Conflict of Interest and Professionalism in the American Corporation

A Srinivas Rao

I cannot but contain the quiet indignation and outrage while watching the film “Inside Job” (2010) by Charles Ferguson. The film is an intelligent critique on the financial crisis of 2008 pieced together with good research into the “Fall of the Wall” of our present times i.e. Wall Street. This film while a critique on the disastrous consequences of deregulation in the financial services industry in the US, throws into the foreground the underbelly of corporate cupidity and caprice and more so the hollow posturing of professionalism. That the US Federal Reserve is influenced, not merely by lobbying by, but staffed by Wall Street at its highest levels of policy making (Rubin, Paulson, Geithner-almost as though Goldman Sachs and Citigroup ran the Treasury) to stymie any regulation of the industry shows how thin the Government line is, in being a custodian of a public trust and espoused values. That, the champions of deregulation included several professors and economists from the best Business Schools and Economics faculty (Summers, Bernanke, Hubbard, Mishkin) makes it sound almost hopelessly corrupt. While some have pointed out that it was the Democrat led Clinton Administration that not only repealed the Glass Steagall Act in 1999 but initiated wholesale deregulation, purportedly against the campaign contributions by professional services firms, it is a partisan view.  In this entire tale what gets overlooked is the fact that the genesis of this lay in dissolving the sentinel like vigil for over seven decades, the regulation to avoid conflict of interests and monopoly power instituted by the New Deal of the depression years of 1930s and in it lay the foundations of the institutional infrastructure of the American Corporation; the prototype for all corporations worldwide. 

No other institution in such a short period has become as ubiquitous and powerful, invasively infiltrating our daily lives as the corporation. While much of our modern culture and democratisation of consumption has been possible because of the same, it also has been at a significant cost, social, psychological and environmental. At the heart of the institution lies an idea of balancing conflict of interests. Conflict of interest exists when judgements concerning a primary interest of one party are clouded by a secondary interest of the other party attempting to re-prioritise interests, and arise because the agent is expected to be a fiduciary of the principal’s interest.

What defines the modern corporation according to 'Berle & Means’ canonical text “The Modern Corporation and Private Property” (1932) was the separation of ownership and administrative control. The corporation was a legal entity, a person, with legitimate claims over residual surpluses upholding the primacy of the shareholders and their wealth maximization (even with the notion of multiple stakeholders).  However the trustee relationship between the shareholders and the board was diminished by the separation of ownership and control and presented an inherent conflict of interest, authors argued, since the board no longer has substantial equity in the corporation. The New Deal legislation in the early 1930s stiffened the legal liability for negligent acts of the board and instituted that consultants be hired for due diligence called banker’s surveys. This was the true birth of the “Newest Profession” of management consultants (not industrial engineering as earlier thought). Since the legislation also specified that US corporations (from the time of President Woodrow Wilson) had to pay income tax, their accounts were to be audited and filed by a new breed of professionals the public accountants like Arthur Andersen, providing a stable and secure source of revenues for them. However it was stipulated that the same firm would not provide both consulting and accounting services, to avoid conflict of interests, thereby creating management consulting firms like those begun by James O McKinsey and Edwin G Booze. However the most far reaching piece of legislation was the Glass Steagall Banking Act 1933 which prohibited the commercial and investment banks to be under the same firm, compelling commercial banks to abandon underwriting and stock broking; as also outlawing consulting and reorganisation by the bank of their clients. Given that the commercial banks in Chicago suddenly found themselves in the early 30s unable to get investment bankers who were concentrated in New York to do their survey,s they became the first clients to the new breed of management consultants making Chicago the birthplace of that profession, migrating in the late fifties to New York and across the Atlantic (when sheep like the three Big firms McKinsey Booze Allen and Cresap McCormick shifted to the same building 'The American Brands'. Accounting, consulting, banking and securities firms and the regulations that surrounded them constituted the institutional infrastructure that defined the Corporation; the blurring of whose boundaries and the dilution of whose regulation correlates with the greatest crash since the Great Depression (and correlation is not necessarily causation, though the case for it is strong).

In other words, the new professions were a system of checks and balances to address the fundamental schism in the idea of the corporation i.e. the separation of ownership and management giving rise to the “Agency” problem i.e. aligning the interests of the shareholders, the board and those of management. In the 1940s the reimbursement of legal fees to board members by the management was outlawed and boards offset potential liability from shareholder lawsuits by “indemnity insurance”. By the mid eighties as lawsuits rose and indemnity insurance became short of supply, consultants became the brokers of legitimacy rather than brokers of knowledge selling the staple of due diligence.

These new professions were hard pressed to establish their credentials in their early years. Management Consultants for example did not have specialized journals, formal university education (Marvin Bower of McKinsey started the practice of recruiting at Harvard only in 1954), centralized body of abstract knowledge or a social mission of the classical professions. The consultants augmented their professional comportment by recasting public perception of their professional activity by using language that emphasised the metaphorical similarity with the older professions to gain cultural authority; sometimes going to the ridiculous extent of deep conformity of conservative dress styles of dark grey suits, neckties and hats. Notwithstanding the criteria of professionalism enumerated above, at the heart of professionalism lay a central idea, a promise to hold the interest of the client above one’s own firm or oneself. This was “professus” the Latin word for a public declaration. In other words professionalism was an institutional mechanism that sought to resolve the conflict of interest between client and provider. This was not the only feasible solution, there were also classical solutions viz. supervision as an internal solution which has a cost of hierarchy i.e. monitoring; or alternatively an agency solution of aligning interests with incentives on contract performance; or even a moral solution like the Hippocratic Oath or professional pledges. Putting it differently, when the inputs and outputs of services have different levels of verifiability by client, the nature of institutional interaction varies from “caveat emptor” or ‘buyer beware’ in case of high verifiability to “noblesse oblige” or ‘honourable behaviour’ by the professional when verifiability is low.

