Edited by Jeff Kaplan
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Gatekeepers
While most duties for COI purposes are owed to discrete individuals or organizations (i.e., an agent’s duties to her principal) COIs can arise from breach of broader “gatekeeper” duties, too – such as those governing the work of public auditors and securities lawyers.
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Years ago, a firm I knew moved its chief compliance officer from a relatively nice office to a decidedly not nice one. The move was intended to send a message and it was received that way. I noted at the time that this would not end well for the firm. Sadly, I turned out to be right.
In a recent post on the Harvard Corporate Governance Blog, “Bernie Ebbers and Board Oversight of the Office of Legal Affairs,” Michael W. Peregrine, McDermott Will & Emery LLP revisits the once-famous World Com accounting fraud scandal from the early 2000s and particularly the aspect of it that entailed the CEO (Ebbers) marginalizing corporate counsel. The details of this matter are less important (to me) than are the author’s very useful recommendations for mitigating this sort of risk.
Here are a few – of many:
1.Providing periodic board education on the nature of the general counsel’s role as counsel to both the board and management.
3.Incorporating in the general counsel’s job description the role of promoting compliance with the law and ethical standards.
10.Giving the general counsel access to, and collaboration with, other corporate executives with risk, audit and compliance portfolios.
12.Providing for general counsel participation in periodic executive session meetings with independent directors.
13.Establishing effective reporting relationships between general counsel and the in-house counsel assigned to corporate subsidiaries.
14.Assuring participation by appropriately senior in-house counsel in board, committee and management meetings relating to risk, legal or compliance matters.
15.Identifying members of the internal legal team to whom employees may confidentially address concerns.
16.Confirming that compensation of the general counsel is not determined in a way that might reasonably be considered to compromise the independence of its legal advice.
Of course, most of these questions can – with some modification – be asked about a company’s chief compliance officer, as well as its general counsel. And in conducting program assessments one should consider identifying and addressing marginalization in both roles.
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What role do corporate lawyers play in preventing wrongdoing by executives in their client organizations? And how is this role impacted by behavioral ethics?
In “Behavioral Legal Ethics Lessons for Corporate Counsel,” to be published in the Case Western Reserve Law Review, Paula Schaefer of the University of Tennessee College of Law first examines “the corporate lawyer’s consciously held conceptions and misconceptions about duty owed to her corporate client when company executives propose a plan that will create substantial liability for the company—when and if it is caught.” As she shows, lawyers often have an unduly limited view of what that duty is.
Schaefer next “turns to behavioral science and highlights some of the key factors that corporate attorneys are unconsciously influenced by as they try to decide how (or if) to address client conduct that may amount to a crime or fraud.” Those factors are:
– Attorney self-interest. A key point on how to become a criminal defense lawyer is this: “Corporate advisors keep their jobs (as inside or outside counsel) when they keep executives happy; they do this by finding ways to implement corporate executives’ plans, and not by saying no.” Of course, on some level this is obvious but, based on the research of Tigran W. Eldred of New England Law School, she notes that lawyers are often not aware of the extent to which self-interest corrupts the professional conduct of attorneys vis a vis clients.
– Obedience Pressure. A key point here: “Obedience research explains the power an authority figure or colleagues have to influence bad advice.” The best-known study in this area is, of course, that conducted by Stanley Milgram, which measured the extent to which participants were willing to inflict shocks on apparent learners in the experiment when instructed to do so by an apparent authority figure and which demonstrated just how powerful obedience pressure could be. As Schaefer notes: “In the case of a corporate attorney addressing planned conduct that may be criminal or fraudulent, the authority figure is likely the corporate executive that the attorney reports to in the professional relationship.” And as she notes this is likely to create more pressure than the instruction of some man in a white coat in Milgram’s experiment.
– Conformity Pressure. Here, Schaefer describes experiments by Solomon Asch concerning the extent to which the participants gave knowingly incorrect answers to a question because of the fact that other participants did so. The results showed a high degree of such correlation. As she notes: “Asch’s research should be particularly concerning for lawyers. For Asch’s subjects, the stakes were low—the subjects likely did not know the other participants in the study and had no ongoing relationship with them. Further, the right answer was black and white, and they still felt pressured to choose the wrong answer selected by the majority. For a corporate lawyer addressing possibly fraudulent or criminal conduct, the group (with whom she feels pressure to conform) might be fellow attorneys or other decision makers at the corporation.”
– Partisan Bias. Schaefer writes: “The research reveals that partisanship makes it difficult for a lawyer to filter and interpret information objectively. One study found that students who participated in a moot court competition overwhelmingly perceived that their assigned side had the better case. In another study, subjects were asked to play the role of attorney for plaintiff or defendant in determining the settlement value of a case. Even though both sides received identical information, those who were randomly assigned to play the plaintiff predicted an award substantially higher than that predicted by the defendant.”
Schaefer next considers “interventions to combat a corporate attorney’s wrongful obedience and conformity.” All of these seem sound, but I don’t have space to discuss them here.
