Conflict of Interest Blog

Liability for faking compliance – a new-fashioned type of deterrence?

I have long felt that C&E programs should do more to appeal to the better angels of our nature. (For more information on how “pro-social” qualities can be built on to promote more ethical workplaces, see this research page from the Ethical Systems web site.) But at the end of the day there will always be a place for good old-fashioned deterrence.

Deterrence, in the business realm, traditionally operates by punishing those who engage in conduct that harms others (e.g., corruption, collusion, pollution). But as C&E program expectations themselves become more central to promoting responsible behavior by companies,  it is inevitable that a more “upstream” form of deterrence should emerge – in which faking compliance is itself the punishable (or otherwise addressable) wrong.  Indeed, this could be considered “new-fashioned” type of deterrence.

The COI Blog has previously discussed two cases of this sort – one involving Goldman Sachs , the other S&P  – both having to do with allegedly false claims by the defendant firms that they had taken strong compliance measures against conflicts of interest.  And at the end of last month, another case was brought in which faking compliance was itself found to be a punishable wrong.

The case – In the Matter of Mark Sherman — can be found here, but readers may find more useful a post about it on the Harvard corporate governance blog by attorneys from the Ropes & Gray law firm.  As they note:

“On July 30, 2014, the Securities and Exchange Commission (“SEC”) advanced a novel theory of fraud against the former CEO (Marc Sherman) and CFO (Edward Cummings) of Quality Services Group, Inc. …, a Florida-based computer equipment company that filed for bankruptcy in 2009. The SEC alleged that the CEO misrepresented the extent of his involvement in evaluating internal controls and that the CEO and CFO knew of significant internal controls issues with the company’s inventory practices that they failed to disclose to investors and internal auditors. This case did not involve any restatement of financial statements or allegations of accounting fraud, merely disclosure issues around internal controls and involvement in a review of the same by senior management. The SEC’s approach has the potential to broaden practical exposure to liability for corporate officers who sign financial statements and certifications required under Section 302 of the Sarbanes-Oxley Act (‘SOX’). By advancing a theory of fraud premised on internal controls issues without establishing an actionable accounting misstatement, the SEC is continuing to demonstrate that it will extend the range of conduct for which it has historically pursued fraud claims against corporate officers.” (Emphasis added.)

Of course, there is much more that could be said about the various connections that the legal systems draws between violations of law and poor compliance than what’s in this and the other two cases mentioned above.  (See, for instance, this prior post about the SAC insider trading case brought last year - where the weakness of the company’s compliance program was used as a basis for finding corporate liability for insider trading by individual employees.) And, the notion of punishing fake (or otherwise weak) compliance efforts has long been part of enforcement strategies in highly regulated areas (e.g., broker-dealer compliance). But the Sherman case seems especially important, as it can be utilized in training corporate officers in public companies of all kinds on the need to be careful in executing their S-Ox certifications which, in turn, should lead them to have a greater appreciation of the value of strong compliance generally.

Finally, the Ropes & Gray post concludes with the following observation: “this case, which includes fraud charges in an accounting case without any restatement of financials, seems to represent an application of SEC’s ‘Broken Windows’ strategy first announced by Robert Khuzami and reiterated by Mary Jo White—to pursue small infractions on the theory that minor violations lead to larger ones—to the public company disclosure and accounting space.”  To this I would add that a “Broken Windows” strategy to preventing wrongdoing is also supported by behavioral ethics research (see this post ), and the Sherman case should also be a reminder for C&E officers to review whether their own companies’ deterrence systems  take this approach into account to a sufficient degree.

 

 

New proof that good ethics is good business

In a simpler economic time, the tangible rewards to oneself from doing good for others were fairly self-evident. A memorable articulation of this (from a chronicler of Eskimo life who is quoted in Robert Wright’s book  Nonzero: the Logic of Human Destiny): “’the best place for [an Eskimo] to store his surplus is in someone’s else’s stomach.’”  But as we have  progressed from hunter-gatherer societies – where it was clear that sharing food today could lead to life-saving reciprocation tomorrow – to the modern world of complex capital markets more is now required to make the economic case for helping others.

