Moral Hazard and Bias

These two “cousins” of COIs – which are related in that they tend too fall outside of traditional COI analysis, but still can be harmful in ways similar to the harm caused by COIs – will be the source of relatively consistent focus in the blog, with each discussed under its respective tab below.

Is compliance still just “putting on its shoes”?

Mark Twain famously said “A lie can travel half way around the world while the truth is putting on its shoes,” and one might think something similar about risk and C&E. Perhaps it has always been this way and maybe it always will be, at least to some extent.  But forward looking companies should look for ways to narrow or possibly eliminate the gap between the immediacy of the problem and that of the solution.

In a sense, this is much of the point of the “cultural” approach to compliance and ethics, and it can also be seen as part of the promise  – albeit still largely theoretical  – of  “behavioral” C&E.  Both seek to have C&E operate, in effect, as an instinct. (For more on behavioral ethics visit the Ethical Systems web site.) But, at least in part, the idea goes back much earlier  –  to Aristotle’s focus on ethics and habit.

There are various avenues for pursuing this goal but, as a general matter, a valuable though often underutilized approach lies in the realm of incentives. Incentives tend, I believe, to reach employees more deeply than policies and procedures do – and thus can help create instinct-like ethical behavior.

Companies indeed do seem to be more interested than ever in exploring ways to use incentives to promote strong C&E. For instance, one company I know now uses the results of internal controls testing in setting compensation for its senior executives. This kind of measure might not sound particularly exciting, but it could  – at least over time – help make compliance operate as something of a reflex, in that it presumably contributes to  managers being focused on risk on a day-to-day basis (and not just on the far less frequent occasions of responding to cases of possible violations).  More generally, this and other incentive measures could be part of a larger C&E strategy of moving from  a necessary but somewhat limited “culture of honesty” to also include a broader and deeper “culture of care,” as described in this earlier post.

Moreover, C&E incentives need not be solely of the negative type, nor need they be tangible. Appealing to the better angels of our nature through praising pro-social behavior could, to my mind, be a powerful force for helping ethics move at the speed of risk, particularly with the somewhat idealistic generation of younger employees.

But, in some cases traditional economic incentives are indeed called for. That is why  – as discussed in these earlier posts – the notion of “moral hazard” should play a greater part than it currently does in many C&E programs.

Finally, note that incentives are just one type of tool in the C&E “tool box.”  And, whether it be through a cultural/behavioral approach or something else, the risk-reduction discussion should include consideration of all available tools – which is what a C&E risk assessment offers …or, at least, should. (For more on risk assessment generally, please download this complementary e-book, available at CCI.)

 

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).

 

A behavioral ethics and compliance index

While in the more than three years of its existence the COI Blog  has been devoted primarily to examining conflicts of interest it has also run a number (close to fifty) of posts on what behavioral ethics might mean for corporate compliance and ethics programs. Below is an updated version of a topical  index to these latter posts. Note, however, that to keep this list to a reasonable length I’ve put each post under only one topic, but many in fact relate to multiple topics (particularly the risk assessment ones).

INTRODUCTION 

Business ethics research for your whole company (with Jon Haidt)

– Overview of the need for behavioral ethics and compliance

BEHAVIORAL ETHICS AND COMPLIANCE PROGRAM COMPONENTS

Risk assessment

– “Inner controls”

– Is the Road to Risk Paved with Good Intentions?

– Slippery slopes

– Senior managers

– Long-term relationships

– How does your compliance and ethics program deal with “conformity bias”? 

– Money and morals: Can behavioral ethics help “Mister Green” behave himself? 

– Risk assessment and “morality science”

Communications and training

Publishing annual C&E reports

– Behavioral ethics and just-in-time communications

– Values, culture and effective compliance communications

– Behavioral ethics teaching and training

– Moral intuitionism and ethics training

Accountability

– Behavioral Ethics and Management Accountability for Compliance and Ethics Failures

– Redrawing corporate fault lines using behavioral ethics

– The “inner voice” telling us that someone may be watching

Whistle-blowing

– Include me out: whistle-blowing and a “larger loyalty”

Incentives/personnel measures

– Hiring, promotions and other personnel measures for ethical organizations

Board oversight of compliance

– Behavioral ethics and C-Suite behavior

– Behavioral ethics and compliance: what the board of directors should ask

Corporate culture

Is Wall Street a bad ethical neighborhood?

