Short-Term Incentives and Their Impact in Enabling Illicit Conducts
Wednesday 4 August 2021
Giovanni Paolo Falcetta
TozziniFreire Advogados, São Paulo
gfalcetta@tozzinifreire.com.br
Lais Cury Rezende
TozziniFreire Advogados, São Paulo
lcury@tozzinifreire.com.br
The reason why embedding financial policies with compliance and corporate governance best practices is key and up to date
There has been plenty of discussion recently about the impact of a company’s corporate governance rules in enabling illicit conducts by employees, including corruption and other offences. With the market increasingly requiring companies to establish appropriate corporate governance, together with compliance and anti-corruption measures, corporations have had to adapt to this ‘new’ reality – although corporate governance best practices’ guidelines have been around for quite a while.
The implementation of short-term incentives to executives (or, as some scholars call it, ‘short-termism’)[2] has generally been believed to be one of the main corporate governance-related causes of corrupt practices. While we know that any corporation’s focus is financial success, which is understandable and necessary, we also know that taking this to the ultimate level can put excessive pressure on employees, causing them to believe that they have to do whatever it takes to achieve it, lest they lose their jobs. Believing that, naturally, makes them act in a ‘whatever it takes’ mode towards this goal, which, as any direct analysis will show, can lead to corruption or other related illicit acts. This can harm not only the employees, but also the company, its reputation and, even worse, the whole market and stakeholders.
Let’s take a closer look at it:
- Companies setting incentives for top management based only on financial goals, aiming quarterly positive results or a one-year timeframe are a good example. Knowing that financial results, in a short term, are the focus of such companies, most employees would find it difficult to consider an option that does not match these goals, even if they have to break some rules, putting their jobs at stake. This, allied with the lack of proper training and lack of compliance culture, can lead them to find an easier way to ensure that the financial goal is matched within the necessary timeframe.
- Investors who decide to prioritise investments with short-term wins – which also directly incentivises the adoption of the measures mentioned above – is another example. If investors only prioritise short-term wins, companies do not have any counterincentive to change their financial short-term policy. Instead, they may promote a cost-cut approach, that could target areas not related to the core business, but that could act to avoid issues, such as audit, compliance and internal controls. This, however, is one of the aspects that is currently changing. The market is increasingly demanding companies to implement compliance and anti-corruption measures and corporate governance best practices.
- Last but not least, companies could establish unattainable goals, which commonly involves setting large targets to be met in a short amount of time. Setting goals that cannot be matched without employees ‘cutting corners’ will cause serious harm to any corporation in the medium- to long-term. Also, as mentioned in the United Nations Anti-Corruption Toolkit, ‘setting unachievable goals will seriously damage the credibility of anti-corruption efforts’.[3] It will direct individuals to adopt any measures necessary to maintain their jobs even if, in the long-term, these measures can cause harm to them or the company itself (due to government enforcement actions, financial losses due to penalties, reputational impact, etc).
Two main cases can demonstrate the above discussions into facts.
The summary of the complex context that led to the USD 285m penalty paid by a financial institution to the Securities Exchange Commission (SEC), involves the company failing to disclose to investors and stakeholders that the bank held a short position in relation to investments that were backed by residential mortgages.[4],[5] Holding a ‘short position’ means, in blunt terms, that they were betting against the investors’ investments, so if investors lost because their assets devalued, the bank would win – that is, the bank had a clear conflict of interests. The bank’s financial incentive model – based on a one-year timeframe and performance metrics that considered financial goals regardless of whether investors lost with their investments[6] – added by the probable lack of the compliance culture being passed on to employees, are some of the most logical causes that may have enabled the executive’s corruptive conduct.
