TCS Daily

Incentives and Business Ethics

By Stephen Bainbridge - March 11, 2004 12:00 AM

The list of corporate scandals is now depressingly familiar: Enron, WorldCom, Tyco, ImClone, and Adelphia, to name but a few. Sadly, the list continues to grow as ever more corporations announce accounting irregularities and investigations. In all too many of these scandals, negligence by corporate lawyers allowed management misconduct to go undetected. Sometimes lawyers even acted as facilitators and enablers of management impropriety.

Will new rules of legal ethics lead to more ethical lawyers? If so, will more ethical lawyers contribute to a renewal of business ethics? Congress thought so. In June 2002, Congress passed the "Public Company Accounting Reform and Investor Protection Act," popularly known as the Sarbanes-Oxley Act (or just SOX). SOX § 307 commanded the Securities and Exchange Commission (SEC or Commission) to develop new legal ethics rules for lawyers appearing before it.

In my view, however, tinkering with legal ethics rules will do very much to improve the ethical climate of business. My analysis draws, at least metaphorically, on tournament theory. Although tournament analyses are somewhat controversial, tournament theory has become a widely-used tool for analyzing the institutional structures and cultures of large law firms.

As the story goes, in a promotion tournament, the principal ranks its agents by their performance relative to one another. The best performing agents are promoted to positions with higher pay and/or status. Hence, law firms supposedly rank associates and then promote the best performing associates to partner at the end of an evaluation period.

Sarbanes-Oxley Section 307

SOX § 307 required the SEC to adopt "rules ... setting forth minimum standards of professional conduct for attorneys appearing and practicing before the Commission." In January 2003, the SEC responded by promulgating new rules, the principal substantive feature of which is a so-called up-the-ladder reporting requirement. This requirement is intended to create an "early warning system" about management wrongdoing through mandatory attorney disclosures to the board of directors.

When a lawyer who appears and practices before the SEC "becomes aware of evidence of a material violation by the issuer or by any officer, director, employee, or agent of the issuer" the lawyer's initial duty under the new rules is to report such evidence to the issuer's chief legal or executive officer. Unless the lawyer "reasonably believes that [that officer] has provided an appropriate response within a reasonable time, the attorney shall report the evidence of a material violation to" the audit committee of the board of directors, subject to several exceptions and alternatives. The SEC thus implemented Congress' intent that § 307 give lawyers a very "simple" obligation: "You report the violation. If the violation isn't addressed properly, then you go to the board."

Critics of § 307 have raised serious federalism-based objections to Congress' intrusion into legal ethics, an area long governed by states. Likewise, they've argued that legislative intrusion into a regulatory area traditionally within the purview of courts raises separation of powers concerns. These arguments failed to gain traction, however, because Congress no longer trusted lawyers to regulate themselves.

The Issues

It's important to recognize that we face three distinct sets of cases: (1) Counsel knows of aggressive or risky conduct by management, but is unaware of fraud or other illegality. In these cases, the lawyer is unlikely to report up-the-ladder. (2) Counsel actively participated in, or at least facilitated, actual fraud. In these cases, the lawyer also is unlikely to report up-the-ladder, albeit for the different reason that he now has something to hide. (3) Counsel has grounds for suspicion of fraud or other illegality, but no direct evidence. Only in this third scenario will the up-the-ladder reporting requirement come into play.

My intuition is that the third scenario is rare. In many of the recent corporate scandals, the misconduct was committed by a small group of senior managers who took considerable pains to conceal their actions from outside advisors such as auditors or legal counsel. As many observers noted, in the post Sarbanes-Oxley § 307 environment, managers are even more likely to conceal any hint of impropriety from counsel. In my view, however, this is only part of the problem. I argue below that lawyers will rarely perceive their own situation to fall within the third scenario. The tournament of lawyers will not be won by whistleblowers.

Tournament Theory as Applied to Law Firms

Law firms use the promotion-to-partner tournament to minimize the agency costs inherent in employing associates. On the one hand, the firm makes investments in its associates' human capital -- i.e., skills and client relationships -- during their apprenticeship. The firm will want to discourage associates from leaving the firm before it has fully amortized those investments. On the other hand, the firm must also deter shirking by associates.

The firm incents associates both to remain for the optimal period and to maximize their productivity during that period by holding a tournament in which all the associates in a particular entering class compete for the ultimate prize of membership in the partnership. The prize of promotion to a more secure and higher status position, plus the accompanying increase in compensation, gives lawyers an incentive to remain at the firm. Conversely, the threat of losing the tournament deters shirking.

What skills and attitudes contribute to success in the promotion-to-partner tournament? As one might expect, the ability to develop good working relationships with clients and peers is a highly ranked consideration in the promotion to partnership decision. Also highly ranked are a willingness to pursue the interests of clients aggressively and the potential for bringing new business to the firm.

