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Monday
Jan302017

How perverse incentives cause companies to abandon controls

In the prior post, we talked about reasonable goal setting that can turn into perverse incentives, leading to compliance and reputational disasters like Wells Fargo. In this post, we look at whether companies can contain the excesses of their incentive programs with controls.

Controls that work well always come at a cost. A robust compliance and control environment might mean that a business unit gets poorer results now, in exchange for longer-term gains. The conflict between short-term results and long-term goals can pit management against compliance personnel in a struggle for whose voice is the loudest. That tension doesn't go away.

We have seen a number of cases of corporate misconduct where controls were ignored or overridden, which can be more dangerous than no controls at all. That’s compliance without consequences.

Controls that aren't taken seriously or are distorted to fit short-term business objectives can lead to channel stuffing, holding back orders, or not writing down bad debt or a depreciated asset. Supervisors (who also depend on incentive plans) are sometimes aware of the practices but don't stop them. It's not surprising, then, to see middle management playing the odds of not getting caught or thinking that a managerial “wink and nod” should be OK because it's so common.

But when controls are ignored to achieve a temporary improvement of financial results, it erodes the ethical tone inside the organization and compliance is discarded. Further, any financial benefit to the company is short-lived. Channel stuffing in one quarter merely robs from sales numbers in subsequent quarters.

Another unintended consequence of a bad incentive system is the squeezing of margins. Channel stuffing, for example, can result in unnecessary warehouse fees (if the customer is not ready to take possession) and discounting to clear inventories.

In short, disregarding controls leads to bad (and sometimes illegal) behavior, hiding behind “good" performance. It's a scenario that can't last long. As Warren Buffet once noted, “Only when the tide goes out do you discover who's been swimming naked.”

In the next post, we'll look at how steep incentive plans produced some of the worst corporate scandals of the decade. And how companies can avoid those problems going forward.

____

Richard Bistrong is a contributing editor of the FCPA Blog and CEO of Front-Line Anti-Bribery LLC. In 2010 he pleaded guilty to a conspiracy to violate the FCPA and served fourteen-and-a-half months at a U.S. federal prison camp. He now consults, writes and speaks about compliance issues. In 2015 he was named one of Ethisphere's 100 Most Influential in Business Ethics. He can be contacted by email here and on twitter @richardbistrong.

Marc Hodak is Partner at Farient Advisors, an independent executive compensation and performance advisory firm. He has taught corporate governance as a professor at NYU’s Stern School and as visiting lecturer at the University of St. Gallen in Switzerland. He can be contacted here.

This post was adapted from an article that appeared in Compliance Week “Is It Time For An Incentive Mine-Sweep?” by the same authors.