Edited by Jeff Kaplan
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Conflicts
In this section of the blog (and the various sub-categories below) we will examine the many ways in which interests can conflict for COI purposes.
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As noted in a previous post, CEO’s tend to have different COIs than the rest of us. Today’s post will look at a few CEO-related COI stories that have been in the news lately.
Most notably, yesterday the pharma company Novartis dropped a controversial plan to pay outgoing CEO Daniel Vasella up to $78 million over the course of six years. As described by Forbes, “The board had originally justified its decision in order to ‘protect’ the drug maker, since Vasella knows ‘the company’s business intimately, having built the leading R&D organization and personally recruited most of the top executives.’ In other words, the payoff was hush money designed to keep him from telling secrets to competitors.” The notion that a board could even consider paying a CEO something extra for keeping shareholder secrets is – at least on its face – pretty distressing.
Public sector organizations have CEO’s, too – and various press accounts have noted that super-lawyer Mary Jo White, who President Obama has nominated to head the Securities and Exchange Commission, will need to take conflict avoidance measures if confirmed for that post. But as noted in this recent story in Bloomberg News , while it is hardly unusual for a lawyer going from private practice to public service to have COIs of this sort, White’s particular contemplated mitigation approach to her potential COIs (which concern not only her law firm partnership but that of her husband, himself a prominent securities lawyer) appears to be of less than optimal efficacy.
I should stress that I don’t think there is any chance that White will personally act in a conflicted way in the discharge of her duties at the SEC. But individual honesty is presumably not the end of the analysis regarding any leader’s COIs – and that is particularly so where a) the leader leads a government agency whose mandate includes, among other things, addressing COIs (at least in the financial services field); b) that agency has an uneven record over the years in enforcing that mandate; and c) there is a reasonably strong concern among press and public that the reason for the agency’s shortfall is one of regulatory capture.
And speaking of the SEC, there is this story from yesterday about a deposition of hedge fund chief Steve Cohen whose firm, SAC Capital, is being investigated for insider trading. Cohen apparently testified: “I’ve read the compliance manual, but I don’t remember exactly what it says,’’ and, according to John Coffee, a noted securities-law professor at Columbia, “That’s a dangerous statement. The fact that he doesn’t know what’s in his compliance manual is useful to the SEC,” should it decide to pursue the firm on a “control person” theory of liability (which essentially involves supervisory neglect).
But is this really a COI issue? It is in the sense that under Delaware law compliance oversight failures by directors and officers can be deemed a violation of the duty of loyalty, which – even if not technically involving a conflict – is from the same neck of the woods as COIs.
Finally, just today an internal investigation cleared former Chesapeake Energy CEO Aubrey McClendon of any “intentional wrongdoing” in connection with the controversial borrowing practices that were the subject of the prior post linked to at the top of this one. But presumably it did not do the same with respect to creating an appearance of a conflict – given the facts as described in the prior post, that could not be done with a straight face. And with CEOs, proper appearances can matter just as much as avoiding actual COIs, as evidenced by the great costs and disruption that befell Chesapeake when the borrowing practices became known to the company’s shareholders and others. Indeed, the company evidently continues to be the subject of an SEC investigation concerning these matters, and COI watchers may be able to look to the outcome of that inquiry for an early view of how seriously that agency will address conflicts in the era of Mary Jo White.
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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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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.
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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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In a recent post to his Conflict-of-Interest.Net blog (which is mostly about COIs in the university context), Prof Bryn Williams-Jones of the Université de Montréal writes about a story from earlier this year regarding “changes to [a certain university’s] COI bylaw for its board of governors; the critique being made by the University is that student representatives on the board were in a COI when discussing issues of student tuition. What’s odd about this move is that it seems to assume that all members of the board are neutral with regards to all subjects. And so because students can’t be neutral about issues regarding students, then they probably shouldn’t be on the board. The problem, though, is that the very reason that students are and should be representatives on boards or committees of various sorts, is to represent student interest – they are explicitly not disinterested, nor should they be!”
This is a good point, and there are indeed other situations like the one with the board of governors where interests can differ but are not seen as conflicting, for the very reason that the individuals in question are not seen as representing all relevant parties. One example occurs with the boards of joint ventures – where a JV’s owners typically waive their respective fiduciary duties of loyalty with regard to JV board members.
However, when going down this path – not only in the board context, but in any other involving what might be called a trimmed fiduciary duty – it is critically important to have clear governance documentation, to avoid the type of confusion of which Prof. Williams-Jones writes.
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I was reminded of this famous saying of Mark Twain’s when reading the latest news about the now notorious Facebook IPO.
