On 7 November, the Hayne Royal Commission published a paper it commissioned from Professor Sunita Sah about conflicts of interest.

The paper, apart from being an interesting read, provides an excellent foundation for boards seeking independent, unbiased advice.

It is a credit to the Commission that it considers matters of behavioural economics, as well as law, because as the Commission has been finding out, behaviour is more about psychology than setting and enforcing laws. Professor Sah is Professor at the Johnson Graduate School of Management at Cornell University and has a PhD in psychology as well as numerous awards and honours in behavioural psychology research.

In a nutshell, the professor says that advisers (across a range of industries and professions) give significantly more self-serving, biased advice when they have a conflict of interest. Importantly, Professor Sah says they do this even when the adviser believes they are being objective and impartial.

The paper describes the reasons and tactics advisers use to rationalise, excuse or deny the influence of their personal interest in giving advice. It refers to accountants who believe their expertise and professional standards are such that they can put aside their personal interest, and surgeons who think they deserve the gift from the pharmaceutical company because they have sacrificed so much for their work. The research is equally applicable to lawyers, financial advisers, investment bankers, and remuneration advisers, among others.

One response, arising out of audit conflicts in the UK, has been for the UK arm of one large international audit firm to stop providing advice to management of audit clients.

The US Sarbanes Oxley Act (noted on page 21 of her report) bars audit and other board advisory firms from providing specified other services that contributed to the conflicts of interest and massive failures of Worldcom and Enron and, as it turned out, their auditor, Arthur Anderson.

Our own firm does not provide services to management which may result in conflicts of interest with the work commissioned by the company’s board.

Of relevance to the Royal Commission, Professor Sah’s paper points out that telling the client about the adviser’s conflict may not help and can make matters worse. Apparently, conflicts disclosure can lead to increased trust (‘my adviser is so trustworthy that they warn me about their advice’). It can also lead to a desire in the client or patient to demonstrate that they trust the adviser, despite the adviser’s personal and conflicting interest (I don’t want my doctor to think that I don’t trust them, so I will follow their advice).

We would be remiss if we did not note that, for those who govern or lead vertically integrated businesses, there are significant exceptions to these behavioural predispositions that may apply to their businesses (see pages 13 and 14 of Professor Sah’s report).

Professor Sah uses a term that explains an experience many of us will recognise – ‘ethical fading’. It describes a decision-making process in which moral issues are pushed to the background, or ‘fade’. For example, remuneration reports may refer to good financial performance that supports a pay decision, despite poor customer service, a bullying work environment, or poor safety record.

Professor Sah says that ethical fading is especially likely if there is pressure to meet business or sales targets.

And then, something that will resonate with all stakeholders on pay issues, there is complexity – the longer and more complicated the process, the less likely it is that anyone will remember the needs of shareholders/customers/employees– more ethical fading.

Professor Sah concludes in the paper that a person with a conflict of interest cannot be trusted – not only, or even because they may act corruptly (i.e. knowingly in their own interests) but, rather, because they will do so unwittingly.

This suggests the following checklist. Our checklist of policy approaches provides a cascading level of independence for board remuneration consulting. However, the following policy approaches could be applied for any other services required by the board – simply replace “remuneration” with “legal”, “insurance”, “accounting”, “tax” or whatever other advice is being sought.

1 . Independence of remuneration advice through ultimate authority of the remuneration committee

This policy would require the remuneration committee to be the ultimate authority on remuneration matters considered by the consultant and that the committee determines to whom the consultant reports on these matters.  This would allow the consultant to work for management if authorised to do so by the remuneration committee.  The committee may also require the remuneration committee chair to be copied on all material matters (conclusions and recommendations) made by the consultant in their work for management.

The board needs to be aware of the full circumstances of the consultant’s total relationship with the company so that it can assess the nature and extent of any possible conflict. There is an argument the value of the consultant’s advice will be enhanced for the board by the additional knowledge and understanding of the company’s circumstances and its remuneration practices the consultant will obtain in such circumstances.

Further, it can be argued that the remuneration arrangements for the CEO and direct reports and other executives need to be consistent, and this is more easily achieved if the same consultant is advising in relation to both areas.

2 . Independence of remuneration advice through exclusivity of client

This policy would require the remuneration adviser to be employed exclusively by the board, and not be an adviser to management.  This does not preclude the adviser liaising with management to seek information, comment, or opinion.

3 . Independence of remuneration advice through exclusivity of client and consultant services

This level of independence is a refinement of level 2.  It, additionally, requires the services of the chosen consultant to be such that the firm,could not, at some time in the future, be employed by management.  This level of independence removes the potential for conflicts of interest.

This level of independence is the ultimate level that a board remuneration committee can apply.

4 . Independence of remuneration advice through exclusivity of client and fearlessness of advice

This is a refinement of the independence requirements of levels 2 and 3, and requires that the firm employed not be too dependent on the fees from any one client relative to other clients.  In fact, this requirement is hardwired into the US rules for compensation adviser independence implemented with the Dodd-Frank Act.That is, a more diversified fee base may allow the consultant to more easily take issue with directors’ opinions if, in the adviser’s judgement, they are not in the best long-term interests of shareholders.

This last level of independence will, to an extent, depend on the personality of individual advisers, as even consultants with a diversified fee base could also be “yes” women or men.

5 . Other considerations

Assessing the level of independence best suited for a board requires that consideration be given to the impact such a selection could have on the full range of advisers to the board on remuneration matters.  While there may be a primary adviser, the committee may also make use of specialist legal, tax, insurance, strategy, accounting or other advisers from time to time.

Given this, the committee may want to consider two levels of independence requirement – one for the primary adviser, and another for all other specialist advisers.

Professor Sah’s paper can be found HERE

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