Conflicts and the Law

While there is no overarching legal regime applicable to COIs generally, many laws are relevant to COIs in business organizations. In this section we will explore the principal intersections between law and COIs, including examining when a COI can lead to criminal prosecution.

Mitigating holiday cheer: what’s new in gifts and entertainment compliance

It is that time of year again, and so we look once more at what’s new under the C&E officer’s tree to help with the timeless challenge of gifts and entertainment (G&E)  compliance.

First, in what seems like just yesterday (because  it was just yesterday), “[a]n employee of Deutsche Bank‘s Japanese brokerage unit was arrested on … suspicion of showering a local pension fund manager with expensive meals, golf outings and trips overseas in return for some 1 billion yen in investments,”  as reported by the NY Times,   The piece continues: “The wining and dining of corporate pension fund executives had, in fact, become commonplace at Deutsche Securities, which set up shop in Tokyo in 2005, [t]he Nikkei business daily said. In some cases, the feasting got so out of hand that employees filed the mounting expenses over many days in a bid not to attract attention, the paper said. The [Securities and Exchange Surveillance Commission] advised that the government reprimand Tokyo-based Deutsche Securities over its conduct.”

This story is still developing, but it seems like a huge black eye for the bank.  However, presumably the lessons of how one of the world’s largest financial institutions could allow this type of very damaging conduct to occur will be a gift to others seeking to stay out of trouble.  (Among other things, this case could show why high-risk organizations need to do more  G&E monitoring, but that’s just a guess.)

Indeed, one of the most useful things that C&E officers can do regarding G&E is to keep track of others’ missteps in this treacherous area – and use that information in training and periodic communications to employees.   A helpful stocking stuffer in that regard is   this chart recently prepared by K&L Gates partners Amy Sommers and Matt Morley showing FCPA enforcement actions involving gift-giving in China, which I found via one of Tom Fox’s many excellent writings on anti-corruption compliance.

Another G&E  goody  to consider getting for that hard-to-please C&E officer on your shopping list is this recently published article “Honing a compliant gifts policy: the trends we are seeing today,” by Laura Flippin of DLA Piper. Among these trends:  “setting global limits on the amount that may be spent on any single meal, with three tiers covering low, medium and high cost markets. …Limiting gift giving, globally, to no more than $50 worth of low-value items which may be given at any one time to a single individual, with a cap of no more than four gifts annually…Requiring all gifts to be sourced centrally by procurement and prohibiting the use of vouchers or gift cards that can be easily converted to cash….Mandating prior written approval from a regional or above-country compliance officer if an employee wants to provide more than two gifts yearly to any single recipient (whether or not a government official) …Using a specific, documented process to address hospitality provided for high-profile, unique events in countries where the company has a large presence or business interests – for instance, the London Olympics.”

Of course, global companies increasingly need to keep track of the increasing number of “local” G&E laws and regulations, e.g., those of Nigeria – presented here by ethixBase  (the publisher of the COI Blog).  EthixBase has compiled  domestic gift giving rules from more than 80 countries – something that should bring joy to even the most Scrooge-like C&E officer of a global company.

Finally, some recent possibly relevant articles from our own back pages:

–          Gifts, entertainment and “soft core” corruption.

–          Complying with customers’ COI requirements.

–          COIs and industry culture.

Ho, ho, ho…


When blowing the whistle is a conflict of interest

Employees generally owe duties of loyalty to their companies (at least under US law), but for some time whistleblowing has not seen as a breach of such duty.   This was the underpinning of an important Supreme Court case thirty years ago – Dirks v SEC  – which held that an employee who told a securities analyst about a fraud at the employee’s company had not breached a fiduciary duty to the company (and hence under applicable law the securities analyst could not be prosecuted for insider trading based on this disclosure). But not all duties of loyalty are the same, and lawyers (and other professionals) are typically seen as having a stronger duty in this area than are employees in general.   Additionally, the related obligation to protect the confidentiality attorney-client  privileged information is stronger than is the general obligation employees have to protect the confidential information of their employers. These differences, in turn, impact the analysis of whistleblowing by lawyers.