However, I do want to add that – although not the focus of Schaefer’s paper – the research may also be relevant to the longstanding debate about whether the general counsel or other member of the law department should serve as chief ethics and compliance officer (CECO) or if the individual in that role should be independent with respect to reporting purposes. At least to me, the research suggests that it may be more difficult for in-house attorneys to rise above the potential conflicts in this role than is generally thought.
Of course, even an independent CECO would be subject to the various biases described in this article. However, they would still – in my view – stand a better chance of ethical success since the notion of independence is truly foundational to their role, i.e., there is presumably not the same confusion about their duty than Schaefer found was the case with in-house attorneys.
Finally, note that I am not saying that this means that the General Counsel can never serve in a CECO role – only that the implications of this research should be considered along with various other factors in determining what approach makes the most sense for a given company.
For further reading:
– The Legal Ethics Blog
– An earlier post from the COI Blog with a different view on lawyers as compliance officers
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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.”
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Last week the Financial Reporting Council (FRC), the body that regulates the accounting profession in the UK, fined Deloitte L.L.P. £14 million pounds – a record setting penalty for that body – and issued the firm a severe reprimand, as well as fining a former director of the firm £250,000 and banning him from accounting work for three years. As described in the NY Times, the case arose from the firm’s work for MG Rover, a failed automaker, and for the “’Phoenix Four,’ four businessmen who took over the automaker in 2000 and ran it into the ground, taking out millions of pounds for themselves in highly dubious transactions before the company failed.” Although Deloitte had been the company’s auditor it was not the audits that were faulted but the corporate finance work run by the former director – particularly its “very prominent role” in some of the questionable transactions.
In the UK, “ethics rules require accountants to consider the ‘public interest’, but Deloitte argued that this duty was inapplicable to corporate finance work.” The FRC rejected this argument, noting that, among other things, the applicable rules make no such distinction. The FRC’s decision on this issue seems correct to me, as one can readily imagine the difficulty clients and others would have in trying to discern whether an employee of an accounting firm was in any given instance being guided by a very high standard of ethicality (as a public interest test entails) or something less. Indeed, the notion of an ethical carve out would tend to diminish the overall trust the public has in accountants, and that would be bad not only for the profession but – given the key role they play in various aspects of business life – the economy generally.
But is it possible to have an overly narrow view of self interest? Eddie Lampert of Sears may have had just that, as described by Jonathan Haidt and David Sloan Wilson in their new column for Forbes – “Darwin at Work.” The article is based in part on a recent profile of Lampert by Mina Kimes in Bloomberg BusinessWeek, which had noted: “’Lampert runs Sears like a hedge fund portfolio, with dozens of autonomous businesses competing for his attention and money. An outspoken advocate of free-market economics and fan of the novelist Ayn Rand, he created the model because he expected the invisible hand of the market to drive better results. If the company’s leaders were told to act selfishly, he argued, they would run their divisions in a rational manner, boosting overall performance.”
Haidt and Wilson write: “The results have been disastrous, in part because Lampert was ideologically committed to the metaphor of the invisible hand and the associated idea that people are purely selfish. Ideology is a lens – it makes some things more visible, others less so. Lampert’s ideology prevented him from seeing that he was destroying the invisible band – the bond that forms around groups that can trust each other and work together toward shared goals. Evolution is a different lens – one that we believe brings unparalleled focus and resolution when examining complex human systems. A brief look through the evolutionary lens would have made it obvious how dysfunctional Lampert’s reorganization was likely to be.”
They further note: “Evolution is all about competition, and the dramatic effects that competition has on the structure and behavior of organisms over time. But here’s the key idea: competition occurs at multiple levels simultaneously, and the winner at any one level generally succeeds by suppressing destructive forms of competition at the level below.” Finally, they suggest that “the next time someone suggests changing the organizational chart, incentives, or culture of your company to ‘align incentives’ or appeal to selfish interests, ask them if they have thought about the full range of motives evolution has bequeathed to our complex species.”
In effect, what Haight and Wilson are doing is identifying a different type of conflict of interest – where an interest – or at least one’s perception of such – conflicts with human nature itself. It is an important area to pursue, and I certainly look forward to reading more of Darwin at Work.
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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.
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I recently referred to COIs in the financial services field as a never ending story, and the same might be said of COIs in the accounting field. But accounting conflicts are different than most financial service ones because, as described by the Supreme Court, “the independent auditor assumes a public responsibility transcending any employment relationship with the client.” Public accounting involves gatekeeper duties, which the COI Blog has previously discussed in other professional contexts, and in today’s post we look at a few recent stories of note in this ever-noteworthy area.