A prior post described allegations that the lead underwriter, Morgan Stanley, apparently shared information about Facebook’s flagging prospects with some, but not all, customers before the IPO – a claim of COI that will now be tested in the courts. In the past few days a different COI issue has surfaced, with reports that “eight of the top nine U.S. mutual funds with Facebook shares as a percentage of total assets are run by Morgan Stanley’s asset-management arm [which may be suggestive of a COI because] Morgan Stanley had a crucial role in lining up orders for Facebook as the social-media company prepared to go public. It helped advise Facebook executives to increase the size and price of the IPO, despite warnings the company was making about its profit outlook. The New York securities firm, which declined to comment, took in $200 million in underwriting fees and trading profits, according to regulatory filings and people involved in the deal.” As noted by one commentator, “the Morgan Stanley funds’ large stakes raise questions about whether the firm’s role as lead underwriter influenced [the funds' investment] decisions.”
It should be stressed that no one apparently has proven an improper motive in the purchasing decisions in this instance. But, as was stated more generally by another commentator: “Institutions that underwrite shares and buy them on behalf of individuals represent another of those too-big-to-fail conflicts of interest that no one seems bothered enough by to actually change. Until, of course, they get burned by one of these deals.”
A famous case in COI history where regulators were able to prove that a bank’s investment advisory business was polluted by other commercial considerations involved HP and Deutsche Bank. In 2003 the Securities and Exchange Commission brought charges against the advisory unit of the bank where its “investment banking division was working for HP on [a] merger, and had intervened in [an asset management] proxy voting process on behalf of HP.” As stated by the SEC: “This created a material conflict of interest for [the advisory business], which had a fiduciary duty to act solely in the best interests of its advisory clients.”
And looking back further still… nearly ten years before this, one of my colleagues at NYU’s business school had penned a case study that eerily prefigured the HP/Deutsche Bank matter, for use in discussing how external forces could impact investment decisions made by fiduciaries. Perhaps it was a work of pure imagination (I never asked him) but even at the time it seemed to have the ring of truth – and does even more so today.
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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.”
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By Judith Irwin, Institute of Business Ethics
Let’s start at the beginning. What is a conflict of interest? Wikipedia defines it as ‘a conflict of interest occurs when an individual or organisation is involved in multiple interests, one of which could possibly corrupt the motivation for an act in the other’. Is this an accurate description?
Arguably, it is unwise to attempt to define a conflict of interest in absolute terms, for like many things in life, there is more than one definition. What is deemed to be a conflict of interest in one social or cultural context may be entirely appropriate in another. The same decision can be interpreted as entirely legitimate in a different setting. Take the example of nepotism in Africa. In Africa, where family bonds are highly valued, nepotism is a common practice, and an employee may face ostracism for not hiring a relative for a position at the firm. However, most Western-based multinationals actively discourage allowing personal relationships to influence an employee’s business judgment.
Who decides what constitutes a conflict of interest in a business context? A company’s board directs the policy, actions and affairs of the organisation. The UK Corporate Governance Code (2010) (formerly the Combined Code) states that corporate governance is about what the board of a company does, including how it sets the values of the company: “the board should set the company’s values and standards and ensure that its obligations to its shareholders and others are understood and met.” The most common way that a large corporate sets out the company’s values and standards is through an ethics policy and/or a code of ethics, which aims to govern employees’ day-to-day conduct. Frameworks for dealing with a conflict of interest are normally included in such guidance documents.
It is without doubt that guidance for employees is necessary, especially since the definition of a conflict of interest will vary with context. Thus, providing a framework based on the company’s ethical values for employees to refer to, will help to ensure consistency in employee’s decision-making across the organisation when it comes to dealing with a conflict of interest. And it goes without saying that training for staff on the framework (and the company’s values) is required to help them identify, manage, and resolve potential conflicts of interest. This should be coupled with a broader awareness of why it is important to manage those conflicts.
But no framework and no amount of training can cover every potential conflict of interest or guarantee that every employee will make the ‘right’ decision, by the company’s standards. Are conflicts of interest not moral dilemmas? And are people’s morals not inherently different?
There is often an expectation by senior management that many conflicts of interest are avoidable; an expectation that is not shared by experience. Conflicts of interest are not necessarily of our own creation. It could be argued that in fact the conflicts that employees encounter are the product of the structures implemented at a more senior level. Normal human relationships can be transformed by individuals’ professional roles into a source of conflict, regardless of whether they do in fact influence the individual, or just create the perception of influence. But we are very often influenced, and driven to act in certain ways, unconsciously.
Having a framework to govern employees behaviour when it comes to conflict of interests shouldn’t stifle people’s ability to make their own decisions. But trusting the ethical judgement of employees may not fit well with effective governance of a company. The middle ground is hard to find. Perhaps conflicts of interest is such a moral maze that it cannot be governed with a framework? A supportive and open culture, which encourages employees to understand how their relationships may be perceived so that they may be transparent about their interests, may be the middle ground we are striving for.
Judith is Senior Researcher at the Institute of Business Ethics where she researches and writes on best practice on a range of business ethics topics, advises companies on embedding ethics in their organisations, and regularly engages in training and public speaking to raise awareness of the subject.
(Editor’s note: Jeff Kaplan is on vacation until July 23, so there will be no additional posts on the COI Blog until after that, and any comments received about this or other pieces won’t be posted until then.)
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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 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…”
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