– Too close to the line: a convergence of culture, law and behavioral ethics

Values-based approach to C&E

– Values, structural compliance, behavioral ethics …and Dilbert

Appropriate responses to violations

– Exemplary ethical recoveries

BEHAVIORAL ETHICS AND SUBSTANTIVE AREAS OF COMPLIANCE RISK

Conflicts of interest/corruption

– Does disclosure really mitigate conflicts of interest?

– Disclosure and COIs (Part Two)

– Other people’s COI standards

– Gifts, entertainment and “soft-core” corruption

– The science of disclosure gets more interesting – and useful for C&E programs

– Gamblers, strippers, loss aversion and conflicts of interest

– COIs and “magical thinking”

Insider trading

– Insider trading, behavioral ethics and effective “inner controls” 

– Insider trading, private corruption and behavioral ethics

Legal ethics

– Using behavioral ethics to reduce legal ethics risks

OTHER POSTS ABOUT BEHAVIORAL ETHICS AND COMPLIANCE

New proof that good ethics is good business

– An ethical duty of open-mindedness?

– How many ways can behavioral ethics improve compliance?

– Meet “Homo Duplex” – a new ethics super-hero?

Behavioral ethics and reality-based law

Behavioral ethics and reality-based law

Historically, one of the ways law has advanced is by becoming more “reality based” in general and accepting of social science information and ideas in particular. This is a legacy of the great Louis Brandeis.

In the latest issue of Compliance & Ethics Professional (on the second page of  the PDF) I ask whether behavioral ethics can play a role of this kind – by providing the social science basis for more C&E friendly law.  Another way to ask this: Is behavioral ethics and compliance ready for a “Brandeis moment”?

I hope you find it interesting.

Business ethics research of interest to your whole company

In this article from the most recent issue of Ethisphere magazine Jon Haidt of NYU and I take readers on a tour of the Ethical Systems web site. “EthSys” offers  cutting edge social science research that should be of  interest not only to C&E professionals but also  to board members and executives; to those working in finance, law, HR, audit and procurement; and to many others in the workplace as well.

The ideas and information on EthSys can be helpful in developing C&E training, drafting ethics sections of employee newsletters and in other types of  company communications.  This knowledge can enrich the ethics-related dialogue in workplaces by turning what sometimes seems like a dry and static subject into a compelling and dynamic one.  It can help leaders lead ethically – and show that the same sort of social science findings and insights that increasingly are seen as key to running a profitable business are also essential to running an ethical one. It can also be useful in designing risk assessments; creating various types of policies and procedures; and crafting recognition strategies to promote ethical behavior.

And, that’s only part of what EthSys can do for your company.

So, take the tour yourself.

Operational transparency and internal selling of C&E programs

While all companies try to “sell” their  C&E programs, often such efforts are  not particularly robust. And that’s too bad, because the need for effective C&E program selling measures is considerable.  This is due in part to the behavioral ethics/psychology-related phenomenon that we tend to overestimate how ethical we are, which leads us to underestimate how much we need the kind of help that C&E programs can provide.  Also relevant here is the moral hazard/economics-related phenomenon that leads to a misalignment of risk vis a vis rewards in many companies when it comes to C&E, meaning that the internal “market” for C&E services in many companies is not an efficient one.  On top of both of these challenges is, at least in some companies, a growing sense of  “compliance fatigue.” With all these forces aligned against them, what should C&E professionals do to sell their programs in an effective manner?

A few years ago, in a paper published in Management Science – “The Labor Illusion: How Operational Transparency Increases Perceived Value”  – Ryan W. Buell and Michael I. Norton, both of the Harvard Business  School, reviewed the results of experiments involving  the near-ubiquitous experience of consumers reacting to wait times on web sites. They found that “when websites engage in operational transparency by signaling that they are exerting effort, people can actually prefer websites with longer waits to those that return instantaneous results—even when those results are identical.”   While the context is obviously not at all specific to C&E work, the general learning about individuals valuing services more positively when they understand the amount of effort involved in providing those services seems broadly applicable,  and worth considering for possible lessons to those seeking to “sell” C&E programs.

