ROT229

Putting Integrity
Into Finance
Integrity is a factor of production that is as important to success
in all aspects of life as knowledge, technology and human capital.
by Werner Erhard and Michael Jensen

we have witnessed an endless stream of value- paper, “Prospect Theory: An Analysis of Decision Under Risk,”
destroying behaviour by individuals and organizations in the counter-to-self-interest behaviour was, in a sense, invisible
when viewed through the lens of the prevailing rational/self-
interest paradigm. Along with Kahneman and Tversky, scholars
- such as Thaler, Sunstein and others have since contributed to a
mation. paradigm-altering understanding of human behaviour.
In this article we will propose an addition to the generally However, one key aspect of counter-to-self-interest behav-
iour has gone virtually unnoticed in the behavioural literature to

of regulatory agencies and legal authorities have so far failed to such behaviour: out–of-integrity behaviour. Let us begin with the
stem the tide of value-destroying behaviour. We will argue that Webster’s:
the core issue at hand is the lack of recognition that integrity (as
- 1. The quality or state of being complete; unbroken condition;
cess in all aspects of life as knowledge, technology and human wholeness; entirety.
and physical capital. 2. The quality or state of being unimpaired; [in] perfect condition;
soundness.
Defining Integrity 3. The quality or state of being of sound moral principle; upright-
It took Economics over 100 years to wake up to the fact that the ness, honesty and sincerity.

to-self-interest behaviour was right in front of our eyes the en- -

tire time. Until Daniel Kahneman and Amos Tversky’s (1979) rity to economic value in the following way:

