Do Your Executives Have (Compensation) Skin in the Game?

This year marks the 150^th anniversary of the ascent of the most famous mountain in Europe, the Matterhorn. On Bastille Day, in 1865, four British climbers and three guides were the first climbers to reach the summit. In an article in the Financial Times (FT), entitled “In Whymper’s steps”, Edward Douglas wrote, “It was a defining moment in the history of mountaineering, arguably as pivotal as the first ascent of Everest. Before this calamity climbing was a quirky minority pastime and Zermatt an indigent and obscure village. All that changed on July 14, 1865. As locals cheerfully acknowledge, the Matterhorn disaster enthralled the public around the world and sparked an unprecedented tourist boom.”

The disaster had befallen the climbing team on its descent after having scaled the summit. The team was led by Edward Whymper. As they were coming back down, they were all tied together with rope. When one of the team slipped, he knocked over his guide and “their weight on the rope pulled off the next man…and a fourth climber as well.” Only expedition leader Whymper and two Swiss guides, a father and son duo from Zermott, survived the disaster when “they dug in and the rope tightened – then snapped – leaving them to watch in horror as the bodies of their companions cartwheeled thousands of feet down the mountain.” The depiction of the disaster by the French artist Gustave Doré captures for me the full horror of the tragedy.

Yesterday I wrote about the role of compensation in your best practices compliance program. Today I want to focus on the same issue but looking at senior management and compensation. I thought about this inter-connectedness of compensation in a compliance program, focusing up the corporate ladder when I read a recent article in the New York Times (NYT) by Gretchen Morgenson, in her Fair Game column, entitled “Ways to Put the Boss’s Skin In the Game”. Her piece dealt with a long-standing question about how to make senior executives more responsible for corporate malfeasance? Her article had some direct application to anti-corruption compliance programs such as those based on the US Foreign Corrupt Practices Act (FCPA) or UK Bribery Act. Morgenson said the issue was “Whenever a big corporation settles an enforcement matter with prosecutors, penalties levied in the case – and they can be enormous – are usually paid by the company’s shareholders. Yet the people who actually did the deeds or oversaw the operations rarely so much as open their wallets.”

She went on to explain that it is an economic phenomenon called “perverse incentive” which is one where “corporate executives are encouraged to take outsized risks because they can earn princely amounts from their actions. At the same time, they know that they rarely have to pay any fines or face other costly consequences from their actions.” To help remedy this situation, the idea has come to the fore about senior managers putting some ‘skin in the game’. Her article discussed three different sources for this initiative.

The first is a current proxy proposal in front of Citigroup shareholders which “would require that top executives at the company contribute a substantial portion of their compensation each year to a pool of money that would be available to pay penalties if legal violations were uncovered at the bank.” Further, “To ensure that the money would be available for a long enough period – investigations into wrongdoing take years to develop – the proposal would require that the executives keep their pay in the pool for 10 years.”

The second came from William Dudley, the President of the Federal Reserve Bank of New York, who made a similar suggestion in a speech last fall. His proscription involved a performance bond for the actions of bank executives. Morgenson quoted Dudley from his speech, “In the case of a large fine, the senior management and material risk takes would forfeit their performance bond. Not only would this deferred debt compensation discipline individual behavior and decision-making, but it would provide strong incentives for individuals to flag issues when problems develop.”

Morgenson reported on a third approach which was delineated in an article in the Michigan State Journal of Business and Securities Law by Greg Zipes, “a trial lawyer for the Office of the United States Trustee, the nation’s watchdog over the bankruptcy system, who also teaches at the New York University School for Professional Studies.” The article is entitled, “Ties that Bind: Codes of Conduct That Require Automatic Reductions to the Pay of Directors, Officers and Their Advisors for Failures of Corporate Governance”. Zipes proposal is to create a “contract to be signed by a company’s top executives that could be enforced after a significant corporate governance failure. Executives would agree to pay back 25 percent of their gross compensation for the three years before the beginning of improprieties. The agreement would be in effect whether or not the executives knew about the misdeeds inside their company.”

