The thorny world of moral hazard: what to do when a company does wrong?

http://www.theguardian.com/money/2014/jul/10/moral-hazard-company-practices-business-investing

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So you think that just because you’re an investor, you get to sit back and wait for the profits to roll in? That your job stops with providing the capital – the investment dollars via your 401k plan or IRA account – to the businesses in which you’re a shareholder. And that if those profits don’t materialize as expected, you have a right to join one of those class action lawsuits, because the only conceivable reason for such an eventuality is that corporate malfeasance, right?

Think again.

That was the timely reminder of FBI Director James Comey late last week. Discussing the record $9bn fine levied on France’s BNP Paribas, one of the world’s largest financial institutions, for violating US laws that prohibit doing business with nations such as Iran and Cuba, Comey chided the bank’s investors that the billions of dollars “walking out the door today is your money”. Unless and until those shareholders can figure out a way to make management focus on the long-term interests of the institution and their investor base – instead of their personal short-term interests – “the money will keep walking out the door.”

Welcome to the thorny world of moral hazard.

In a nutshell, this is the phrase coined to describe what happens when CEOs and their sidekicks take risks if they know they aren’t going to have to suffer the consequences of getting it wrong. It can be stretched to cover a multitude of corporate sins, such as the state of affairs created by the 2008 banking bailout.

Those who argue that the banks haven’t learned anything from the subprime lending mess rest their case, in part, on the fact that those bailouts and the de facto acceptance of the “too big to fail” status of some institutions may have given the giants tacit encouragement to push the envelope on risk, if that’s what they need to do in order to generate short term profits, boost their bonuses and compensation packages and inflate the bank’s share price. There is no “moral hazard” here, since if they get it wrong – the argument goes – another bailout will follow.

When there’s a chance for a company to duck the full consequences of its behavior, it will act less prudently. It won’t do its due diligence – and it will stick somebody else with the job of cleaning up after it. But if the motivations for this kind of thinking may be driven by financial considerations – the urge to cut costs or boost short-term results; the quest for an extra few percentage points of market share, perhaps – the consequences aren’t always confined to the financial domain.

Consider the years leading up to the 2010 BP oil spill in the Gulf of Mexico, when the limit on payouts for environmental damage claims was capped at $75m (unless safety rules were flouted, or there was some other form of negligence). After that, the government picks up the tab for things like the damage done to the local fishing industry.

In comparison, drilling in the deepest parts of the Gulf can cost billions of dollars – and the rewards also are in the billions. No wonder some speculate about the potential for a moral hazard calculus to lead to the cutting of corners. Meanwhile, the Obama administration has proposed boosting that cap to $134m.

Then there are the clothing retailers that are scrambling to keep ahead of the trends, and to keep up with the demand by teens for a steady supply of inexpensive fashion-forward clothing. It doesn’t matter if a garment falls apart the fourth or fifth time it’s washed because by then it’s out of fashion and, since someone may only have forked over $15 or $20, they’ve had their money’s worth long since. This kind of “fast fashion” is taking a bite out of the market share of more traditional teen apparel retailers, who are adopting similar tactics to try to keep up.

The problem? The costs of fast fashion are paid – just not by consumers or retailers. Little over a year ago, the collapse of a shoddily-built building in Dhaka, Bangladesh, killed 1,129 people, the vast majority of them garment workers, and brought to light the horrendous working conditions in which these individuals – including children as young as 10 or 12 – work making T-shirts sold here for $5, or a $10 dress.

Even retailers who pledge to do business with firms that offer good working conditions can’t seem to control the supply chain; there is a lot of illicit sub-sub contracting. And ultimately, the costs of policing that supply chain would wipe out the already miniscule profits from “fast fashion”.

Why does this matter to us?

Because to the extent that we invest in a business and provide it with capital – however small an amount that is – we’re tacitly accepting its business practices, whatever they may be, even if we don’t necessarily endorse them. We’ve got two options when we spot a situation like this. One, as the FBI’s Comey pointed out, is to speak up – to demand that the boards of the companies in which we own shares pick CEOs that don’t choose to make these high-stakes gambles. As investors, our long-term interest is in the preservation of the company’s business as a going concern. To the extent that it’s damaged because of a giant oil spill, a scandal surrounding the use of child labor, or a $9bn fine, that’s bad news. But we do have the right – and the duty – to stand up and shout about it.

And if we don’t have the time, energy, resources or know-how to throw ourselves into a fight for better corporate governance – and yes, it is a fight that individuals can wage alongside big pension funds and other investors – then we have the right – and yes, probably the duty, too – to take our money elsewhere and to at least stop rewarding those companies that seem to us to court moral hazard.