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.

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. The offshore cyber security firm will always put forth the interest of the customers first and suggest the best security package to their customers since they entrust their safety completely to them only. 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.

Piling on: where antitrust and conflicts of interest meet

The recent imposition of a record tying $500 million criminal fine in an antitrust case is an important reminder to C&E professionals about the need for strong measures in this risk area.  But while there’s a lot that can be said about antitrust/competition law generally, rarely is mention made of possible connection between that area of risk and the subject of this blog,  COIs.  Yet, historically there have been cases where the two meet, and understanding their points of intersection can in fact be useful for certain aspects of C&E program management.

One  well known – if not necessarily typical – example was in a case that was decided by the Supreme Court  thirty years ago (American Society of Mechanical Engineers  v. Hydrolevel) in which a nonprofit membership association that issued codes for various areas of engineering was sued by a company that sold safety devices for use in water boilers.  The basis for the suit was that an employee of a competitor of the plaintiff – who was working as a volunteer of the non-profit – caused the non-profit  to publish a letter saying that the plaintiff’s device was unsafe.   This conduct – clearly a COI on the part of the association – was held to be an antitrust violation.  Or, another way of looking at it was that the COI was the motivation for the antitrust offense.

More recently (and perhaps more typically in terms of how these two areas can intersect) cases brought against insurance brokers regarding certain un- (or under-) disclosed payments from insurance issuers – a COI – had antitrust elements, too, meaning that the  insurers allegedly agreed among themselves to refrain from competing against each other in order to help protect this COI-laden state of affairs.     And in a related vein, in the famous (at the time) specialty steel cost-plus corruption cases  competitor suppliers took bidding instructions from a “quarterback” so that a long standing kickback scheme would not be disrupted.

This sort of connection between antitrust and COIs doesn’t happen frequently.  But it is predictable enough so that C&E professionals should – in connection with risk assessment and investigations – be alert to the possibility of it occurring in or to their respective organizations.



Political contributions, bribes – and a barrel of worms

A congressman from Texas once said, “Ethics is a barrel of worms,” which, according to this article, is “a pungent summing up of the problem of deciding who is ethical in politics.”  And when it comes to deciding when political contributions cross the line into bribery, the criminal law – to protect First Amendment rights – gives considerable leeway to pungent activity. If you need defense lawyers for property crimes issues, you can click here!

In a recent opinion from a political corruption case,  a federal judge reviewed the law in this area, noting, as a threshold matter, that “[c]ampaign contributions  and fundraising are an important, unavoidable and legitimate part of the American system of privately financed elections.”  Given this framework, the burden of proving illegality in a political contribution must necessarily be a high one.

The judge identified two sorts of situations in which this burden can be met.  First, where a contribution has actually been made,  it can be considered a bribe only where there is an agreement between donor and official that the “contribution is conditioned on the performance of a specific official action,”  i.e.,  a quid pro quo.  That is, a “generalized expectation of some favorable future action is not sufficient” to sustain a corruption conviction,  and proof of a “close in time relationship between the donation and act” is not sufficient either.

Second, even without a contribution having been made, the promise or solicitation of  such in return for an official act can be unlawful.  However, the promise/solicitation must be specific, explicit and material to be illegal, according to the judge’s ruling in this case.  These additional requirements apply to “promises or solicitations because one-sided offers can be misinterpreted.”

In sum, this area of law leaves a whole lotta room to maneuver for campaign contributors seeking favorable treatment from legislators  and – in light of the necessary role that contributions play in our political system – legitimately so, at least as a purely legal matter.  But from a purely ethical perspective one  can view actions as fundamentally criminal even if they are not technically illegal.  And so the last word in this piece goes to Mark Twain, who said, “It could probably be shown by facts and figures that there is no distinctly native American criminal class except Congress.”


Bringing a conflict of interest to justice – at $35,000/hour

Controlling shareholders, because of their dominant share of ownership of a corporation, possess the power to direct its affairs.  As noted by Harvard Law Professor Victor Brudney:  “In the exercise of that power, controllers’ fiduciary obligation precludes their obtaining separate benefits for themselves.”  In an important decision handed down earlier this week, the Delaware Supreme Court affirmed one of the largest damage awards ever in a case involving claimed fiduciary breaches by the shareholders of a corporation.