With the fall of Enron in 2002 what became obvious was that consultants and accountants played insidious roles and stopped being the gatekeepers of corporate legitimacy and both Arthur Andersen and McKinsey were culpable (though McKinsey cleverly avoided a greater guilt with their partners being on board of Enron, than Andersen shredding documents past midnight). What Enron, Andersen and McKinsey, icons of laissez faire capitalism had forgotten was that they had owed their success to opportunities created by regulation. They together with other such fallen firms like Worldcom etc gave rise to the Sarbanes Oaxley Act 2002 to improve accuracy of reporting and disclosures to potential investors and prohibiting consulting and auditing being provided by the same firm.

There are two kinds of conflict of interests; the first is that of scale, also called conflict of duty. Conflict of duty arises when the discharge of duties to one client by the provider infringes upon serving another set of duties to another client. The most common form of it is confidentiality. An advertising agency developing a brand identity for one firm cannot offer the same service to another firm in the same industry; or a strategy consultant to a firm cannot offer the same service to another firm in that industry within a reasonable time frame, unless agreed upon ex ante by the client. Conflict of duty thus restricts the size of the firm when the conflict norms are narrowly interpreted (leading to industry fragmentation) and when loosely interpreted builds on scale (leading to industry concentration) e.g. the difference between Strategy and IT consulting. The second kind of conflict of interests is what is called one of scope or conflict of service and arises when the provider offers many services and leverages ones position in one service to abet a judgement or decision in another. It is this second type of conflict that was used to such disastrous consequences in the great crash of this century when investment banks sold toxic assets to customers and bet against the same through an insurance firm violating the fiduciary trust with the customer. And none of the king’s horses nor men can put back the trust in the once venerable big five of the investment banks, their three rating agencies and the two insurance firms. This was the very thing that regulation was supposed to control and bring under its umbrella other financial instruments that were deemed risky.

The BBC in a study by a Zurich based financial services firm Obermatt stated on May 11^th 2012 that for the companies of the FTSE 100 i.e. the biggest UK companies, there was no correlation between the performance of a firm (profit growth and total shareholder return) and its total realised pay to the CEOs. In other words, many business leaders were paid several times over their actual value to the firm. When the American people felt outraged at the bailout time bonuses at AIG, their indignation was according to Prof Michael J Sandel (famed for his lectures on Justice) at Harvard University, more to do with rewarding failure than the morality of a bonus on bailouts. He then makes the observation that while Wall Street complained that the financial tsunami was a complex of economic forces beyond the reaches of a single firm and thus was above blame, they did not have the same wisdom that when times were good that they were paid a largesse that was also ascribable to the same wide economic forces and not their smart selves alone. This was the result of aligning compensation incentives away from those that clearly sustained client interests to those of firm profits alone.

To describe a consulting  firm’s role as one that legitimizes management decisions rather than providing knowledge transfer gave rise to a charlatan view of the profession prompting wisecracks like “borrowing a client’s watch to tell them the time”.  Ironically some management consultants feel offended if they were to be bundled with IT consultants who according to them live in environments of wide conflict rules and programmatic services with large staff leverage ratios (e.g. Accenture would have a staff to consultant ratio of 30 while McKinsey would have 7). The need for repeated legitimating of the professions of consulting and accounting and advertising etc demands an alternative explanation.  A sociological view would be that it is the belief in the efficiency of particular practices and theories than their proven efficacy that influences a firm’s action. If management ideas are broadcast to an environment with sufficient persuasion, decision makers begin to ascribe efficacy to certain ideas that have been so legitimated by their originators i.e. consultants or to a lesser extent, academics. With a critical mass of firms of ‘early adopters’ attempting practice, many others are forced to copy the same to also legitimate the quality of their own management, and over time creating identical structures across swathes of industries regardless of actual efficiencies. This can be called isomorphism. Notorious examples are the M-Form of organisation or multi divisional form, the BCG Matrix, Japanese Management, Five Forces, Value Chain, TQM, BPR, ERP, and SCM etc. Signalling management quality through such legitimacy exercises leads to a lowered bar in examining real efficiencies and more importantly lowered costs of capital and its access. Besides they sell well with a board who would like the consultant to validate management decisions and thereby indemnify themselves. Finally in markets of credence goods (i.e. those goods whose quality cannot be ascertained even after consumption) viz. management consulting, providers invest in signalling devices like prestige, reliability and exclusivity to highlight input factor quality viz. which business schools they recruit from or whether they are “Baker scholars”.

Professionals despite the mystique of their comportment and lifestyle are a fraught occupation that barely conceals the intimate conflict in the heart of the corporation. While it attempts to rise above temptation in providing advice, information or intervention; shores up its credentials by honing its inferential skills and judgement; it still has at its core a simple idea of placing the client’s interest above ones own. Ultimately it is significant that we hold the idea that the shareholder’s interests are held above those of management, employees, community and other stakeholders and should remain so until a new model is instituted.