The ethics of “backscratching”

The notion of reciprocity plays a foundational role in our ethical order. Most prominently, variations of the Golden Rule are evidently found in all of the world’s major religions.  Ethics-promoting reciprocity can be negative (“an eye for an eye”) or positive (“the best place for [an Eskimo] to store his surplus is in someone’s else’s stomach.”) But, there are also the less ethically savory types – commonly referred to as “mutual backscratching,” but having other names too (my favorite being “the ledger system”).

This past weekend, the Wall Street Journal reported  that the “U.K.’s financial regulator on Friday said it is investigating a banking-industry practice known as ‘reciprocity,’ where investment banks bring rivals into deals in exchange for future business. The Financial Conduct Authority, in a paper detailing the scope of a wide-ranging review into possibly anticompetitive investment-banking practices, said it was investigating whether reciprocity ‘might restrict the entry or expansion of firms which are not party to these arrangements.’ The investigation into reciprocity comes after The Wall Street Journal reported in March on the widespread practice in Europe of investment banks doling out lucrative work to competitors, partly based on how much business they will receive in return.”

Not being a competition law expert, I don’t have a sense of what would need to be involved for this practice to rise to the level of a competition law violation, although I have to believe that occasional acts of “garden variety” reciprocity alone wouldn’t be enough to cross that line.  But in many circumstances – particularly involving “other people’s money” – the potential for a conflict of interest arising from reciprocity seems clear enough.

Consider two cases.  In the first, a bank needs legal services and a law firm needs banking services – both needs being purely internal – and each agrees to use the services of the other.  I see no COI there, as there are no interests for which a duty of loyalty are being compromised.

But in the second case, the law firm is recommending banking services to its clients, in return for the bank  recommending the firm to the bank’s clients. In circumstances of this type – of which many exist – there is the potential for a COI.

How much of a COI is presented will depend in part on whether the referring party has a fiduciary duty to the party receiving the referral.  Presumably the law firm would, and I imagine the bank would as well.   However, in other settings it is more doubtful – e.g., a plumbing supplies store referring a general contractor to a customer to reciprocate for the contractor’s referring her customers to it.

My own view is that there is some kind ethical duty here but not to the same extent as there would be for those who are paid to give unvarnished advice.  The ethical analysis might depend on how long the customer has been dealing with the store – and how much trust he has placed in it during the course of those dealings. Another factor might be how harmful a conflicted recommendation could be. (E.g., substitute “safety equipment” for “plumbing supplies” in the store case above, and you might get a different result.) For further reading on what an “informal” fiduciary duty might entail, please see this post.

From a psychological perspective, reciprocity may not feel like a COI because it does not involve the direct receipt of cash or other things of value – just as barter transactions may not feel as much like tax fraud as does not declaring cash income. A behavioral scientist might say that this increases the extent of ethical peril.

Finally, I believe that – whether based on a true fiduciary duty or some lesser obligation – these sorts of COI (like many others)  generally can be addressed by disclosure: that is, they are not inherently evil as some COIs are, as there will sometimes be quite legitimate reasons for the referral. This is especially true where the referring party’s knowledge of the abilities of the referred party comes from their having previously worked together. However, in all situations involving reciprocity COIs the burden is on the referring party to make sure that the disclosure is indeed meaningful.

For reading on a related topic, here  is a recent post on the issue of “referral fees.”