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.

Must we choose between ethics and compliance?

Ethics and compliance have long been seen by some as representing essentially inconsistent approaches to promoting desirable conduct in companies.  I have never been persuaded by this oddly Manichean worldview. Rather, and as previously argued in Compliance & Ethics Professional (page 2 of  the PDF), I believe that compliance can give ethics “body” and ethics can give compliance “soul.” Or, as the 2004 amendments to the U.S. Sentencing Guidelines for Organizations indicate, companies should have “compliance and ethics” programs.

Moreover, many “middle-aged” programs (discussed more generally in this piece on the CCI web site ) need all the help they can get.  For those struggling to maintain a sense of urgency in their programs, the answer to the question “Ethics or compliance?” is a resounding “Both, please.”

Of course, there are some C&E challenges that companies face that largely require “C” but little or no “E.” (A recent posting here suggests that these include dealing with requirements of anti-corruption, export control and competition law.)  The converse is true as well.

But some risk areas – such as conflicts of interest – clearly need healthy elements of both. More importantly, so does the overall platform for ensuring that companies do the right thing, such as paying due attention to C&E in incentive structures.

The importance of incentives to C&E was addressed in a piece last weekend in the NY Times by Gretchen Morgenson  about a recent proposal by Professors Claire A. Hill and Richard W. Painter of the University of Minnesota Law School “for making financial executives personally liable for a portion of any fines and fraud-based judgments a bank enters into, including legal settlements” regardless of fault.  The proposal, she notes, quoting one of the professors, “would help instill a culture… ‘that discourages bad behavior and its underlying ethos, the competitive pursuit of narrow material gain.’”

Clearly the goal here is to go beyond traditional notions of compliance to promote a more truly ethics-driven approach to banking.  But by using the mechanisms of “carrots and sticks” to achieve that goal, it is also very much in the heartland of compliance.

While the case for this sort of an approach may be strongest in the financial services industry, its logic is applicable more broadly.  For instance, a large company in any industry might adopt a policy that if any of its divisions are prosecuted the leaders of that division will bear some of the costs incurred by the company.  However, and in the spirit of the Sentencing Guidelines themselves, I think that an executive who could show that she made a strong effort to promote C&E in her division – going beyond promoting mere rule abidance, to embrace a truly cultural view of ethics – should be spared some of this punishment.

Of course, few, if any, other industries have had the perverse incentives C&E-wise that financial services (generally speaking) have, which is why I would temper the no-fault aspect of the Hill and Painter proposal as applied to other areas of business.  But any company in which the managers are not the owners faces the potential for at least some “moral hazard” when it comes to mitigating C&E-related risk, as discussed in the prior posts collected here.  That is why  companies of all kinds need to consider how they provide incentives for ethics and compliance.


Compliance programs for the “big people”

Imagine a company where all the senior managers took compliance and ethics as seriously as they do traditional aspects of business (R&D, production, sales & marketing).  In this company, not only would senior managers do whatever was reasonably necessary  to prevent and detect violations in their own business unit or function, they would use their knowledge of and clout within the entity as a whole for making sure their peers were equally committed to promoting law abiding and ethical conduct.  While thought experiments are more art than science, I find it hard to imagine any other single C&E-related factor being as powerful a force for good in organizations as this would likely be.

Leona Helmsley is reported to have said that “only the little people pay taxes” and sometimes it feels like C&E programs are only for the little people – given how often it is the “big people” who engage in the types of unlawful and unethical practices that cause the greatest harm in businesses. Indeed, the “C Suite” seems to be the “final frontier” when it comes to effective ethics and compliance programs. In an article in yesterday’s NY Times, Gretchen Morgenson identifies two recent (and somewhat similar) proposals that offer a path to addressing this area of great weakness in many companies.

One is a proposal to Citigroup shareholders that would “require that top executives at the company contribute a substantial portion of their compensation each year to a pool of money that would be available to pay penalties if legal violations were uncovered at the bank. To ensure that the money would be available for a long enough period — investigations into wrongdoing take years to develop — the proposal would require that the executives keep their pay in the pool for 10 years.”

The other is an article by Greg Zipes in the Michigan State Journal of Business and Securities Law  which “calls for the creation of a contract to be signed by a company’s top executives that could be enforced after a significant corporate governance failure. Executives would agree to pay back 25 percent of their gross compensation for the three years before the beginning of improprieties. The agreement would be in effect whether or not the executives knew about the misdeeds inside their companies.” Its requirements would be triggered if, among other things “a company pleaded guilty to a crime [or]…if an executive signed a financial document filed with the S.E.C. that subsequently proved false and required an earnings restatement of at least $5 million.”

Both of these proposals make sense to me. While a company should, of course, use traditional forms of compliance (e.g., training, auditing, monitoring) to address C-Suite risks, the best mitigant of all may be other “big people” – if they are properly motivated to prevent and detect wrongdoing by their peers.

