Harm / Trust Issues

The potential for loss of trust and other types of harm can have a powerful bearing on the analysis and resolution of various COI issues, as will be examined here.

Massive but (mostly) harmless conflicts of interest

The conflicts of interest will be enormous when  the recently announced merger between Publicis and Omnicom – each a giant ad agency (or collection of agencies) in its own right – is finalized.  Both companies, through their respective subsidiaries,  represent major players in such industries as automotive,   telecommunications,  food,  beverages, and beer (as described in this article) .   Are conflicts of this sort something that business-ethics-minded individuals should find of concern?

Not in my view – because such conflicts can, at least as a general matter,  be addressed by market forces.  By contrast, truly dangerous conflicts typically involve one of several types of “market failures.”

The first such failure is “information asymmetry,” meaning where market players lack the information needed to make an informed – and hence optimal – decision.  In the COI context, this can occur when a conflict isn’t fully disclosed, which, in some cases, can be seen not only as an ethical breach but a legally actionable instance of fraud or corruption.  To this classic type of information asymmetry one should add the various findings of behavioral ethicists – some discussed in this earlier post – showing that, for a variety of reasons,   even when COIs are disclosed the information doesn’t seem to be processed in an optimal manner. (I’m not sure if this would truly count as an information asymmetry, but it is in that neck of the woods.)

The other most often relevant market failure to COIs concerns externalities, meaning where the cost of a COI is not borne by the individual/entity in a position to address it but by a third party who doesn’t have a seat at the decision making table.  COIs in the health care field – the costs of which are passed on in large measure to taxpayers and insurance companies – are a prominent example of the great harm that externalities can cause.  Moreover, the phenomenon of   “moral hazard” – also addressed in various prior posts – can be seen as causing harm in this way.   Of course, some COIs – like public-sector corruption – involve more than one type of  market failure.

COIs caused by the mergers of ad agencies certainly don’t raise the issue of externalities, at least not as a general matter. For the sake of completeness, I should note that if the merger creates a monopoly that would be yet another form of market failure –  but this seems very unlikely to ever happen, due to (what I assume are) relatively low barriers to entry in the advertising industry.

Finally, while it is possible that the above-mentioned behaviorist findings about the weakness of disclosure does raise the prospect  of information asymmetry (or the behaviorist version thereof) in this setting,  I think that the strong presence of market forces in the form of competitors pointing out to advertisers  the risks of staying with a conflicted agency would largely negate harms of this sort too.  Indeed, astute ad agencies looking to recruit new clients could do worse than trying to utilize some of this behaviorist science for their commercial advantage.

For further reading:

here’s a description of the various forms of market failures;  

here’s a piece about another context  – joint venture governance  – in which COIs should not be seen as inherently troublesome; and

here’s something on how market failures should factor into anti-corruption risk assessment.

A telling tale to end the year

One of the most closely watched COI stories of the year concerned the Facebook IPO.  As a piece in today’s Wall Street Journal  notes, this IPO is seen as a “telling example of the divided loyalties at many firms, which woo lucrative investment-banking clients and then prod brokerage customers to buy the same stocks even if they look bruised.”

What is particularly noteworthy about this example is how  starkly quantifiable the apparent conflict seems to be: “Among the 33 firms that sold Facebook shares to the public in the $16 billion deal, 62% of the 208 analyst reports have urged investors to buy the shares, according to Thomson Reuters. None has suggested investors sell the shares.”

For the COI Blog, statistics like these are relevant not only to the financial services industry. They also help inform a broader view of conflicts – one that suggests that, for a variety of reasons, mitigating conflicts generally tends to be much more difficult than is often appreciated.

And, as this blog begins its second full year, we are eager to watch each new “fresh hell” (to borrow from Dorothy Parker) in the realm of conflicts of interest emerge, as many of these do present teachable moments.  See you then, and thanks for reading the COI Blog in 2012.

