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.

The harm from conflicts you often can’t see

A few days ago Newsweek ran a piece on the Trump family’s “endless conflicts of interest,” describing in detail several dozen actual, apparent and potential conflicts, and related ethical infirmities. Another such list is maintained and periodically updated by The Atlantic. The sheer volume of these cases is so overwhelming that it may be worthwhile to step back and consider what the harm from COIs is as a general matter.

Over the years, one of the themes of this blog has been that the harm caused by COIs is often significantly underappreciated. Some of these posts are collected here.

Broadly speaking, COIs often give rise to two categories of harm: they encourage people to make undesirable decisions and discourage them from making desirable ones, as described in this post.  Neither type of harm is generally easy to spot but, of the two, the first – being incented to make bad decisions – is presumably more identifiable as a general matter than is the second – being discouraged from making good ones, as actions are typically more noticeable than inactions.

But an interesting and important case of the latter has been on display the past few days as Hui Chen – a highly regarded member of the compliance and ethics (“C&E”) community – has publicly explained her decision to leave her position as compliance counsel for the Justice Department’s Fraud Section. As described in The Washington Post : As a contractor for the Justice Department, Hui Chen would ask probing questions about companies’ inner workings to help determine whether they should be prosecuted for wrongdoing. But working in the Trump administration, Chen began to feel like a hypocrite. How could she ask companies about their conflicts of interest when the president was being sued over his? “How do I sit across the table from companies and ask about their policies on conflict of interest, when everybody had woken up and read the same news?” Chen said in an interview. “I didn’t want to be a part of the administration whose job it is to question others about these precise things.”

While this may seem like “inside baseball” to those outside of the C&E community, Hui Chen’s departure from Justice represents a loss for all who can be protected by strong C&E programs, meaning millions of shareholders, consumers, employees, taxpayers and others – in short, pretty much everyone.

Welcome to Conflict of Interest World!

How can conflicts of interest harm individuals, organizations and society?

My latest column in Compliance & Ethics Professional (page 2 of attached PDF) counts the ways.

I hope you find it interesting.

Do stock options discourage whistleblowing?

Paying hush money is big business, and hardly a day goes by without some press account of a company or powerful individual buying the silence of those with knowledge of wrongdoing. Sometimes this involves settling individual claims with confidentiality provisions – such as today’s story in the NY Times about the various settlements Fox News has paid to silence individuals who claimed they were sexually harassed by that organization’s Bill O’Reilly.  But of perhaps of greater interest to C&E personnel (or at least to me) are what could be considered structural inhibitions on whistleblowing.

Andrew Call, Simi Kedia and Shivaram Rajgopal recently published research they conducted on the relationship between companies issuing stock grants to their employees and employees at such organizations reporting fraud. As described on HBR.org, the possible connection between receiving stock options and deciding to blow the whistle is twofold. First, “the value of stock options is directly tied to the value of the firm’s stock, and … whistleblowing allegations result in an immediate decline in the firm’s stock price, [so] employees stand to lose financially when they blow the whistle. In addition, employee stock options typically have vesting terms that require employees to wait a few years before they can exercise their options, which may act as a disincentive to blowing the whistle before they’re able to exercise their options.”

Their research approach and findings were as follows:

“Using a Stanford Law School database, we identified a sample of 663 firms that were alleged to have engaged in financial misreporting and were subject to class action shareholder litigation in U.S. federal court from 1996–2011. We examined the number of stock options granted to rank-and-file employees during the period of alleged misreporting, and we found that these firms granted more stock options during the misreporting period than did a benchmark sample of 663 similar firms that were not being investigated for financial misreporting. Option grants by these misreporting firms varied over time. Specifically, misreporting firms granted 14% more stock options to rank-and-file employees when they were allegedly misreporting their financials, but the number of options they granted decreased by 32% after they appeared to stop misreporting. These findings suggest that these firms granted additional stock options strategically during periods of alleged misreporting. We also found that these efforts are effective. Misreporting firms that granted more stock options to rank-and-file employees were less likely to be exposed by a whistleblower. Approximately 10% of the firms in our sample were subject to a whistleblowing allegation. Firms that avoided a whistleblower granted 78% more stock options than these firms did not.”

