Cobras, Mortgages, and Violas: What are Your Contracts and Policies Incentivizing?
Recently, I heard a parent express concern that her child had been encouraged by the school music teacher to switch from violin to viola because the orchestra needed more violas. For switching to viola, the child would receive special recognition as a team player and extra points in the teacher’s incentive program.
The parent was upset and angry at the teacher, because the teacher then proceeded to give the child a poor grade in music because she was not a strong viola player right out of the gate. The result was that instead of being engaged in the school orchestra and excited about playing the viola, the child was demoralized and wanted to quit.
The “Cobra Effect”
This reminded me of what is known in economics as the “cobra effect.” As the story goes in colonial India, the British governor was concerned about the number of wild cobras so he incentivized the population to hunt cobras by having the government pay a bounty for cobra skins. The plan seemed to work fabulously; the government had thousands of cobra skins, and there appeared to be a reduction in wild cobras, so it seemed time to end the bounty program and declare victory.
What the governor did not know is that by placing a bounty on cobras he had incentivized local farmers to breed cobras. There were likely more cobras, but they were specially bred and maintained on farms until their skins could be presented for a bounty. With the abrupt elimination of the bounty, the farmers no longer were incentivized to keep and raise cobras. Therefore, the farmers released all the cobras they had raised, with the end result of their being more wild cobras than there had been before the bounty was put in place.
Arguably, the cobra effect contributed to the collapse of the CMBS market in 2008. Prior to that, mortgage brokers and lenders were incentivized to close on loans. Bonuses were paid to the brokers based upon closing, and lenders quickly took their profit on the mortgages though sale of the loans into the CMBS market. As a result, the focus was on closing and selling loans, not on the long-term viability of the borrower.
As we now know, many borrowers were unable to pay back the mortgage loans, and in some cases, the paperwork submitted to support the loans was downright fraudulent. Borrowers were angry because they lost their homes to foreclosure (albeit homes they could not afford to begin with), and the entire country entered a major recession. This arguably all occurred because the CMBS market had been set up without regard to what behavior the compensation program was incentivizing.
Real-Life Example: The Occupancy Oversight
I’ve seen this play out negatively for clients on a number of occasions. In one instance, a client entered into a contract to purchase a high-rise apartment building. Concerned that the seller might not continue to work hard to obtain and keep tenants during the contract period, my client included, as a condition to closing, that the apartment building retain its current percentage of occupancy through the closing date. My client carefully watched occupancy percentages, and the building had a high occupancy level at closing.
A week after the closing, I received a call from my client. Upon reviewing the apartment building’s rent records after the closing, the client noticed that although there was indeed a high occupancy percentage, that many of the tenants had not paid rent. Many had not paid rent for a number of months and were slated for eviction. The seller, incentivized only to keep tenants in apartments, had simply stopped evicting tenants who did not pay their rent, leaving it to my client to go to the time and expense of evicting dozens of tenants after the closing.
Real-Life Example: The Bonus Blunder*
Another client which operated a retail business noticed that a number of departments were overspending their budgets. A particular concern was cost overruns in the payroll budget items, which appeared to be tied to poor employee scheduling. Some employees were scheduled to work 25-30 hours per week, while others were working 50+ hours per week and receiving overtime pay. Costs could be reduced by more evenly allocating the work hours so most employees worked 40 hours per week, the maximum before overtime pay must be paid. One goal, therefore, was to create a more equitable work schedule and to minimize expensive overtime pay.
To incentivize managers to better manage employees and stay within their budgets, the established a program which paid managers a bonus based solely upon accomplishing budget objectives. The client saw no reason to hire an attorney to prepare such a basic bonus program and assumed that the bonus opportunity would incentivize managers to more carefully establish employee work schedules so as to lawfully minimize payroll expense. The program seemed to be working well. Overtime pay and therefore, total payroll expense, was reduced.
Then, a number of months after the plan was put in place, the client called me in a panic. A Department of Labor investigator was at one location, asking to see all employee time records because an employee had complained that she was not being paid for overtime. I was able to delay the government investigation while we conducted an internal investigation, but I was not able to eliminate the consequences of the client’s failure to consider what it was incentivizing when it created the bonus program.
One manager had decided to carry the overtime reduction goal beyond careful scheduling of employees to changing employee time cards so that those who worked overtime would not be paid at all for those hours. The client never intended that employees be denied pay or overtime pay for work they performed.