Fracking, conflicts of interest and adverse inferences

Being reasonably informed about the issues of the day is fundamental to participating meaningfully in the democratic process, but as those issues become more technically (and otherwise) difficult to understand the bar to such participation gets raised.   And, given the crucial role that experts play in helping others try to understand such issues, the related ethical bar – by which I mean the need for experts involved in a public dialogue to be either conflict free or conflict transparent – is raised as well.

Take the example of “fracking,” an area of considerable complexity, and my own attempts – as a citizen who wants to be reasonably informed – to understand it.   Initially, I was skeptical about the wisdom of the fracking but the more I read the more it seemed, on balance, like a good idea (assuming strong environmental safety measures are put in place and that the embrace of fracking does not diminish the development and deployment of renewable energy sources).

But now I’m a bit less sure – given recent stories like this piece   and this one   about undisclosed ties to the energy industry by those publicly opining on various aspects of fracking.  These and similar pieces make me wonder, if fracking really is a good thing, why do its proponents need to pursue unethical means to promote it?

From the perspective of a citizen seeking to be informed, it can be hard to avoid drawing an “adverse inference” from these sorts of undisclosed conflicts, by which I mean suspecting that the reason a conflicted expert is playing a key role in opining/researching a given matter is because a conflicts-free one would view the merits of a matter differently.  Note that adverse inferences based on wrongdoing are not always logical. (In this connection, here’s a law review article on “adverse inferences about adverse inferences” ).  However, they have long played a powerful role in our thinking and, in addition to having a force born of habit, they have enough logic to be attractive.

Further, as the issues of the day become more complex and difficult to address on their merits, the adverse inference becomes a more attractive – if not necessarily more logical – way to resolve issues.   This is a possibly non-obvious reason why, in my view, the ethical bar for disclosing COIs in research is, in effect, raised as the need of the public to be able to trust experts in understanding significant public policy issues grows.  (But, of course, the main reason is to  prevent the public from being misled by undisclosed COIs. )

Finally, for more information on the danger of overreactions to COIs see this post on “reverse conflicts of interest.”


Compensation consultants and conflicts of interest

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.”


F. Scott Fitzgerald famously said that “The rich are different than you and me,” and, along the same lines, CEO conflicts of interest can be pretty different than those involving people like you and me.  Consider this story – which likely would not have taken place with anyone other than a CEO – about what in going on at Chesapeake Energy.

As background, the company permits its CEO, Aubrey McClendon, to take personal stakes in the wells it drills.   By itself this arrangement – while unusual and controversial – does not, in my view, inherently involve a COI.  Indeed, one could argue that by investing side by side with the company, the CEO aligned his interests with those of the company’s shareholders.

However, “[i]n order to pay for stakes in new wells, McClendon borrowed money — using his stakes in existing wells as collateral — from a group that Chesapeake was trying to sell assets to. Investors complained that the arrangement raised a conflict of interest. They worried that Chesapeake might have sold its assets to the firm because the firm agreed to lend McClendon money, and not because the terms of the deal were the best Chesapeake could have received.  The arrangement was not previously disclosed to shareholders.” Or, as noted in another (more bluntly written) account:  “The overlapping relationship has led many analysts to say that there was at least the appearance of a conflict of interest since Mr. McClendon could give his lenders a sweetheart deal in exchange for a preferential interest rate on his loans.”  (Perhaps some of these analysts recall the harm caused by the tangled personal financial dealings of then CEO Bernard Ebbers at WorldCom.)

Where was the board – which included a former governor of Oklahoma and former US Senator – when this was going on? According to this story, Chesapeake’s general counsel initially claimed that the board “was fully aware of the existence of the loans” but the company soon reversed course on this.   As described by Ben Heineman, a former General Electric Co. general counsel who teaches corporate governance and business ethics at Harvard: “the Chesapeake board, in effect, is declaring that it would ‘rather just look ill-informed and negligent than complicit in McClendon’s deals.’”