 These are certainly interesting findings, although one wonders if the results would be similar with a study of exclusively post Dodd-Frank cases, given how that 2010 law has greatly enhanced the incentives for whistleblowing in public companies. I also have a hard time picturing a meeting of senior executives and human resources personnel agreeing to a strategy of using stock options to buy employee silence. I’m not saying this never happens but doubt it happens a lot – given the personal risks that participating in such a scheme would create for those involved. However, I can definitely see how this would happen in the poorly lit realm of what is understood but not spoken.

Regardless of how this incentive manifests itself, I think C&E professionals should be aware of it in assessing and responding to the challenge of encouraging employees to internally report wrongdoing in their organizations. For some companies the key will be in increasing disincentives for not reporting, such as imposing serious economic penalties for senior managers on whose watch the wrongdoing occurred regardless of fault by such individuals. For other companies, softer incentives might be what is needed – such as the appeal to a “larger loyalty” described in this previous post on behavioral ethics and whistleblowing. For still others, having a point of risk” communication strategy  around the granting of the option – also a behavioral ethics inspired approach – might be what is called for.

Finally, the study also raises a different issue: should C&E personnel receive stock options? I know of no research on this issue, but this post – which  explores the related area of incentive compensation for “governance monitors” (general counsel and internal auditors)  – may be of interest to readers facing this issue in their organizations.

When NOT lobbying suggests a conflict of interest

“It could probably be shown by facts and figures that there is no distinctly native American criminal class except Congress,” Mark Twain famously wrote. Providing some of those facts and figures, Aaron D. Hill, Jason W. Ridge and Amy Ingram – in an article published yesterday in the Harvard Business Review – describe a growing conflict-of-interest problem in the US Congress, an important topic that these days is largely overshadowed by the COIs involving the President.

The authors set the stage by showing that there is now widespread ownership of stock by members of Congress: “the average S&P 500 firm in [their]  sample has about seven members of Congress holding its stock. Some companies have closer to 100 members holding stock, and many firms have 50 or more in a given year.” They next show that “firms where a greater percentage of lawmakers invest have significantly higher performance in the subsequent year — with each percentage of congressional membership owning stock worth about a 1% improvement in” return on assets. “This suggests  that politicians may be privy to nonpublic information about future regulatory or legislative actions that may prove helpful to these companies. It’s also possible that members of Congress use their influence to benefit the firms in which they invest. This finding dovetails with prior research that shows members of the House and Senate generate abnormally higher returns on their investments.”

Hmmm. Perhaps just a coincidence. (As Twain once noted in a different context: “What a delightful thing a coincidence is.”) But wait, there is more.

The authors also show that “firms are taking note of congressional investments in a couple of ways … paying close attention to public disclosure laws that require members of Congress to report their stock holdings annually… [and] also hiring private companies that specialize in a unique business: identifying who owns firms’ stock (among other political intelligence activities). Firms can use information about which members of Congress own their stock to minimize the intensity of their lobbying activity,… [b]ecause owning stock aligns the interests of the firms with those of their stock-holding lawmakers …companies that have congressional stockholders no longer need to spend as much money on lobbying to influence opinion.” One example of this:  a “nearly three-quarter increase in members of Congress who held Apple stock from 2007 (22 people) to 2008 (38) was followed by a nearly 50% reduction in lobbying intensity the following year (2009).”

This is one of the most interesting use of facts and figures to show COIs that I’ve seen in a long time. Indeed, I think that, as a general matter,  more needs to be done to understand not only the incentives that COIs can create but also the disincentives, as discussed in this recent post.

And, there is more still to what Hill,  Ridge and Ingram have to say about Congressional COIs – both their consequences and also mitigation approaches. But for that you’ll need to read the original article, which I hope you’ll do.