The propriety of attorney whistleblowing  (in the US)  is  generally addressed by state bar ethics rules and also (to some extent) by SEC Rule 205 promulgated pursuant to the Sarbanes-Oxley Act.  More recently, the prospect of  an attorney blowing the whistle to recover a bounty for her efforts has been the subject of concern with the promulgation of Dodd-Frank Act whistleblower bounty provisions, which permit bounties of 10-30% of certain securities-law related recoveries by the SEC, CFTC or DOJ where a whistleblower’s “original information” contributed to the recovery. This latter type of whistleblowing was analyzed in an important (for attorneys, that is) opinion issued last month by the New York County Lawyers Association  (“NYCLA”).

The Opinion notes initially that “SEC whistleblower rules exclude from the definition of ‘original information’ most material that lawyers, in-house or retained, are likely to gain in the course of their professional  representation of clients, and thus generally preclude attorneys, in most instances, from receiving  a bounty for revealing such information. SEC Rule 21F-4(b) acknowledges the importance of the attorney-client privilege, as well as state ethics rules, and presumptively excludes the use of privileged or confidential information from the definition of eligible original information under the whistleblower rule. Indeed, the SEC warns lawyers that there will be no financial benefit to lawyers who disclose such information in violation of the attorney-client privilege or their ethical requirements.”  However, the above-mentioned requirements (concerning privilege and state ethical standards) are determined not by the SEC itself but by various state bar entities, like the NYCLA.

Turning to those state law requirements, the Opinion notes that under NY’s Rules of Professional Conduct (“RCP”)  the situations in which a lawyer may disclose a client confidence are even narrower than they are under  applicable SEC rules.  Moreover, the RPC’s exceptions to confidentiality mandates generally permit disclosure only to the extent necessary to correct/prevent (the defined categories of) wrongful conduct – and seeking a whistleblower bounty would not seem to meet that requirement. Thus, even if permitted by SEC rules, the RPCs could independently prohibit a lawyer from seeking a whistleblower bounty in cases involving representation of a client.

Most significantly for the purpose of this blog, the NYCLA faced the issue: “Is a conflict of interest under RPC 1.7 presented when a corporate lawyer, functioning as a lawyer, seeks to collect a whistleblower bounty?” Their answer was presumptively yes. “A lawyer confronted with potential corporate wrongdoing must evaluate and consider varying requirements under SEC and state ethics rules and then make some difficult decisions: Is the potential violation material? Is the potential violation criminal? Should the lawyer report the wrongdoing up the corporate ladder? Should the lawyer report the wrongdoing to an outside body, and if so, when? These complex and potentially inconsistent considerations call for the exercise of objective, dispassionate professional judgment. A lawyer who blows the whistle prematurely could harm the client and be professionally responsible for the precipitous disclosure of client confidences. A lawyer who fails to report credible evidence of corporate wrongdoing up the ladder, if it amounts to an independent violation of the securities laws, could potentially be prosecuted by securities regulators, subject to professional discipline by the SEC, and subject to reciprocal discipline by state bar counsel. Especially under these delicate circumstances, a financial incentive [of the type offered by the Dodd-Frank bounty provisions] might tend to cloud a lawyer’s professional judgment.”

The NYCLA also noted that the ethical rules discussed in the Opinion “would not affect or apply to lawyers who are not representing, or did not represent clients. For example, a corporate officer or compliance officer who happens to be a lawyer may not necessarily be representing a client in the performance of his duties, depending on the facts of the individual case. To the extent that the lawyer is not representing a client, our opinion would not apply to that conduct simply because the lawyer happens to be a licensed attorney.”

For further reading…

Two points from earlier posts in this blog about attorneys, confidential information and compliance:

–          While providing strong protection of the attorney-client privilege is sometimes seen as catering  to corporate stonewalling, a more accurate view (to my mind) is that such protection encourages companies to get legal advice and thus promotes C&E – as discussed here.