Adding to this turmoil – a story has now surfaced of an undisclosed financial tie between the CEO and a director  (albeit one dating back several years).  And, the Securities and Exchange Commission has opened an internal  investigation.

What does all this mean for the shareholders (i.e.,  people like “you and me”)?  Many have apparently lost faith in senior management and the board, which has led to a massive loss in their investments in the company. This is, of course, entirely predictable when a CEO creates an apparent COI of this magnitude and the board – the only meaningful check on a CEO – is either negligent or complicit.

CEO conflicts really can be unique, not only in terms of what they are but also the impact they can have.



“Organizational Justice” and Conflicts of Interest

According to research conducted by the Corporate Executive Board (the “CEB”) of about 600,000 employees of more than 140 companies, one of the most important steps to promoting compliance is maintaining “organizational justice.”  The CEB notes: “A firm’s culture has organizational justice when employees agree that 1) their firm responds quickly and consistently to proven unethical behavior and 2) that unethical behavior is not tolerated in their department.”

What does this have to do with conflicts of interest?

In many organizations COIs constitute one of the most common – and commonly observed – types of wrongdoing.  And, I believe that  – more so than with most types of C&E violations – when COIs that are harmful to a company are permitted to exist, that undermines the sense of justice within the organization.

The special harm that COIs can cause to organizational justice arises from their frequently personal nature: because COIs often involve a personal benefit to an individual employee that is denied to others, the latter (i.e., rule abiding employees) can feel personally harmed (from a relative perspective) by the COI in a way that they would not feel, for example, with an antitrust offense or violation of export regulations.  This  impact has been brought home to me in various client engagements, such as recently hearing at one company how employees “monitor” each other regarding COIs or from a focus group in another company where employees questioned the organization’s commitment to C&E generally based upon its handling of certain COIs.

Given the outsized impact that COIs can have on the overall efficacy of a company’s C&E program, addressing them effectively should be a top priority for companies.  That is, the danger of poor COI mitigation is not only the immediate impact  from individual COIs (e.g., distorted procurement or hiring decisions) but a broader risk to the entire program.

COIs in the News (033112): the Cost of Conflicts

From Chris MacDonald’s The Business Ethics Blog, a piece on the far reaching costs of COIs, occasioned by a story about employees of a public school system receiving gifts from vendors: “when conflicts are accepted and fostered… they erode confidence in the judgment not just of individuals, but of entire institutions.”  As Chris notes, the fault is not with  the receiver alone – and he uses subordination of perjury as a metaphor for the giver’s culpability in third-party situations such as these. We definitely agree with him that not causing COIs in others is a topic worth greater attention, and, also feel that that the costs to society of COIs need to be better understood.

What about the costs to the wrongdoers themselves? Here, the news of the week is mixed (as it likely is in any given week).

Reflecting a strict approach, the head of the Dutch arm of Deloitte resigned due to violations of the firm’s policy regarding investing in audit clients.  This can be seen as a relatively high cost for what was (based on my knowledge of prior similar cases) probably an inadvertent violation, and a reflection of the need for strong compliance measures for businesses (such as auditing) where independence and trust are of the highest importance.

At the other end of the spectrum, in a criminal COI case – where the wrongdoing concerned  receipt of $385,000  in a side deal on maintenance contracts, and thus went well beyond a technical policy violation  – a former general manager of the Los Angeles Memorial Coliseum will escape prison in return for repaying the ill-gotten gains, doing 1,500 hours of community service and possibly paying additional fines.  Indeed, “[a]fter he serves three years of probation, he will be eligible to apply to reduce the felony charge to a misdemeanor, according to the plea agreement.”  While I’m sure there is a lot about the case of which I’m unaware, it is hard to look at this resolution as reflecting the serious impact that conflicts have on our world.

Conflicts of Interest in the News: A transaction “tainted by disloyalty”?