For further reading:

– “Redrawing corporate fault lines using behavioral ethics”

“Behavioral ethics and C-Suite behavior” (discussion of paper by Scott Killingsworth)

“Behavioral Ethics and Management Accountability for Compliance and Ethics Failures”

– “Where is the accountability?” (a dialogue with Steve Priest in ECOA Connects).


Prosecutors, massive fines and moral hazard

Many years ago, I lived next door to a young police officer and his family who, while presumably paid a modest salary, drove a pretty expensive car.   He was able to do this, I learned, because his department seized autos (and other property) of various suspected offenders and then let its officers drive the vehicles for their personal use.  Although he seemed in every respect like an honorable young man, the impact that this practice could have – and also appear to have – on law enforcement decisions left me feeling uneasy.

The latest issue of The Economist has a sweeping indictment of the US system of business law enforcement.  There are many components to this assault, including that: large fines are, in effect, extorted from companies, but the guilty individuals often go free (which, in my view, is quite true); settlements of these cases often obscure facts that should be made known to the public (with which I also agree); US laws are so numerous and complicated that companies face a grave risk of prosecution for conduct that they never could have suspected was wrongful (with which I agree only slightly); and part of the cost of this system is that “[e]normous amounts of time and money are now being put into compliance programmes that may placate judges, prosecutors, regulators and monitors but undermine innovation and customer services” (which I also think is an overstatement,  but also is true enough for companies to be careful not to go overboard in their compliance programs).   But the critique that interested me the most concerned the view that the prospect of recovering large fines influences law enforcement decisions, i.e., a corporate variation on the story in the first paragraph of this post.

This part of The Economist article relied in part on a paper in the January 2014 Harvard Law Review – “For-Profit Public Enforcement,” by Margaret H. Lemos (Professor, Duke University School of Law)   and Max Minzner, (Professor, University of New Mexico School of Law), in which the authors seek to show “that public enforcers often seek large monetary awards for self-interested reasons divorced from the public interest in deterrence. The incentives are strongest when enforcement agencies are permitted to retain all or some of the proceeds of enforcement – an institutional arrangement that is common at the state level and beginning to crop up in federal law. Yet even when public enforcers must turn over their winnings to the general treasury, they may have reputational incentives to focus their efforts on measurable units like dollars earned. Financially motivated public enforcers are likely to…undertake more enforcement actions [and] focus on maximizing financial recoveries rather than securing injunctive relief,… Those effects will often be undesirable, particularly in circumstances where the risk of over-enforcement is high.”

I don’t know if it is quite right to call this a conflict of interest, but it does seem close to a moral hazard, in that those with power to reduce risks (prosecutors) may have interests that are not well aligned with those who bear the consequences of their actions (the public).  Moreover, and independent of this concern, prosecutors sacrificing tomorrow’s interests (as the benefits of deterrence take place entirely in the future ) for a quick buck today – the very trade-off for for which guilty companies are often castigated  – itself can be harmful because, as Justice Brandeis famously said: “Our government is the potent, the omnipresent teacher. For good or for ill, it teaches the whole people by its example.”  

(For more on moral hazard see the posts collected here. And here is a post on implications for risk assessment of the government’s seeking large financial recoveries from corporate defendants.)

A ray of sunshine at the end of an ethically dreary week

From the COI Blog’s perspective, the past week was dominated by two discouraging developments:

– The Supreme Court’s decision in the McCutcheon case, further eroding – on free speech grounds – the federal campaign finance reform legal edifice.  Particularly unfortunate was the holding that Congress’s ability to attempt to curtail corruption in this area is limited to the exceedingly  (one might almost say comically, if it wasn’t so sad) narrow category of cases of “quid pro quo” bribery.

-The various stories, prompted by the publication of Michael Lewis’ The Flash Boys, suggesting that stock exchanges effectively sell customer order information to high-speed traders, which the traders use to financially disadvantage  the customers.

While these two stories are, of course, different in many ways, given the deep connection between democracy and capitalism – and the fact that each requires a widely shared sense of fair play to succeed – they seem to reflect a dangerous insensitivity at high levels of both government and business  to the ethical dimension of the ties that bind us together as a society.

But the week actually ended with some good news concerning the promising but generally underutilized mechanism of ethics-related  “clawbacks,” which was reported in a story by Gretchen Morgenson – “The Wallet as Ethics Enforcer” – in today’s NY Times.  She writes that while the “vast majority of [companies] across corporate America, require recovery of bonuses in only a few circumstances, mostly related to accounting… [and not] other types of unethical behavior … some large shareholders have been working to expand these so-called clawback provisions.”  Among other things, she reports: “the New York City comptroller… and his staff have successfully negotiated expanded thresholds for clawbacks at five companies this year:  Allergan, Halliburton, Northrop Grumman, PNC Financial and United Technologies” and that “[t[hese new clawback thresholds also state that executives can be forced to give back pay even if they did not commit the misconduct themselves; they could run afoul of the rules by failing to monitor conduct or risk-taking by subordinates.”