–          The fact that client confidences and relationships should be protected does not mean that lawyers have no right or obligation to report wrongdoing of any kind.  See this prior post for a review of lawyer reporting obligations that do not involve client confidences  – and how certain behavioral ethics factors can inhibit compliance with such duties.

A  recent obituary for a famous whistleblower in the tobacco industry  who was a paralegal, and whose disclosures included attorney-client communications.

And, a piece about comparative conflicts of interest analysis.


Insider trading, private corruption and behavioral ethics

Both the contours and the purposes of the prohibitions against insider trading have been the subject of considerable dispute – indeed, the lack of clarity regarding insider trading enforcement may be unique among major laws in the business crime field, at least in the US.  Needless to say,  uncertainty regarding any criminal law is unfortunate, as it can serve to deter desirable, as well as undesirable, activity,  and also be the cause of unfairness – which, beyond being harmful to those touched  directly by a prosecution, can delegitimize the law in question.

In “Insider Trading as Private Corruption” – which will be published next year in the UCLA Law Review –  Prof. Sung Hui Kim offers what she describes as a new doctrinal approach to insider trading law:  such law should be viewed as “a form of private corruption, defined as the use of an entrusted position for self-regarding gain.” She explains: ” The corruption theory not only provides answers to the normative skeptics but, as compared to the two leading alternatives, the property theory and the unjust enrichment theory, better fits the core features of the received doctrine… Even better, the corruption theory provides relatively concrete guidance in hard cases, which is the sort of pragmatic theory that the SEC and the courts desperately need.”

Although I handled quite a few insider trading cases in the 1980’s and 1990’s (as a defense lawyer, before switching to full-time C&E work), I’m not familiar enough with the types of “hard cases” that those who trade securities (particularly professional traders/investors)  currently face to have an informed view of how pragmatic this theory is.   But, I do find the private corruption approach compelling from a doctrinal perspective  because, as described in this recent post:

– there are powerful behavioral-ethics-related challenges to promoting compliance with insider trading law having to do with the lack of immediacy of the harm in the offense;  and

– a corruption/conflict-of-interest based approach to promoting compliance in this area seems well suited to addressing these challenges.

In particular, such an approach can help show – hopefully in a powerful way that overcomes such obstacles – what the harm really is with insider trading.  Related to that point, Kim describes (on page 32 of the article) a behaviorist experiment “which found strong correlations between the high levels of perceived public sector corruption in the country and the tendency to view insider trading as acceptable. The more corrupt citizens viewed the country, the less objectionable were the inside trades, and vice versa. Although far from definitive, these correlations provide additional support to the idea that insider trading is best understood as a species of private corruption.”   She also notes: “A key benefit of seeing insider trading as private corruption is that it allows us to see the harms of insider trading more generally as the harms of corruption.”

More generally, given the unprecedented world-wide campaign against public sector corruption, I think broader law enforcement/compliance strategies using (where reasonably applicable) a corruption-based approach – like Kim has done with insider trading – should be considered.   Indeed, that is what I have tried to suggest in this piece about abuses in the gifts and entertainment area  being viewed as “soft-core corruption.”

For a post on private sector corruption generally please click here.  And here is one on the somewhat related topic of “informal” fiduciary duties.  Finally, here is a post on implications of behavioral ethics for the securities law notion of scienter.

How not to get your next job

A prior post catalogued various  COI issues arising from moving from one job to another. To this inventory should be added the recent case of David Ostermeyer (which was brought to my attention by a COI blog reader, for which I am grateful).

As described in this press release issued on October 25, 2013 by the Department of Justice,  Ostermeyer had been the Chief Financial Officer of U.S. Agency for International Development (USAID) and “shortly before [he] retired from the USAID, he helped the agency draft a contract solicitation for a senior advisor – a position that Ostermeyer intended to apply for after he retired.  In an effort to ensure he would be awarded the position, Ostermeyer allegedly tailored the solicitation to his specific skills and experiences.”