An earlier post described a lawsuit brought by shareholders of El Paso Corp. seeking to block an acquisition of that company by Kinder Morgan due to claimed COIs on the part of Goldman Sachs, which advised  El Paso on the transaction, and that company’s CEO.  Last week, the judge – Leo Strine of the Delaware Chancery Court  – refused to issue the requested injunction (a ruling that was expected – given the absence of a competing offer for El Paso), but also had harsh words for Goldman and the CEO, and left open the possibility of a claim for damages against them.

As described in these articles in the NY Times, Bloomberg, and the Wall Street Journal,  (which I draw from since the opinion itself hasn’t, as of this writing, been posted on the Court’s web site):

– The Court found that Goldman was clearly conflicted because at the time it advised El Paso in the negotiations with Kinder Morgan its private equity arm also owned  more than 19 percent of the latter company (and had two appointees on its board).  As noted in the Times piece, the court found that Goldman was not “capable of ignoring its $4 billion investment” in connection with providing this advice: “Goldman was fighting for every dollar, securing a $20 million fee for advising El Paso on the sale…if Goldman was so greedy for $20 million, it surely would be for $4 billion.”

– “While Morgan Stanley was hired as a second adviser to El Paso because of this conflict, [the judge noted that] Goldman also arranged the ‘remarkable feat’ of limiting the scope of Morgan Stanley’s engagement so that it got paid only if El Paso was sold but not if El Paso decided to engage in an alternative”  transaction.  In other words, the attempt to mitigate the COI was structurally defective (and, in my view, could be seen more as a proof of the COI than meaningful mitigation).  Moreover, as noted in the Bloomberg story, “Goldman Sachs was able to ‘exert influence’ on the sale to Kinder Morgan because the investment bank continued to advise on the [alternative transaction]. Goldman Sachs’s conflict was ‘real and potent, not merely potential,’ the judge wrote.”

– El Paso’s CEO – who had told Kinder Morgan, but not his own board, that he hoped to buy El Paso’s pipeline business from Kinder Morgan once the transaction was consummated – “inexplicably caved in to Kinder Morgan” in agreeing to the price of the transaction.  As described in the Times, the CEO “was supposed to be getting the maximum price for El Paso out of Kinder Morgan. Instead, [the judge] observed that [he] appeared more interested in currying Kinder Morgan’s favor in order to make this subsequent purchase.”

Although, as noted above, the judge denied the request for an injunction, the shareholders can still seek monetary damages if they can prove the transaction was “tainted by disloyalty,” which parts of the judge’s opinion certainly seem to suggest occurred.  And, the Times piece concludes that in light of two other recent cases involving claimed COIs by Goldman: “[I]t is hard to see why Goldman Sachs was willing to risk its reputation again for a $20 million fee.  While it will continue to dispute these facts and its liability exposure is limited [due to an indemnity], Goldman is most likely the biggest loser because of its continuing self-inflicted … reputational wounds. This is another black eye.”  Finally, the bank’s COI-related troubles are still not completely behind it: in addition to the continuation of the El Paso case, Goldman Sachs faces a lawsuit filed two weeks ago based on claimed COIs in another (completely unrelated) transaction.

Is There Too Much Worry About Conflicts of Interest?

In materials from a talk last year called Beyond Agency Theory: The Hidden and Heretofore Inaccessible Power of Integrity , Michael Jensen of Harvard Business School and Werner Erhard (affiliation not listed) argue: “There is far too much concern today about the conflicts of interest between people…and not enough attention paid to the damage caused by an individual’s conflict of interest with himself or herself.”   Their focus is on the importance of integrity, meaning “the quality or state of being complete; unbroken condition; wholeness; entirety [and] the quality or state of being unimpaired; perfect condition; soundness” –  not the definition of integrity concerning “sound moral principle; uprightness, honesty, and sincerity.”  The former type of integrity has a profound impact on various aspects of performance but is often disregarded because “[f]or most people and organizations integrity exists as a virtue rather than as a necessary condition for performance.  As a virtue, integrity is easily sacrificed when it appears a person or organization must do so to ‘succeed.’”