Future conflicts of interest

First, a plug: at the upcoming annual conference of the Ethics and Compliance Officer Association , I’ll be speaking on a panel on “A view from the edge: exploring the future of ethics and compliance.”  It is a topic I addressed at the very first ECOA conference – held in 1992, when the organization had a grand total of 19 members and the entire C&E field was so new.  I hope to see you at this year’s event, which will be held next month in Dallas.

Second, the COI story of the week – is also about the future. It concerns the Clinton Global Initiative (CGI) accepting contributions from foreign governments, notwithstanding the prospect that Hillary Clinton will run for President.  When she was Secretary of State, the organization did not take such donations, but they lifted the ban when she resigned from that post.

Of course, since she isn’t president, technically this isn’t an actual conflict.  Rather, it is a potential COI.

What’s the difference? As discussed in this earlier post: Potential conflicts refer, as a general matter, to situations that do not necessarily constitute or appear to constitute a COI but where there is a reasonable possibility of an actual or apparent COI coming into play.

As with the risk analysis of any COI, with potential COIs one should consider the dimensions of likelihood and impact.

On likelihood, there are actually two questions relevant to this inquiry. First, how likely is the COI-triggering event to happen?  Here, that event – Hillary becoming President – seems reasonably likely to occur. (The analysis might be different if we were dealing with a “Bernie Sanders Global Initiative,” or organization associated with another long-shot seeker of the office.)

Second, if the triggering event does occur, can effective mitigation measures then be implemented? That might be difficult in this instance because, if she did win the Presidency, presumably returning the donations to the foreign governments, though not impossible, would be pretty unpalatable – particularly if the money was already spent on the many critically important causes the CGI supports.

Finally, the potential impact of a COI seems high here as well.  That is, the donations from foreign governments could undermine the trust that the American people have in the President, and perhaps cause suspicion in other countries too.

So I agree that CGI should ban foreign government contributions.  But I also applaud the organization for its effective work on climate change (and in other areas), as the actual conflicting interest we have with future generations on that issue may be the greatest COI of all time.

(Some additional reading:

Two conflicts of the apocalypse.

Is the road to risk paved with good intentions?

COI policies for non-profits.)



Referral fees and conflicts of interest

The recent indictment of NY State Assembly Speaker Sheldon Silver on corruption charges has – at least for  the moment – focused some  attention on the age-old practice of “referral fees,” under which a lawyer or other professional receives compensation for referring an individual or entity to some other service provider.  In the Silver case, the (now ex-) Speaker received such fees from two different law firms.  As described in this piece in the NY Times , one of these firms –  “a  large personal injury law firm where he has worked for more than a decade” – paid him more than three million dollars based on  client referrals from a doctor whose research center had been given $500,000 in state grants orchestrated by Silver.  Another part of the prosecution’s case involves his receipt of referral fees from a real estate law firm to which he had steered clients and his performing official action to benefit those clients.

In both of these alleged schemes the principal victims were the taxpayers of NY, whose interests were subordinated to Silver’s personal interest. The element of harm to the two firms’ respective clients was less a part of the picture (although some harm could be presumed with the personal injury referral fees). But in a traditional referral fee situation the harm is principally and often entirely to the client.

Of course, it is not only lawyers who pay/receive referral fees – and who face ethical questions involving these practices.  For instance, architects must, as a matter of professional standards, disclose referral fees.  As noted in this Advisory Opinion from the American Institute of Architects: “It makes no difference under the disclosure rules whether the architect is certain that the contractor he recommends is the best one for the job or that he would make the same recommendation even if no referral fee were paid. Though the architect may be confident there is no actual conflict of interest, any referral fee is an interest substantial enough to create an appearance of partiality and is a factor about which the client is entitled to know.”

Legal and ethical issues regarding referral fees are disturbingly common in the medical profession.  For a discussion of the conflicts of interest inherent in such arrangements see this post  from Chris MacDonald’s excellent Business Ethics Blog: “If the person you’re relying on for advice is financially beholden to the person he or she is recommending, you have every reason to doubt that advice.”

