Moral Hazard

Opposite Day at the COI Blog

Okay, I’m a bit late – since Opposite Day is traditionally celebrated on August 20 (or, by another reckoning, January 25 – in which case I’m very late, or very early).  But given my attraction to opposites – which extends to my wife, who reads only fiction, whereas I read only its opposite  – I can’t pass up another chance to write about opposites here.

In the past, I’ve suggested that one way of looking at the opposite of a COI is not the absence of a conflict but a situation where agents to identify too much – rather than too little – with the interests of their respective principals.  (This is to be distinguished from a “reverse conflict of interest” where a conflict is permitted to exist but those impacted overreact to it. )  And in another post, I suggest looking at “conflict of interest world” – meaning what life would be like in a world without legal and ethical limitations on COIs – as a way of increasing appreciation for such restraints.

“Moral hazard” is certainly not an opposite of conflict of interest.  I see the two more like “cousins,” in that they both entail interests that can detract from optimal decision making (as discussed in some of the posts collected here).    But I hadn’t thought of what the opposite of moral hazard might be until I read this recent piece in the NYTimes  by Sendhil  Mullainathan (an economics professor at Harvard ) arguing that while co-pays can be an important means to reduce wasteful health care choices, in some situations research shows that they unduly discourage patients from taking medicine that – purely as a matter of economic logic – the patients should take.  As he notes:  “The problem here is the exact opposite of moral hazard.”

My interest is moral hazard is largely limited to how it can inform the design and operation of compliance programs, and there too it seems worthwhile to consider opposites.  The specifics of these I hope to explore at a later time, but in its most basic form such an opposite might be a compliance program that instead of doing too little to prevent wrongdoing  creates incentives to do too much along these lines, as described in this post from the CCI website on “Goldilocks compliance” (a reference which I hope will convince my wife that I’m not completely ignorant of the world of literature).

A pharma cure for moral hazard?

“Moral hazard” – one of the three  principal areas of focus of this blog  – refers to a situation in which there is a disconnect between, on the one hand, those with the capacity and motivation to engage in risky behavior and, on the other, those who will bear the likely negative impact of such risk taking.  Notwithstanding the word “moral” in its name, it is primarily an economic concept – not an ethics-related one.  But anyone familiar with the logic of “heads I win, tails you lose” will see the possible connection to the latter area.

Certainly the government – since the 2004 amendments to the Federal Sentencing Guidelines for Organizations   – has been mindful of the role of  incentives in promoting or inhibiting C&E.  More recently, its concern has been reflected in the C&E aspects of some settlement agreements, such as the 2012 money laundering related case against HSBC (specifying, in relevant part, that bank policies provide that “the extent to which a senior executive meets the bank’s compliance standards and values has a significant impact on the amount of the senior executive’s bonus”).  Beyond these government-imposed C&E elements, some companies are instituting compensation “clawback provisions” involving wrongdoing by executives – including, as described in this recent post, Barclays.

The latest news on this front comes from the Wall Street Journal, which last week reported:  “Under pressure from investors, six of the biggest U.S. drug makers [Pfizer, Merck, J&J,  Amgen, Bristol Myers  Squibb and Eli Lilly] are revising their compensation policies to make it easier to recover payouts to an executive who violates ethics rules or otherwise behaves inappropriately. The changes would let the drug makers . . . reclaim compensation from executives whose actions hurt them or their investors, even if the behavior didn’t force a restatement of financial results. The companies also would be able to recover payments to executives who should have stopped bad behavior and to cancel future payouts.”

Note that from a purely economic standpoint, clawbacks  are not an optimal deterrent – as they permit  what is closer to a  “heads I win, tails we tie” calculation than something more truly punitive.  But the recent steps taken by the pharma companies in this regard still represent real progress in the fight against moral hazard – and one hopes that other industries follow this prescription.

Moral hazard, executives and corporate boards – fixing the mix

As noted in an earlier blog post, 2012 was a record breaking year for corporate criminal fines.  But it is unlikely that such fines will lead to record breaking compliance efforts, for the simple reason that  such fines are typically paid by different individuals (meaning shareholders of the prosecuted entities) than the individuals at the company who engaged in the wrongdoing in question (meaning typically employees).  This disconnect between those that take the risks and those who bear the costs of the risk taking is part of the larger phenomenon of “moral hazard,” which has been the focus of various prior posts on this blog.

Given the powerful role that moral hazard plays in promoting wrongdoing by businesses, it was encouraging to read yesterday this story from the Financial Times  about how Barclays had “recouped about £300m in promised bonuses from its bankers in the biggest ever effort by a global bank to strip staff of previous years’ awards.” As noted further in the piece: “About half of the clawbacks will be enforced in relation with the manipulation of the Libor benchmark interest rate, which prompted the bank to pay a £290m fine to regulators in the UK and US last summer.  The other half will be clawed back because of the bank’s involvement in the mis-selling of payment protection insurance and other misconduct.”  This is a promising development and, according to the Financial Times,  “underlines how banks are enforcing clawback provisions on a much broader scale than in the past as they seek to show regulators and investors they are taking tough action to deal with past failures.”

