Wal-Mart Continues to Risk Your Investment

In updating its compliance programs, Wal-Mart (NYSE: WMT  ) has finally applied the advice of investing genius Charlie Munger to "never, ever think about something else when you should be thinking about the power of incentives."

In its 2013 proxy, the Bentonville Behemoth announced that it would tie executive pay to compliance improvements. In doing so, it is giving leadership a strong incentive to strengthen the company's compliance systems in addition to improving its sales, operating income, and return on investment.

This is a progressive move. But if Wal-Mart wishes to take meaningful steps toward reducing compliance risks, I believe it needs to do more.

Strong compliance requires empowerment
Without empowerment, it doesn't matter how much employees want to meet key standards or how much they stand to gain by achieving them. If they can't meet a standard, they won't. This means that if Wal-Mart wants to meet its compliance goals, it needs to empower its compliance professionals to do their jobs well in addition to motivating executives to improve its compliance program.

And as long as the Chief Compliance Officer is subordinated to the General Counsel, I believe that empowerment is compromised.

Here's why.

Conflicting mandates
A company's GC and CCO have distinct (and sometimes conflicting) mandates. The CCO's job is to foster an ethical, law-abiding culture and to detect and prevent internal wrongdoing. The GC's job, on the other hand, is to defend the company against allegations of illegal behavior and reduce external liability risk. When a CCO reports to the GC, I believe there's a risk that the GC will muffle the CCO when they disagree about what is best for the company.

How can these roles come into conflict?

Suppose an organization discovers that one of its employees committed fraud. To reduce external liability risk, the GC may want to settle the problem quietly and let the employee leave with a severance.

However, the CCO may worry that such lax treatment can send a message to other employees that the company does not stand behind its rules, and that it won't harshly punish illegal behavior. In other words, the CCO may worry that settling the matter quietly may cause long-term damage to the company's culture by failing to discourage illegal activity.

In cases like this, upper management should hear both the GC's and the CCO's arguments so they can weigh the short-term litigation risks against the value of long-term culture-building. However, if the CCO is subordinated to the GC, upper management may only hear the GC's proposals. And without the CCO's input in cases like these, Wal-Mart executives will lack key information needed to make significant improvements to its compliance program.

Granted, Wal-Mart reports that its Global Chief Compliance Officer and "other appropriate members of management" regularly meet with the board's audit committee. However, as long as the GCCO is subordinate to the GC, I believe there is a serious risk that he will be pressured to filter his input according to the GC's preferences.

Disregarding best practices
Having the CCO report to the GC also goes against best practices in ethics and compliance. The U.S. government has increasingly required companies to separate the GC and CCO roles, and to ensure both have a voice at the top through corporate integrity agreements and deferred prosecution agreements. For example, regulators imposed this requirement on Tenet  Healthcare after it was accused of Medicare fraud. They also required Pfizer to separate its GC and CCO roles after it was accused of illegal promotional practices.

The Foolish bottom line
The quality of Wal-Mart's compliance programs are of serious import to investors. Aside from the reputational risks associated with scandals such as its alleged FCPA violations in Mexico, the company faces concrete liability risks if it fails to keep its employees in compliance with the law in the future.

In a recent SEC filing, the company already reported estimated costs of $157 million for investigations in fiscal 2013 and resulting from shareholder lawsuits. Furthermore, the company has admitted that "Given the on-going nature and complexity of the review, inquiries and investigations, we cannot reasonably estimate any loss or range of loss that may arise from these matters."

In other words, Wal-Mart cannot quantify the risk posed to investors by its alleged FCPA violations.

To protect shareholders' investment, I believe it's crucial that Wal-Mart -- one of the world's largest companies -- create an effective ethics and compliance program that can help prevent scandals that bring ongoing expenses. And while its decision to tie executive compensation to compliance improvements is a step in the right direction, I think Wal-Mart should take additional steps to empower its compliance professionals to do their jobs effectively.

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