That need, as described in a post earlier this year,  arises in part “because of the enduring  influence of a free-market critique of business ethics associated with Milton Friedman’s 1970 article ‘The Social Responsibility of Business is to Increase Profits.’   While I do not agree with his view, I understand its appeal:  it has the virtue of simplicity – and hence being easy to apply; and, particularly with respect to public companies – where managers act as stewards of other people’s money – it can certainly be seen as fairness based.” Indeed, Friedman’s critique has special relevance to the COI Blog, as it suggests that managers acting in a socially responsible way may in fact constitute a conflict of interest vis a vis their shareholders.

However, like many business ethics issues generally and COI issues in particular, resolving this one is less a matter of drawing from philosophy than social science, as Friedman’s view is based largely on an essentially zero-sum notion that a company’s acting ethically tends to disadvantage its shareholders economically.  But, what if that premise were factually questionable? Indeed, as also noted in the above-referenced prior post, a then just-published study – looking at promoting integrity values, a different but related aspect of business ethics than corporate social responsibility (“CSR”) – had helped to show that “’high levels of perceived integrity are positively correlated with good outcomes, in terms of higher productivity, profitability, better industrial relations, and higher level of attractiveness to prospective job applicants,’” thereby undermining at least partly the view that good ethics is bad for business. Still, given how complex, contentious and consequential it is, this issue calls out for more research.

So, it is good news that another study – this one focused on CSR itself – has recently been added to the relevant literature in this area: “Socially Responsible Firms,” which is published by the European Corporate Governance Institute (ECGI) and authored by Allen Ferrell of Harvard University and ECGI, Hao Liang  of Tilburg University and Luc Renneboog of Tilburg University and ECGI .  It is available on SSRN  and a summary of it can be found on the Harvard Law School Forum on Corporate Governance and Financial Regulation.

As noted in that summary, the authors’ focus was on the area of agency and particularly the Friedman-inspired critique that “socially responsible firms tend to suffer from agency problems which enable managers to engage in CSR that benefits themselves at the expense of shareholders.  Furthermore [the critique posits] managers engaged in time-consuming CSR activities may lose focus on their core managerial responsibilities… Overall, according to the agency view, CSR is generally not in the interests of shareholders.” Using “a rich and partly proprietary CSR dataset with global coverage across a large number of countries and covering thousands of the largest global companies, [the study’s authors] test [both this agency view and its opposite – which argues that CSR in fact is value enhancing for companies] by examining whether traditional corporate finance proxies for firm agency problems, such as capital spending cash flows, dividend payouts and leverage, are associated with increased CSR. [They also test] the relationship between CSR and managerial pay-for-performance.”

As noted in the Harvard blog summary, the findings from this research help support the notion that good ethics – in this particular instance, CSR – is good business: “We do not find empirical evidence that CSR is associated with ex ante agency concerns, such as abundance of cash and a weak connection between managerial pay and corporate performance. Rather, higher CSR performance is closely related to tighter cash—usually a proxy for better-disciplined managerial practice in the traditional corporate finance literature … and higher pay-for-performance sensitivity. In addition, firms in countries with better legal protection on shareholder rights receive higher CSR ratings…. Finally, we find that CSR can counterbalance the negative effects of managerial entrenchment, and lead to higher shareholder value…”

So, definitely more complicated than the adage about filling Eskimo tummies, but the bottom line is that these and other results of their research “suggest that good governance is associated with higher CSR, and that a firm’s CSR practice is consistent with shareholder wealth maximization.” While no one study could ever definitively make the case for strong CSR or other aspects of good business ethics (just as no one study could never disprove such a case), the work of Ferrell and his colleagues should enhance the comfort that managers and boards of directors feel in moving in this direction.