As you might guess, corporate leaders are somewhat less than thrilled at the prospect of being held accountable. Zipes was cited for the following, “Corporate executives are unlikely to sign such codes of conduct of their own volition.” Indeed Citibank went so far as to petition the Securities and Exchange Commission (SEC) “for permission to exclude the policy from its 2015 shareholder proxy.” But the SEC declined to do and at least Citibank shareholders will have the chance to vote on the proposal.

In the FCPA compliance context, these types of proposals seem to me to be exactly the type of response that a company or its Board of Directors should want to put in place. Moreover, they all have the benefit of a business solution to a legal problem. In an interview for her piece, Morgenson quoted Zipes as noting, “This idea doesn’t require regulation and its doesn’t require new laws. Executives can sign the binding code of conduct or not, but the idea is that the marketplace would reward those who do.” For those who might argue that senior executives can not or should not be responsible for the nefarious actions of other; they readily take credit for “positive corporate activities in which they had little role or knew nothing about.” Moreover, under Sarbanes-Oxley (SOX), corporate executives must make certain certifications about financial statement and reporting so there is currently some obligations along these lines.

Finally, perhaps shareholders will simply become tired of senior executives claiming they could not know what was happening in their businesses; have their fill of hearing about some rogue employee(s) who went off the rails by engaging in bribery and corruption to obtain or retain business; and not accept that leaders should not be held responsible.

This publication contains general information only and is based on the experiences and research of the author. The author is not, by means of this publication, rendering business, legal advice, or other professional advice or services. This publication is not a substitute for such legal advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified legal advisor. The author, his affiliates, and related entities shall not be responsible for any loss sustained by any person or entity that relies on this publication. The Author gives his permission to link, post, distribute, or reference this article for any lawful purpose, provided attribution is made to the author. The author can be reached at tfox@tfoxlaw.com.

© Thomas R. Fox, 2015

Mickey Rooney and The 90 Cent Solution

We begin today with a word on the death of Mickey Rooney. Rooney’s career, spanning nearly 90 years was certainly was from a different era. He was short of stature and long in his number of marriages but as Bob Lefsetz noted in his blog post tribute to Rooney, “But they stood in front of us twenty feet tall. At the drive-in. Even when the pictures truly got small on the tiny old screens of yore they emerged triumphant, because they were so good-looking, so charismatic. And if you were big enough, a bright enough star, your legacy lived on, even if your present day circumstances bore no resemblance to fame.” But here’s why there is always a place in my heart for Mickey Rooney. When I was very young I lived with my grandparents and one night I watched the 1935 movie version of Shakespeare’s A Mid Summer Night’s Dream on television with my grandmother. Rooney’s so over the top performance of Puck began for me a life long love affair with the Bard. So here’s to the grandmother that started me off on a lifelong love affair of Shakespeare’s works and here’s to the Mickster—you did it your way.

I have often considered the role of senior management is to set a proper ‘Tone-At-The-Top” to do business ethically and in compliance with anti-corruption laws like the Foreign Corrupt Practices Act (FCPA) or the UK Bribery Act. Incentives to do business ethically and in compliance are also recognized as an important part of any best practices compliance program. The flip side of incentives is disincentives, such as discipline or financial penalties for affirmatively engaging in misconduct. But how far should such disincentives go and how strong should they be? Should there be penalties for not only affirmatively engaging in misconduct but also failing to monitor risk-taking that allows misconduct to occur? If the latter becomes prevalent, how close do we come to criminalizing conduct, which is arguably negligent and not simply intentional?

