A Criminological Perspective on Business Ethics

White-collar crime has a strong influence on business ethics. Joseph Heath uses a criminological perspective to help illuminate some traditional questions in business ethics in his paper: “Business Ethics and Moral Motivation: A Criminological Perspective”

Heath starts off with the premise that the ‘‘ethics scandals’’ in the early years of the twenty-first century was not a business ethics failure. What really took place at companies like Enron, Worldcom and Parmalat was high-level, large-scale white collar crime. Their illegal acts were probably surrounded by unethical conduct. But their core actions all involved a failure to comply with the law.

The bulk of the paper is spent looking at the techniques of neutralization that offenders use to deny the criminality of their actions. When white collar crime is viewed from the perspective of techniques of neutralization you can see why bureaucratic organizations such as large companies and the market, might constitute “peculiarly criminogenic environments.”

These are institutional contexts that generate a very steady stream of rather plausible (or plausible-sounding) excuses for misconduct. This is the result of a confluence of factors: first, corporations are typically large, impersonal bureaucracies; second, the market allows individuals to act only on the basis of local information, leaving them in many cases unaware of the full consequences of their actions; third, widespread ideological hostility to government, and to regulation of the market in particular, results in diminished respect for the law; and finally, the fact that firms are engaged in adversarial (or competitive) interactions gives them broader license to adopt what would otherwise be regarded as anti-social strategies.

Denial of responsibility

The offender claims that conditions of responsible agency were not met: it was unintentional; he was insane, he was provoked, he had ‘‘no choice’’ but to do it, it was all an accident, etc.

In a company, an employee can blame his boss for telling him to do something wrong. The boss can pass the blame back down to the worker saying they acted independently.  The competitiveness of the marketplace and the workplace means that if one individual refuses to perform an illegal act, he may feel that he could simply be replaced by someone else who would.

Denial of injury

The offender seeks to minimize or deny the harm done.

Most white collar criminals never meet or interact with those they harmed.  In many cases they wouldn’t even know how to find their victims.  “In these cases, there is potential confusion as to the identity of the individuals who are harmed by the criminal’s actions. In other cases, the mere fact that there is diffusion of the harm over a very large number of persons is appealed to as grounds for denial that anyone was injured by the person’s actions.”

Denial of the victim

The offender acknowledges the injury, but claims that the victim is unworthy of concern because he deserved it.

The underpayment inequity is common. It’s hard to find an employee who believes that an enhancement of  justice in society would require a reduction of his compensation package. On the other hand workers may feel undercompensated, ignoring the difference between the ease with which they can be replaced that determines their wage rate, and their contribution to the company.

It is really easy for workers to convince themselves that they are not stealing. Instead they believe they taking what they are owed, or they are punishing the company for treating employees poorly.

Condemnation of the condemners

The offender attempts to ‘‘turn back’’ the charges by impugning the motives of those who condemn his actions.

The classic examples in corporate crime are the charges fired back at Eliot Spitzer during his time as Attorney General when he exposed a wide range of  practices in the financial services industry. His political ambitions were often discussed side-by-side with his prosecutions.

Appeal to higher loyalties

The offender claims that the action was done out of obedience to some moral obligation that conflicted with the law.

You often hear “I did it for my family.” The offender can see the company as a proxy and serve as an object of higher loyalty. One theory with Ken Lay and Jeffrey Skilling at Enron is that they misled investors for the sake of the company, insisting that it was a great company. There is also the more common business ethics excuse that it was done for profit and the benefit of the shareholders.

Everyone else is doing it

The mere fact that others are breaking the law is used to suggest that it is unreasonable for society to expect compliance.

This is an excuse for all kinds of crime, but it is very common in a business context because of the competitiveness of the business environment.

Claim to entitlement

An offender claims he was acting ‘‘within his rights’’ and that the legal prohibition of his conduct constituted unjust or unnecessary interference.

One of the big differences between corporate crime and street crime is how often white collar criminals deny the authority of the laws that they have broken. The argument is that the government should not regulate certain forms of private transactions.

Folk Tales of Moral Motivation

Heath argues that the focus on these techniques of neutralization are more effective in addressing business ethics and corporate crime than theories of “moral motivation.” The field of criminology has largely discredited those theories as folk tales. It’s not about character, greed, and values.

A criminologist does not think it’s mysterious that some people commit crimes. They find it mysterious that more people do not commit crimes. Only a small percentage of people chose to advance their interests through criminal activity. Even though criminal activity is punished, the chances of getting caught are usually small and the threat of punishment distant.

There are lots of lessons to be learned from this paper by compliance professionals.

