Ethical Choices and Legal Obligations_5 pot

information, he knew that Qwest’s dire financial straits made it unlikely that it would achieve its publicly announced earnings tar- gets. When a publicly traded company fails to meet its earnings tar- gets, its stock price usually falls. By selling before the bad news became public, he made a huge sum of money. The result? Nacchio looks like he is on his way to jail. 7 The court sentenced him to six years in prison and fined him $19 million. He was also ordered to forfeit $52 million in stock-trading profits. The insider trading rules do not allow violations to be classified like category three conflicts of interest. The government doesn’t have to show that the insider’s trades actually harmed others. The policy enacted by Congress, administered by the SEC, and not chal- lenged by administrations of either political party since inception is that the public securities markets need to be fair to all. ‘‘Fairness’’ means that every investor who wishes to buy or sell securities has access to the same public information as every other. Fairness resides in the procedure. That’s why the accused inside trader can’t try to escape civil liability or a criminal conviction by saying, in a variation of the win-win theme, ‘‘I won and you (at least) didn’t lose,’’ for example, ‘‘because my trades were too small to affect the market price at which other people traded.’’ Because disclosure is generally impractical, it’s easiest to under- stand the SEC’s insider trading rules as forbidding the practice. Before we look at the need for internal conflict-of-interest disclosure requirements within a company, we need to look at a counterexam- ple to the idea that win-win outcomes can justify self-dealing. This can be found in the law governing self-interested transactions by corporate officers and directors. SELF-INTERESTED TRANSACTIONS AND THE DOCTRINE OF ‘‘ENTIRE FAIRNESS’’ ‘‘Probably the longest standing concern of corporate law,’’ write two scholars of the subject, ‘‘has been that corporate officials may cause the corporation to enter into overly generous transactions with them- selves.’’ 8 Corporate law is not just the field of law that governs large multinational behemoths. It’s the branch of law that regulates busi- nesses, large and small, which are incorporated, and its doctrines are similar to those in partnerships and other forms of business The Multiple Dimensions of Conflicts of Interest 123 organization as well. One of its key principles is what’s called the ‘‘duty of loyalty.’’ The central requirement of the duty of loyalty is that a director or an officer must act in a way to benefit the corporation, and not himself or herself personally. There’s no mystery why this is a major problem: a corporation, obviously, can act only through its offi- cials, and when officials have the power to act, temptation is present. Historically, and today, many have found it difficult to resist. As Klein and Coffee put it, a corporate official can sell property to the company ‘‘at an inflated price or buy assets from the corporation at a bargain price.’’ 9 In the early days of American business, such self-dealing transac- tions were simply forbidden. If the corporation came into court and showed that an officer or director had self-dealt, the court would rule that the transaction was void ‘‘without regard to fairness or unfair- ness of the transaction.’’ 10 That’s changed. Although the law varies from state to state, 11 the self-interested transactions of officers and directors can be OK’d if either or both of two conditions are satisfied: (1) a disinterested majority of the board of directors (or sometimes shareholders) ratify the transaction; and/or (2) the court, at a trial, determines that the transaction was ‘‘entirely fair’’ to the company. The unspoken premises of these rules, and cases under these rules, is that persons acting in conflict-of-interest situations can get away with enhancing their own ACPs if they can persuade the board of directors to ratify what they did and (usually) if, through their attorneys, they can persuade a court to pronounce it ‘‘fair to the company.’’ After- the-fact category three conflict justifications, absent insider trading, are alive and well in straight-out cases of managerial self-dealing! To illustrate, let’s look at the facts of a case that I regularly discuss with my law students in a class on corporations. It involves a food products company well known in the Midwest, called Cookies, which makes not cookies but barbeque sauce. 