The press release further notes: “Federal conflict of interest laws prohibit executive branch employees from participating personally and substantially in matters in which they have a financial interest.  Since Ostermeyer had a financial interest in the contract solicitation, the government alleged that he could not participate in drafting it and, therefore, violated 18 U.S.C. § 208(a),” which is one of the Federal COI statutes.  Ostermeyer agreed to settle (without admitting wrongdoing) and pay a penalty of $30,000.

For those interested in learning more about the federal COI law – violations of which, in some instances, can be prosecuted criminally as well as civilly – the web site of the Office of Government Ethics (“OGE”) is the place to start.   Of course, other governmental entities have their own COI rules – and sometimes have web sites like that of OGE.   (An example that is rich in information – particularly concerning prior enforcement actions – is the web site of the NY Conflicts of Interest Board. Among other things, much of what’s on this and similar web sites can be useful for drafting COI policies and designing COI training.)

Even smaller municipal governments than that of NYC often have COI issues, too. Indeed, the very size of small communities may make COIs relatively more likely to occur in their governmental bodies than in those of larger municipalities  (i.e., on average, I assume there would be a higher percentage of people with multiple roles, and thus opportunities for conflicts, in the former than the latter). Also,  local governmental units may well lack robust ethics-related controls that larger official entities more typically have, as noted in this prior post. On the other hand, where ethics issues involve dealing with neighbors instead of strangers,  there would seem to be a greater chance  of virtue prevailing (although note that I may be stretching the logic of certain behavioral ethics research a bit in saying this and indeed some findings in this area suggest an opposite impact of closeness on ethicality).

Indeed, in the very town where I live – Princeton, New Jersey – the top local news story of the past week was the mayor’s decision whether to participate in negotiations with Princeton University (over the issue of  voluntary payment-in-lieu-of-taxes contribution to the town)  given that her husband is employed as a professor there. While “the town attorney, had given an opinion in August saying the mayor’s marriage did not constitute a conflict of interest under the state local government ethics law,”  the mayor commendably determined that the issue had become too much of a distraction for the town government and so decided to recuse herself from taking part in the negotiations. One wishes that the former USAID official had shown the same degree of sensitivity to COIs that the mayor did, and I imagine that he now does too.

The monstrous offspring of two conflict-of-interest titans?

Perhaps no types of conflicts of interest cast bigger shadows on the US ethical landscape than do those of doctors prescribing medicines based on the doctors’ economic interests and financial advisors giving investment advice motivated by their own, and not their clients’, economic interests.  And now, these two COI giants seem to have joined together to form a new and particularly grotesque COI:  doctors advising patients to sign up for medical credit cards where doing so benefits the doctor but causes economic harm to the patient.

As described in a NY Times editorial today: “Patients around the nation are being victimized by medical credit cards that can lead to financial calamity. These cards, issued by specialty finance companies as well as commercial banks, carry exorbitant interest rates after an initial period of zero interest expires — with heavy penalties for late payments. They are often pushed on patients with modest incomes by health care providers who want to make sure that they get paid, even if some of their patients end up with huge credit card bills they can’t afford. [It is] hard to imagine a situation in which a consumer is more susceptible to financial coercion by a provider with a conflict of interest.”  As also described in the Times piece: “Numerous civil lawsuits have been brought by state authorities and lawyers for consumers against care providers and financial companies for misleading practices,”  but the problem cries out for a national solution.

Meanwhile, efforts to find comprehensive solutions to the perils posed by the two COI titans proceed apace. With respect to medical doctors, the most important recent development on this front is the advent of the Sunshine Act  earlier this year.  Indeed, this new law may serve as an unprecedented test of Louis Brandeis’ famous saying  that “[s]unlight is said to be the best of disinfectants,” and so should be of keen interest not only to  C&E practitioners but also scholars  in the business ethics field looking for data to analyze.