The manager was fired and all employees quickly were paid for all of their work, including overtime where appropriate. I was able to prevent the government from imposing penalties or extending the audit to cover multiple years and all of the employer’s locations, but this cost the client tens of thousands of dollars for attorney fees and countless hours of internal accounting and payroll personnel time on an internal and government investigation.
Real Life Example: Prevention*
Both clients learned from their experiences and made changes to prevent a recurrence. In the first instance, we made sure that future real estate purchase contracts tied occupancy to paying tenants (economic occupancy), not just tenants occupying apartments (physical occupancy). For future bonus programs, among other things, the client implemented verification procedures designed to detect and deter improper modification of time cards without employee consent, and expressly made employees ineligible for bonuses and subject to employment termination if they engaged in unlawful activity.
However, the best way that a business attorney can help a client is if the attorney is brought in for “preventive” work before there is a problem. The “solutions” in both of the above situations could have been incorporated into the clients’ documents proactively, with a savings to the clients of both time and money.
Case Study: School Orchestra Violist
Using the school orchestra violist situation as a case study, it sounds like the resulting bad grade due resulting from the impossibility of performing well on an instrument one has just started outweighed any incentive for a student to switch instruments. Therefore, the music teacher’s incentive program wasn’t a viable long-term solution to improve instrumentation in the school orchestra.
Yet, to prevent a “Cobra Effect,” it did make sense not to base the incentive solely upon the switch of instruments. After all, that would incentivize a switch but would not incentivize the child to learn to play the new instrument well and could even incentivize serial switches of instruments so that no child ever mastered any instrument. Either of those alternatives would harm, rather than help orchestra quality.
What, then would be a creative solution to this dilemma? I would suggest a deferred incentive, where the child receives the merit points if he/she switches instruments AND after a reasonable period of time accomplishes a defined level of proficiency on the instrument. Alternatively, the incentive could be doled out over time, with part being awarded upon the switch of instruments and the remainder being given upon achievement of certain proficiency goals over a period of time.
Either alternative could be combined with a “one use per student” provision to discourage serial switching of instruments. There also could be a limitation on the number of switches permitted in total during the year so as to prevent an imbalance in instrumentation.
Living in the World of “What Could Go Wrong”
Although I’m not in the business of incentivizing children, as a business lawyer, I do live in the world of “what could go wrong.” Even the most optimistic and entrepreneurial business owners and managers need someone who is looking out for their interests and addressing “what could go wrong.” By “outsourcing” that worry to the business lawyer, the owners can put their focus into accomplishing their goals in the more positive and entrepreneurial world of “what we want to happen,” while also knowing that it is much less likely that their own businesses will be overrun by the business equivalent of cobras, rats, or violas.
©2018 by Elizabeth A. Whitman
DISCLAIMER: The content of this blog is for informational purposes only and does not provide legal advice to any person. No one should take any action regarding the information contained in this blog without first seeking the advice of an attorney. Neither reading this blog nor communication with Whitman Legal Solutions, LLC or Elizabeth A. Whitman creates an attorney-client relationship. No attorney-client relationship will exist with Whitman Legal Solutions, LLC or any attorney affiliated with it unless and until a written contract is signed by all parties and any conditions in such contract are fully satisfied.
* Real Life Examples are based upon my actual experiences in the practice of law, but the facts have been modified significantly to protect client confidentiality.
 German economist Horst Siebert created the term “cobra effect” to describe unintended consequences which can occur when a party is given the opportunity to exploit an ill-thought-out policy. See Dale Hartley, Ph.D., MBA The Cobra Effect: Good Intentions, Perverse Outcomes, Psychology Today, posted October 8, 2016.
 Although there is some debate whether the cobra incident ever occurred, a similar incident occurred in colonial Vietnam. In 1902, rats were taking over the Hanoi sewer system, much to the distress of the French. Therefore, the French colonials decided to put a bounty on rats. To get the bounty, the Vietnamese would need to delivery the dead rat’s tail to city hall. Tens of thousands of rat tails are delivered, as many as twenty thousand in a single day, and bounties were paid. Then, one of the health officials discovers a rat farm where rats are being bred so the farmer can cut off their tails for the bounty. For additional stories see: http://freakonomics.com/2012/10/11/the-cobra-effect-full-transcript/
 Collateralized mortgage-backed securities