As described in this article, the case arose “from a proposal by Grupo Mexico SAB in 2004 [which had a controlling share in Southern Peru Copper]  …to sell its 99.15% interest in Minera Mexico SA to Southern Peru Copper for about $3 billion in Southern Peru shares. “ As was later determined by the court in a derivative case brought by minority shareholders in the company, the interest in Minera Mexico was worth far less than what Southern Peru Copper ultimately paid for it.  Based on this difference, the court awarded more than $2 billion to plaintiffs.

The Supreme Court’s decision this week drew most attention in the press for its affirmance of the lower court’s awarding 15% of these damages in attorneys fees (which was apparently 66 times what the lawyers would have been paid based on their regular hourly rate).  This $300 million amount is evidently the largest award of attorney’s fees in any derivative case ever.  (For those interested in this part of the decision,  the discussion begins on page 85 of the court’s opinion.)

However, in addition to making history this way, hopefully the decision – and particularly the two billion dollar number – will stand as an important reminder of the need for controlling shareholders to act fairly with respect to minority shareholders.  But the $300 million figure is relevant to that, too – because finding lawyers to bring cases of this sort should now be a lot easier than it was before.

Beyond the revolving door: misalignment of interests in enforcement decisions

recent study  shows that – contrary to what might be called popular suspicion –  lawyers with the Securities and Exchange Commission do not seem to try to curry favor by making lax enforcement decisions when dealing  with law firms that might offer future employment prospects. Rather, the study found evidence to support a “human capital” hypothesis that SEC lawyers interested in future private sector employment would use such encounters to showcase their skills, and be “tough.”

Perhaps because they are somewhat surprising, the study’s results have not been universally accepted.  The author of this piece, for instance, argues that it seeks to “measure the unmeasurable,” and she points to another recent study showing that “that SEC alums may exert a much more subtle influence at their old agency when they begin to represent clients in private practice.”

Having been a white collar defense lawyer in a prior life, I was not especially surprised by the results (although I also agree that some of what the study is looking at is immeasurable).  If anything, what I saw of former enforcement personnel who became defense lawyers is that many of them still viewed the world through a prosecutorial lens, i.e., a reverse revolving door.

But I do believe that there two dysfunctions in the enforcement realm which, if not constituting true COIs, come from the same neck of the woods, meaning they reflect the operation of forces that lead to enforcement decisions that are not well aligned with the public’s interests.

The first is that prosecutors seem too easy to accept resolutions of investigations where the company (meaning its shareholders) pay a heavy price but the guilty executives go free. As described last week in a NY Times story : “The ballooning settlements are for civil charges of fraud against the government, criminal charges often related to the same conduct and, in the case of health care companies, recovery of money for states for Medicaid fraud.  But while the collections are a boon to the government and taxpayers, they are resurrecting questions about the relative lack of charges against executives at the companies that are getting the stiffest penalties.”  The misalignment of interests here is that while prosecutors can claim credit for record settlements in charges against companies, the outcomes do little to protect the public from future crimes, since it is executives – much more than shareholders – who are in a position to engage in or prevent wrongdoing.  (Of course, to the extent that a company pays extra to allow an executive to go free,  the shareholders, as well as the public, are being ill served.)

The second (and related) misalignment of interests is that prosecutors are often rewarded (in terms of enhanced future job prospects) for the large settlements that they win in cases but, to my knowledge, none has ever been recognized for the crimes that they prevented, meaning for their work in promoting compliance programs.  One can readily see what would be wrong with a health care system that measures success only by the number of surgeries conducted – not the health of the patients it serves, and indeed this criticism has been directed against aspects of the current health care regime.  But when it comes to embracing prevention, medicine is light years ahead of law enforcement.  (For more on how the legal system does too little to promote compliance programs, see this piece.) Aligning the interests of individual prosecutors with society’s interest in preventing crimes as well as punishing them is key to a more overall effective approach to promoting law abidance by businesses than we have now.



Is your company ready for a conflict of interest close up?

Last week an alert reader of the COI Blog forwarded to us a copy of this letter FINRA recently sent to broker-dealers.  While of most obvious interest to the financial services industry, the letter also provides an occasion for other types of organizations to engage in a “thought experiment” to see how – and how well – they would fare in the event that their COI assessment/management processes were ever scrutinized in legal or regulatory setting.  (Given the many ways that ethical handling of conflicts can be relevant to determining legal liability – some of which are discussed here  –  such an experiment could be a worthwhile preventive measure.)