And a potentially significant step forward regarding conflicted financial advice is this report issued last week by the Financial Industry Regulatory Authority (“FINRA”). As described by FINRA’s Chairman and CEO Richard G. Ketchum:    “While many firms have made progress in improving the way they manage conflicts, our review reveals that firms should do more,” and the report provides “examples of how some large broker-dealer firms address conflicts” including “identifying and managing conflicts on an ongoing basis through an enterprise-level approach that is scaled to the size and complexity of a firm’s business and that starts with a ‘tone from the top’ that carries through to the organization’s structures, policies, processes, training and culture; establishing new product review processes that include perspectives independent from the business proposing products, that identify potential conflicts raised by new products, that restrict distribution of products that may pose conflicts that cannot be effectively mitigated and that periodically re-assesses products through post-launch reviews; making independent decisions in the wealth management business about the products they offer without pressure to favor proprietary products or products for which the firm has revenue-sharing agreements;  minimizing conflicts in compensation structures between customer and broker or firm interests where possible and including heightened supervision when conflicts remain; for example, around thresholds in a firm’s compensation structure;   mitigating conflicts of interest through disclosures and other information that enables customers to understand the factors that may affect a product’s financial outcome—such as the use of scenarios and graphics for a particular product; and  including ‘best-interest-of-the-customer’  standards in codes of conduct that apply to brokers’ personalized recommendations to retail customers in order to maintain and increase investor trust.”

The FINRA report is indeed a virtual encyclopedia of COIs involving brokers and sound mitigation measures addressed to such COIs.    It is a must read not only for C&E professionals in the financial services industry but for COI aficionados of all kinds, and in future posts I hope to “mine” the report for mitigation ideas that could be useful in other contexts (perhaps even the credit card business).

A bad week for weak compliance programs

“The secret of life is honesty and fair dealing. If you can fake that, you’ve got it made,” Groucho Marx famously said. But having fake C&E programs may not be such a good idea, as two recent important legal developments suggest.

The first involves a case brought by the U.S. Department of Justice against the ratings firm S&P for, among other things, falsely claiming that that company had “established policies and procedures to address the conflicts of interest through a combination of internal controls and disclosure.”  (The original complaint was the subject of an earlier post.)   The company filed a motion to dismiss on the grounds that these claims were mere harmless “puffery” but the court rejected the defense   which it called, in a decision handed down on July 16, “deeply and unavoidably troubling.” (Another judge, in a case decided last year, had called a similar argument by Goldman Sachs “Orwellian,”  and – at least to my mind – this defense has all the absurdity of a Groucho gem without any of the humor.)

As the court noted, S&P’s defense was that, “out of all the public statements that [the company] made to investors, issuers, regulators, and legislators regarding the company’s procedures for providing objective, data-based credit ratings that were unaffected by potential conflicts of interest, not one statement should have been relied upon by investors, issuers, regulators, or legislators who needed to be able to count on objective, data-based credit ratings.” The court concluded: “Despite defendants’ protestations to the contrary, the court cannot find that all of these ‘shalls’ and ‘must nots’ are the mere aspirational musings of a corporation setting out vague goals for its future. Rather, they are specific assertions of current and ongoing policies that stand in stark contrast to the behavior alleged by the government’s complaint.”

Of course, this was merely a motion to dismiss – not a final adjudication on the merits of the government’s claims.  But this decision certainly augers ill for S&P for whenever that day of judgment should arrive, and, given that the government is seeking a $5 billion recovery, this has to be worrisome for the company and the shareholders of its parent entity, McGraw-Hill.

Also of a preliminary nature are the  criminal indictment  handed down last week against the giant hedge fund SAC Capital Advisors for insider trading  and the related SEC administrative case against the firm’s owner, Steven Cohen.  As described in a must-read (for C&E officers, that is) article in yesterday’s NY Times, while SAC has claimed that it had a strong compliance program, the program in fact seemed to be ineffective in many ways.  E.g., the firm supposedly hired many employees precisely because of their possible access to inside information;  the compliance “training seems only to have alerted some employees to the type of activity they needed to conceal”; and the compliance department had little success in  detecting possible insider trading.

Note that the government is not merely saying that SAC shouldn’t get the benefit of a compliance-based defense.  Rather, a faked compliance program is itself alleged to be part of the criminal scheme.