 

Is compliance anti-capitalistic?

In 1990, the dawning of what in retrospect can now be seen as an “age of compliance,” the senior partner in the law firm where I worked penned a note of dissent in an op-ed piece he published in the Wall Street Journal.  “Be a good corporate citizen,” he wrote, adding that by this he meant that companies should “fight the feds.” Although I saw great promise in the then-new notion of corporate compliance programs, I could also envision, as he did, the dangers in going overboard.

I still can.  Indeed, that is why – whether in my writing or advisory work – I promote a notion of “Goldilocks compliance.”

But a different issue is whether compliance should be seen broadly as anti-capitalistic.  This seems to be the gist of an argument against the Sunshine Act by libertarian commentator John Stossel who recently asked:  “[W]ithout government regulation, what prevents greedy doctors and greedy medical device makers or drug companies from colluding? ” His answer: “Market competition. Other scientists will try to replicate dramatic findings and debunk false claims and sloppy scientists. Companies worry about scandal, lawsuits, the FDA and recalls. They can’t get rich unless their reputation is good.”

I wish it were that easy, but also believe that the market in question is not as efficient as is suggested.   Rather, this seems to be an area of significant market failures – primarily “information deficiency” (but also public costs), meaning that information needed by patients, health care providers and manufacturers of pharmaceutical and medical device products has not always been readily available/understandable for the markets to work their magic. Indeed, the many prosecutions of life science companies for fraud are by definition cases of information deficiency, and the very purpose of the Sunshine Act is, at least in part, to remedy  deficiencies of this sort.  Also relevant here is the notion of moral hazard, and specifically the fact that for various reasons those who create COI risks in life science companies may not be the same individuals who bear the brunt of prosecution, scandal, etc., further diminishing the efficacy of the market in question.

Additionally, I don’t think that it in the interest of libertarians to broadly reject the notion of using a market failure analysis to help frame approaches to law or ethics (although I hasten to add that in his recent piece Mr. Stossel did not say that he was in fact doing this).   In that connection, I believe that part of the reason that public debt has reached the scandalous point that it has has to do with various conflicts of interest and other market failures, as discussed in this earlier post.  More broadly, there is nothing inherently politically left wing (let alone anti-capitalistic) about considering the impact of market failures.   Rather, a market failure analysis treats capitalism – appropriately – as an economic phenomenon, and not a theological imperative.

On the other hand,  care must always be taken that a market failure analysis doesn’t lead to compliance/ethics overkill.  To twist the words of Einstein a bit, market-failure-based interventions (whether legal or ethical) should be undertaken to the extent necessary, but not more so. At least as a general matter, I believe that Mr. Stossel and I would agree on this.

Finally, compliance generally and mitigation of  conflicts of interest in particular are not the only areas where business ethics can bump up against capitalism. For a look at this important and fascinating (at least to me) area through a broader lens I encourage you to read this recent post on “Three stories about capitalism”  by Jonathan Haidt on the Ethical Systems web site.

(For more on:

-  market failures and conflicts of interest generally see this post;

-  the Sunshine Act see this guest post by Bill Sacks and a recent post from another blog about how ”[t]he federal government has made financial disclosure very easy with the Sunshine Act.”

- the many ways that COIs in fact corrupt the behavior of business people, including well meaning professionals, see the various posts collected here

- moral hazard, and its meaning for ethics and compliance,  see posts collected here.)

How to “sell” a C&E program or risk assessment internally

C&E officers generally understand the need for risk and program assessments, but such understanding is less common in the top regions of the corporate org chart.

In our latest dialogue on ECOA Connects,  Steve Priest and I examine four commonly encountered hurdles for getting buy-in for both sorts of assessments – and “sales” strategies for surmounting such hurdles.

We hope you find it useful.

