When it’s easy to cheat and steal in a system, the psychological forces of incentive caused bias and social proof tendency feed each other and result in a very dangerous phenomenon where the system becomes hostile towards the honest participants.
In 2004, a US-trained young research executive joined an Indian generic drug company. In the first few months of his employment, Dinesh Thakur was not only appalled but utterly shocked to learn about the widespread unethical practices in the company. Upon further investigation, he was flabbergasted to discover the extent to which the firm, Ranbaxy Laboratories, had provided false data to the World Health Organization (WHO).
Ranbaxy had been seeking prequalification — which enables pharmaceutical companies to sell their products to WHO member countries — for drugs used by HIV patients in South Africa. The U.S. was the largest buyer of these drugs…[Thakur] discovered a company culture that not only tolerated fraud, but also apparently celebrated and encouraged it among its employees. He found that the company was playing fast and loose with its testing of drugs. The company had taken shortcuts, never tested their products before they released them to the market and fabricated data in its clinics to prove they would work in patients. (Source:Fighting a culture of fraud)
Ranbaxy board ignored Thakur’s findings and was asked to leave the company. However, the story doesn’t end there. Thakur decided to do something about this problem. He reported it to U.S. FDA (Food & Drug Administration). It took eight long years for FDA to investigate the fraud. In 2013, Ranbaxy pleaded guilty to the charges and was fined $500 million. Thakur collected $48 million for his whistle-blower role.
Unfortunately, not every whistle-blower story has a happy ending like Mr. Thakur’s. In fact, most don’t. Dinesh Thakur was an outlier when it comes to being successful at blowing up the lid on corruption at higher levels.
Satyendra Dubey was a project director at the National Highways Authority of India (NHAI). He reported the financial irregularities in the Golden Quadrilateral project to Prime Minister’s Office. Soon after that, Satyendra was shot dead. Shanmugam Manjunath was another such whistle-blower who was murdered for fighting the corruption in Indian Oil Corporation petrol stations.
On the surface, these stories showcase the sad state of affairs. Be it the government or large corporates; the pattern is pretty much the same. An honest guy risks his life and decides to stand against corruption. A lone ranger, trying to do the right thing and the crowd turning against him.
Whenever there’s a pattern of human behaviour, there’s a psychological bias behind it.
In this case, we could call it the Whistle-blower effect. But that’s a boring name, isn’t it? Charlie Munger has his own nomenclature for behavioural biases. And the words that he coins are hard to forget. So, it’s not a surprise that Munger has a name for the behaviour pattern that we’re discussing today.
He likes to call it The Serpico Effect. It’s named after a popular movie, Serpico.
Serpico was a popular film directed by Sidney Lumet, based on the book by journalist Peter Maas of a “true story.” The plot concerns undercover police officer Frank Serpico who does his best arresting criminals of all ages, but especially drug dealers, despite working in a corrupt police department. Serpico refuses to accept bribes and becomes sufficiently appalled at his shady colleagues that he testifies against them, thus placing his life in jeopardy.” (Source:Poor Charlie’s Almanack)
In his 1996 lecture at Stanford Law School, Charlie Munger explained Serpico Effect –
If enough people are profiting in a general social climate of doing wrong, then they’ll turn on you and become dangerous enemies if you try and blow the whistle.
In Munger’s famous speech, The Psychology of Human Misjudgement, while discussing social proof bias, Munger once again spoke about Serpico effect. He said –
Not everyone resists the social contagion of bad behavior. And, therefore, we often get “Serpico Syndrome,” named to commemorate the state of a near-totally corrupt New York police division joined by Frank Serpico. He was then nearly murdered by gunfire because of his resistance to going along with the corruption in the division. Such corruption was being driven by social proof plus incentives, the combination that creates Serpico Syndrome. The Serpico story should be taught more than it now is because the didactic power of its horror is aimed at a very important evil, driven substantially by a very important force: social proof.
Serpico effect is the outcome of three other fundamental human biases – commitment bias, social proof and incentive caused bias. It explains how and why corruption, unethical practices, and bad behaviour becomes rampant in any system.
We had covered incentive caused bias in the November 2017 issue of Value Investing Almanack. You may want to revisit that discussion to refresh your memory.
In any system, where it’s easy to cheat, i.e., the chances of getting caught are very low and where the punishment for cheating isn’t big, it creates an indirect incentive for people to cheat. And once someone commits an act, good or bad, because of commitment and consistency bias, he becomes prone to repeating his behaviour. Following this, the social proof starts taking over, where others find it justifiable to indulge in bad behaviour because some people are already doing it.
This creates, what Munger calls a Lollapalooza effect. When two or more psychological forces act in the same direction, they create a cascading effect and the outcome is far more than the sum of its parts.
Serpico effect is the Lollapalooza of commitment bias, social proof, and incentive bias.
In case of Ranbaxy, the fraud didn’t happen overnight. Nor did the promoters consciously decide to indulge in unethical practices. It must have started as a small obscure questionable action. Then it becomes a slippery slope from there. Slowly it engulfs the whole organization and becomes the part of the culture.
The problem is that the atmosphere does not yet exist in which an honest police officer can act without fear of ridicule or reprisal from fellow officers. We create an atmosphere in which the honest officer fears the dishonest officer, and not the other way around. ~ Frank Serpico
So, what’s the lesson for an investor here?
Bad behaviour and lack of integrity aren’t just individual traits. They can characterize an organization’s culture too. So, it would be foolish to assume that a single person, like Serpico, can bring a cultural shift in the entire organization. Any attempt to do that will result in a severe backlash. So, it’s always a good idea to avoid companies and businesses where the lack of integrity is part of the culture. Never bet on a single person to turnaround an organization.
Heed Buffett’s words. He said, “Turnarounds seldom turn.”
I guess Frank Serpico would agree.[/show_to] [hide_from accesslevel=’almanack’]
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