively novel, even within academia, although behavioral concepts are slowly making their way into traditional textbooks and into research agendas. However, the rate of diffusion is slow. We suggest that ignorance about behavioral corporate finance allowed publicly available information about BP’s high risk operations to go unnoticed by analysts, investors, and regulators.

We already teach elements of the four processes in traditional corporate finance courses. When we teach our students the principles of valuation and financial ratios, we are teaching them about standards. When we teach them pro forma forecasting techniques, we are teaching them about planning. When we teach them about agency theory, we are teaching them about incentives. And when we teach them about financial reporting and the preparation of incremental cash flow forecasts in respect to capital budgeting, we are teaching them about sharing information.

What traditional corporate finance courses tend to ignore is how to integrate the four processes together in a way that recognizes and mitigates managers’ vulnerability to psychological pitfalls. One conclusion we draw from BP’s recent history, and for that matter the choices made by financial firms, is that there should be a sense of urgency about integrating behavioral concepts into traditional courses in corporate finance. Otherwise, we remain as vulnerable as ever to future environmental disasters, financial crises, and severe economic downturns.

REFERENCES

1 | 2 | 3 | 4 | 5 | 6


–Hersh Shefrin and Enrico Maria Cervellati. Shefrin is the Mario L. Belotti Professor of Finance at the Leavey School of Business at Santa Clara University. Cervellati is an assistant professor of corporate finance at the University of Bologna, Italy.

Electronic version of an article accepted for publication in the Quarterly Journal of Finance, Volume 1, Issue 1, 2011, Article DOI: 10.1142/S2010139211000043. © World Scientific Publishing Company.


28. An effective leader can change its company’s culture and its performance with it. SRC, a privately held firm, provides an illuminating example of how a leader can institutionalize well structured processes. Its CEO, Jack Stack, is recognized for having pioneered open book management.

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