12 (Its name comes not from its product but from the fact that it was originally founded by a Mr. Cook.) The company’s initial start-up was rocky. The turn- around into a successful business came after Duane ‘‘Speed’’ Herrig acquired control, but not complete ownership, of the company. Cookies boomed. Minority shareholders became upset, however, because Mr. Herrig engaged in a few transactions that unquestion- ably enhanced his own ACP. On Cookies’s behalf, he extended an exclusive distributorship agreement with a company he personally owned, Lakes Warehouse. He entered personally into a royalty 124 Temptations in the Office agreement with Cookies for a taco sauce recipe he developed. From his point of view, it was a good deal. Finally, Cookies’s board of directors, which consisted entirely of people that Herrig selected because he was the controlling shareholder, increased his compensa- tion. Minority shareholders sued the company, complaining about Herrig’s self-dealing. Nobody could deny that Herrig had made Cookies a profitable company. He was obviously a hard-working and talented businessman. Where self-interested transactions are concerned, however, that really isn’t the issue. Rather, the question is, do we think it wise to allow someone who is running a company, of which he or she is not the sole owner, to self-deal, and then say it’s OK if the deal turned out to be a goodoneorafaironetothecompany?Moreprecisely,arewegoing to say that a self-interested transaction should be allowed to stand where a self-dealing officer or director is able to hire good enough law- yers to persuade a court that, to use our terminology, the self-dealing is a category three and not a category two transaction? Wouldn’t that require us to say, returning to our examples of Jane and Harry, that the only thing they did wrong was the result they achieved? The problem with this approach is that it puts us right back in the consequentialist mess from which we’ve tried to extract ourselves ear- lier. Good outcomes shouldn’t be allowed to cure the defects of ques- tionable motives. If they could, the improper, self-dealing motives don’t matter at all. Self-dealing is a problem only if the results turn out—or a court can be persuaded that they turn out—not to harm the company that thought it could claim the loyalty of its employee. Yet that is what the law of self-interested transactions by officers and directors provides. In the Cookies case, that’s exactly what happened. The majority of the Supreme Court of Iowa ruled against the minor- ity shareholders and upheld what Herrig had done on the ground that it was fair and reasonable to the company. The dissenting justice thought that the majority had ‘‘been so enthralled by the success of the company’’ 13 that it didn’t analyze carefully enough whether Her- rig’s action had been fair to the minority shareholders. The only bar- rier that the self-dealing officer or director has to surmount, then, is to carry the burden of proof on the fairness question. The dissenting justice disagreed with the majority on the working of that technical legal requirement. He did not disagree that proof of fairness to the company would allow the self-interested transactions to stand. If the transaction is ‘‘win-win,’’ the self-dealing motive gets a pass. The Multiple Dimensions of Conflicts of Interest 125 SHOULD GOOD RESULTS IMMUNIZE SELF-INTERESTED TRANSACTIONS? Some people say that there are good arguments to justify this approach to self-dealing. 14 I don’t think any of them work. I think that the law became more lax in permitting this kind of self-dealing because, in the twentieth century, the climate of opinion about busi- ness persuaded corporate leaders and their lawyers to take a shot at limiting the prohibition on self-dealing, and they got courts to buy it. But our question is this: Can companies that want to maintain high ethical standards afford to say that self-dealing is OK provided that the result is ‘‘fair’’ to the company? Should companies tailor their conflicts-of-interest rules to validate transactions if, when all is said and done, the outcomes are win-win? I don’t think so. Let’s return to thinking about Joan and Hal, our retailer employ- ees whose self-interested transactions wound up benefiting the com- pany as well. If you’re Joan’s boss, or Hal’s, or the company’s senior management or board of directors, is what they did perfectly OK? Is it really true that no one would care about conflicts of interests if they always, on after-the-fact study, are shown to have produced the benign results? I believe that the answer to all of these questions is no. MANDATING DISCLOSURE What’s wrong with what Joan and Hal did is that they acted with- out disclosing what they were doing. They acted in secret. Like Jane and Harry, they had every opportunity to enhance their own ACPs at the company. As we’ve stipulated with the facts, they didn’t do so. But they had the chance, and it’s the opportunity that’s critical. There are two basic reasons why disclosure should be required. First, most people are neither saints nor sinners. Most won’t bla- tantly ignore the duties they owe the companies that employ them, but a number—a substantial enough number to make conflicts of in- terest a pressing problem—are capable of succumbing to temptation. Second, in the real world, there will nearly always be doubt about whether the self-interested choice was really the choice that was best for the company as well. This means you ordinarily can’t know whether self-dealing will fall into category two or category three 126 Temptations in the Office until all of the chips have fallen and you’ve conducted a thorough investigation. Or, in the right kind of case, until a court has made its decision. No company should signal that it condones employee self-dealing. To do so fatally compromises the commitment to integrity that has to be at the base of any meaningful, and realistic, set of ethical standards within a company. After-the-fact validation of self-dealing as win-win subordinates integrity to a financial outcome. That can’t be right. It also can’t be safe. Look at what it invites. Jane or Harry’s conduct would get them immediately fired in many companies, particularly if either had a record of previous in- tegrity violations. 