Targeted Examination Letters

July 2012

 Re: Conflicts of Interest

 FINRA is reviewing how firms identify and manage conflicts of interest. As part of this review, we would like to meet with executive business and compliance staff of your firm to discuss the firm’s approach to conflict identification and mitigation. At the meeting, we would like your firm to present on, among other conflicts related topics, the most significant conflicts your firm is currently managing and the processes in place to identify and assess whether business practices put your firm’s-or your employee’s-interests ahead of those of your customers.

 This inquiry is not an indication that FINRA has determined that your firm has violated any rules or regulations. FINRA’s goal in speaking with firms about their conflict identification and review process is to better understand industry practices and determine whether firms are taking reasonable steps to properly identify and manage conflicts that could affect their clients or the marketplace. Knowing what firms do to address conflicts and the challenges they face will help FINRA develop potential guidance for the industry and determine other steps FINRA could consider taking in this area.

  In preparation for the referenced meeting, we request that your firm submit the following information to FINRA by September 14, 2012:

 1.Summary of the most significant conflicts the firm is currently managing.

2.Names of departments and persons responsible for conducting conflicts reviews.

3.Summary of the types of reports or other documents prepared at the conclusion of a conflicts review.

4.Names of departments and persons who receive any final report or other documentation summarizing a conflicts review.

5.Available dates and times in the fourth quarter of 2012 that executive management of your firm can meet with FINRA staff for approximately three hours to discuss the firm’s approach to conflicts of interest.

(The original letter is available at:

False claims of ethicality can lead to legal liability

Many years ago, I heard the great federal judge J. Skelly Wright tell this wonderful story.  He was presiding over a trial in Louisiana and asked one of the attorneys why the attorney referred to all the witnesses as “Colonel,” to which the attorney responded:  That don’t mean anything – it’s like when I call you Your Honor.

More recently, another federal judge was asked to decide whether an investment bank could in effect say the same thing to shareholders who claimed that they were defrauded by the bank’s representations that it operated in an ethical way.  But this time the court was not amused.

The  lawsuit was brought by shareholders of Goldman Sachs who alleged that they bought the company’s stock at a price that was inflated.  The suit was based in part upon the claim that the firm had falsely represented that “it complies with the letter and spirit of the law, values its reputation, and is able to address ‘potential’ conflicts of interest,” when it was really involved in serious conflicts, including one that led to a $550 million settlement with the Securities and Exchange Commission, causing the stock price to fall.

The company defended against the suit by contending that its professions of being law abiding and ethical were “mere puffery and statements of opinion.”

However, in a decision handed down on June 21, the judge soundly rejected these contentions as “Orwellian,” noting:  “If Goldman’s claim of ‘honesty’ and ‘integrity’ are simply puffery, the world of finance may be in more trouble than we recognize.”  The court also stated:  “Given Goldman’s fraudulent acts [as alleged by shareholders], it could not have genuinely believed that its statements about complying with the letter and spirit of the law — and that its continued success depends upon it, valuing its reputation, and its ability to address ‘potential’ conflict of interests — were accurate and complete.”

In so ruling, the court relied on the holding of another, somewhat similar, case from 2006 brought against…. you guessed it – Goldman Sachs (Lapin v Goldman Sachs Grp, Inc., 506 F. Supp 2d 221 (SDNY 2006)) concerning the firm’s alleged failure to disclose conflicts of interest in its research business.

Compliance programs and the law – an unfinished history

Last month, I spoke at a Rand Corporation symposium on compliance programs, corporate culture and public policy and Rand has graciously allowed me to share my white paper on C&E programs and the law from that event.  The paper – which is still being edited for final publication in a Rand proceedings book – charts how, over the past 20 years,  developments in the law have played a key role in the creation  of C&E programs of unprecedented scope and vigor.  It also argues that  – due to inconsistent enforcement of that law – we have now entered a more ambiguous era, increasingly characterized by a division of companies into  C&E “haves” and “have-nots.”

While the paper was written largely for public policy purposes (encouraging the government to do more to promote C&E programs) it may also be of interest to anyone looking for a “crash course” on the interplay of law and C&E programs.