I have thought about several of these questions and many others over the past few days when reading about the ongoing struggles of General Motors (GM) over its Cobalt recall issues and Citigroup in regards to its Mexican banking operations. In an article by Gretchen Morgenson in the New York Times (NYT), entitled “The Wallet as Ethics Enforcer”, where she asked “Who decided—and who agreed—that 90 cents was too much to pay for each switch that would have fixed the problem that apparently led to 13 deaths? How much did that decision add to the bottom line and add to executives’ compensation over the years? What will the company have to pay in possible regulatory penalties and legal settlements?” One of her own answers to these questions reads, “While the shareholders of G.M. will shoulder the cost of the fines, the settlements and loss of trust arising from the mess, the executives responsible for monitoring internal risks like these are unlikely to be held accountable by returning past pay.”

Citigroup, which had previously indicated that it had been the victim of a huge fraud perpetrated by one of its customers in Mexico, Oceanografía. However, now Citigroup now faces both federal criminal and civil investigations over the affair. As reported in a Wall Street Journal (WSJ) article, entitled “Crime Inquiry Said to Open On Citigroup”, Ben Protess and Michael Corkery reported that both the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC) have opened investigations “focusing in part on whether holes in the bank’s internal controls contributed to the fraud in Mexico. The question for the investigators is whether Citigroup—as other banks have been accused of doing in the context of money laundering—ignored warning signs.” For a bank to be criminally liable, “prosecutors would typically need to show that the bank willfully ignored warning signs of the fraud.” However, to show a civil violation, the threshold is lower and there may only need to be a showing that the bank lacked the proper internal controls or internal oversight.

In her article, Morgenson spoke with Scott M. Stringer, the New York City Comptroller, who is a strong advocate of corporate requirements which “make sure that insiders who engage in questionable conduct are required to pay the piper” in the form of clawback provisions. Stringer has worked with companies to expand clawback provisions beyond those mandated by Sarbanes-Oxley (SOX), which required “boards to recover some incentive pay from a chief executive and chief financial officer if a company did not comply with financial reporting requirements.” Now, clawbacks have expanded to require executives to return compensation “even if they did not commit the misconduct themselves; they run afoul of the rules by failing to monitor conduct or risk-taking by subordinates.” Stringer believes that such clawback provisions not only “speak to the issue of financial accountability but also to setting a tone at the top.”

Morgenson ends her article by noting that unless GM makes public its internal investigation, “we may never know how many G.M. executives knew about the Cobalt problems and looked the other way.” In the meantime though, this debacle shows the importance of policies that hold high-level employees accountable for conduct that, even if not illegal, can do serious damage to their companies. Directors creating such policies would be sending a clear signal that they take their duties to the company’s owners seriously.”

At this point, we do not know high up the decision went in GM not to install the 90 cent solution. But I would argue it really does not matter. Somewhere in the company, some engineer figured out a solution and indeed one was implemented without changing the part number. I am sure the GM Board would have been sufficiently shocked, just shocked, to find out that such decisions as monetary over safety were going on inside the company. What does all of the information released so far tell us about the culture inside GM when these decisions were made? While I am certainly willing to give current GM Chief Mary Barra the benefit of the doubt about her intentions for the company going forward, particularly after a grueling couple of days before Congress, what do you think the financial incentives were in the company when the 90 cent solution was rejected?

It initially appeared that Citigroup was the victim of a massive fraud perpetrated by one of its customers. However, even initially it was reported that Citigroup let its Mexican operation, Banamex run its own show with very little oversight from the corporate office in New York. Now Citigroup is not only under a civil investigation for lack of proper internal controls but also a criminal investigation for willful ignorance of Banamex’s operations. Does any of this sound far-fetched or perhaps familiar? Think about Frederick Bourke and ‘conscious indifference’. Even the judge in Burke’s criminal trial mused that she did not know if he was a perpetrator or a victim. Perhaps Citigroup is both, but if he was both it certainly did not help Bourke. While I am certainly sure that the Citigroup Board of Directors would also say that it would also simply be shocked, just shocked, to find that there were even insufficient internal controls over Banamex, let alone willful ignorance of criminal actions of its Mexico subsidiary, it does pose the question as to what is the culture at the bank?