19

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 Honouring your word entails being honest and straightforward:
nothing is hidden, there is no deception, no untruth.
• THE RELATION BETWEEN INTEGRITY AND WORKABILITY: Integrity (the
state of being whole, complete, unbroken, unimpaired, sound, in
perfect condition) is the necessary and sufficient condition for
maximum workability.
• THE RELATION BETWEEN WORKABILITY AND PERFORMANCE: Workabil-
ity is a necessary but not sufficient condition for Performance
(however one wishes to define Performance.)
• THE RELATION BETWEEN INTEGRITY AND PERFORMANCE: Integrity (the
state of being whole, complete, unbroken, etc.) is thus a neces-
sary but not sufficient condition for Performance.
These relationships lead to what we call The Law of Integrity:
As the integrity of an object, system, person or other human
entity declines, workability declines, and as workability de-
clines, the opportunity for performance declines. Integrity is
therefore a necessary but not sufficient condition for long-
term value maximization.
As indicated, integrity is a necessary but not sufficient condition
for long-term value maximization. For example, if you have in-
tegrity and thus a large opportunity for performance, but you are
committed to only a small game in life (e.g. ‘I will get up in the
morning’), you are not likely to create anything of value, in spite
of having complete integrity. For an organization to create maxi-
mum value, it must also create and execute brilliant competitive,
organizational, technological and human strategies in addition
to having integrity.
Integrity for Individuals, Organizations and Systems
Integrity for a person or other human entity (i.e. family, orga-
nization) is a matter of that person’s or entity’s word — nothing
more and nothing less. When a person’s or human entity’s word
is less than whole, complete, unbroken, sound, in perfect condi-
tion, that person or entity is less than whole, complete, unbroken,
sound and in perfect condition. This results in workability declin-
ing for the person or entity, and therefore diminishes the oppor-
tunity for performance.
A person’s or other human entity’s word includes six elements:
• WORD-1: What you said you would do or not do.
20 / Rotman Management Spring 2014
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• WORD-2: What you know to do or not to do.
• WORD-3: What is expected of you by those with whom you de-
sire a workable relationship (i.e. their expectations that are un-
expressed requests of you), unless you have specifically declined
those expectations.
• WORD-4: What you say is so (i.e. you are willing to be held ac-
countable by others that your evidence for what you say is so, and
would satisfy those others.)
• WORD-5: What you stand for.
• WORD-6: The moral, ethical and legal standards of the group, or-
ganization, community or state of which you are a member.
Keeping your word means that you fulfill your commitments and
promises (and all other aspects of ‘your word’ as defined above) in
full and on time. However, if you always keep your commitments
and promises, you are undoubtedly not playing a big enough
game in life. In cases where you cannot keep your word, you
must honour it to be in integrity. Honouring your word means that
you either:
• Keep your word, and on time, or
• When you have failed (or expect to fail) to keep your word, you
honour your word by:
- Acknowledging that failure as soon as you realize it, and
saying by when you will now keep that word, or that you
never will keep that word; and
- Cleaning up any ‘mess’ you created for those who were
counting on you to keep your word.
Honouring your word entails being honest and straightfor-
ward: nothing is hidden, there is no deception, no untruths,
no violation of contracts, etc. Your word also includes conform-
ing to the ‘rules of the game’ you are in (i.e. the ethical stan-
dards of your profession, the moral standards of your society.)
If you refuse to play by any of these rules, integrity requires you
to make this clear to all others and willingly bear the costs of
doing so.
As indicated, all of the above applies not just to individuals,
but also to human entities such as organizations, and to systems
and objects.
INTEGRITY FOR ORGANIZATIONS: An organization or other human
entity is ‘in integrity’ when its word is whole and complete. This
means it honours its word to its employees, customers, suppliers
 and other stakeholders. Nothing is hidden, there is no deception,
no untruths, no violation of contracts, etc. If the organization re-
fuses to play by any of the rules of the game it is in, it must make
this clear to all others and willingly bear the costs.
INTEGRITY FOR SYSTEMS AND OBJECTS: Likewise, a system or object
is in integrity when it is whole and complete. An object without
integrity simply doesn’t work. Think of a bicycle wheel with
missing spokes: it is not whole and complete, and is therefore
not stable. For a system or object to be in integrity, it must satisfy
the following conditions:
1. The design of the system or object must be in integrity. Spe-
cifically, the design, when executed, must be capable of
producing the intended result or performance.
2. The implementation of the design must also be in integrity.
Specifically, the implementation must realize the object or
system as designed.
3. The use of the implemented object or system must be in
integrity. Specifically, the use of the object or system must
be allowed by its design and be consistent with its designed
purpose: a 200-pound man using a life vest designed for a
50-pound child will drown, unless he can swim.
Integrity in the Financial System
The long history of Finance implicitly defines the fiduciary duty
of managers to be to current shareholders only, ignoring fu-
ture shareholders and other claimants on the firm. As a result,
many commonly recommended practices are out of integrity
and leave the organization being out of integrity. Let us delve a
bit deeper into some common out-of-integrity behaviour in the
realm of Finance.
FINANCIAL REPORTING. Managers regularly choose to treat the
firm’s relations with the capital markets as a ‘game’, where finan-
cial reporting is not driven by creating long-term value but is little
more than a strategy for managing and meeting analyst expecta-
tions. Managing earnings, income smoothing, and manipulating
financial analysts does not leave the word of executives or the
word of the firm whole and complete.
Until recently it was generally considered part of every top
manager’s job to manage earnings — that is, to report earnings
other than as they actually are (and while somewhat less so now,
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this still tends to be true.) When managers give their word to
something other than what is actually so, this leaves them less
than whole and complete, and diminishes the opportunity for
maximizing value.
INVESTMENT BANKS DEFRAUDING CLIENTS. Banks and investment