I look forward to your comments.

Conflicts of interest in the Facebook IPO?

In the wake of the Facebook IPO the chief underwriter, Morgan Stanley, has been accused of a conflict of interest in alerting some, but not all, potential purchasers of the stock to negative news about the company.  Additionally, the sharp drop (more than 25% from its initial price  as of this writing) of Facebook shares is itself taken as indication of some kind of wrongdoing by the firm.

With respect to the latter issue, a piece in a blog published by The Telegraph argues –  pretty convincingly, I think – that this criticism is unfair: “the Facebook IPO hasn’t been all that great for those who bought shares in it is true. …But that’s not the point. Quite the contrary: that sagging share price is evidence of the huge success of the stock offer. For… the banks were not working for the new investors. They were selling to the new investors. And their gaining a good high price for the shares was exactly what they were supposed to do. Further, there is in fact a conflict of interest at such banks. If an IPO gets away with a good pop ….as the shares rise after issue, then the bank has failed its own customer, the issuer, for it has left money on the table. Money that rightly should be going into the pockets of the issuing company or the previous shareholders. However, making an issue with a good pop increases the business franchise of that issuing bank. It makes the various fund managers, hedge funds and investment managers like them. Be willing to do more business with them and thus increase their longer-term profits. Which is where the conflict comes in: screw the issuing company and be the popular boy on the block, or actually work for your customer, the issuing company, and damage your own longer term prospects?”

And what of the claim of selective disclosure?  According to this report,  the head of the chief industry self-regulatory body (FINRA) said, “The allegations, if true, are a matter of regulatory concern,..”  On the other hand, this analysis  suggested that due to rules that investment banks must follow in IPOs, Morgan Stanley in fact acted properly – although the piece also noted that the rules, which were intended to reduce conflicts of interest in the securities industry,  themselves are unfair.

For readers looking to learn more about this – particularly thorny – legal landscape, here  is a place to start.  But while in any  regulated business (such as financial services) an analysis of conflicts or any other ethics-related issue should generally start with the law, that ought not to be the end of the inquiry.  So, as this story develops, the COI Blog will return to it to see what broader ethical lessons (if any) can be drawn from it.

Finally, for “extra credit,” consider this story from the somewhat parallel universe of commodities regulation about a set of new rules which are also intended to reduce conflicts of interest but which some critics feel will end up having unintended negative consequences (perhaps similar to what happened with Facebook): “To the extent that the rule inhibits the flow of analysis and trade ideas to small investors, it will give an informational trading edge to larger entities…”




Informal fiduciary duties and criminal liability

No, I don’t mean a fiduciary duty wearing loafers and khakis. (That, of course, is a casual fiduciary duty.)  An “informal” fiduciary duty is a duty of trust that arises even absent traditional fiduciary relationships, such as agent-principal or employee-employer.

In an important recent decision, a federal appeals court held that that independent contractors who have no formal fiduciary relationship with the government nonetheless can be prosecuted for “honest services” fraud for taking bribes based on a breach of “a comparable duty of loyalty, trust, and confidence.”  See US v Milovanovic.     There are several things about this holding that are worth noting, as described in this analysis by the Jenner &  Block law firm (registration required).    First, the court’s “formulation of an informal fiduciary relationship, the breach of which could trigger criminal liability for honest services fraud where the alleged fiduciary takes bribes or kickbacks, is extremely broad…. Second, the …opinion arguably makes even subcontractors susceptible to prosecution for honest services fraud…Finally, the Milovanovic case does not appear to be limited to government contractors.”

The decision – which has been the subject of some criticism for its breadth  – indeed appears to be a significant addition to the landscape of COI-related legal risk, at least from a criminal law perspective.  (Here is an article on informal fiduciary duties and civil liability.)

However, from an ethics-based  risk assessment logic standpoint, informal fiduciary relationships have always been worth paying attention to because even in the absence of a legal duty betraying the trust of others could have an adverse reputational impact and, under any mainstream ethical standard (e.g., utilitarianism, deontology or virtue ethics) , is clearly wrong.  And perhaps the Milovanovic opinion will serve as a reminder of the need to consider these types of relationships in identifying and addressing COI risks.

 For more on what makes a COI a crime, see this post  by criminal defense attorney Patrick J. Egan