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Do Hedge Funds Create Criminals?

Lynn Stout takes the recent charges against arrest of Raj Rajaratnam, founder of the Galleon Group, and the recent raids on expert networks as an indictment of the entire hedge fund industry. She makes the mistake of using a few bad apples to state the whole industry is corrupt. The vast majority of hedge funds operate completely in compliance with the law and ethical obligations. You would not say the entire energy industry is corrupt because of the failures of Enron.

The expert networks Stout mentions are not your classic cases of insider trading. The involved parties were trying to get information about how a company is doing. By getting access to orders for computer chips you can make some estimates about how many computers a company is producing. Depending on the type of information, some should have been protected and some is just business intelligence.

After all, there is nothing wrong with looking at satellite photos of a shopping center to see how many cars are in the parking lot. Compare the photos from year to year and you may have a good indication of whether sales are up or down.

There is plenty of evidence demonstrating that bad environments contribute to bad behavior. That is backbone for compliance. Create an environment where there is more pressure to follow the rules than to break the rules.

Stout lays out three social signals that have been repeatedly shown in formal experiments to suppress pro-social behavior:

Signal 1: Authority Doesn’t Care About Ethics.
Signal 2: Other Traders Aren’t Acting Ethically.
Signal 3: Unethical Behavior Isn’t Harmful.

Signal 1 is the classic call for a tone from the top. Signal 2 is the classic call for corporate culture. Signal 3 is the classic call for regulatory (and criminal) enforcement.

No. Hedge funds do not create criminals. Unethical work environments create criminals. It’s a problem not just at hedge funds, but every industry.

Lynn Stout is the Paul Hastings Professor of Corporate and Securities Law at the UCLA School of Law and the author of Cultivating Conscience: How Good Laws Make Good People.

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The Case for Professional Boards

If you want to improve governance at a corporation, do you need professional directors? Did SOX merely add a layer of legal obligations of board, and do little to improve the quality of those serving as directors?

Robert C. Pozen makes the case in The Case for Professional Boards in the December issue of the Harvard Business Review.

Pozen starts by limiting the size of the board to seven people: the CEO plus six independent directors. He points to research that groups of this size are optimal for decision-making. Bigger groups can result in “social loafing”, relying on others to take the lead and ceding decision-making. Six also gives you enough people to populate the three key committees: nominating, compensation and audit.

The greatest need in a board is expertise. Pozen expects an accounting expert to head the audit committee. He also allows for one generalist to provide a broad perspective on the company’s strategy. But the rest should be experts in the company’s main line of business. That is not easy. Independent experts are most likely working for company’s competitors. He expects that most professional directors would be retired executives in the company’s industry. That would also lead to the elimination of mandatory retirement ages for directors.

Pozen makes a strong case. “To improve corporate oversight we need not more legal procedures but a culture of governance in which directors commit to the role as their primary occupation.” It’s just very radical strategy for companies who have grown and gathered their directors organically.

The SEC Wants to Know if You Are Systemically Important

The Securities and Exchange Commission proposed a new rule that would require advisers to private funds to report information for use by the Financial Stability Oversight Council in monitoring risk to the U.S. financial system. Sections 404 and 406 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires the SEC to gather this information.

The SEC is proposing a new Rule 204(b)-1 under the Investment Advisers Act that would require SEC-registered investment advisers to report systemic risk information on Form PF if they advise one or more private funds.

Each private fund adviser would report basic information about the operations of its private funds on Form PF once each year. Large Private Fund Advisers would be required to submit this basic information each quarter along with additional systemic risk related information required by Form PF concerning certain of their private funds.

“Large Private Fund Advisers” would be

  • Advisers managing hedge funds that collectively have at least $1 billion in assets as of the close of business on any day during the reporting period for the required report;
  • Advisers managing a liquidity fund and having combined liquidity fund and registered money market fund assets of at least $1 billion as of the close of business on any day during the reporting period for the required report; and
  • Advisers managing private equity funds that collectively have at least $1 billion in assets as of the close of business on the last day of the quarterly reporting period for the required report.

The SEC estimates that approximately 4,450 advisers would be required to file Form PF. Of those, approximately 3,920 would be smaller private fund advisers not meeting the thresholds for reporting as Large Private Fund Advisers.

It looks like the definition of private equity fund for purposes of the Large Private Fund Adviser reporting requirements will exclude real estate funds.

Private equity fund:

Any private fund that is not a hedge fund, liquidity fund, real estate fund, securitized asset fund or venture capital fund and does not provide investors with redemption rights in the ordinary course.