15 The same is less likely to be the fate of Joan or Hal. You don’t have to be a consequentialist, unconcerned about people’s motives, to reach this conclusion. Joan and Hal acted only when they had established to their own satisfaction and in good faith that the outcomes that benefited themselves personally also were optimal outcomes for the company. They could say, and their bosses might well believe, that they would not have chosen the course that enhanced their own ACPs. And it might be true. No outsider will ever know for sure. Perhaps Joan and Hal don’t really know them- selves. The human capacity for self-delusion is substantial. That is exactly why a company’s ethical standards must emphasize disclosure. Upfront disclosure is the best antidote there is to self- dealing that harms the company, just as the disclosure requirement servestoinhibitmostinsidertrading. If you’ve had to disclose your self- interest, the chance vanishes that you’ll ‘‘fiddle the numbers,’’ as Jane did in our example. A disclosure requirement, in short, functions as a gentle nudge to push you in the direction your conscience recommends. Are there going to be men and women who ignore a requirement to disclose before the self-dealing as easily as they ignore a bar against the self-dealing itself? Of course. But explicitly requiring dis- closure counsels a course of action that can avoid the wiles of temp- tation before they have fully taken hold. Moreover, requiring disclosure can ease the task of managers and other decision-makers when they are faced with assessing employee self-dealing. ‘‘Did you tell somebody about your personal interest in a proposed transac- tion?’’ leaves a lot less wiggle room than ‘‘Was the company harmed by your self-dealing?’’ A company, then, asks for trouble if it doesn’t prohibit self-dealing in the clearest terms. I’ve never heard of a company that, at least The Multiple Dimensions of Conflicts of Interest 127 implicitly, doesn’t do so. Implementing a disclosure requirement, as we’ve just seen, can be a valuable tool to prevent people from think- ing they can justify their self-dealing by pleading win-win. We’re not going to eliminate conflicts of interest. But it’s ‘‘taking care of business’’ to require disclosure when employees find themselves in conflicts-of-interest predicaments. Yet that’s not the whole conflicts story. A basic part of implementing business strategy nowadays is incentive compensation, which implicitly invites people to enhance their own ACPs. We’ll turn to the peculiar conflicts of interest problems this presents in the next chapter. NOTES 1. The phrase was popularized by Matthew Josephson, The Robber Bar- ons (New York: Harcourt, 1934). 2. For a more detailed analysis of this problem, in the context of the corporate law of Delaware, where a large number of publicly traded Ameri- can corporations are incorporated, see Sarah Helene Duggin and Stephen M. Goldman, ‘‘Restoring Trust in Corporate Directors: The Disney Stand- ard and the ‘New’ Good Faith,’’ American University Law Review,vol.56,no. 2 (December 2006), pp. 211–274. 3. Wikipedia, the online encyclopedia. See entries for ‘‘game theory’’ and ‘‘zero-sum games.’’ 4. Not all insider trading is a conflict of interest. Sometimes corporate ‘‘outsiders’’ receive ‘‘inside’’ information and trade on it. When they do, they may be charged by the SEC as ‘‘tippees,’’ that is, traders on informa- tion received by way of a tip. The government initially investigated Martha Stewart for illegal insider trading as a tippee, but she was ultimately charged and convicted on other, easier to prove charges. 5. Securities and Exchange Commission v. Texas Gulf Sulfur Co., 401 F.2d 833 (1968). The case was decided by one of the eleven (now twelve) U.S. Circuit Courts of Appeals, this one sitting in New York City and known as the Second Circuit. The case did not go to the Supreme Court. 6. The Supreme Court embraced this concept in Basic, Inc. v. Levinson, 485 U.S. 224 (1988). 7. At this writing, an appeal is pending. 8. William A. Klein and John C. Coffee, Jr., Business Organization and Finance, 10th ed. (New York: Foundation Press, 2007), p. 163. 9. Ibid. 10. Harold Marsh, ‘‘Are Directors Corporate Trustees?—Conflicts of Interest and Corporate Morality,’’ 22 Business Lawyer 35, 36 (1966). 128 Temptations in the Office 11. Because the power of Congress under the Constitution was, once upon a time, limited, corporate law has historically been a creature of state law. As such, the details vary from state to state, unlike the provisions of federal securities law that are in principle applicable nationwide. 12. The decision of the Supreme Court of Iowa can be found at Cookies Food Products v. Lakes Warehouse, 430 N.W.2d 447 (Iowa 1988). 13. 430 N.W. at 456. 