Conflicts of interest and “the social nature of humans”

Private supply chain auditing continues to serve an increasingly important role in compliance and ethics efforts worldwide.  A recent working paper from the Harvard Business School  – “Monitoring the Monitors: How Social Factors Influence Supply Chain Auditors,” by  Jodi Short, Professor of Law at the University of California Hastings College of the Law; Michael Toffel of the Technology and Operations Management Unit at the Harvard Business School; and Andrea Hugill of the Strategy Unit at the Harvard Business School – examines various factors that impact the efficacy of such audits.  The paper can be downloaded from SSRN and a summary of it can be found on the Harvard Corporate Governance web site.

For this study, the authors conducted a review of “data for thousands of code-of-conduct audits conducted in over 60 countries between 2004 and 2009 by one of the world’s largest social auditing companies, …”  They found that “auditors’ decisions are shaped not only by the financial conflicts of interest that have been the focus of research to date, but also by social factors, including auditors’ experience, professional training, and gender; the gender diversity of their teams; and their repeated interactions with those whom they audit.”  The authors state that this  “finer-grained picture suggests that audit designers should moderate potential bias and increase audit reliability by considering the auditors’ characteristics and relationships that we found significantly influencing their decisions,” and also that these findings “should likewise inform the broader literature on private gatekeepers such as accountants and credit rating agencies.”

Indeed, and beyond the scope of the paper, a focus on social – and not just economic – ties may be key to assessing various  independence issues regarding boards of directors.  In an important decision from 2003 involving a derivative action brought by shareholders of Oracle Corp., then Vice Chancellor Leo Strine noted: “Delaware law should not be based on a reductionist view of human nature that simplifies human motivations on the lines of the least sophisticated notions of the law and economics movement.  Homo sapiens is not merely homo economicus.  We may be thankful that an array of other motivations exist that influence human behavior; not all are any better than greed or avarice, think of envy, to name just one.  But also think of motives like love, friendship, and collegiality, think of those among us who direct their behavior as best they can on a guiding creed or set of moral values,” adding, “[n]or should our law ignore the social nature of humans.”

Finally, thanks to friend of the blog Scott Killingsworth for recently reminding me of the Oracle decision;  here’s an earlier post about the Oracle case, albeit with a different focus; and here is a post briefly discussing (and linking to) a paper by Jon Haidt and colleagues about business ethics implications of a model of human nature called “Homo Duplex,”  a term coined by the sociologist/psychologist/philosopher Emile Durkheim, which posits that we operate on (or shift between) two levels: a lower one – which he deemed “the profane,” in which we largely pursue individual interests; and a higher – more group-focused – level, which he called “the sacred.”

The Caterpillar criminal investigation: culture, risk and “informal” duties of trust

As described in an article in today’s Wall Street Journal  (which may require a subscription for access): “Ten thousand railcars a month roll into [the] sprawling [Terminal Island] port complex in Los Angeles County. While here, most are inspected by a subsidiary of Caterpillar Inc. [Progress Rail Services]. … When problems are found, the company repairs the railcars and charges the owner. Inspection workers, to hear some tell it, face pressure to produce billable repair work. Some workers have resorted to smashing brake parts with hammers, gouging wheels with chisels or using chains to yank handles loose, according to current and former employees. In a practice called ‘green repairs,’ they added, workers at times have replaced parts that weren’t broken and hid the old parts in their cars out of sight of auditors. One employee said he and others sometimes threw parts into the ocean.”

Caterpillar is being investigated by the US Attorney’s office in Los Angeles, and it should be emphasized that no charges have yet been brought.  Still, the article provides some nourishing food for thought about two key topics in the C&E field, as well as one narrower but, likely for some companies, dangerously under-appreciated risk.

First, there is the issue of culture.  As noted in the article, current and/or former employees told the Journal that while ‘[t]hey weren’t instructed to do [these things], …some managers made clear the workers would be replaced if they didn’t produce enough repair revenue…Current and former employees interviewed said those who found large numbers of parts to replace didn’t receive extra pay, but they tended to be favored by the supervisors and sometimes honored with employee-of-the-month recognition. Employees said newer workers sometimes learned bad habits from veterans. ‘I was trained to do everything the wrong way,’ one current worker said. ‘I basically fell into a bandit’s nest.’”