Under the proposed rule, real estate private equity funds will be subject to the annual reporting, but not subject to the more detailed quarterly reporting. This is just a proposed rule, so the final requirements and definitions may change in the final rule when it is issued. In the meantime, you can make comments.

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Data Privacy Day

Data Privacy Day is January 28, 2011.

There have events throughout the week to inform and educate us all about our personal data rights and protections.

Here are some key reminders:

  1. Never Post or Share Personal Information such as a date of birth, personal address, or maiden name because identity thieves now friend as many people as possible and join networks solely for the purpose of harvesting information to use to commit identity fraud.
  2. Always Update Your Software
  3. Use Complex Passwords
  4. Don’t Download Just Any Application
  5. Avoid Peer-to-Peer File Sharing

Read more:

Compliance Bits and Pieces for January 28

Here are some recent compliance-related stories that caught my eye:
Compliance Professionals Ask Justice Department for Data Showing Programs Pay Off

Corporate ethics and compliance officers want the U.S. Department of Justice to provide data “that identifies how often an effective ethics and compliance program yields a direct return in enforcement decisions,” according to three leading professional organizations. In a letter to the Department of Justice (DOJ), the three organizations – the Ethics Resource Center (ERC), Ethics & Compliance Officer Association (ECOA), and the Society of Corporate Compliance and Ethics (SCCE) – said that recent surveys of 1,223 ethics and compliance officers indicate “disappointment” with DOJ statements on past cases which linked favorable treatment for offenders to their cooperation with investigators yet ignored the value of existing ethics and compliance programs.

Real estate managers’ co-investments no comfort to investors by Arleen Jacobius in Pensions & Investments

Real estate managers have been sampling their own cooking for decades, but that didn’t make losses among the largest co-investments any more palatable to outside investors after the economic meltdown of 2008-“09.

Institutional Limited Partners Association Publishes New Private Equity Fund Guidelines by Michael Wu in the Investment Law Blog

Earlier this month, the Institutional Limited Partners Association (“ILPA”) published Version 2.0 of its Private Equity Principals (the “Principals”). The Principals set forth the ILPA’s take on the best practices in establishing private equity partnerships between limited partners (“LPs”) and the general partner (“GP”). The Principals focus on three guiding tenets for developing effective partnership agreements: Alignment of Interest Between LPs and GP, Fund Governance and Transparency to Investors. The revised version of the Principals incorporate feedback from GPs, LPs and third parties in the industry to increase “focus, clarity and practicality.”

California Commissioner Expresses Concern About Proposed Venture Capital Fund Definition by Keith Paul Bishop in California Corporate & Securities Law blog

As I wrote in this early posting, California is ground zero for the venture capital industry.  Many of our most succesful and innovative companies have been funded by the venture capital industry.  Thus, it is good to see that Commissioner Preston DuFauchard has submitted this letter of comment with respect to the Securities and Exchange Commission’s proposed rule defining “venture capital fund”.

SEC looks at Cahill, Goldman Sachs link by Frank Phillips in the Boston Globe

The US Securities and Exchange Commission has delivered subpoenas to the state treasurer’s office in a wide-ranging request for documents concerning dealings between investment banking giant Goldman Sachs and former treasurer Timothy P. Cahill, onetime top staff members, and former campaign aides, according to an official briefed on the document request.The agency’s subpoenas, which seek e-mails, phone records, schedules, files, and memorandums, come just over a month after Goldman Sachs removed itself from two state bond deals in Massachusetts following the disclosure that a vice president at the firm, Neil Morrison, was active in Cahill’s 2010 gubernatorial campaign, which could violate federal securities regulations. Morrison had previously served as a top deputy to Cahill in the treasurer’s office.

How to Find Answers Within Your Company – Would Quora Work?

Making sure that people get the right answer to questions is vital to the success of a business. From a compliance perspective, it’s important that questions in the compliance domain get answered correctly. It’s just as important that compliance professionals can find the correct answers to their questions.

On one side you have GRC, trying to answer questions related to governance, risk and compliance  in an integrated platform. But lots of questions will still be ad hoc and outside the information in the GRC systems.

One of the latest Web 2.0 darlings is Quora. It’s a continually improving collection of questions and answers created, edited, and organized by the community.

Quora

I found Quora mildly interesting, but a compliance nightmare.

From the perspective of a lawyer, answering legal questions in a public platform is fraught with peril. I found most of the legal questions to be vague and incomplete. It’s an easy trap for a less-careful lawyer to inadvertently create an attorney-client relationship or legal liability. For financial professionals, you can easily trip over the requirements for record-keeping and preapproval if the answer related to financial advice. (I have only answered questions about snowboarding.)