14. See Business Organization and Finance, p. 163. Here is how Klein and Coffee articulate the arguments that allow self-interested transactions, in the circumstances we have been discussing, to stand: ‘‘Those who believe the prophylactic rule of the nineteenth century was too strict can argue that often a corporation, in its start-up years, must turn to its directors for fi- nancing or specific assets. Also, directors frequently represent various con- stituencies with which the corporation does business: customers, suppliers, creditors—each of whom may want a representative on the board to moni- tor the corporation. These representatives may provide useful advice and expertise for the corporation. Finally, with the emergence in recent decades of independent boards of directors, staffed by outside directors, it may be that the need for judicial monitoring has declined.’’ These arguments seem specious to me, particularly the last. The presence of so-called independent directors has reduced the need for judicial monitoring the self-interested transactions? Tell that to ex-WorldCom shareholders. 15. Managers must remember that, even in the case of an egregious ethi- cal violation such as Jane’s or Harry’s, there may be legal considerations that should prompt you to think twice before firing them immediately, unless there is absolute and uncontradicted evidence of wrongdoing, such as catching Jane red-handed fudging the numbers on her property evalua- tion. For instance, Jane, as a female, is a member of a protected class under employment discrimination laws, and either might be a member of a racial minority, over forty (the age at which age discrimination protection kicks in), or disabled. While members of protected classes aren’t immunized from ethical violations, the astute manager must be aware that firing such a per- son could buy the company a lawsuit which, though ultimately successful, would likely prove time-consuming and expensive. As we’ve said in discus- sing prong one of the foursquare protocol, the facts will be decisive. The Multiple Dimensions of Conflicts of Interest 129 CHAPTER 6 Incentive Compensation: Honesty, Greed, and Fraud Conflicts of interest pit individual interests against company inter- ests. That’s why, as we saw in the last chapter, they have to be watched so carefully. This chapter considers a situation that seems, at first blush, to lie at the opposite end of the spectrum—incentive compensation. The point of incentive compensation, after all, is to align the company’s desire to achieve certain goals with employees’ objectives to make themselves better off, that is, to enhance their personal ACPs. The most common available reward is money— whether by way of a bonus or a higher commission rate on sales. In a number of notable instances, and at the higher echelons, rewards frequently are stock options—the right to buy the company’s stock at a particular price. If the market price goes up, the option holder exercises the option at the lower price, resells at the market price, and sweeps in the gain—like winning at a roulette table. Stock options, at least as initially conceived, were themselves a kind of val- uable incentive compensation. If top executives owned stock in the company, so the theory went, their ‘‘piece of the action’’ would moti- vate profit-maximizing choices that, in turn, would benefit all stockholders. The reality has been different. Efforts to achieve the benchmarks that trigger incentive rewards have led to some of the most flagrant breaches of trust in recent memory. I wish it were true that abuses are simply the result of a few bad actors. Then the solution would be straightforward—do your best not to hire ’em, and if by mistake you do, fire ’em. But it’s not that simple. Incentive compensation by its very nature incentivizes conduct no company interested in the quality of its ethics can afford to tolerate. The problem is made worse when incentives are supported by a cutthroat culture of ‘‘winning.’’ Incentive compensation and motivational programs are at the core of modern American business. Incentive compensation (comp) plans and exhortations to ‘‘win’’ are as much a part of the workplace land- scape as is the presence of both men and women. Taking on the working of incentive compensation is going to raise some eyebrows. So let me be very clear: I am not going to argue that incentive com- pensation plans and success-oriented motivational programs should be eliminated. They are valuable, and in some cases, essential. But their unquestioned value must not be permitted to obscure the nega- tive side. Incentives inevitably create certain kinds of problems. ‘‘Boys will be boys’’ is not an adequate defense of a sexual harass- ment lawsuit; but because boys will be boys, there are going to be sexual harassment problems. By the same token, greed is going to prompt abuses of even the most carefully designed incentive comp plans. Managers must be equipped to deal with this reality. INCENTIVE COMPENSATION AND THE INCENTIVE TO LIE To see how and why greed is a persistent problem, let’s step back for a moment and think about incentives. Incentives, as we all know, are a key tool for management to secure the performance it wants. Say you have an objective you wish to reach. You can tell the people who work for you that you really hope they’ll accomplish it. Or you can tell them that if they fulfill your goal, you’ll pay them for the success. Which is likely to be more effective? Generals, admirals, and other high-ranking military officers may be able to get their subordinates to do what they want simply by giving orders. Military institutions, after all, are characterized by their command structures. Successful business organizations, except in isolated cases, are not. People react more favorably to the carrot than to the stick. Busi- nesses prosper when employees are motivated—and, of course, even military commanders need to worry about morale. As Jack Welch, the acclaimed retired chairman of General Electric (GE) put it, ‘‘If you want people to live and breathe the [company’s] vision, ‘show 132 Temptations in the Office [...]