What disclosure hides – Jacob Burak explores conflicts of interest in business
The annual exhibition at the Royal Academy of Arts in London has long been an arena for artistic rivalry among Britain’s finest painters, and the exhibition of 1832 was no exception. Paintings executed by two of the United Kingdom’s most illustrious landscape artists – J.M.W. Turner and John Constable – were hung side by side that year in the main hall. Constable had been working on his painting, Inauguration of the Waterloo Bridge, for a decade. On the day before the opening of the exhibition – known as Varnishing Day, when painters were allowed into the galleries to put finishing touches to their works – Constable took great pains with a few final brushstrokes to his painting, which was already hanging on the wall. Turner stood by observing and decided to touch up his own painting as well – a seascape called Helvoetsluys – the City of Utrecht, 64, Going to Sea – by adding a small red spot, which became a buoy floating in the water, that is so prominent against the backdrop of the blue-gray sky and sea that one cannot stop looking at it. Constable’s wonderful painting was pushed aside in the face of Turner’s genius.
The two had had a long history of rivalry before this incident, culminating the year before when Constable had sat on the Academy’s committee that decided which paintings would hang where and had relegated Turner’s painting to a side room and hung his own work in the newly vacated central spot. Impulsive Turner resolved to use his prodigious artistic talent to avenge the man who had worked against him. But not all of us are Turner, and conflict of interest is a widespread phenomenon. So, what can we do when faced with such a situation?
First of all, we ask that people with a conflict of interest identify themselves and disclose their conflict of interest to all so that we may consider our subsequent actions with the necessary precaution. In the capital market we are accustomed to seeing the general disclosure statements of warning that alert the reader of economic research reports, for example, to possible conflicts of interest on the part of the analysts who penned them. The writer assumes the reader will know to judge whether there is inherent bias, and how to deal with it. But is full disclosure enough to keep us safe from the ravages of the phenomenon?
George Loewenstein of Carnegie Mellon University and his colleagues Don Moore and Daylian Cain created a game that is not much different from the one we play when we invest in the stock market. In Loewenstein’s game, players were asked to estimate the value of coins in a glass jar. Loewenstein even provided the players with paid advisors who also took part in the experiment. While the estimators were allowed to glance at the jar for only ten seconds, the advisors were more knowledgeable; they were given information regarding the actual spread of true values of the coins in the various jars, and the estimators knew this. The goal of the experiment was to test the effects of conflicts of interest on the behavior of the advisors, but no less so, the effects of conflicts of interest on the behavior of the estimators.
The advisors who were asked to provide the estimators with recommendations regarding the value of the coins in the glass jar received recompense according to the accuracy of the estimation made by those they advised: the closer the estimate was to the actual value, the more money for the advisor. In other instances, however, the advisors were paid on the basis of the value of the estimate made by the estimators who had received their advice. The higher the estimate, the more the advisor received. In these cases the advisors were clearly exposed to a conflict of interest; while the estimators anticipated receiving an accurate, objective estimate, the advisors’ financial motive encouraged them to recommend a high estimate. Some of the estimators did not know how the advisors’ wages were determined while others did, and this latter group could assess the potential inherent conflict of interest and try to account for it in their estimates. The results of the experiment were absolutely clear but not always predictable.
In cases in which the advisors’ wages were linked to the accuracy of their estimates they estimated the value of the coins in the jar at sixteen dollars. Their estimates rose to twenty dollars when their wages were determined according to the value of the estimate made by their client, the estimator. And what were their estimates when acting under full disclosure, revealing the fact that their compensation was linked to the value of their estimates? Well, their ‘estimates’ rose to twenty-four dollars! Various studies have shown that advisors’ behavior is based on a phenomenon known as ‘moral self-licensing.’ People who proclaim public incorruptibility may well demonstrate improper behavior at a later stage by relieving themselves of the guilt that comes along with behaving unfairly.
And what about the estimators? While they tried to account for the potential conflict of interest, they failed to do so to a sufficiently significant degree. Their estimates were on average four dollars lower than those of the advisors, while the latter raised their estimates by eight dollars the moment that the potential conflict of interest was disclosed. The bottom line of Loewenstein’s study is disturbing: when conflict of interest was disclosed the advisors earned more money and the clients (estimators) less.
The solution to conflict of interest does not lie in full disclosure. On the contrary, full disclosure becomes a moral fig leaf that expands the freedom of the advisors to act according to their own interests. The true solution to this situation lies in the ability to avoid any kind of conflict of interest at all, which removes the need for disclosing it.
About author Jacob Burak:
Jacob Burak (b. 1948) founded Evergreen Ventures in 1987 and became one of the founding fathers of the Israeli venture capital community. Five years ago he took a step back from the business world and now devotes his time to social activism and writing.
He has written two books: Do Chimpanzees Dream of Retirement?, which deals with the encounter between business, psychology and evolution; and Noise, which maps the „noises“ in our lives – external but mainly internal. Jacob also lectures on these topics.