Often they can be a relatively innocuous, such as failing to declare an interest when there are complex decisions and interests to navigate through.
But at its worst, conflicts of interest can degenerate into systemic corruption, where the interests of insiders are invariably put before the interests of others, including investors, employees and customers.
Essentially all business is based on trust and the integrity of relationships – and even the appearance of a conflict of interest – can damage an individual.
If the person is a director or senior executive of a company, the collateral damage may be considerable as people lose conviction in the integrity and capacity for fair dealing of the organization.
Systemic corruption is often associated with emerging economies with weak institutional foundations in law, finance and governance where businesses are often founded on family interests and self-dealing is sometimes considered the normal way to do business.
However, advanced industrial economies are not immune to these institutional and corporate weaknesses, and the Australian business community is certainly no exception.
In the definitive book on Australian corporate crashes in the 1980s, The Bold Riders, Trevor Sykes reveals how in many spectacular corporate failures in Australia including the Bond empire, and Christopher Skase’s Quintex consortium, the entrepreneurs consistently put their own interests far ahead of their investors, with apparently no institutional restraint until their eventual conviction.
Internationally, on a much larger scale, the crashes of US corporations Enron and WorldCom and others revealed huge series of insider deals. The CFO of WorldCom, Scott Sullivan established hundreds of off-balance sheet special-purpose entities he controlled to conceal the debts of the corporation, while WorldCom chief Bernard Ebbers loaned himself $430 million of the company’s money to invest in his personal businesses.
This prompted the severe Sarbanes-Oxley Act that attempted to enforce stringent compliance with detailed regulations, while failing to change the corporate values and culture that caused these problems in the first place.
Similar episodes in corporate excess occurred at HIH and One-Tel at this time, leading to the HIH Royal Commission on the largest bankruptcy in Australian corporate history.
In a vast three-volume report, author Justice Neville Owen summarised the HIH crash as a ‘failure of fiduciary duty,’ where directors were were so busy pursuing their own interests they were incapable of recognising their duties to the company and the shareholders.
At the time, the conviction of the Sydney stockbroker Rene Rivkin in 2003 by ASIC for insider trading seemed to spell the end of an era in which stock tips routinely were based on insider knowledge of a tightly-knit investment community.
Increasingly rigorous rules on continuous disclosure insisted that any development at a listed company that was material to its share price needed to be revealed to the market immediately.
The Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Bill 2003 (the CLERP 9 Bill) introduced a much more robust requirement for companies to ensure continuous disclosure and empowered ASIC to maintain closer scrutiny of potential breaches of the continuous disclosure rules.
However, years of regulatory reform did not prevent the global financial crisis in 2007-2008, that revealed misaligned incentives rewarding executives and traders for creating and trading in toxic securities.
Even as they enriched themselves, their financial institutions foundered and governments were forced to spend billions of dollars of taxpayers’ money in expensive rescue operations.
In the aftermath of the financial crisis, Bernie Madoff was convicted of running a Ponzi scheme which defrauded investors of $65 billion, the largest and longest fraud in corporate history.
In another jarring incident, Goldman Sachs agreed to pay $550 million to the Securities and Exchange Commission (SEC) – one of the largest penalties ever paid by a Wall Street firm – to settle charges of securities fraud linked to mortgage investments.
As The New York Times reported, Goldman created Abacus 2007-AC1 at the request of prominent hedge fund manager, John Paulson, who earned an estimated $3.7 billion by betting the housing bubble would burst.
Telling investors that the bonds would be chosen by an independent manager, Goldman sold these investments to foreign banks, pension funds and insurance companies, which would profit only if the bonds gained value.
The Commission revealed that European banks IKB and ABN Amro and other investors lost more than $1 billion.
In New York presently the trial continues of Raj Rajaratnam, the founder of hedge fund, Galleon Group.
Accused of running the biggest insider trading scheme involving a hedge fund, Rajaratnam and five others are accused by the Justice Department and the SEC of relying on a vast network of company insiders and consultants to make more than $20 million in profit from 2006 to 2009.
Over the last 18 months, federal prosecutors in Manhattan have charged 46 people with insider trading. Astonishingly, 29 people charged have pleaded guilty.
Establishing a culture, values, and practices in businesses to eliminate conflicts of interest is a challenging task that requires constant vigilance.
Yet the great majority of businesses and other organisations rise to this challenge, and take pride in their reputation for integrity.
There are some simple and well-tried practical methods to avoid conflicts of interest:
• Removing conflicts by selling or placing in a blind trust company shares or other assets that may lead to conflicts.
• Abstaining from decisions where a conflict might arise (often involving leaving the room and not taking any part in the relevant discussion, or receiving any of the relevant documents);
• Third party evaluation – involving a third party, as for example the adjudicator of a fair price, to ensure an independent and market based evaluation; or offering an independent and professional view on a contested matter.
• Codes of ethics – a clear, well-understood and widely canvassed code of ethics can help people in making the right decision in difficult circumstances by working carefully through the issues involved.
However, the frequent failure to remove conflicts of interest in corporate life in the recent past, and the apparent inability of an army of intermediaries to recognise them when they occur including boards of directors, accountants, auditors, analysts, regulators, academics and media commentators suggests that more concerted action is required.
Incentive systems and employment practices that reward sustained irresponsibility and define this as ‘success’ are antithetical to good behavior.
Business needs to rediscover professional and fiduciary values if the trust of the community is to be restored and deserved.
This needs to be reinforced by better regulation based on sound principles, and energetically enforced.