Such practices are also common in the financial advisory services realm.  See this discussion of  relevant ethical standards,  and note that – as with doctors – these cases sometimes cross legal, as well as ethical, lines.

Finally, the regulation of referral fees in the legal profession has existed for many years. However, the area is increasingly complicated by the phenomenon of referrals being made by non-attorneys to law firms, as described in this paper by John Dzienkowski of the University of Texas School of Law.

Indeed, in my own practice I have been offered referral fees by vendors selling C&E products and services.  I always say No.  I’d like to think that my steadfastness is the result of being virtuous, but in reality, it is just a matter of common sense. That is, for clients or prospective clients to have to worry about whether my advice was tainted would be devastating to my business.  And no referral fee could ever compensate for that.


The cost of director and officer conflicts of interest just went up

In the vast realm of conflicts of interest those involving boards of directors tend to stand out. That is because part of the reason the role of corporate director even exists is to mitigate the conflict-of-interest-type tensions (which fall under the broad heading of “agency problems”) that managements may have vis a vis shareholders.  Moreover, while the role of officers obviously differs somewhat from that of director, the duty of loyalty that both owe shareholders is the same.

Director and officer COIs can arise in many settings but often the most consequential of these involves mergers. And, as described in a post last week in the D&O Diary:  ”Within the past few days, two merger objection settlements – one involving Activision Blizzard, Inc. and the other involving Freeport-McMoRan, Inc. — have been announced involving massive cash payments,… The Activision settlement may represent the largest cash settlement payment ever in a shareholder derivative lawsuit.” The post further describes that “[t]he common feature of these two cases that may account for the magnitude of the cash payments seems to be the conflicts of interest that were alleged to be part of the challenged transactions.”

The specific facts of these two cases – both of which are complex, as COI cases involving mergers typically are – may be less important than is what they (and another one last year involving News Corp, which is discussed in the same post) may mean for insurance costs to companies: “The rise of jumbo shareholder derivative lawsuit settlements has a number of implications. Among other things, it is a topic that will have to be taken into account as D&O insurance buyers consider how much insurance they will need to ensure that their interests are adequately protected.”

While most directly relevant to risk managers and others in companies in charge of securing D&O coverage,  I think C&E professionals also need to know about this development – because directors and officer of their companies  likely will and will be concerned about it.  And, hopefully this awareness will contribute to a greater overall sensitivity at high levels in companies to COIs generally – meaning that this may be a good time to train (or retrain – or schedule training of) your directors and officers on COIs.

For those looking to develop such training, here is a prior post on that topic.  And here are some other posts, portions of which might provide helpful ideas or information for training boards on COIs:

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

CEOs’ ethical standards and the limits of compliance.

Are private companies more ethical than public ones?

Catching up on the backdating cases

Behavioral ethics training.

Catching up on CEO COIs.

Catching up on director COIs.

The largest derivative lawsuit settlements (from the D&O Diary).

Here are some pertinent words of wisdom from two good friends of the blog: Steve Priest (on keeping ethics training real) and Scott Killingsworth (on mitigating C-Suite risks).

Finally, if you are training your board, and want to use the occasion to look beyond the COI area to general C&E oversight by directors this recent article by Rebecca Walker and me  from Compliance and Ethics Professional magazine might be useful.



Conflicts of interest, compliance programs and “magical thinking”

An article earlier this week in the New York Times takes on the issue of “Doctors’ Magical Thinking about Conflicts of Interest.”  The piece was prompted by a just-published study  which examined “the voting behavior and financial interests of almost 1,400 F.D.A. advisory committee members who took part in decisions for the Center for Drug and Evaluation Research from 1997 to 2011” and found a powerful correlation between a committee member having a  financial interest (e.g., a consulting relationship or ownership interest ) in a drug company whose product was up for review and the member’s voting in favor of the company – at least in circumstances where the member did not also have interests in the company’s competitors.

