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Memo to the governance committee: It’s time to “kick the tires” of the board’s conflicts policies. There are new signs of a tougher regulatory approach to conflicts of interest, whether arising in the boardroom or the C-suite. An approach that may be much less forgiving of traditional, perhaps more relaxed practices of conflicts disclosure and review. An approach that is focused on holding officers and directors to a higher standard of accountability. An approach that can be met by greater governance commitment to identifying, properly disclosing and diligently vetting potential conflicts.
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The most ominous sign of this new approach can be seen in the highly public ethics investigation of the now former general counsel of the Securities and Exchange Commission (SEC). You may remember the basic story line from the many news reports: highly respected attorney returns to the SEC at the request of the chairwoman; he discloses to the chairwoman that he that he inherited Madoff-related proceeds from his mother’s estate; when he realizes he could become involved in formulating a compensation formula for Madoff victims, he makes additional internal disclosures, including to the SEC chief ethics officer, who approves his continued participation in the matter. Further criticism of his role in setting the compensation formula prompts an investigation by the SEC Inspector General, who alleges that the SEC Commissioners approved the compensation formula without knowledge of the general counsel’s conflict. Concluding that the former general counsel participated materially in a matter in which he had a financial interest, the Inspector General refers the matter to the Department of Justice. While the Department of Justice ultimately declines to investigate, the damage is done.
We’re not trying to guess at the “rights” and “wrongs” in this situation–we’ll leave that to the process of law. Still, it’s hard not to pause at the view from 10,000 feet (courtesy of news reports): a renowned public servant heeds the call to leave the private sector to return to government; was the first to identify the (controversial) financial relationship; discloses the relationship to seven separate senior SEC officials (none of whom identified a conflict); submits the matter to internal ethical review which clears him to participate in the work in controversy, and still ends up the subject of a Department of Justice (DOJ) review. One might fairly ask, “What else was he supposed to have done?”
This scenario ought to send more than a few chills up board member spines. Not because we’re certain of the facts. We aren’t. Not because conflicts standards for federal employees—which can have criminal penalties in certain instances—are going to be applied to the corporate sector. They’re not. And not because the DOJ is going to assert jurisdiction over conflicts of interest matters in private companies. It’s not. Rather, it’s because of what this mess might be telling us about how standards for conflicts review might be evolving, what might be driving this evolution, and about how boards ought to be responding.
The concern is with the “hot button” nature invariably associated with financial conflicts of interest. It’s exacerbated by the current “corporate accountability environment,” in which regulators are more willing than before to hold individual officers and directors responsible for corporate wrongdoing, in which a distinctly more personal face is being placed on allegations of organizational misconduct. We’re seeing it in any number of places—the SEC’s focus on personal liability in Foreign Corrupt Practices Act (FCPA) investigations; the IRS holding officers strictly liable for the company’s failure to “pay over” tax withholding payments; “responsible corporate officer doctrine” prosecutions by the DOJ and the Food & Drug Administration; and the Department of Health and Human Services’ right to exclude from the Medicare program key employees of a company convicted of a criminal violation—regardless of whether they knew of the problematic conduct. In an environment in which “finger-pointing” is more frequently the order of the day, the “bulls-eye” of scrutiny is increasingly being pasted on the backs of corporate leadership—temptingly so in situations involving allegations of self dealing and conflict of interest. And don’t be distracted by the fact that the current controversy is in essence an “inside government” matter; corporate governance regulators are likely to be closely following the story, wondering how the issue may apply to their own jurisdictions.
The SEC controversy hints of a higher standard of conduct of all parties to the conflicts review process. Didn’t see how that contract or relationship could constitute a conflict? Well, think again. Isn’t it enough to have told my board chair? My CEO? Maybe not. But the compliance officer knew about it and told me I could stay involved “in the deal”! Not so fast. If, as the former SEC general counsel alleges, seven separate conflicts disclosures wasn’t enough to foreclose DOJ investigation, one wonders what would suffice. Seventy times seven?
A more realistic response to this development would involve the following steps:
- Instill the board and key executives with an appreciation for the “corporate accountability” environment, and how it might be incited by conflicts of interest-related issues. Remind them that the purpose of a good conflicts of interest policy is not only to protect the organization and its governance decision-making process, but also to protect as possible the reputation of its officers and directors from avoidable conflicts of interest allegations.
- Improve the diligence applied in the director nomination process. Closer attention should be applied to identifying candidates’ relationships that might be prone to conflict problems were they appointed to the board.
- Challenge individual directors—as well as governance committee members—to view more broadly the conflicts implications of financial and even personal relations. Even if you don’t see the potential for conflict, take another look. How would the press see it? A corporate constituent? A regulator (you know, like maybe the SEC Inspector General). When in doubt, disclose.
- Confirm the process by which disclosures are to be made—who is the party to whom questions on the appropriateness of disclosure are to be made; to whom/what body is the disclosure to be addressed, and whom/what body is the actual arbiter of a disclosure?
- Assure the absolute independence of the conflicts review process; there’s no sense in compounding the problem by tolerating a conflict of interest involving those charged with the responsibility of reviewing the disclosure.
- Make sure there are objective criteria available for the conflicts arbiters to use in determining whether a disclosure constitutes a conflict and, if it does, whether the conflict can be effectively managed.
- Review for effectiveness and legal consistency the details of how conflicts affect the process of meeting quorum, supermajority voting requirements, participation in meeting discussions and, where necessary, recusal.
- When conducting a particular conflicts review, remember that the board is expected to act in a manner that preserves the reputation of the organization; making a “media be damned” type approach more than a little problematic.
- Ask your D&O carrier whether the board policy contains a coverage exception for violations of the duty of loyalty.
- Remind board members that disclosure of a conflict of interest doesn’t provide a free pass to engage in related actions that may constitute a breach of fiduciary duty.
Oh, while you’re at it, make sure the positions of general counsel and compliance officer are separated, and held by separate persons. The compliance officer shouldn’t be reporting to the general counsel, and corporate officers shouldn’t be asking their subordinates to conduct conflicts evaluations of their direct reports, unless closely supervised by independent parties.
If you think this all just a dustup between regulators, you might think again. This disclosure dispute should be viewed in the context of the larger climate of accountability. Simply put, there is broad-based public sensitivity to allegations of self-dealing by persons in positions of control and responsibility. The concern that led to the Inspector General’s DOJ referral is one that is increasingly likely to be shared by a corporate governance regulator. While sanity may have ultimately prevailed here, it did so at such a cost. So, the perception of inequity in the SEC situation should prompt a corporate officer or director to pause, recognize that the rules may indeed be changing, and encourage a boardroom review of conflicts policies and procedures. There is no downside.
Michael W. Peregrine is a partner with McDermott Will & Emery based in the firm’s Chicago office.