I view Quora as another knowledge management platform placed in the public web. It’s interesting to see it work, but I’m skeptical of its viability. I’ve seen many question and answer platforms come and go. Quora adds the improvements of requiring registration, community run organization and rating of answers.

Quora seems to still be at the stage of altruism. People are asking questions and answering them out of curiosity and the willingness to share. The marketers and self-serving, underemployed consultants will come eventually and fill it full of inane answers and ads.

Once the shiny newness wears off, what will keep someone coming back to contribute content? That has always been the problem of knowledge management. It’s hard to get the experts who really know the answer to contribute their response. A recent article in the MIT Sloan Management Review drove home this point: How to Find Answers Within Your Company.

Knowledge Markets

Altruism will only last so long and a person’s willingness to contribute will wane as the next fad comes along the web. The challenges and the needs are different when you bring a knowledge market, like Quora, inside your company.

The first generation of knowledge management was all about centralized systems. They produced mixed results. They ignored the market for knowledge and just imposed a top-down centralized structure to try capturing work product.

How to Find Answers Within Your Company points out that the system failed to place a value on contributed material or, if it did, the value was fixed. The failure to gain contribution was largely a failure to understand the economics of contribution. Bebya and Van Alstyne point to three forms of incentives: spendable currency, recognition for expertise and the opportunity to have a positive impact.

You can’t fix the price. Information that is more valuable than the price is less likely to be created. Experts won’t waste their time. When information is less valuable than the price, less-expert workers will volunteer just to get compensated. This is the classic knowledge management problem, getting the experts to contribute and highlighting the best content. The paper offers examples of knowledge systems that added a marketplace to better value and price contributions.

It’s not just about cash. Take FourSquare as an example. They use gameplay to encourage people to check-in to locations. Earn a badge or try to become mayor. They also offer the cash reward of specials offered by merchants.

For anyone interested in improving their ability to capture knowledge, the article provides lots of other great insights in what works and does not work in knowledge markets.

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Proposed “New” Standard for Accredited Investor

If you are involved in the private placement of securities, then you have been waiting to hear how the SEC was going to change the definition of “accredited investor.”

Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires the definitions of “accredited investor” to exclude the value of a person’s primary residence for purposes of determining whether the person qualifies as an “accredited investor” on the basis of having a net worth in excess of $1 million. Previously, the standards required a minimum net worth of more than $1,000,000, but permitted the primary residence to be included in the calculation.

Other than changing the calculation of net worth change mandated by Dodd-Frank, the SEC has declined to change the definition.

The other test for determining qualification was an individual income in excess of $200,000 in each of the two most recent years (or joint income with a spouse in excess of $300,000). I expected those number to nearly double to keep pace with inflation.

Section 415 of the Dodd-Frank Act requires the Comptroller General of the United States to conduct a “Study and Report on Accredited Investors” examining “the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds.” That study is not due for three years. The SEC indicated that they will likely use the results of that study when they once again address the accredited investor standard in 4 years, as allowed under Dodd-Frank.

It seems to me that the SEC found an opportunity to reduce its rulemaking agenda, by not significantly changing a rule. Maybe this is the first sign of the SEC creaking under the weight of the Dodd-Frank mandates.

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SEC Study on Enhancing Investment Adviser Examinations

Now that most private funds managers are required to register with SEC as investment advisers, the SEC is considering abandoning them to regulation by FINRA.

The SEC released the much anticipated report, a 40-page “ Study on Enhancing Investment Adviser Examinations” mandated by Section 914 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The report is more a plea for resources than an abandonment. The report makes a simple statement: ” the Commission will likely not have sufficient capacity in the near or long term to conduct effective examinations of registered investment advisers with adequate frequency. The report points out that the frequency of examination is a function of the number of registered investment advisers (and their complexity) and the amount of SEC’s OCIE staff dedicated to examination. While the number of advisers and their complexity have increased, the staff of OCIE has decreased. The complexity will only increase as thousands of private fund managers come under the registered investment adviser umbrella.

The SEC staff recommended three options for Congress to consider:

  1. Self-Funding Authorize the SEC to impose user fees on registered investment advisers.
  2. Self Regulatory Organization Authorize one or more SROs, under SEC oversight, to examine all registered investment advisers.
  3. Limited SRO Authorize FINRA to examine all of its members that are also registered as investment advisers for compliance with the Advisers Act.

I read the report as a plea for more resources to oversee investment advisers.