This is a promising development indeed, for just as financial incentives can serve as a powerfully corrupting force in both politics and stock markets so can such incentives – if properly directed – unleash energy and attention in the service of promoting ethical conduct … and building trust.   (For more on the importance of – and great challenges in – aligning incentives with ethical standards, see the posts collected here.)  

Are private companies more ethical than public ones?

To those in the C&E field, the notion that privately held companies could, as a group, be more ethical than publicly held ones seems implausible.  After all, public companies are required by law to be transparent in ways that private ones are not – and are also required to have various compliance measures that are not mandated for the latter.  Moreover, at least based on anecdotal evidence, when companies go from public to private they tend to cut back on their C&E programs.

But that might not be the whole picture.  As mentioned in a post last week, research in a recently published paper  – “The Value of Corporate Culture,” by Luigi Guiso, Paulo Sapienza  and Luigi Zingales   –  found that public firms seem to have a greater difficultly in maintaining cultures of integrity than do private ones.  In that earlier post we focused not on that finding but what could be described as the “headline” story of that piece: that “high levels of perceived integrity are positively correlated with good outcomes, in terms of higher productivity, profitability, better industrial relations, and higher level of attractiveness to prospective job applicants.”   Today, we return to the article to consider what could be the cause(s) of the link between private ownership and ethical cultures – for which the authors offer three possible explanations.

First, they note that there could be greater integrity-related communications challenges facing a public company than a private one: “if a violation of internal norms is discovered in a public corporation, in deciding the punishment, the CEO has to send two signals: an internal one to the managers and employees that also serves as deterrent for future violations and an external one to the market that maintains transparency of internal procedures. The latter poses the risk of being (wrongly) interpreted by the market as the tip of an iceberg rather than an isolated episode, inducing the top manager to dilute the punishment and the internal message. These complications may weaken integrity norms in publicly traded companies vis-à-vis private firms.”

This is indeed an interesting possibility, and something that I’ve not heard before.  But the very fact that I have not heard it mentioned previously – in more than two decades of advising companies on C&E matters, attending C&E conferences  and otherwise keeping track of the field –  makes me somewhat skeptical about it.

Second, the authors note: “Public ownership…changes …the trade-off between the costs and benefits of strict integrity norms…  If… some assets are not considered (or underappreciated in the short term), public ownership creates a distortion in decision making…” They further argue that integrity may in fact be underappreciated in the market, so that “a CEO who allocates company resources to maximize the current stock market value of a company will tend to underinvest in integrity.”

Unlike the first explanation, this one seems virtually self-evident, given the absence of any meaningful indication (at least of which I am aware) that capital markets really give sufficient weight to integrity cultures.  Fortunately, the above-noted “headline” finding of the authors’ research  –  linking ethical cultures with profitability and other desirable business outcomes –  itself has the power to change that, at least if it becomes widely appreciated and further developed by practitioners and researchers.

Finally, they state: “public ownership comes with a separation between ownership and control and the CEOs of a public corporation are not always driven solely by shareholder value maximization, since they do not fully internalize the cost of deviating from value maximization.”   This, too, seems compelling to me.  It has  its roots in Adam Smith’s powerful insight that “[M]anagers of other people’s money [rarely] watch over it with the same anxious vigilance with which . . . [they] watch over their own,”  and is, of course, broadly consistent the notion of “moral hazard,” about which much has previously been written in this blog and elsewhere.  

So, for C&E professionals what is the import of these findings?

For those who work in/with public companies I think the overriding lesson is that the board needs to be involved to a meaningful extent with the C&E program.  That is because directors are generally far better able to resist the pernicious effect of short-terming thinking and “moral hazard” on a company’s integrity culture than is management. Of course, much has already been written about the need for strong board oversight of compliance.  But, having the relevant data from this paper should help some directors who are under-involved with C&E see the business case for stepping up their game.

Private companies, meanwhile,  should not get cocky.  While good news for them in a general sense, the paper doesn’t mean the pressure is off.   Indeed, the overwhelming percentage of companies punished under the Federal Sentencing Guidelines tend to be small    – and therefore (I assume, though can’t be totally sure) are mostly private.  Moreover, as discussed in this recent posting on the D&O Diary  (which was based on the results of the Chubb 2013 Private Company Risk Survey): “‘private companies increasingly are at risk of professional and management liability from a vast range of events, including costly lawsuits, governmental fines, data theft and other criminal activities’.”’

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.