Finally, one obviously cannot predict a trend based on two cases alone. But as I point out in this recent article in Compliance & Ethics Professional, given the escalating costs of non-compliance generally we are likely to see more cases involving claims of compliance fakery in the future – for the simple reasons that the companies and executives who don’t grasp the logic of having an effective compliance program may perceive a growing incentive to conceal compliance shortfalls, i.e., a true vicious circle.   Even Groucho would have a hard time finding a joke in that.

When ethics is more than parsley on the legal plate

In a case (previously featured in this blog) that the Department of Justice recently brought  against S&P and its corporate parent McGraw-Hill based  in part on S&P’s allegedly false claims that its ratings of certain financial instruments were free of COIs, the defendants last week  filed a motion to dismiss on the grounds (among others) that such claims of ethicality were mere “puffery.”    Readers of this blog may recall a case last year (involving Goldman Sachs) also based on allegations of false professions of ethicality in which a judge rejected a puffery defense, calling it “Orwellian.”  On the other hand, S&P/McGraw-Hill has recently prevailed on a puffery defense in an lawsuit based on its ratings.

The court’s decision on the instant motion will, of course, be driven both by prior precedents (presumably those mentioned above and others) and also the specifics of the alleged operative facts, and other commentators will do a better job of dealing with these than the COI Blog could.  So instead, I want to use this occasion to consider the broader issue of whether false claims of ethicality should, at least in some instances, be legally actionable,  as S&P’s defense seems to suggest should never be the case.

To begin, the basic concept of a puffery defense is certainly logical, as one wouldn’t want every sales or marketing related exaggeration to be grounds for a lawsuit.  Mike’s Coffee House should be spared an onslaught of litigation from customers if its claim of serving “the best coffee in the world” is something of a “stretcher.”  The common-sense issue in all puffery cases is whether a false claim can reasonably be said to make a difference to a buyer and while the ethicist in me dreams of the day when ethics is a significant part of every commercial decision my lawyer self knows that that day hasn’t arrived (and probably never will).

Indeed, from a purely economic perspective, in many commercial settings, an ethics-related “stretcher” – while ethically deplorable – should not give rise to a lawsuit.  If you buy a widget from a manufacturer that makes vague and false pronouncements of being an ethical company, the courts presumably will not order that damages be paid to you – because the widget is likely no less valuable due to the falsity of the proclamations.  Moreover, making all false claims about ethics legally actionable could have the undesirable consequence of making companies less eager to speak publicly about their ethical efforts.

But then there are cases where the claim of ethicality is not – from an economic perspective – mere parsley on the plate, but is baked into the actual meal.   And – again, without knowing what the evidence in the S&P case will be – it certainly seems possible that a ratings agency’s allegedly falsely claims that it has addressed conflicts of interest in its ratings would fall into that category, given a) how essential independence is to making a rating valid and b) the industry’s troublesome history in ensuring that its ratings are actually conflicts free.  That is, unlike the hypothetical widget case, the user of credit ratings would presumably have zero commercial interest in a product tainted by conflicts of interest.

A final point from a historical perspective, which is that while there was a time when little beyond good intentions was expected of an organization claiming to be ethical that has changed in recent years.  Owing in part to the Federal Sentencing Guidelines for Organizations and their progeny – as discussed here – companies are now expected to have effective policies, procedures, resources and accountabilities to support their good intentions.  In determining what the users of S&P’s ratings could reasonably expect from that organization’s professions of ethicality one hopes that the court will take that important development into account.

Insider trading, behavioral ethics and effective “inner controls”

Late last week the U.S. Securities and Exchange Commission announced that it had reached a settlement with a hedge fund involving the largest penalty ever imposed for insider trading. But it is a fair bet that even this record breaking fine will do little to deter future insider trading, because of the unique compliance challenges raised by this area of the law.