In parallel, in another case involving financial institutions, the bank demanded employees to achieve a level of sales that was later considered to be a mathematically impossible one, naturally creating a culture of fear amongst employees. If the employees did not match their goals, the shortfall was added to the next day’s goal.[7] The setting of such unattainable targets led employees to open two million accounts without the authorisation of the bank’s customers, between 2002 and 2016.[8],[9] The culture imposed by the bank likely, and logically, influenced employee’s behaviour, which led to the imposing of the USD 185m fine to be paid to the Consumer Financial Protection Bureau (CFPB). The consequences of such account fraud scandal still linger, as, just last year (2020), the bank settled with the SEC for payment of a USD 3bn fine, also due to such account fraud,[10] and is still under investigation by the CFPB.[11]
These two emblematic cases allow us to draw certain conclusions: (i) the loss caused by the banks’ illicit practices generated reflections not only to the banks themselves, which suffered lingering financial losses and reputational hardship, but also to the market and its stakeholders, who saw their banks and investments immensely devalue, and, finally, to the executives who lost their jobs, had to pay several fines and also suffered reputational impact; (ii) the type of remuneration and timeframe considered for purposes of performance metrics have a direct and big impact in how most employees behave; and (iii) the culture created by the company and its top management executives also shapes how most employees conduct their work.
Having explained the nexus between a company’s culture and policies and its employees’ behaviour, one can ask what is the solution to avoid such problems from happening?
Enforcement is key to make companies and its employees understand that these ‘shortcuts’ are more harmful than helpful. In this sense, however, the status of the global anti-corruption enforcement and market demands of implementation of compliance measures, should be enough to show companies that adopting these best practices is paramount.
But hasn’t the market been working like that for so long and never considered it an issue? Well, the big, blockbuster cases mostly have this pattern. Nevertheless, the market itself has been changing and only now the idea that it can lose more than win with short-termism, based on a long-term assessment, is taking form.
Once the company has acknowledged this fact, it can move on to implementing the main measure that will help avoid such issue: allying financial targets with compliance and anti-corruption-related goals. Including other goals in the mix, although consequent positive results will only be seen in the medium- to long-term, will be undoubtedly beneficial for the company and its stakeholders, considering the current changes in the market. In doing so, the company will create a positive impact to its image, corporate culture and reputation, which will automatically and naturally reflect in their employee’s behaviour and further financial wins in the future.
Conclusion
In summary, establishing corporate governance practices driving to sustainable practices is key to any company that wants to set the compliance and anti-corruption culture, while ensuring long-term and lasting financial wins. By establishing the rules that will guide company employees, promoting a compliant behaviour to achieve its targets, companies will show what is expected of them, avoid corruptive conducts, and set the right corporate culture.
Notes
[1] Salter, Malcom S, How Short-Termism Invites Corruption…And What to Do About It, April 2012, p 4. Accessed on 31 May 2021. Available at: www.hbs.edu/ris/Publication%20Files/12-094_8260785f-0417-45d1-8abc-0afe86f87eaa.pdf.
[2] Salter, Malcom S, How Short-Termism Invites Corruption…And What to Do About It, April 2012, p 4. Accessed on 31 May 2021. Available at: www.hbs.edu/ris/Publication%20Files/12-094_8260785f-0417-45d1-8abc-0afe86f87eaa.pdf.
[3] United Nations Office on Drugs and Crime, The Global Programme Against Corruption Un Anti-Corruption Toolkit, Sept 2004, p 165. Accessed on 31 May 2021. Available at: www.un.org/ruleoflaw/files/UN_Anti%20Corruption_Toolkit.pdf
[4] This happened in the imminence of the 2008 housing crisis that hit the United States and other parts of the world. Such mortgages’ value, as historically known, suffered a downturn that led to the devaluation of assets, in the context of the 2008 crisis.
[5] Citigroup to Pay Millions to Close Fraud Complaint, The New York Times. Oct 2011. Accessed on 31 May 2021. Available at: www.nytimes.com/2011/10/20/business/citigroup-to-pay-285-million-to-settle-sec-charges.html.
[7] Harvard Law School Forum on Corporate Governance, The Wells Fargo Cross-Selling Scandal, Feb 2019. Accessed on 31 May 2021. Available at: https://corpgov.law.harvard.edu/2019/02/06/the-wells-fargo-cross-selling-scandal-2.
[9] The New York Times, The Price of Wells Fargo’s Fake Account Scandal Grows by $3 Billion, Feb 2020. Accessed on 31 May 2021. Available at: www.nytimes.com/2020/02/21/business/wells-fargo-settlement.html.
[11] Reuters, Wells Fargo says U.S. consumer watchdog has opened new probe on mishandling of accounts, May 2021. Accessed on 31 May 2021. Available at: www.reuters.com/article/wells-fargo-cfpb-idUSL1N2MT2XU.