And then there’s this piece of information: “Three years ago, two workers who were fired from a Progress Rail repair shop in Florida filed lawsuits making allegations similar to what the U.S. attorney is looking into at Terminal Island…. A lawyer who represented the two said the suits were settled on terms that barred them from discussing the case.”

Again it should be emphasized that this is only an article – no charges have yet been brought.  But, if these allegations turn out to be founded, then clearly the culture in Caterpillar’s Progress Rail business will – under current enforcement policy – weigh in favor of bringing criminal charges against the company, meaning, in the first instance, the Progress Rail subsidiary.

But what about Caterpillar itself?  Here, the key issue may turn on whether Caterpillar conducted a meaningful risk assessment after it bought Progress Rail in 2006. I recall, from various conferences at that time, that Caterpillar had a C&E officer and program  – and so if it did not look closely at Progress’s risks (then or since) a prosecutor might well wonder why.

Finally, besides broad lessons about culture and risk assessment, the Caterpillar matter – depending, of course, on how it turns out – may reinforce a narrow but important learning about risk for some companies.  That is, when a company expands its business from just manufacturing goods to providing services it often enters a new realm of risk – because its employees are effectively in a relationship of trust with customers that involves opportunities and motives to cheat beyond those in the context in which it is used to operating.  As described in an earlier post in Corporate Compliance Insights,   risk assessments typically should include “[e]xamining whether a company has any relationships (with customers or others) where the need for good faith and candor might not be sufficiently understood by employees or third parties acting on its behalf. Relationships such as these – which tend to involve a high degree of trust but not necessarily a formal fiduciary duty – may be rife with ethics risk potential.”

Businesses facing this risk typically should consider enhanced C&E mitigation measures, and as the Caterpillar matter progresses (pun not intended) it will be interesting to see what – if anything – the company did on this front. (For further reading on informal fiduciary duties  see this post. )

Compliance risk assessments for the little guy

As a matter of both law and common managerial sense, risk assessment is the foundation for an effective C&E program.  But for many reasons risk assessment can also be the most daunting aspect of developing, implementing and improving programs – and especially so for many small and mid-sized companies.

With this in mind, in my latest column in Corporate Compliance Insights, I outline a (relatively) easy-to-deploy 8-step risk assessment process for companies that don’t have the resources to conduct more elaborate fact gathering and analytic efforts about their C&E risks.

As the saying goes, don’t try this in your own home – but consider trying it out in your company.

Summer C&E movies for the holiday weekend

Well,  perhaps not technically movies, but three short and to-the-point videos from the Ethical Systems website – on effective C&E programs, the cultural approach to C&E and possible collaborations between behavioral ethicists and C&E professionals.

Steven Spielberg – watch out!

Have a happy Fourth.

Friendship – and the ties that blind (directors to conflicts of interest)

King Herod the Great had something of a problem: he had backed the losing side in the contest between Marc Antony and Octavian to rule Rome,  and now fully expected to lose his life for it.  But, as described in Jerusalem: the  Biography, by Simon Sebag Montefiore,  when they met he cleverly asked Octavian “not to consider whose friend he had been but ‘what sort of friend I am.’”  Octavian was evidently persuaded by this, for not only was Herod’s life spared but the size of his kingdom was increased.

Loyalty is, of course, fundamental to friendship.  But, while potentially more physically dangerous in the Roman Empire than it is today, friendship in our world can be ethically treacherous.

