In-house lawyers, equity-based remuneration, and improved governance

In a fascinating paper, Executive lawyers: gatekeepers or strategic officers? Morse, Wang and Wu seek to measure the influence of individual lawyers in explaining variances in compliance, monitoring, and business development on public corporations in the US. Their claims are eye-catching and important.

Firstly, they find that, “hiring lawyers into executive positions associates with 50% reduction in compliance breaches and 32% reduction in monitoring breaches.” Hiring a GC or placing lawyers into very senior positions in the corporate hierarchy (the top 5 by remuneration in any company) has a significant and measurable impact on compliance and monitoring, especially (it seems) on more poorly performing companies.

Their methods are explained below.*

So far, so good; lawyers make a difference and they make a positive difference. It’s not a story you see empirically as often as one might like. They explore whether the impacts they attribute to the hiring of senior lawyers reflects is attributable to the lawyers or to, “an overall strategy implemented by boards or CEOs to improve governance on many dimensions.” They are naturally limited in what they can do here but as far as they can tell, “We show that individual lawyers matter.”

Secondly, they examine whether, the “contracting of lawyers into strategic activities” reduces that gatekeeping effort. Those paid proportionately more by way of equity-based remuneration do less monitoring, preventing 25% fewer breaches than are typically mitigated by having an executive gatekeeper.”  Compliance levels were not significantly affected though (see below for why). So on monitoring, executive lawyers appear to do less monitoring, “when they have incentive contracts designed to reward business development effort”.

This faces up to the classic guardian-partner tension that Heineman writes so thoughtfully about. Put another way, it suggest that, in the desire to be commercially focused and ‘deliver for the business’, lawyers can take their eye off the gatekeeping ball. Culturally, the pressure on lawyers to be commercially focused is ubiquitous. This impacts on the management of ,and behaviour by, lawyers. Morse, Wang and Wu point to a Reynolds Associates survey report which supports the successful mainstreaming of the commercial awareness orientation: “contrary to conventional wisdom, the legal executives go well beyond spotting legal issues to helping the business actually take risks and find creative solutions.”

The pressure to be commercially aware, or business focused, goes well beyond remuneration incentives. It can lead to a higher risk appetite. We are told – from the same report – that, “executive lawyers that receive the best performance ratings are 11% more willing to take risks than the average executive lawyers, and they are as likely to take risks as any other executive.” Such analyses are concerningly one-sided: there is sometimes a machismo in the ‘risk is good’ analysis which is painfully dangerous. What Morse, Wang and Wu have done is show is how equity-based remuneration can discount the gatekeeping function.

That risk appetite can sometimes be harmfully high, and lead lawyers, as part of their ‘management’ of legal risk to recharacterise unacceptable conduct as higher risk strategy can be seen reasonably clearly in a whole host of corporate scandals involving lawyers (for the latest one in a long line on this blog see here or scan the pages of the Ethics Room for a broader sense of when things go wrong when gatekeeping fails).

Our Mapping the Moral Compass work points to two different orientations at work when lawyers think ‘commercially’: one is a broadly sensible commercial orientation, thinking about how legal work is fit for purpose in commercial contexts. The other is an exploitation orientation which seeks law’s uncertainty as an opportunity to be managed for commercial advantage. The latter, in particular, was associated with weaker ethical inclination. The exploitation of uncertainty orientation stood in contrast to orientations that emphasised independence and ethicality.

In that light, it is worth noting why Morse, Wang and Wu think the data is different for the compliance function. Equity-based incentives did not impact on compliance levels. They think is because, compliance breaches were in areas where lawyers had a “signing -off function”. They had to take personal responsibility for (say) SEC disclosures and, as a result, the lawyers faces personal exposure to liability.” Interestingly, the FCA/PRA are in the process (probably) making clear that the Senior Managers’ Regime should extent to those heading up a Bank’s legal function. Depressingly, when lawyers discuss this, they talk only of legal professional privilege concerns and conflict of interest concerns (see here for an example). They do not mention their obligations to the rule of law or how a regime like the SMR can provide important sustenance to their independence. Morse, Wang and Wu’s study is evidence, though, that personal accountability can work.

The bottom line is really this:

We find that higher equity incentives imply materially lower monitoring performance.

…We interpret the magnitude relative to the benefit of having an executive lawyer gatekeeper: when firms strongly contract  executive lawyers to be strategic officers, lawyers do less monitoring, preventing 25% fewer breaches than are typically mitigated by having an executive gatekeeper.

Or put another way:

Our results imply that whereas on average the hiring of a [senior] lawyer implies a 31.4% reduction in securities fraud (in column 2 of Table 7), when the lawyer is hired with high equity incentives, she only reduces fraud by 6.6%.

Incentives will only be part of the picture. The lawyers’ own inclinations and the approach of their host organisation may be as or more important influences. But this study supports the claim that lawyers can and do improve compliance, monitoring and even perhaps business performance, but must be managed appropriately. Incentives tied to the bottom line harm their gatekeeping functions whilst being only weakly related to business development.  Both gatekeeping and business development are legitimate aims, but the balance has to be well struck. The challenge to equity linked remuneration for lawyers practising in-house is made stronger by this study and the case for external, individual accountability for leaders of in-house functions is strengthened.

___________________________

* Let me spend a moment explaining their terms. Compliance breaches occur in areas where there are “gatekeeping tasks that require a lawyer to sign off to be SEC compliant” related to accounting and insider training regulation. Monitoring as they define it encompasses a broader range of legal risk management such as guarding against potential breach of law or contract, antitrust, disclosure and so on. In the study, they measure compliance failures from Accounting and Auditing Enforcement Releases (AAERs) and SEC allegations of insider trading. Monitoring failures are measured from, “securities fraud, securities lawsuits purged of AAERs, and general lawsuits.” They also seek to measure the commercial impact of these lawyers by measuring “business development”. They measure, “capital expenditure intensity, R&D, business segments, and filing of patents”. They find a modest (they say weak) positive relationship between hiring executive lawyers and increases in business development.

The sample period for their data is extensive (1995-2012) and includes 32,372 firm-year observations for more than 3,000 unique firms. What they essentially do is look at significant hiring decisions (GCs and GCs/lawyers being hired in the very top bracket of corporate officers by pay) and see if there are any differences in compliance, monitoring or business development performance they can attribute through statistical analysis to such hires.

Interestingly also, Morse, Wang and Wu’s analysis suggests that senior in-housers coming from private practice may, initially, be less prone to dial down their gatekeeping responses than those who have moved from other in-house positions.

 

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About Richard Moorhead

Director of the Centre for Ethics and Law and Professor of Law and Professional Ethics at the Faculty of Laws, University College London with an interest in teaching and research on the legal ethics, the professions, legal aid, access to justice and the courts.
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