As important as clawbacks are, until the message of compliance gets down from the top of an organization, into the middle and then to the bottom, a culture of compliance will not exist. I have worked in an industry where safety is goal number one. But in the same industry I have heard the apocryphal tale of the foreign Regional Manager who is alleged to have said, “If I violate the Code of Conduct, I may or may not get caught. If I violate the Code of Conduct and get caught, I may or may not be punished. If I miss my numbers for two quarters, I will be fired.” Clawbacks for Board members would not have influenced this apocryphal foreign Regional Manager, any more than they would have worked on the psyche of the GM engineers who proposed and then later dropped the 90 cent solution. It was clear to them what their bosses thought was important for them to keep their jobs. As long as management has that message, doing business ethically and in compliance will always take a second seat.

This publication contains general information only and is based on the experiences and research of the author. The author is not, by means of this publication, rendering business, legal advice, or other professional advice or services. This publication is not a substitute for such legal advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified legal advisor. The author, his affiliates, and related entities shall not be responsible for any loss sustained by any person or entity that relies on this publication. The Author gives his permission to link, post, distribute, or reference this article for any lawful purpose, provided attribution is made to the author. The author can be reached at tfox@tfoxlaw.com.

© Thomas R. Fox, 2014

 

Grand Central Station, Mary Jo White and the End of No-Admission Settlements in SEC Cases?

Last week we celebrated one of the world’s great urban architectural marvels, the London Underground. This week we celebrate one a little closer to home. This week is the 100^th anniversary of Grand Central Station. In an article this week in the New York Times, (NYT), entitled “Looking Out on the Grand Central, and Looking Back on Saving It”, reporter Clyde Haberman interviewed Kent L. Barwick, former Executive Director of the Municipal Art Society, who was instrumental in the fight to save the Station in the 1970s. I knew about the legal fight that the City of New York had put up after its designation of the venerable landmark had been overturned by a state judge. This landmark case went all the way to the US Supreme Court and ended with a victory for the City of New York and the establishment of the right of a municipality to protect the public environment and its history by historic designation. What I did not know about this process was that one of its most active supporters was Jacqueline Kennedy Onassis, who supported the cause with time, money and effort. It was a classic effort of several processes moving forward on several fronts at once which led to this important legal decision and one of the most compelling journeys in landmark preservation.

This article came to mind when I read another article in the NYT, entitled “Make Them Pay (and Confess)” by reporter Gretchen Morgenson, about President Obama’s nomination of Mary Jo White to head the Securities and Exchange Commission (SEC). Morgenson used the nomination of White to argue that the SEC has not been aggressive enough in its prosecution of financial wrongdoing during the first four years of the Obama Administration. She believes that the no-admission settlement is merely a “slap on the wrist” for companies who are guilty of securities violations involving fraud. I believe that this would include Foreign Corrupt Practices Act (FCPA) violations.

One of the techniques that she argues should be used more often and would have greater impact is requiring companies to admit to facts in settlement agreements. As most compliance practitioners know, the SEC has, in the past, allowed companies to settle without admitting or denying the findings which are the basis for the enforcement actions. Generally the SEC has supported this position arguing that by doing so this helps it “avoid costly, time-consuming litigation that would tax already-stretched resources.” In addition to time-consuming trials, there is always the possibility that the SEC could lose at trial. Further, by having quicker settlements, more victims would be getting restitution faster.

But Morgenson argues that a no-admission settlement does not really qualify as a punishment. In addition to having no precedential value going forward, because there are no facts admitted, she maintains that even the financial penalties are meaningless. This is because ultimately the fines and penalties are paid by the shareholders or the company’s insurance carrier. Such situations are “not much of a deterrent.”