Of course, this is hardly a surprise, and the Times piece also recounts the findings of earlier studies showing strong correlations between financial connections (e.g., receiving gifts, entertainment or  travel from a pharma company) and professional decision making (e.g., prescribing that company’s drug). Nonetheless, some physicians “believe that they should be responsible for regulating themselves.”

However, such self regulation can’t work, the article notes,  because “our thinking about conflicts of interest isn’t always rational. A study of radiation oncologists  found that only 5 percent thought that they might be affected by gifts. But a third of them thought that other radiation oncologists would be affected.  Another study asked medical residents similar questions. More than 60 percent of them said that gifts could not influence their behavior; only 16 percent believed that other residents could remain uninfluenced. This ‘magical thinking’ that somehow we, ourselves, are immune to what we are sure will influence others is why conflict of interest regulations exist in the first place. We simply cannot be accurate judges of what’s affecting us.”

While the findings of these and similar studies are, of course, most relevant to conflicts involving doctors and life science companies, there is a broader learning here which, I think, is vitally important to C&E programs generally.  That is, they help to show that “we are not as ethical as we think” – a condition hardly limited to the field of medicine or to conflicts of interest, as has been discussed in various prior postings on this blog.

One of the overarching implications of this body of knowledge is that we humans need structures – for business organizations this means  C&E programs, but more broadly these have been called “ethical systems” – to help save us from falling victim to our seemingly innate sense of ethical over-confidence.  So, to make that case, C&E professionals should – in training or otherwise communicating with employees (particularly managers) and directors  – address the issue of “magical thinking” head-on.

Moreover, using the example of COIs to prove the larger point here may be an effective strategy, because employees are more likely to have experience with ethical challenges in this area  than with other major risks, such as corruption, competition law or fraud – which indeed may be so scary as to be largely unimaginable to many employees.  I.e., these and other “hard-core” C&E risk areas might be subject to an even greater amount of magical thinking than is done regarding COIs.  So, at least in some companies,  discussing COIs might offer the most accessible “gateway” to addressing the larger topic of ethical over-confidence.

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

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

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

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

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

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

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

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


Spanking bankers for conflicts of interest. Again.

Two years ago the Delaware Chancery Court had harsh words about Goldman Sachs’ advising El Paso Corporation on a possible sale of the company while also having an ownership interest in the buyer.   Ultimately, the bank lost a $20 million fee due to this and other conflicts.

Goldman’s ethical lapse was not unique in the banking world.  Indeed, just a few months before the El Paso case, Barclay’s paid/gave up claims for about $45 million to settle a lawsuit in the Chancery Court based on its undisclosed dual role  in advising Del Monte on a sale the company while also providing financing to the buyers.  

The most recent addition to the banking COI hall of infamy is the Royal Bank of Canada, which, as described in this Reuters piece, the Chancery Court last week found should be “held liable to former shareholders of Rural/Metro Corp because [the bank] failed to disclose conflicts of interest that tainted the $438 million buyout of [Rural/Metro. The bankers] were so eager to collect higher fees that they convinced Rural/Metro directors to sell the company in June 2011 to private equity firm Warburg Pincus LLC at an unreasonably low” price,  while “conceal[ing] their efforts to provide financing to fund the buyout and other transactions,…” The court will “decide later how much RBC should pay former Rural/Metro shareholders in damages, including possibly damages for bad faith.”

That this could happen after the El Paso and Del Monte cases seems amazing.  But maybe it isn’t – since we’re seeing only the cases where the conflicted bankers got caught.  Perhaps there are many others where the betrayal went undetected and the wrongdoing proved profitable.  If so, the prospect of giving back fees – even large fees – may be a weak deterrent.

A piece on the case in the Wall Street Journal concluded:   “The bottom line is that investment banks that aren’t paying attention the Chancery Court’s continuing admonitions on conflicts will continue to be spanked.”  Yes, but will they be spanked enough to deter future COIs of this sort?

(For those wanting to learn more about the actual spanking, the court’s 91-page opinion can be found here.)