Operational transparency can, of course, play a role in C&E programs in various ways – most obviously through the day–to-day work of compliance officers in training on and otherwise communicating about a company’s standards of business conduct, work which is presumably well understood in a company.  Beyond this, employees generally have some understanding that a C&E officer receives and responds to reports of suspected wrongdoing. But there is, of course,  much more to a C&E program than these two functions, the depth and breadth of which is often unknown to (or under-appreciated by)  its  “customers”  – meaning the employees.

For some companies, what is needed to make a strong and positive impression on the work force is an annual C&E report.  Such reports typically summarize major efforts and accomplishments  of  a company’s C&E department in a given year, and thereby hopefully have the kind of impact that will make employees truly value what goes into the program.  To my mind, the opportunity to publish reports of this kind should be seen as “low hanging fruit” in more than a few companies – and I hope that C&E officers who don’t currently engage in this practice will revisit the issue at some point soon.

There are, however, two caveats to this suggestion.  First, in publicizing the work of a C&E department, one must be careful not to do anything that might indicate that the promise of confidentiality in responding to helpline calls and undertaking other sensitive inquiries could be compromised.   Second, as the authors of the paper state: “Whereas operational transparency involves firms being clearer in demonstrating the effort they exert on behalf of their customers—an ethically unproblematic strategy—inducing the illusion of labor moves closer to an ethical boundary,…” to which I would add that this should indeed be seen as over the line for any C&E professional.  More broadly, while C&E officers often should make greater efforts to sell themselves and what they do, they must be mindful of restraints that are particularly relevant to (with apologies to The Godfather) “the business [they have] chosen.”

For further reading see this post on annual C&E reports in Corporate Compliance Insights.

Conflicts of interest, compliance programs and “magical thinking”

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

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

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

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

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

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

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.)

Conflicts of interest and “the social nature of humans”

Private supply chain auditing continues to serve an increasingly important role in compliance and ethics efforts worldwide.  A recent working paper from the Harvard Business School  – “Monitoring the Monitors: How Social Factors Influence Supply Chain Auditors,” by  Jodi Short, Professor of Law at the University of California Hastings College of the Law; Michael Toffel of the Technology and Operations Management Unit at the Harvard Business School; and Andrea Hugill of the Strategy Unit at the Harvard Business School – examines various factors that impact the efficacy of such audits.  The paper can be downloaded from SSRN and a summary of it can be found on the Harvard Corporate Governance web site.

For this study, the authors conducted a review of “data for thousands of code-of-conduct audits conducted in over 60 countries between 2004 and 2009 by one of the world’s largest social auditing companies, …”  They found that “auditors’ decisions are shaped not only by the financial conflicts of interest that have been the focus of research to date, but also by social factors, including auditors’ experience, professional training, and gender; the gender diversity of their teams; and their repeated interactions with those whom they audit.”  The authors state that this  “finer-grained picture suggests that audit designers should moderate potential bias and increase audit reliability by considering the auditors’ characteristics and relationships that we found significantly influencing their decisions,” and also that these findings “should likewise inform the broader literature on private gatekeepers such as accountants and credit rating agencies.”

Indeed, and beyond the scope of the paper, a focus on social – and not just economic – ties may be key to assessing various  independence issues regarding boards of directors.  In an important decision from 2003 involving a derivative action brought by shareholders of Oracle Corp., then Vice Chancellor Leo Strine noted: “Delaware law should not be based on a reductionist view of human nature that simplifies human motivations on the lines of the least sophisticated notions of the law and economics movement.  Homo sapiens is not merely homo economicus.  We may be thankful that an array of other motivations exist that influence human behavior; not all are any better than greed or avarice, think of envy, to name just one.  But also think of motives like love, friendship, and collegiality, think of those among us who direct their behavior as best they can on a guiding creed or set of moral values,” adding, “[n]or should our law ignore the social nature of humans.”

Finally, thanks to friend of the blog Scott Killingsworth for recently reminding me of the Oracle decision;  here’s an earlier post about the Oracle case, albeit with a different focus; and here is a post briefly discussing (and linking to) a paper by Jon Haidt and colleagues about business ethics implications of a model of human nature called “Homo Duplex,”  a term coined by the sociologist/psychologist/philosopher Emile Durkheim, which posits that we operate on (or shift between) two levels: a lower one – which he deemed “the profane,” in which we largely pursue individual interests; and a higher – more group-focused – level, which he called “the sacred.”

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

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

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

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

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

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

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

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