First, an article published last week in the Wall Street Journal – “Eyebrows Go Up as Auditors Branch Out” – noted that the UK unit of Deloitte LLP not only performed audit work for Autonomy Corp. – which was acquired by HP and now stands accused by its new owner of accounting fraud – but also received substantial fees for other work from Autonomy. More generally, the story notes: “Nonaudit businesses form a steadily increasing portion of Deloitte’s business, with 39.6% of revenue now coming from consulting or financial advisory, up nearly a third since 2006. The rise in Deloitte’s nonaudit revenue spotlights a recent resurgence in consulting and other nonaudit work by the Big Four accounting firms, a decade after conflict-of-interest concerns and corporate scandal sharply limited such work… the move has revived fears that an increased focus on nonaudit work compromises companies’ capacity to sniff out fraud. ‘If firms become too preoccupied with consulting, I think it hurts the authenticity of the audit,’ said former Federal Reserve Chairman Paul Volcker in an interview.” (Note that what Volker is describing here is less a true conflict than what might be considered a professional tension.”)
Also last week, the Australian Securities & Investment Commission published a report which found that a decline in the quality of audits reviewed compared to its immediately prior review. As noted by one business columnist in Sydney : “The real or perceived conflict is that auditors get paid by the company that they have been hired to independently audit. It is a flawed system because it puts auditors in the invidious position of being torn between getting paid by retaining the audit job – which is code for keeping the client happy – and suffering the ignominy of being sued for complacency if a company blows up…”
Still, the “client-pay” system has been with us for a long time, and it is hard to imagine it ever being completely replaced. But there are other ways to strengthen auditor independence, and doing so is indeed one of the purposes that, pursuant to the Sarbanes-Oxley Act, the Public Company Accounting Oversight Board was established. The Board is currently evaluating a wide range of ideas and information regarding possible auditor rotation requirements, and for those interested in learning more about this (obviously complex) topic I recommend this recent post on the Harvard Law School Forum on Corporate Governance and Financial Regulation by one of the Board’s members, Jeanette M. Franzel.
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An analysis published this week in The Guardian found of the “50 most valuable UK public companies, 33 hired pay consultants who also sold services to other parts of the same company during 2011. The list includes businesses that attracted some of the greatest attention during the shareholder spring, in which investors began rebelling against pay awards.” Both the consultants and companies involved denied any conflicts but, as the paper reported: “the High Pay Commission was ‘concerned at the extent to which remuneration consultants are encouraging the ratcheting up of executive pay. In particular we are concerned that remuneration consultants have a direct conflict of interest where they provide executive pay advice and cross-selling for other business.’ [The Commission] added: ‘While the voluntary code for remuneration consultants specifies that they should not cross-sell services, anecdotal evidence and interviewees the High Pay Commission met during this research suggest this practice is widespread.’ ”
But is there truly harm in these sorts of COIs? The research in this paper – Compensation Consultant Independence and CEO Pay – published last year suggests that there is. As described by the authors: “Using a unique data set of compensation consultant service fee in U.S. S& P 500 firms in 2009, we find strong evidence that compensation consultant’s conflicts of interest is associated with higher CEO pay…evidence shows that that CEO receives 7% more salary, 22.9% more bonus and 15.6% more total compensation in firms where compensation consultants provide other services than that of firms where the consultants do not provide other service. In addition, we also document that CEO’s pay-for-performance-sensitivity (PPS) is lower in firms where the consultants have potential conflicts of interest.”
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In his blog on law and other subjects, Professor Bainbridge recently asked: “Did Wal-Mart lawyers violate their [Sarbanes-Oxley] 307 duties?” It is a good question – among other reasons, because it provides an occasion to reflect on a conflict-of-interest based set of rules that were the subject of much attention when first issued but which have since fallen into semi-obscure status.
Securities and Exchange Commission Rules of Part 205 – which are based upon Section 307 of S-Ox – mandate that lawyers practicing before the SEC take certain actions when faced with evidence of a securities law violation. At the time they were enacted, the rules caused many corporate law departments to issue policies for both their in-house and outside attorneys and to undertake related measures, such as training.
But are law departments still concerned enough about these standards to take even minimal steps to promote compliance with them?
An article published in 2010 in the Georgetown Journal of Legal Ethics (Sonne, “Sarbanes-Oxley Section 307: A Progress Report on How Law Firms and Corporate Legal Departments Are Implementing SEC Attorney Conduct Rules”), indicated a lack of attention to the rules by law departments and also law firms. Inspired by this piece, when speaking at a session later that year on “Legal Ethics for Compliance Lawyers” at the PLI Advanced Compliance and Ethics Institute in New York, I asked the audience: “If you are in a law department, do you regularly send your [Sarbanes Oxley 307/205] policy to newly retained law firms?” Of twenty responses received, nineteen were No.
I know of nothing in the past two years to suggest that the situation is improving. Indeed, the passage of time will likely have made it worse.
Let’s hope Professor Bainbridge’s question – combined with other focus on the role of lawyers and compliance professionals in Wal-Mart’s woes – does the trick. One can imagine how little sympathy the SEC – in the face of a violation – would have for law department or law firm members who failed to take reasonable steps to promote compliance with the rule (which sending out a copy of their policy would surely seem to be). As was said in a very different context (Death of a Salesman), “Attention must be paid…”
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