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At Large: The cobra effect is an enemy of compliance

I had a simple (and unoriginal) thought years ago that has helped me understand why compliance can be so difficult. My thought was that people will do whatever they’re paid to do. Not that everyone will always do what they’re paid to do. But that some people will do anything they’re paid to do.

In corporate life, it means always getting what you pay for, but not always what you were hoping for.

For example, Enron’s board adopted a compensation plan that rewarded top people with huge cash bonuses whenever the company’s stock climbed to certain prices. What happened as a result is well known. Some clever executives found (mostly legal) ways to keep mountains of debt off the company’s balance sheet. Using the hidden debt, they invested in deals and booked “anticipated” profits from them, instead of waiting for actual profits, which often never materialized. The stock soared while the company sank.

Getting what you pay for but not what you hope for is also known as the cobra effect. During colonial rule in India, British officials came up with a plan to reduce the number of dangerous cobras in Delhi. They offered a bounty for every dead snake. Over time, more and more dead cobras were delivered. It turned out that some people started breeding cobras to cash in on the program. When the British caught on and canceled the bounty, the snake breeders released their now-worthless cobras, thereby increasing the danger to everyone.

Mark Twain said, “The best way to increase wolves in America, rabbits in Australia, and snakes in India, is to pay a bounty on their scalps. Then every patriot goes to raising them.”

I saw the cobra effect first hand. The board of a company I knew rewarded executives for hitting revenue targets. Predictably, the company added piles of revenue and the executives collected their bonuses. Unfortunately, profits dried up and eventually disappeared, and the company plunged into debt. In their drive for revenues, the executives ignored rising costs. So, the more revenues they booked, the worse the company’s P&L became. It ended badly, especially for the poor shareholders.

Wells Fargo’s recent scandal is a reminder of the cobra effect. The bank’s executives decided to reward managers based on cross-selling — how many different products (checking accounts, mortgage loans, credit cards) the bank could sell to each existing customer. The managers, whose pay now depended on their unit’s cross-selling success, reacted by putting enormous pressure on their workers, sometimes announcing the cross-selling scoreboard for each worker twice a day. The “pressure cooker” created by the cross-selling reward scheme resulted in Wells Fargo workers opening around two million unauthorized accounts of various types for existing customers. When the customers noticed new fees for products they hadn’t asked for, prosecutors charged the bank and some executives with fraud.

For compliance officers, the cobra effect is always a concern. How should the company pay employees, especially sales and marketing folks, and third-party intermediaries? Companies want to encourage success and are happy to pay for it. But should they ever promise success fees? In the FCPA Resource Guide, the feds expressly designate “the success fee structure” in consultant contracts as a compliance red flag.

The red flag isn’t theoretical. In 2015, the SEC charged Hitachi with FCPA violations in South Africa. The company paid a success fee of $1 million to a politically connected firm and recorded it as consulting fees, the SEC said. Hitachi settled FCPA books and records and internal controls offenses by paying the SEC $19 million.

In 2017, a Pennsylvania-based consultant named Dmitrij Harder was jailed five years for bribing an officer at the European Bank for Reconstruction and Development for loan approvals. Two companies the DOJ didn’t name paid Harder and his firm a total of $8 million in success fees after the bank approved their loans.

And so on . . . .

It’s easy for the aims of a compliance program to become subservient to commercial goals. Paying the salesforce a modest base with a big performance component can produce a felonious cobra effect, as can success fees for all sorts of intermediaries. But can a company that pays people to focus on compliance instead of profits even survive? Compliance might be a reason why a company stays alive and prospers. But compliance alone doesn’t pay the bills.

There’s no easy answer. And the cobra effect is always lurking.

Your comments are welcome.

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8 Comments

  1. Great and thoughtful article.
    What can one say…? The implied “barrier” to the Cobra effect has to be a sense of personal integrity that translates into a person’s work ethics – on both sides of the equation; the pressuring manager & the employee.

  2. Nice insights.

    One option to try managing this challenging topic is the deferral of executive bonuses in the future (> 3 or more years), but the results of this practice aren’t obvious and creativity never ends when it comes to commit fraud, corruption, etc..

  3. I do wonder if this problem has always been with us, except today we may be facing a society that is increasingly dishonest. So institutions which once prided themselves on trusted staff, e.g. banks, now are employing dishonest staff.

  4. This is a great question, and the reason the Sentencing Commission was so wise to make the issue of addressing incentives a core part of any compliance program. Incentives need to be there as a motivator, but also need to be controlled. This is difficult, but the fact that something is difficult doesn’t mean it can’t be done. One important step is making sure the compliance person is in the room and has a voice when incentives are being established. It is also important to have positive recognition for those who show leadership in supporting the compliance program and the company’s values. There is more on this in the white paper, Murphy, “Using Incentives in Your Compliance and Ethics Program” (SCCE; 2012), https://assets.hcca-info.org/Portals/0/PDFs/Resources/library/814_0_IncentivesCEProgram-Murphy.pdf

  5. Very good article! Grateful for the reflection that helps to think about common bonus policies here in Brazil.

  6. Very helpful, Richard: you have prompted me to think about what I might call ‘The Reverse Cobra Effect’ for supporting Whistleblower Protection compliance programs…
    HW

  7. I think that is why a system or group of metrics is so important. They should also counter and help balance each other based on the core values of the company, the original mission and current goals. Weights should be adjusted on a periodic basis to help focus on opportunities while not undermining counter metrics, ex. Speed and/vs Safety or Quality Control and/vs Cost. Ideally an equilibrium should be met where the company adds stability to their market, with growth and expansion happening at a predictable and (dare I say) responsible rate.

  8. Another excellent discussion topic Richard.

    I also think Phillip hit the nail on the head. Its an ongoing process of identifying the risk and putting in place the metrics that drive good behavior. No organization will be able to claim victory; however, they should be able to instill the behaviors (the realization you have had) that recognize the problem and outline a path for corrective action.

    Some years ago (25 in fact) I was a senior manager in a Fortune 100 corporation that had each manger at my level attend a one-week management training course, which was designed by one of the leading universities in the United States. The course had each student run through a computer simulation that assigned the participant as a general manager for a production line of a new product.

    The student had a budget and was required to decide how much of that budget was spent on: salaries; bonuses; R&D; health and safety; governance; environment protection; human resources; etc. (it was a comprehensive budget).

    The fictional GM experienced, in an accelerated simulation, what would happen to their business, based on the decisions the GM made with respect to budgeting and investment. It was an enlightening process, which allowed the student to further tweak their investments in specific categories to see what would happen to their fortunes.

    That one-week training course changed the way I approached management for the rest of my career. I quickly realized that there were many aspects to running a successful business and it was naive to categorize some of those aspects as “compliance” or as a “burden”.

    Experienced boards and executive management teams understand the complexity of running a successful business. They should be held accountable, and not allowed to use the excuse that “I didn’t know” or that “I was unaware of the potential cobra effect”.


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