One key aspect of integrity is the importance of honoring one’s word, by which they mean: “1. Keeping your word  or: 2. Whenever you will not be keeping your word, just as soon as you become aware that you will not be keeping your word (including not keeping your word on time) saying to everyone impacted: a. that you will not be keeping your word, and b. that you will keep that word in the future, and by when, or that you won’t be keeping that word at all, and c. what you will do to deal with the impact on others of the failure to keep your word…”

On this latter point they argue:  “When giving their word, most people do not consider fully what it will take to keep that word.  That is, people do not do a cost/benefit analysis on giving their word.  In effect, when giving their word, most people are merely sincere (well-meaning) or placating someone, and don’t even think about what it will take to keep their word. This failure to do a cost/benefit analysis on giving one’s word is irresponsible.”

This notion of doing a cost/benefit analysis when giving one’s word  seems very important, and  I think it should be woven into ethics training of all kinds (among other reasons, because the underlying idea of ethics as requiring more than good intentions needs far more support than it currently gets).  Still, one can embrace this point without agreeing that we pay too much attention to conflicts of interest. 

Indeed, many COIs can be seen as failures to honor one’s word – whether it is an explicit promise of loyalty or the inherent promise of such  that comes from entering into and staying in a relationship of trust.    For this reason, paying more attention to COIs might, in my view, support the authors’ cause of promoting integrity generally and encouraging individuals to keep their word in particular.

Conflicts of Interest in the News: 123011 Edition

This is not all the COI news that’s fit to print, but hopefully some items of interest that you might not otherwise see – with notes on why I think they’re noteworthy.

COIs and Government

NY State “Attorney  General Eric Schneiderman has asked the state’s 932 towns to show his office their ethics codes in an effort to bolster self-policing by local government.” As explained in the article, “one practical aim is providing the attorney general’s office with referral information for calls from New Yorkers with concerns, which have recently included questions about officials with connections to wind power and hydrofracking interests.”

This seems like an important initiative, given the COI risks that can occur on local levels of government – risks exacerbated by often weak controls.   Because, over the years, the NY AG’s office has been a leader in addressing many COI issues, I imagine that other states’ enforcement officials will be watching this effort as it unfolds.  The story may also be of particular interest to private sector organizations that deal with local governments.

A story about conflicts that occur when individuals have more than one government role   This not your typical public sector COI, which involves a conflict between a public duty and a private interest.  (But it is not altogether unique, either: NY’s legendary “Power Broker” Robert Moses  once held twelve public posts  at  the same time.)  More generally, the  story shows that an interest for COI purposes  can itself be a duty – something we’ll return to next week when we look at COIs arising from  outside board service.

COIs in Business

For Wall  Street Deal Makers, Sometimes It Pays to Be Bad (may require registration).  This is about COIs in the buy-out area –  which  can indeed be a COI minefield.  The story is  interesting for, among other reasons, showing the difficulties  that shareholders  can face in seeking redress for COIs in corporate governance settings.  (Also, this is the first time in my more than thirty  years as a lawyer that I’ve heard a court use the word “icky.” )

Drug company  money on rise for 2 Minn. clinics Among other things, the piece a) has an  interesting discussion of conflict of interest management plans, which can be  crucial for this one – very significant – type of COI; b) reveals a split in  approaches between the two institutions at issue (the Mayo Clinic and the University  of Minnesota) on whether to have a de minimis threshold for COI reviews. (Both COI management and de minimis COIs are topics we’ll explore in 2012.)

COIs and Criminal Law

Prosecutor’s  Literary Contract Creates Conflict of Interest. Even though he cancelled the contract  and returned the advance, the court held, “this is a bell that cannot be  unrung.”  Note that cases concerning COIs  in the legal profession are rarely useful for analyzing those in business  organizations, but this one may be an exception for at least some cases where a  party tries fecklessly to “undo” a COI.