In other words, winning the tournament requires developing a set of skills and attitudes aimed squarely at keeping clients happy. The tournament thus develops lawyers with strong incentives to overlook management wrongdoing. Because it is corporate management -- not the board of directors -- that hires outside legal counsel, it is management whom attorneys must please in order to retain or attract business.

Winning the promotion-to-partner tournament does not eliminate these incentives that discourage lawyers from reporting misconduct by the managers who hire them. In the first place, all partners have an incentive to keep key clients happy. Consider the example of Enron, which was Vinson & Elkins' largest client, generating about 7% of the law firm's revenues. About 20 former Vinson and Elkins lawyers took jobs in Enron. All Vinson & Elkins lawyers, perhaps especially the partners, therefore had strong incentives to remain on good terms with Enron's managers.

In the second, winning the tournament does not put an end to survival of the fittest competition. In recent years, law firms have shifted away from the old rules of partnership in which promotion to partner carried with it job tenure and seniority-based compensation to new models in which compensation is variable and partners lack job security. Because an individual partner is even more likely than a firm to be dependent on billings to a single major client, the "eat what you kill" compensation phenomenon makes it highly unlikely that such a partner will risk antagonizing key clients absent the proverbial smoking gun (and maybe not even then).

Third, human nature induces even individuals who are acting in subjective good faith to convince themselves that they are doing the right thing when their chosen course of conduct is personally beneficial. Lawyers who made the decision to associate with a particular client therefore are less likely to recognize client misconduct, because evidence thereof would be inconsistent both with the lawyer's self-interest in maintaining a relationship with the client and the lawyer's self-image as someone who identifies and associates with honest people.

In the floor debate on § 307, Senator John Edwards (D-NC) explained how such lawyers, even though acting in good faith, can come to identify with management:

We have seen corporate lawyers sometimes forget who their client is. What happens is their day-to-day conduct is with the CEO or the chief financial officer because those are the individuals responsible for hiring them. So as a result, that is with whom they have a relationship. When they go to lunch with their client, the corporation, they are usually going to lunch with the CEO or the chief financial officer. When they get phone calls, they are usually returning calls to the CEO or the chief financial officer.

Taken together, these incentives suggest that, despite the new legal obligation to report misconduct, the attitudes engrained by the promotion-to-partner tournament will incline counsel to overlook evidence of management misconduct -- whether intentionally or subconsciously.

Sarbanes-Oxley does not address these incentives. Indeed, while it is intended to create counter-incentives in the form of potential disciplinary proceedings, § 307 may have the unintended consequence of actually encouraging lawyers to turn a blind eye to corporate problems. Under the regulations, an attorney is only responsible for material violations of which he "becomes aware." As such, the rational lawyer has yet another rationale for closing his eyes to potential misconduct. Avoiding detailed information about their clients' conduct is one way of avoiding the risk of incurring a duty to report or any subsequent liability exposure.

In the wake of Sarbanes-Oxley, it will become even easier for lawyers who wish to turn a blind eye to client misconduct to do so. Corporate managers will not welcome the kind of investigation that an attorney's "reporting up" would engender. Even a mistaken accusation of wrongdoing by an attorney could have adverse consequences for the implicated managers, who in turn will minimize the overall amount of information to which an attorney has access ("just to be on the safe side"). Indeed, managers likely will try to shield their lawyers from information not only about potential wrongdoing but also of aggressive -- edge of the envelope pushing -- accounting and disclosure practices.

In evaluating the likelihood that Sarbanes-Oxley § 307 will prove effective, it is worth remembering that Enron and its ilk were hardly the first time corporate lawyers fell down on the job. In connection with the Lincoln Savings & Loan scandal, Judge (and former SEC Director of Enforcement) Stanley Sporkin famously observed:

Where were these professionals, a number of whom are now asserting their rights under the Fifth Amendment, when these clearly improper transactions were being consummated? Why didn't any of them speak up or disassociate themselves from the transactions? Where also were the outside accountants and attorneys when these transactions were effectuated? What is difficult to understand is that with all the professional talent involved (both accounting and legal), why at least one professional would not have blown the whistle to stop the overreaching that took place in this case.

The answer is that they were doing precisely what the promotion-to-partner tournament taught them to do -- keeping their clients happy even if it meant sticking their heads in the sand.

The point is not that lawyers are pervasively co-opted or immoral. The point is only that lawyers have both economic incentives and cognitive biases that systematically incline them to at least shut their eyes to instances of client misconduct. The principal flaw in Sarbanes-Oxley § 307 is that it focuses on the wrong players. What is necessary is to change the incentives of clients. Only after that happens, can we then enlist legal counsel to add an additional layer of protection.

Stephen M. Bainbridge is a professor at the UCLA School of Law, where he teaches corporate and securities law. His blog, offers eclectic commentary on law, business, politics, and wine. This column is based on remarks he made at a recent conference on law and business ethics held at the University of St. Thomas law school. Those remarks, in turn, were based on his forthcoming law review article The Tournament at the Intersection of Business and Legal Ethics.


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