banks have been known to provide clients with misleading in-
vestment recommendations that are not whole and complete
with regard to their word. Goldman Sachs, for example, was
accused of intentionally misleading its clients with the Abacus
mortgage-backed securities, which were intentionally structured
to fail (and for which Goldman paid a $550 million settlement, at
the time the largest ever in the history of the SEC.)
Consistent with the dramatic decline in organizational in-
tegrity at Goldman Sachs in recent years, former executive di-
rector and head of U.S. equity derivatives business in Europe,
the Middle East and Africa, Greg Smith resigned on March 14,
2012 with a New York Times Op Ed article entitled “Why I am
Leaving Goldman Sachs”. Quoting Smith:
After almost 12 years [at Goldman Sachs]… I can honestly
say that the environment now is as toxic and destructive as
I have ever seen it…Culture was always a vital part of Gold-
man Sachs’s success. It revolved around teamwork, integ-
rity, a spirit of humility, and always doing right by our cli-
ents. The culture was the secret sauce that made this place
great and allowed us to earn our clients’ trust for 143 years…
Today, if you make enough money for the firm you will be
promoted into a position of influence.
What are two quick ways to become a leader [at Goldman]?
a) Execute on the firm’s ‘axes’, which is Goldman-speak for
persuading your clients to invest in the stocks or other prod-
ucts that we are trying to get rid of because they are not seen
as having a lot of potential profit.
b) ‘Hunt Elephants’. In English: get your clients — some
of whom are sophisticated, and some of whom aren’t — to
trade whatever will bring the biggest profit to the firm.
I attend derivatives sales meetings where not one single
minute is spent asking questions about how we can help cli-
ents. It’s purely about how we can make the most possible
money off of them. I don’t know of any illegal behaviour,
but will people push the envelope and pitch lucrative and
Rotman Management Spring 2014 / 21
 No organization for which there are issues that are
undiscussable can be whole and complete.
complicated products to clients even if they are not directly
aligned with the client’s goals? Absolutely. Every day, in fact.
What is clearly hidden from Goldman Sachs’ management is that
such out-of-integrity behaviour is counter to its own interests. Of
course, such behaviour is not limited to Goldman Sachs: in their
study of “The Dark Role of Investment Banks in the Market for
Corporate Control,” Bodnaruk et al found this behaviour to be
far-reaching.
MONEY MANAGERS DEFRAUDING CLIENTS. Money managers have al-
lowed certain ‘favoured investors’ to engage in market-timing
operations (for example, after-hours trading at ‘stale’ prices)
that allow them to sell or purchase shares at prices above or
below their actual value. Such practices allow investors to trans-
fer wealth from non-favoured fund investors to themselves. Well-
known organizations that were accused of allowing such behav-
iour (and fired employees as a result of the investigations and/
or paid penalties to settle the charges) include Putnam Invest-
ments, Strong Capital Management, Morgan Stanley, Janus
Capital Group, Bear Stearns, Bank of America and Invesco.
In some cases the managers of the funds (for example, Strong
Capital Management) engaged in such trading themselves in
personal violation of their fiduciary duties to investors.
CORPORATE GOVERNANCE ISSUES. Given that boards of directors are
ultimately accountable for organizational performance, and giv-
en that out-of-integrity behaviour diminishes an organization’s
opportunity for performance, this necessarily leaves boards of
directors accountable for the integrity of the organization.
What gets said—and remains unsaid—in the boardroom is
an example of the organization as a human entity, and as indi-
cated, integrity for a human entity is a matter of that entity’s
word, nothing more and nothing less. Therefore, when what is
said is less than whole, complete, unbroken, etc., such out-of
integrity behaviour diminishes the workability and hence the
value of the board.
A prime example of such behaviour in boards of directors
(and for that matter, executive teams) is the existence of ‘undis-
cussables’— things that the firm may be getting by with, but that
are highly questionable. If anything is undiscussable, the board is
less than whole, complete, unimpaired, etc., and as a result, work-
ability and value are sacrificed. No organization for which there
are issues that are undiscussable can be whole and complete.
22 / Rotman Management Spring 2014
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RELATIONSHIPS WITH CAPITAL MARKETS. A major contributor to the
lack of integrity in relations between firms and capital mar-
kets is that markets reward and punish managers in ways very
similar to those budget-based compensation systems that ‘pay
people to lie’.
Many readers have undoubtedly heard leaders explicitly
announce, “Under promise and over deliver” as a management
philosophy. Such a philosophy actually means, in many situa-
tions, “Lie”: I lie to you about what I can deliver, and I lie about
what is actually delivered. By now it is obvious what happens to
integrity when such behaviour becomes generally accepted.
Interestingly, the relation between a firm’s top management
team and the capital markets has resulted in an equilibrium that
replicates many counterproductive aspects of corporate internal
budget or target-based bonus systems. Thus, the capital markets
provide further short-run incentives for managers to take out-
of-integrity actions to meet market expectations.
Consider a manager’s incentives in the following scenarios.
A. ‘JAKE’ IS STRUGGLING TO REACH THE MINIMUM HURDLE. As long as
he believes he can make the ‘threshold’ (commonly 80 per-
cent of the target or budgeted performance level), he will
engage in actions to increase his performance, and this can
be done by legitimate or illegitimate means. When the mea-
sure is profits, or some variation thereof, he has incentives
to increase this year’s profits by moving expenses from this
year to the future (by delaying expenses, for example) or by
moving revenues from future years into this year by book-
ing orders early, giving special discounts this year, and so
on. When these actions simply move profits from one year
to another, the adverse impact on firm value is probably
small; but it can pay managers today to engage in actions
that reduce the total value of firm cash flows by moving
profits to the current period, even when future profits are
dramatically reduced.
B. JAKE CONCLUDES THAT HE CANNOT MAKE THE MINIMUM THRESH-
OLD HURDLE. When a manager concludes that he cannot
make the minimum hurdle, his incentives shift dramati-
cally, to the opposite of what we just described: Jake now
has incentives to move profits (if that is the performance
measure) from the present to the future. He can do this
by moving expenses from the future to the present period

