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.