Proving the benefit of a compliance and ethics program

How do you convince management to implement a strong compliance program? There may be two different schools of thought on this: economic, and let’s say, moral.

The economic one posits that companies will perform better financially if they have a strong compliance program. In simple economic terms, you attempt to show that investing $X in the compliance program returns $X+Y, and thus management should make the investment.

The moral view starts with the proposition that having a strong compliance and ethics program is the right thing to do. It ties in with the company’s values. It may benefit the company financially, but that is not the prime reason for doing it.

So consider the elements of the economic view. There are studies that suggest companies with strong compliance programs perform better in the stock market. A strong program can increase employee loyalty, make it easier to recruit talented employees, and increase their willingness to remain employed. There is also the enormous potential cost of violations – fines, lawyers’ fees, civil damages, reputational harm, and disruption of valuable management time. Weak compliance programs can also be associated with increased employee theft and embezzlement. A strong compliance program thus increases value and decreases direct and contingent costs. This would seem to be a powerful argument. But is this the best or only approach to take?

First, there may be some skepticism about the studies showing increased value, since it can be difficult to establish cause and effect. One might argue that companies that are already successful are the ones with the resources to have strong programs, so the cause and effect runs the other way. The contingent costs are dependent on the happening of an uncertain event – a violation. Managers may listen to the pitch, but in their hearts they may believe their company is not like the others, “has good people,” and doesn’t need to worry about a serious violation. This may be unrealistic, but the belief may still be there. There may also be the arrogance factor, where wrongdoing managers believe they are too smart to get caught, and thus don’t care about fines. For an example, see the book, McLean, “The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron.”

There is another, very important cost element that these economic arguments usually ignore, and that is the concept of opportunity cost. I don’t just invest $X to earn $Y, if instead I can invest the same $X and get $Y+$Z. The opportunity cost of the first investment is $Z. In practical terms, suppose you present a plan to management that will cost $2,000,000, but you argue it will return $500,000. Not a bad investment. But after you the new product development team gives a presentation showing that a $2,000,000 investment in their new product plan will return $50,000,000. All things being equal, and removing any moral element from the calculation, where would you invest?

So what is the alternative? Here we look at the moral element. We create a strong compliance and ethics program because it is the right thing to do. Is that unrealistically naïve? Do we ignore the financial element? One early clue I received on this was in doing a program about compliance programs for PLI, where the audience was mostly lawyers. I did a poll of reasons for having a compliance program, including the economic ones. To my surprise, “it’s the right thing to do” won handily.

We still tend to be heavily influenced by the simplistic view that corporate people are “econs,” whose choices are determined singularly by financial calculations. Much of this is tied back to a simple analysis conducted by Professor Becker, who calculated the likelihood that a rational actor would commit an economic violation. He determined that one would look at the benefit from the violation versus the penalty times the risk of being caught. So, by analogy, we would determine whether to have a compliance program based on a similar calculation; if it returned more money than it costs we would do it. If it did not, then we would not have a program. Yet adherents to the narrow analysis overlook what Professor Becker actually meant. In his Nobel Prize lecture, he explained that he had:

“tried to pry economists away from narrow assumptions about self interest. Behavior is driven by a much richer set of values and preferences. The analysis assume[d] that individuals maximize welfare as they conceive it, whether they be selfish, altruistic, loyal, spiteful, or masochistic.” Gary S. Becker, Dep’t of Econ., U. Chi., Nobel Lecture: The Economic Way of Looking at Life 38, 41 (Dec. 9, 1992), http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1992/becker-lecture.pdf.