In “Will Disclosure of Friendship Ties between Directors and CEOs Yield Perverse Effects?”  (to be published in the July 2014 issue of the Accounting Review), Jacob M. Rose, Anna M. Rose, Carolyn Strand Norman and Cheri R. Mazza  describe how they conducted thought experiments involving both actual corporate directors and MBA students to determine  whether “directors who have  friendship ties with the CEO [are more likely that are directors without such friendships] to manage earnings to benefit the CEO in the short term while potentially sacrificing the welfare of the company in the long term” and also whether “public disclosure of friendship ties mitigate or exacerbate such behavior, and will disclosure of friendship ties influence investors’ perceptions of director decisions.”

Sadly but not surprisingly, their research  found “that friendship ties caused directors to be more willing to approve reductions to research and development (R&D) expenses that cause earnings to rise enough to meet the CEO’s minimum bonus target more often than  when the directors and CEO were not friends.” Seemingly more of a surprise, they also found that “disclosing friendship ties resulted in even greater reductions in R&D expenses and higher CEO bonuses than not disclosing friendship ties.”

But this latter finding is not so surprising – given other  behavioral research showing that disclosure can “morally license” individuals  to act inappropriately when faced with a conflict of interest ( as discussed in this   and other prior posts.) As described in a recent piece in the NY Times  by Gretchen Morgenson, one of the study’s authors explained: “When you disclose things, it may make you feel you’ve met your obligations…They’re not all that worried about doing something to help out the C.E.O. because everyone has had a fair warning.”

Morgenson added: “There are two messages in this study. One is for regulators: Simply disclosing a conflict or friendship does not eliminate its potential to create problems. The other,” again quoting one of the study’s authors (but echoing Herod) “is for investors: ‘Shareholders should take a more active role in finding out what kinds of relationships their boards and C.E.O.s have…and recognize the potential traps created by them’.”

For more on conflicts of interest and directors see the posts collected here .

 

Dead peasants, conflicts of interest and Immanuel Kant

In an unforgettable exchange in Michael Lewis’s wonderful book Liar’s Poker a Wall Street executive tosses a ten-dollar bill to a salesman who is heading for the airport and whom he tells to “take out some crash insurance for yourself in my name.” The salesman asks, “Why,” to which the executive replies:  ”I feel lucky.”

A story in today’s NY Times reported on a growing business in company-owned life insurance – in which a worker’s life is insured with the company as the beneficiary:    “Because so-called company-owned life insurance offers employers generous tax breaks, the market is enormous; hundreds of corporations have taken out policies on thousands of employees.”  There has been some effort to rein this business in: under “a law enacted in 2006 … [which] sought to curb the practice — companies now are restricted to insuring only the highest-paid 35 percent of employees, who must give their consent.”  However, this type of insurance “remains a growing, opaque and legal source of corporate profit” – and something that, understandably, can be unsettling to those whose lives are insured for the benefit of their respective employers.  Indeed, it has even earned a colorful sobriquet:  “’dead peasant’ insurance, an allusion to Nikolai Gogol’s novel ‘Dead Souls,’ in which a con man buys up dead serfs to use them as collateral in a business deal.”

Certainly if an employee was betting against her employer that would be considered a conflict of interest (at least as a general matter).  This is presumably why some companies’ policies prohibit employees’ short selling of company stock, irrespective of insider trading concerns.   However, a COI-based line of analysis is a non-starter here because – at least in the US – employment-based fiduciary duties are largely (and starkly) asymmetric: employees owe duties of loyalty to their employers, but not the other way around.

But that’s  not the end of the ethical inquiry, as deontology  - the school of moral reasoning founded by Immanuel Kant,  which provides much of the foundation for modern business ethics – instructs that you should “[a]ct in such a way that you treat humanity, whether in your own person or in the person of another, always at the same time as an end and never simply as a means.”  And, while in the rough-and-tumble world of modern capitalism there may be many close calls with respect to application of this principle, dead peasant insurance seems pretty far over the line to me. Indeed, I was going to add that this is a practice that almost calls out for a modern-day Gogol to capture fully its moral ghoulishness – except that it might be hard to improve on Lewis’s non-fiction version.