One challenge is that insider trading can be enormously difficult to detect.   This is particularly so where the individual misusing the information is neither an insider herself nor tied to one in an obvious way. Insider trading is sometimes described as a “perfect crime” and, sad to say, in many instances it doubtless proves to be just that. (Part of the way we know this is that “numerous academic studies [have] …. [u]ncover[ed] indicators like spikes in a stock’s trading volume just before key information, such as quarterly earnings, is made public…” which suggest that there is a fair bit of insider trading going on –  yet the number of actual prosecutions in this area is relatively low. )

The other challenge  (which is germane to the behavioral ethics aspect of this blog) is that the opportunity for insider trading may fail to trigger the sorts of “inner controls” – meaning an individual’s moral restraints – that the prospect of committing various other crimes typically does.  Part of the reason for this is that while in most instances (at least under U.S. law) insider trading involves a breach of fiduciary duty – i.e., improper disclosure of a corporate secret –  often the individual benefitting from that transgression is several steps removed from the original wrongdoing (due to the information being passed along or “tipped”).  Per several behavioral ethics experiments, “distance” between the wrongful act itself and the beneficiary of the transgression increases the likelihood of wrongdoing, and in insider trading that distance can be significant indeed.

A related problem is that the specific victims of insider trading – typically anonymous market participants – are not evident to would-be violators. Per  other behavioral research, this second type of distance also tends to diminish internal moral restraints.  Moreover, this sense that insider trading is harmless is, in my view, exacerbated by the arguments of some commentators that such conduct should actually be lawful, to make markets more efficient.

Can any of this be remedied?  I’ll leave the detection issue to those others, but on the behavioral ethics side I think it is imperative that these two types of distance be addressed by, among other things, imagining what things would be like if insider trading was not in fact a crime. Using this sort of “what if?” approach – as we did earlier with conflicts of interest generally  – one can envision a world in which businesses are reluctant to engage in transactions that require confidentiality to be successful, which would hurt productivity in many ways.  This thought experiment also suggests that individuals and organizations would be reluctant to invest in capital markets that they fear may be rigged by insiders, which, in turn, substantially raises the cost of equity to businesses.

Like “conflict of interest world,” insider trading world “is a place of needlessly diminished lives, resources and opportunities.” In my view, effective deterrence in this area requires greater recognition of these harms so that they can fully inform the operation of our inner controls.

The S&P conflicts debacle: questions for the board of directors

Last week shareholders of McGraw-Hill got walloped, as its stock plunged by 27% on news that the Department of Justice had brought a conflicts-of-interest- and fraud-based lawsuit against the company and its Standard & Poor’s Ratings Service unit.  As described by Attorney General Eric Holder, the case alleges “that S&P falsely claimed that its ratings were independent, objective, and not influenced by the company’s relationship with the issuers who hired S&P to rate the securities in question — when, in reality, the ratings were affected by significant conflicts of interest…” With a $5 billion damage claim, the lawsuit – which arose from S&P’s ratings of certain collateralized debt obligations and residential mortgage backed securities during the financial crisis – seems to pose considerable peril to McGraw-Hill.  Moreover, the claim does not include the damages sought in various similar lawsuits by state governments.  All told, this legal assault – which S&P has called unjustified and without merit – could be one of the costliest COI matters in U.S. history, with some observors wondering whether the company will ultimately suffer the fate that Enron and Arthur Andersen did.

I’m not a McGraw-Hill shareholder but if I were I’d want to know what the board of directors had done to try to prevent something like this from happening.  Of course, boards are not responsible for managing all compliance and ethics efforts at a company.  However, where both the likelihood and potential impact of a risk are great, the C&E-related expectations of a board are obviously enhanced – and that would certainly seem to be the case with COIs in a ratings provider given the long-standing concern with the “issuer pays” model and the great damage (both from direct liability and harm to the brand) that could be expected from tainted ratings (even in a setting less dramatic than that of the financial meltdown of 2008).

Additionally, the case for a relatively high degree of board C&E program oversight becomes greater still in situations of  what might be called C&E-related moral hazard, i.e., where the individuals creating the C&E risks (or responsible for managing the actions of such risk creators) might have a strong short-term interest in the continuation of non-compliant practices, to the detriment of the long-term interests of the shareholders.  The ratings business in the years in question might well fit that description, assuming – as seems likely – that senior executives of these companies received significant compensation from revenues based on the practices now being questioned. (Indeed, the government’s complaint is replete with references to how important this business was to S&P.)