Dodd-Frank is clearly pulling private fund managers into the domain of the Investment Advisers Act. That will require extra resources. On the other hand, they are kicking advisers with less than $100 million in assets out for SEC oversight and over to state registration and oversight. It’s unclear if that trade will result in more, less or about the same number of advisers under SEC oversight. The SEC has stated that about 3,500 advisers will go over to the states. They can only guess how many fund managers will become new registrants. (My guess is that the SEC will have a net loss.)

The report is interesting but holds not legal influence. All of the recommendations require Congressional action. My perception of Congress is that little will be done that helps Dodd-Frank during the next two years.  I doubt they will give up the appropriations as a control method over the SEC.

In addition to the official report, Commissioner Elisse Walter issued a separate dissenting opinion expressing her disappointment with the SEC’s final report and reiterating her stance in favor of an SRO, citing funding as an issue that is too great to overcome both in the short and long terms.

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What Caused the 2008 Crisis?: All the Devils are Here

Was it Fannie Mae? Was it the lack of regulatory oversight? Was it the rating agencies? Was it pure greed?

Yes, yes, yes and yes. Plus, there were lots of other factors.

Bethany McLean and Joe Nocera put together an insightful look at the many factors that created the housing bubble and amplified the destruction when it popped in All the Devils are Here: The Hidden History of the Financial Crisis. Pundits and purists have tried to pin the blame on a single element. It seems clear that many “devils” were at work. It’s not just institutions that failed in the crisis. The authors paint the pictures of key individuals who helped inadvertently build up the housing bubble or allowed for it cause mass destruction.

Certainly, Fannie Mae and Freddie Mac were part of the problem. It was their stranglehold on the securitization of conforming mortgages that lead Wall Street to look at non-conforming mortgages as a source of profits. Subprime mortgages, by definition, were outside the definition of “conforming” by Fannie Mae and Freddie Mac standards.

Wall Street’s thirst for product was an ample funding source for subprime lenders. They didn’t need the deposits of conventional banks for funding. They could just sell their loans to Wall Street for packaging into mortgage-backed securities. Wall Street would also provide the warehouse funding to help subprime lenders with capital to originate mortgage loans.

The federal government was pushing for increased home ownership. The Clinton administration announced its National Homeownership Strategy, with the goal of raising the number of homeowners by 8 million over the next 6 years. (Bush carried on a similar strategy.) The flaw is that to meet that goal, riskier borrowers would need be made homeowners.

JP Morgan developed Variance at Risk, an analytical method to analyze the risk in a bank’s portfolio. They understood that the mathematical models were merely an indicator risk. Although correct 95% of the time, they were also wrong 5% of the time. Other lenders adopted VaR, but failed to grasp its limitations.

AIG and its Financial Products division played a key role. They helped provide the back stop that helped the market accept the AAA rating of mortgage-backed securities. Eventually they also moved into credit default swaps. The authors paint a picture of AIG-FP as a collaborative workplace where employees could express their skepticism about deals. Then Hank Greenberg threw out the management and replaced them with Joe Cassano. He ran the shop in a more dictatorial manner and doled out information on a need-to-know basis.

Of course there were the rating agencies who gave the RMBS and CDOs undeserved AAA ratings. That was supposed to mean that the securities are just a little riskier than US Treasuries. It was Fitch that changed things. Moody’s and Standard & Poor’s had a business model based on subscribers. Fitch changed things by charging the issuers instead of the subscribers. That would eventually lead to the ratings shoppings that became part of the subprime bubble. Of the AAA rated subprime residential mortgage-backed securities from 2007, 91% were downgraded to junk status and 93% of those from 2006 were downgraded to junk status. That is a horrible track record.

I suppose that was a bit of a spoiler, but we all know that the financial markets came to a grinding halt in 2008, crushing big banks, speculative investors, small banks, and those just hoping for a small part of the American Dream.

There are a dozen other “devils” discussed in the book, but you should just read it yourself instead of reading my ramblings.

The worst part of the subprime crisis is that the bigger goal of increasing ownership was a failure. Between 1998 and 2006 only about 1.4 million first-time home buyers purchased their homes using subprime loans. That was only about 9% of all subprime lending. The remaining 91% of subprime lending was refinancings or second home purchases (or third or fourth …). “By the second quarter of 2010 the homeownership rate had fallen to 66.9% percent, right where it had been before the housing bubble.”

I found this book to be a great companion to The Big Short and In Fed We Trust. The Big Short does a great job of focusing on how the CMBS and CDO markets worked. In Fed We Trust focused on the events of 2008. All the Devils are Here focuses on the macro events that swarmed together into an apocalyptic mix of bad bad loans, bad underwriting, bad risk assessment, bad investing and bad goals.