Of course, the first line of defense against moral hazard at the executive level should be a company’s directors, not its regulators. (See for instance the series of questions in this post for the McGraw-Hill board concerning what they did – or possibly didn’t do – to prevent the conflict of interests at its S&P subsidiary that are now threatening the future of both companies.)  However, the incentive structure for corporate boards often undercuts such a role. That is, directors are typically paid very well for their board service, but face little prospect of individual liability when things go wrong.

But that, too, may be in the process of changing,   as suggested by this piece  (also from yesterday) in the D&O Diary about an important new decision from the Delaware Chancery Court refusing to dismiss a lawsuit against the directors of a Delaware company with significant operations in China that suffered a  massive theft-related loss there. The court noted: “If you’re going to have a company domiciled for purposes of its relations with investors in Delaware and the assets and operations of the company are situated in China that, in order for you to meet your obligation of good faith, you better have your physical body in China an awful lot.  You better have in place a system of controls   to make sure that you know that you actually own the assets. You better have the language skills to navigate the environment in which the company is operating. You better have retained accountants and lawyers who are fit to the task of maintaining a system of controls over a public company. This is a very troubling case in terms that, the use of a Delaware entity in something along these lines. Independent directors who step into these situations involving essentially the fiduciary oversight of assets in other parts of the world have a duty not to be dummy directors.”

As noted by the D&O Diary, the implications of this decision “could include heightened responsibilities and even heightened liability exposures that may come as a surprise to some outside directors.” And just as clawing back bonuses could help better align the interests of executives and shareholders when it comes to risk taking, so could the news from Delaware also help change the incentives mix and encourage some corporate boards to take a more active role in monitoring compliance risks in their companies.

Product liability, moral hazard and compliance and ethics officers

Yesterday the New York Times reported that at the opening day of a trial last week in a law suit against Johnson & Johnson the plaintiffs “introduced  evidence [that] executives knew years before they recalled a troubled artificial hip in 2010 that it had a critical design flaw, but the company concealed that information from physicians and patients… .”  While obviously only one side of what is likely a very complicated issue, this story provides a fitting occasion to return to our exploration of moral hazard.

As described in several earlier postings,  moral hazard refers to situations where the interests/incentives of an individual in a position to take risk differ from those of individuals/entities who will bear the consequences of the risk taking in question.  Moral hazard issues are – despite its name – not necessarily ethics related, but they certainly can be.

While a moral hazard analysis in the product liability setting would typically entail looking at the allocation of risks as between the producer and consumers of a good (e.g. this paper on aviation safety risks)  there is another dimension to it, at least for publicly traded  companies. That is, the managers of an organization (who often can create or reduce risk) might have different (i.e., more short-term) interests than do the owners of the company (the shareholders) when it comes to deciding whether to disclose a product safety issue.  An early disclosure might imperil the managers’ compensation, but presumably the shareholders would prefer that alternative to a later but far costlier disclosure.

I’m not suggesting that this was at issue in the J&J case. However, I do have a pretty good sense – from having been in the C&E field for more than two decades –  that in a great many organizations  C&E officers are often not involved either in critical decisions concerning their companies’ products/services or in responding to crises.   A moral hazard analysis suggests that they should be.

(For further somewhat related reading, here is a post on C&E officer compensation/incentives  and here is a story from the mid-1990’s   about how a member of a company’s ethics committee took public his grievances concerning the company’s response to a product safety issue.)

Conflicts of interest and industry culture

In the C&E world, culture most often refers to the culture of an organization.  In this connection, an earlier post discussed how permitting COI violations near the top of an organization can undermine the sense of “organizational justice” among employees generally – and thereby diminish the C&E program as a whole.

C&E-related culture also commonly refers to the culture of a given geography.  For instance, as this prior guest post by Judith Irwin of the Institute of Business Ethics describes, in some places what is considered a COI by Western standards might be seen an ethical mandate in other places.  (“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.”)

But there is also a third dimension to the intersection of culture and C&E that is too often overlooked: industry culture.

An example of this unrelated to COIs is that in the chemical industry some years ago there seemed to be a culture that encouraged sharing of information among competitors.  This contributed, predictably,  to a high incidence of antitrust violations.

And, industry culture can be relevant to COI risks, too.  For instance, the advertising business (at least in the U.S.)  is one in which gift giving/entertaining is pretty prevalent and so even an organization that has strong COI policies may wish to devote extra C&E-related attention to its employees (typically in marketing or procurement) who interact with members of that industry. (The Wal-Mart ad agency case from a few years back – discussed briefly here  – offers a pretty good lesson in how important that can be.)

Beyond the COI risks that industry culture can create in a company’s functions (as in the advertising example) culture can be risk causing vis a vis distinct business lines or units within a company, particularly a large decentralized one. So, for example, a large energy company whose principal business is a regulated utility that needs to maintain the trust of key regulators should be mindful of  the reputational danger of a casual approach to COIs in its unregulated subsidiaries. (Note that this sort of situation can also involve “moral hazard” –  a topic of occasional discussion in this blog.  Specifically, the risks of adversely impacting the interests of the organization as a whole might not be fully felt by the risk-taking unregulated business.)

As a general matter industry culture is not as significant a cause of risk as organizational or geographical culture.  But it can be potent, particularly in industries with a high degree of inter-company mobility, such as financial services.  And,  industry culture should be considered in all organizations’ COI risk assessments.

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.