Moral Hazard

A condition of moral hazard exists when an employee or other agent’s compensation creates an incentive for her to perform her duties in ways that are not consistent with the interests of her employer/ principal. We will examine how C&E programs can identify and address risks of this sort.

Moral Hazard – Part Three: Intangible Interests, Monitoring By Boards

In prior postings, we introduced the concept of “moral hazard” (which, again, is principally based on economics, not ethics) to the Blog and considered how moral hazard risks can be addressed through appropriate attention to incentives, both positive and negative.  In this posting we discuss the less common form of intangible moral hazard based interests.

Consider the example of corporate support for political causes or candidates for public office (hopefully a good example to use in an election year).  In some instances, a senior manager with the power to make decisions  for a company regarding such support may use that power to embrace a candidate or cause even if doing so is against her company’s interests  (e.g., the cause or candidate’s positions may offend a large percentage of the company’s customers).   For the purposes of our example, assume further that the manager does not expect to be tangibly rewarded for providing the company’s support to the candidate, and thus may not have a true “interest” for COI purposes (at least not in the traditional sense).  Nonetheless, because of the manager’s political beliefs, she may cause the company to take risks in supporting the candidate that are unjustifiable from the organization’s perspective.  In other words, this is a case of an intangible moral hazard risk.

Of course, compared to other C&E risks (e.g., corruption, competition law) political support is not an area of great danger to most companies.  Nonetheless, presumably because of this potential for divergence of interests, it is in fact area of relatively significant amount of board oversight and other high-level compliance measures, as described in The Conference Board’s  Handbook on Corporate Political Activity Emerging Corporate Governance Issues.

I should emphasize that most moral hazard risks really are of the tangible variety – and come particularly from the area of compensation.  But as with COIs, organizations need to think broadly about moral hazard to have an effective C&E approach regarding all the ways in which employees might be moved to act inconsisently with  the interests of the organization.

Next up on the Blog: “behavioral ethics and compliance.”

Moral Hazard – Part Two: Risk Assessment and Incentives

The immediately preceding post introduced the concept of “moral hazard” to the blog.  In today’s post and others to follow we examine how C&E programs can address moral-hazard C&E-related risks.

The principal way to deal with such risks is, of course, through attention to compensation approaches. There are, in turn, two dimensions to this.

The first is to assess how current  (or planned) compensation approaches can create or exacerbate risks.  This can be done by building into the risk-assessment process questions addressed to all forms of compensation, meaning not only salary and annual bonuses but also such matters as business unit and project plans.   For example, a project plan that creates incentives for finishing the project by a certain time but does not sufficiently dis-incent unduly risky conduct (which, depending on the project, could involve a wide range of compliance issues) could be seen as creating moral hazard.

The second general approach focuses on the other side of the compensation coin, and specifically, mitigating risks through creating “positive”  (from a C&E perspective) compensation approaches.  Among the obvious possibilities here are including C&E-related criteria in decisions about promotions, salaries and bonuses, and also having tangible awards for truly exemplary ethical service.

A less obvious measure that can be taken in this regard is to give the chief ethics and compliance officer formal input into promotion and succession planning decisions, at least for senior positions.  Relatively few companies currently do this, but it can be a powerful way to correct for moral hazard and other risks.

Additionally, non-monetary forms of recognition for highly commendable ethical conduct can be helpful.   This can occur either centrally (such as mention in a company newsletter, as appropriate) or on a local basis. To facilitate the latter, companies should consider training managers on means to recognize (meaning here both identify and acknowledge) exemplary ethical conduct.

The third posting in this series will examine non-economic moral hazard issues and also board oversight as a control for moral hazard risks at the senior manager level.



Moral Hazard, Conflicts of Interest and Compliance Programs

The concept of moral hazard was used originally to refer to the phenomenon that providing insurance tended to promote risky behavior by insured parties.  Subsequently, the idea has been applied more generally to mean the provision of incentives that encourage unduly risky conduct by shifting the impact of a bad decision to a party other than the decision maker. 

Most recently, moral hazard was seen as playing a major role in the economic crisis of 2008, as some of the individuals creating the risks at issue there evidently did not have interests sufficiently aligned with those jeopardized by their actions.  A perfect example of this can be found in an SEC report on ratings agencies quoting an e-mail between two analysts concerning their plans to give positive ratings to certain financial instruments that were, in fact, unworthy of such ratings: “Let’s hope we are all wealthy and retired by the time this house of cards falters.”

Notwithstanding its name, moral hazard is generally viewed as more of an economic phenomenon than a moral one.  Moreover, moral hazard risks are often seen as somewhat distinct from COIs, perhaps because the interests at issue in the former are not external or unknown to an affected organization.  (A typical COI concerns ownership of or compensation from an entity other than one’s employer, whereas a typical moral hazard risk is likely to be based on the employer’s own compensation scheme.)

However, the two are similar in that both diminish the fidelity of employees to their employers’ interests.  For this reason, I believe that addressing moral hazard risks lies squarely in the province of C&E programs, and subsequent posts will explore strategies for doing this – principally through risk assessment, monitoring and attention to both positive and negative incentives.

Additionally, beyond individual areas of risk (e.g., corruption, competition law), it is worth considering the impact that moral hazard may have on some companies’ overall commitment to C&E.  That is, under the Federal Sentencing Guidelines for Organizations and related policies, companies are encouraged through enforcement-related incentives to develop and maintain effective C&E programs. However, because of the pernicious effects of moral hazard, some individual executives with the power to ensure that their respective companies maintain strong C&E programs may not feel personally motivated enough by these incentives to do so.

In other words, the general moral hazard danger for C&E programs is that a company’s senior managers or other key decision makers will think that they are likely to be “wealthy and retired by the time” the company is forced to pay a heavy price for not having an effective program .   And, as we will discuss in future postings, the best way for a company to address this peril is by having strong C&E program oversight by the board of directors.