(by pre-paying expenses, taking write-offs for restructur-
ing, etc.), and by moving revenues from the present to the
future. This is the ‘big bath theory’, and the phenomenon
is regularly observed when firms faced with missing ana-
lyst expectations take a ‘big bath’ to improve their ability to
meet expectations.
C. JAKE IS WITHIN REACH OF THE BONUS CAP, BUT HAS INCENTIVES
TO NOT EXCEED IT BECAUSE HE GETS NO REWARDS BEYOND THAT
POINT. In this situation, people have incentives to move ex-
penses from the future to the present and revenues from the
present to the future to avoid exceeding the bonus cap this
year, and increase bonuses in future years. And again, they
have incentives to do this even if it imposes real costs on
their company.
All of the out-of-integrity behaviour just described is mo-
tivated by the fact that the bonus plan itself is out-of-integrity
in its design as a system. Asking human beings who are oper-
ating in a badly-designed system to change their behaviour will
always fail, unless and until the system itself is redesigned to put
it into integrity.
Popular recommendations to solve these incentive prob-
lems tend to focus on eliminating bonuses — motivated by the
perception that the way bonus plans work leaves top people paid
too much rather than that the bonus plan rewards people in the
wrong way and for the wrong things. The time has come to re-
think these poorly-designed systems.
In closing
The model of integrity we have described makes clear just how
widespread out-of-integrity behaviour is, and the enormity of its
costs. Going forward, integrity must be understood such that:
1) Out-of-integrity behaviour actually shows up as being out-of-
integrity;
2) The damaging consequences of that behaviour, both immed-
ate and long term, show up in the present time, right along with
the behaviour; and
3) Those consequences show up as being caused by the out-of
integrity behaviour.
The recognition of the foregoing is only a beginning for people
and organizations to have access to acting with integrity. To be
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LIVING WITH INTEGRITY
Imagine what your life would be like if it were true that:
• You have done what you know to do, you did it the way it was
meant to be done, and you did it on time.
• You have done what those with whom you desire a workable
relationship expect you to do (even if they never asked you to
do it and you never said you would do it), and you did it on time.
• Conversely, you have informed others of your expectations of
them and have made explicit requests to those others.
• Whenever you have asserted something, you are willing to be
held accountable that your evidence for what you are asserting
would satisfy your listeners that your assertion is valid.
• And, whenever you realized that you were not going to do any of
the foregoing:
– You have said so to everyone who might be impacted, and you
did so as soon as you realized that you wouldn’t be doing it, and
– You have competently dealt with the consequences of your not
doing it on time, or not doing it at all, for all those who are im-
pacted by your not doing it.
Beyond the positive effects on your own life, can you imagine what
the world would be like if everyone around us operated in this way?
a man or woman of integrity (or an organization of integrity)
requires constant vigilance and consistent examination. In this
sense, integrity is like a mountain with no top: one never ‘gets
there’, and to be a person of integrity, one must learn to love
climbing. The good news is, as the climb continues, your life will
continue to improve.
Werner Erhard has been creating transforma-
tional models and applications for individuals
and organizations for over 40 years and has
been a guest lecturer at Harvard, Yale and MIT,
amongst others. Michael Jensen is the Jesse
Isidor Straus Professor of Business Administration, Emeritus, at Harvard Busi-
ness School and founder of the Social Sciences Research Network (ssrn.com).
The complete paper on which this article is based can be downloaded at
http://ssrn.com/abstract=1985594
Rotman Management Spring 2014 / 23