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.