Morgenson points out that Preet Bharara, the United States Attorney for the Southern District of New York, who was hired by Mrs. White when she ran the office, “has made it a priority to require admissions from defendants in civil fraud cases” brought by his office. Bharara has stated that “Such admissions are a way to hold defendants accountable, as well as being an important part of the public record.” By public record, Bharara means that plaintiffs can then use those admissions in shareholder derivative actions against corporations in tag along law suits. Do you think that the plaintiffs’ bar will be salivating over that prospect?

Morgenson discussed several reasons for the reluctance of the SEC to require such admissions of fact. The first and foremost is that you have to be ready, willing and able to go to trial. Bharara handles this in the Southern District with the following comment, “We’re not in the business of bluffing. When people know you’re not bluffing, they come to the table.” However, the SEC itself may not have this same attitude. Morgenson notes that “It won’t be easy to change the mind-set at the S.E.C. from one that regularly allows defendants to avoid culpability.” Other federal agencies such as the Federal Trade Commission also allow corporations to settle civil enforcement actions while not admitting to any facts.

Morgenson acknowledges that it will not be easy for the SEC to change its philosophy. Further, defendants will probably fight this change tooth and nail because they know that the cost of any settlement will increase exponentially if they make such admissions. The aforementioned plaintiffs’ bar will be waiting to jump on any corporations which make such settlements. Morgenson quotes William F. Gavin, Secretary of the commonwealth of Massachusetts and its securities regulator, who admitted that negotiating admissions of liability is challenging due to the fact that the cost of settlements will go up. His response, “Well, that’s kind of the idea – you did something wrong, you should be liable. You’re not going to change practices or behavior if there’s no penalty associated with it.”

Federal judges have also begun to question the use of SEC no-admission settlements. There is the quite well known example of Judge Rakoff and his initial rejection of the Citigroup settlement. A couple of other federal judges also initially rejected no-admission settlements but did so on the grounds that there was not enough evidence to enforce an injunction if there was a breach of the settlement by the defendant. Their concerns were addressed and they all eventually signed off on the SEC settlements. Now, however, Judge Richard Leon has rejected a SEC settlement with IBM, for FCPA books and records violations, as Judge Leon wanted IBM to report to the SEC if it sustained a FCPA violation going forward. IBM, with the SEC standing at its side on this point, said that to do so would be “too burdensome.” Judge Leon has set a hearing date of February 4, 2013 for IBM to present evidence of how they plan to collect the data to show that it is too burdensome. If IBM cannot do so, Judge Leon may well not approve the no-admission settlement.

Morgenson clearly wants Mary Jo White to engage in more and greater enforcement of financial fraud cases. She does not speak to FCPA cases specifically so it is not clear on whether her desire would also include FCPA books and records enforcement actions brought by the SEC when there is no criminal case brought by the Department of Justice (DOJ). However, if no-admission enforcement actions are no longer the norm in SEC financial fraud or other securities actions, this will probably also bleed over into FCPA actions. Judge Leon’s challenge to IBM and to the SEC may also portend an increasingly active judiciary which may delve into the substance of any FCPA settlement agreement with the SEC.

So for you New Yorkers out there, or any of you travelling through New York, I would suggest that the next time that you go through Grand Central Station look up with some wonder and awe at one of the true architectural marvels of the city. You may not do so as I did the first time I went through it but still take a few minutes to think that it was headed for the wrecking ball back in the 1970s, scheduled to be replaced by a skyscraper. Morgenson argues that the SEC should become more aggressive in its prosecution of financial fraud and with her prosecutorial background the agency may well be headed that way.

This publication contains general information only and is based on the experiences and research of the author. The author is not, by means of this publication, rendering business, legal advice, or other professional advice or services. This publication is not a substitute for such legal advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified legal advisor. The author, his affiliates, and related entities shall not be responsible for any loss sustained by any person or entity that relies on this publication. The Author gives his permission to link, post, distribute, or reference this article for any lawful purpose, provided attribution is made to the author. The author can be reached at tfox@tfoxlaw.com.

© Thomas R. Fox, 2013