Of course, it is possible that the McGraw-Hill board recognized the risks at issue but felt that they were adequately mitigated. Indeed, as noted by the government’s complaint, the company had COI-related policies at the time (and, in fact, part of the theory of liability is that S&P’s promises to adhere to such policies were false).

But McGraw-Hill shareholders will presumably want to know about more than the company’s promises to be ethical, since written policies by themselves often provide little protection from C&E risks. The real issue – given the likelihood and potential impact of the risks, combined with potential for moral hazard – is likely to be whether the board had sufficient reason to believe that relevant policies were being effectively enforced and promoted.  Among the questions going to this key issue are to what extent did S&P:

Have a robust risk assessment process, to identify service lines most likely to create COI risks?

– Have COI monitoring and auditing protocols addressed to COIs?

– Encourage employees, in a persuasive way, to report concerns around COIs?

– Investigate any such reports and respond with appropriate discipline when a violation has been proved (meaning not only discipline for those engaged in violations but those who could have but failed to stop the misconduct).

– Use incentives to encourage effective COI mitigation?

– Assess the efficacy of its efforts in this area?

Create a culture that helped prevent COIs from arising in the first place?

– Empower a compliance officer to help with all of the above?

Finally, given that the conduct at question in the S&P case took place in 2004-2007, is asking these questions in 2013 an unfair exercise in Monday morning quarterbacking?  I don’t think it is,  because all are based on the federal government’s most important C&E standards – the Sentencing Guidelines for Organizations – as they existed at the time at issue. Indeed, the fact that the Guidelines had been amended – with great fanfare – in 2004 to add many of these expectations would make the board’s failure to determine if they were being taken  hard to defend.  Moreover,  as far back as 1996 the Delaware Chancery Court had said “[a]ny rational person attempting in good faith to meet an organizational governance responsibility would be bound to take  [the Guidelines into]  account…” (Note: I’m not saying that the board necessarily failed in this regard.  But I’m pretty sure McGraw-Hill shareholders will be eager to find out if the board made an adequate effort in trying to protect their investment.)

Some related posts:

The Goldman Sachs case holding that false claims of COI mitigation can be the basis for legal liability.

The costliest COI cases ever.

How boards should oversee C&E programs.


A never-ending story? Conflicts of interest in the financial services sector (Part One)

According to this recent article, “UK asset managers are unable to demonstrate they are not putting their interests before those of customers or saddling them with unneeded costs, a survey of sector firms by” the Financial Services Authority suggested last week.  Among other things, “the FSA highlighted inadequate controls on how much money was paid to brokers for research and execution, casting doubt on the transparency and control of such commission payments. Other failings identified by the regulator included inadequate reporting of errors to customers while some ‘applied limited thinking’ to conflicts of interest arising from accepting gifts or entertainment.”

Meanwhile in the US, Carlo V. di Florio, Director, Office of Compliance Inspections and Examinations of the Securities and Exchange Commission, recently gave an important speech on Conflicts of Interest and Risk Governance to the National Society of Compliance Professionals   Among other things, he noted:

– Conflicts of interest are significant to the SEC because of the “long experience of [its] exam program that conflicts of interest, when not eliminated or properly mitigated, are a leading indicator of significant regulatory issues for individual firms, and sometimes even systemic risk for the entire financial system.”

– “Especially when combined with the wrong culture and incentives, conflicts of interest can do great harm. [Thus,] conflicts of interest are an integral part of [the SEC’s] assessment of which firms to examine, what issues to focus on, and how to examine those issues.”

– “Failure to manage conflicts of interest has been a continuing theme of financial crises and scandals since before the inception of the federal securities laws”; “[r]ecent decades have seen numerous examples of conflicts leading to crisis”; and “ [t]he financial crisis of 2008 could itself be the basis of a seminar on conflicts of interest….”

In subsequent posts, we’ll examine Di Florio’s suggested framework for managing conflicts of interest in the financial services industry – and speculate on what aspects of it might mean for firms in other industries.