Saturday, October 28, 2006

The Complete Ethical Person (Musings Provoked By Fleischer on Backdating)

FleischerPosted by Jeff Lipshaw

Conglomerate blogger Victor Fleischer (left, Colorado) has posted Options Backdating, Tax Shelters, and Corporate Culture on SSRN, and provokes me to a series of musings on what I would call the "complete ethical person."  Here is the abstract of Vic's article:

This Essay examines the problem of tax noncompliance through the prism of the options backdating scandal. The noncompliance of backdating was obvious, at least to tax lawyers. Backdating wasn't a sophisticated tax scheme. Rather, the noncompliance was collateral damage from weak internal controls and, in some cases, the rent-seeking of executives. Noncompliance in the face of clear rules is an overlooked problem in the corporate tax shelter literature, which tends to focus on disclosure, deterrence, or statutory interpretation. We should also study what creates the demand for tax shelters. The evidence from backdating suggests that a fast-and-loose attitude can develop when innovative companies outgrow their internal controls. When viewed in institutional context, a subset of corporate tax shelters, although adorned with more formal attire than backdating, may also be best understood as a compliance issue rather than a problem of textualism or inadequate penalties. The implication for law reform is that process matters. Culture matters. We may have more success in closing the tax gap if we support procedural changes in the way companies approach tax compliance rather than altering the substantive rules in ways that may have unintended consequences for non-fraudulent transactions.

This is a very interesting article!  Like Vic, I am concerned about corporate cultures that too eagerly transport the value of innovation and creativity in product and organizational design to the financial and regulatory side of the house.  Indeed, you can cheat on both sides.  It's fair game to take cost out of a product by achieving the same result - the ASTM standard, or defect level, or whatever - with better design, less material, less inspection, etc.  It's cheating to cut corners by mixing sand with plastic resin when you know the product can't perform as warranted.  It's also fair game to interpret the rules reasonably and to one's advantage.  Perhaps the gray area is wider, but we know when somebody has gone over the line.  (My own musings on the backdating issues are over in the dusty archives at PrawfsBlawg.)

Vic talks about revealed preferences, and I heartily concur that the cynicism that grows in an organization upon perception of dissonance between the company executives' rhetoric and their inconsistent reality is a cancer.   I continue to believe, however, that the solution lies in deontological execution by real people, and not more consequentialist regulatory schemes.   Vic's paper cites the work by Claire Hill and Erin O'Hara on trust:  that either smaller or more cohesive and trusting groups are more willing to tolerate fraud or misconduct.  To return to an allusion I have no doubted beaten (or pithed) to death, that's the rational frog approach.   Put enough rational frogs in a boardroom with enough economic incentive (punishment?  liability?) to croak on each other, and we solve the problem.  Vic moves away from the economic incentive in suggesting disclosure, "distrust" (a la the Hill and O'Hara work), and most intriguingly, "identity," in which one hires as the director of the particular area of compliance a person whose "sense of identity" prevents him or her from undertaking the non-compliant activity.

More below the fold.

I come away from years in the corporate arena convinced that no amount of economic incentive, nor organizational design, substitutes for the complete ethical person.  Let me give an example.  In large companies, it's a matrix.  One axis of the matrix has the so-called "line managers" who have responsibility for profit and loss  There may be a VP of the Geegaw Division, the Widget Division, and the Thingamabob Division, each of whom has plant managers and other purchasing, sales, and production people that make up the organization.   

The other axis of the matrix are the "functional managers" who have responsibility for . . . you guessed it . . . functions.  There will be a VP of Finance, of Law, of Human Resources, of Quality.  Often their job is to be "accountable" for the compliance of the company in their respective areas, even though much of what is required in the nature of compliance occurs within the line organization.  The paradigm of this for the law department is the tired cliche of a talking head presentation about price fixing and other sins to the sales people on the line, an oft-slept through or ignored joke.  (I had my department do it once as a skit in which we all played Star Trek characters - yours truly as cross between James T. Kirk and our CEO doing a riff in front of 200 executives like the old Yangs and the Kohms episode:  "WE......the people....."  I still break into spontaneous laughter thinking about how I managed to get one of our divisional GCs to wear the Spock ears.  "Compliance...the final frontier.")

An even better example is Health, Safety, and Environment.  The plant managers have this "matrixed" relationship, in reporting and in substance, between their line boss and the HS&E compliance organization.  The mantra is that a clean, safe, and healthy plant is generally a more profitable one, but the essence is that the people within the matrix have to be complete.  They, not the organizational design, and not the economic incentives baked into their compensation, have to make the judgments day after day, and usually well out of the monitoring range not only of the board and senior management, but of their own direct supervisors.

I want to suggest that the solution is in the execution, not in the plan, and in the moral fortitude of the actors, and not the economic incentive or organizational design set before them.  In any environment, from the board room to the plant floor, it only takes a few courageous and influential actors up and down the line - the complete ethical persons - to make the reality of Jeff Skilling's pathological "loose-loose" culture come closer to the empowered but ethical "loose-tight" of the ideal culture.

http://lawprofessors.typepad.com/legal_profession/2006/10/fleischer_on_ba.html

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