... rests on A company’s ethical infrastructure isn’t a set of rules or a nicely stated (and elaborately reproduced) corporate code of ethical conduct It’s a real-life, we-really-mean-it commitment to trust and Incentive Compensation: Honesty, Greed, and Fraud 135 honesty There can be no ‘‘ifs’’ or ‘‘buts.’’ Cutting corners and engaging in ‘‘sharp’’ practices can’t be acceptable ever and, with particular... normal and perfectly acceptable part of being human So where does (illegitimate) ‘‘greed’’ start and the (legitimate) desire to make a profit stop? The answer is the line between trust and honesty and breaches of trust and an absence of integrity That’s the line between genuinely achieving what’s incentivized and manipulating the data so that it appears that you did The Computer Associates scandal wasn’t... dwell on ‘‘conflicted personal priorities,’’ though no reader of this book who has worked a demanding job has any doubt about what these are and the real costs they impose But compromising ethics and values demands to achieve the goal of winning demands our serious attention INCENTIVES AND RULES It’s all well and good to say, as Jack Welch does in Winning, that a company should hire or promote only people... its efforts, the company is likely to face a host of ethical problems, low employee morale and consistently high legal costs Karl Marx is distinctly out of fashion these days, both in politics and philosophy One of his key ideas, however, continues to resonate When you’re examining any social institution, you need to know what undergirds it to understand its essence Marx called this the infrastructure... against the benefits such plans undoubtedly confer in motivating employees, and senior managers, to achieve performance goals that will benefit the company and its stockholders in the long run We’ve considered this argument before and seen the problems with it Sure, identifying trust and honesty as the backbone of a company’s ethical culture is a good thing, you might say, but ultimately abuse is simply... distinguish between fair play and cheating If you just look at the incentive comp plan itself and in isolation, there is no difference between the incentive to perform and the incentive to make it appear that you have performed! The difference between incentivizing real performance and the mere pretense of such performance has to do with integrity, the culture of trust, and honesty The incentive plan... ‘‘the rules,’’ Welch means people who ‘‘know the laws of their country, industry, and company—both in letter and spirit and abide by them.’’8 I agree Incentive Compensation: Honesty, Greed, and Fraud 143 How could anyone disagree? But behind this nice talk, there’s a problem The problem is incentive compensation plans and how they work We generally think of rules as telling us what not to do: do not... a culture of trust and honesty is going to be effective, it has to start at the top Books on leadership routinely trumpet the necessity that leaders govern by example There’s no sphere in which this is more powerfully true Unfortunately, however, members of senior management, because of their status and power, are often likely to be in a position to avoid adhering to the standards and obeying the rules... tells the audience: The point is, ladies and gentleman, that greed, for lack of a better word, is good Greed is right, greed works Greed clarifies, cuts through, and captures the essence of the evolutionary spirit Now, of course, greed is not good, and you’re not supposed to come away from Wall Street thinking it is But where do you draw the line between ‘‘greed’’ and the ‘‘profit motive’’? The great earlytwentieth-century... hard to come by As far as putting hands metaphorically in the corporate cash register and removing a portion of the contents is concerned, however, untrustworthiness and dishonesty is not the byproduct of another problem, like the way some men relate to women It is the problem It would be impossible to attempt to catalogue all of the small ways in which people can and do cheat their employers about . trips the first month and three the second. Additionally, the reports contained Incentive Compensation: Honesty, Greed, and Fraud 1 35 airport parking fees, meals, and mileage to and from the airport. who has worked a demanding job has any doubt about what these are and the real costs they impose. But compromising ethics and values demands to achieve the goal of winning demands our serious attention. INCENTIVES. investigated Martha Stewart for illegal insider trading as a tippee, but she was ultimately charged and convicted on other, easier to prove charges. 5. Securities and Exchange Commission v. Texas