Economics tells us we should engage in rational decision making.  We shouldn’t take irrational risks.  Okay, then tell me why do so many successful, high-profile, and otherwise smart individuals take what appears to irrational risks that can turn their world upside down?   

Enron financial engineers, the Wall Street wizards who helped implode the financial market and deepen our recession, and of course the parade of sex scandals such as Governor Elliot Spitzer and his call girls, former presidential candidate John Edwards and a campaign consultant with a love child, Governor Mark Sanford and his Argentinean soulmate mistress, Senator John Ensign and the wife of a former top aide, and just last week – David Letterman and certain Late Night Show staffers, all demonstrate a lack of “good judgment” or rational risk taking. 

What were they thinking?  How could smart people get it so wrong?

Senator Tom Coburn, in talking about Senator John Ensign who admitted to having an affair with the wife of his close friend and former top aide, offers some interesting insight.  Coburn was recently quoted in the New York Times as saying, “John got trapped doing something really stupid and then made a lot of other mistakes afterwards.”  But my favorite line is when he said, “Judgment gets impaired by arrogance.” 

 Bingo!

Coburn’s observation dovetails with the research done by behavioral economists.  Those are the folks who look below the surface at what we do and examine how decisions are really made.  Among the interesting findings in this field is the role of overconfidence.

Overconfidence contributes to hubris and arrogance.  It causes people to take huge risks.  Their perceptions of invincibility can lead to large scale risk taking and have legal implications that trigger liabilities ranging from negligence to brazen malfeasance, such as fraud. 

Organizations seeking to effectively manage their enterprise wide legal risk need to be cognizant of this behavioral flaw and blind spot it creates.  The best way to guard against it is to properly train all employees, including the most senior AND to create a system of rational checks and balances to protect the business from poor individual judgment.   

The conflict between behavioral economics and business economics presents serious and continuous leadership challenge.

It’s hard to digest the Wall Street headlines of the past week:  Lehman filed for bankruptcy, AIG got a huge loan and Uncle Same as a business partner, Merrill Lynch got a new home, and other bank merger talks were in high gear.

It’s the latest after shock of the collapsed U.S. hosing (sic) market.  It’s a collapse that has led to foreclosures of brick and mortar homes and now the collapse of Wall Street’s house of cards.

Some fingers wag and point to the “Housing Bubble” as the source of all our woes, as if there is a Mr. Bubble* out there plotting and planning the demise of Western capitalism by giving us all a “bath.”  Others point to insufficient regulation.  The situation appears hopelessly tangled to Main Streeters, and to a few Wall Streeters too.  But there is probably one thing we can all agree on: we feel betrayed.

There has been a colossal breach of trust involving obscene amounts of money.  Tax payers are now being asked to foot the bill for a financial frat party while those who work at the other end of the salary/bonus food chain are losing their homes and struggling to keep gas tanks full.

Last week I found an interesting piece by Michael E. Lewitt shortly after the Bear Stearns fiasco last Spring.  As an industry insider, Mr. Lewitt provides a fascinating look behind the scenes.  He points to short sightedness, excess leverage in unregulated activities (sounds like Enron’s off the books accounting, doesn’t it?), as well as a narrowly focused notion of fiduciary duty as part of the problem.  The structural problems we’re facing, he says boil down to “bad economic policies and bad political values.”

The blame game will no doubt continue for the next 18 months or more while our policy makers in Washington, including the new administration, figure out what to do.  If Enron and Worldcom have us Sarbanes-Oxley, you can be sure that this debacle will bring additional regulation and oversight too.  It’s merely a question of when.

So what does all this stuff on Wall Street have to do with Main Street and your day-to-day business activities?  Well, it’s food for thought on several fronts:

1.  To what extent is your business turning a blind eye to the ethics of certain profitable activities?  Is overconfidence creating a business blind spot?  Relying, for example, on lax enforcement of certain regulations or the fact that there are no regulations can backfire.  Being accountable to a government regulator is no fun.  But having one look over your shoulder and help you make business decisions, as AIG is about to find out, is even less fun.  Yet, that’s exactly what happens in deferred prosecution agreements.  Big Brother won’t prosecute, but in exchange they become your business “partner” until there is sufficient confidence that you have the necessary systems in place to “do the right thing.”

2.  To what extent are lawyers giving their clients the green light on whatever they want just to keep the clients happy and make a few bucks?  Take for example the case of the alleged Ernst & Young tax shelter fraud:  Wealthy clients asked friendly law firms to write opinion letters assuring them that their tax shelters were “likely” to survive scrutiny if the IRS challenged their legality.  One big firm lawyer has already pleaded guilty to tax fraud charges, another has paid the IRS $39.4 million to avoid criminal charges and his lawyer says his client and the accounting execs were “only guilty of greed.”  He makes it sound like a temporary head cold instead of the character flaw that it is.

3.  To what extent is your business tying compensation to short-term performance and encouraging risky behaviors that jeopardize long term stability?  Take a moment to stand back and examine your business policies and the behaviors they are driving.  Could they be improved to better align company actions with sound business practices and good decision making.

Let’s keep the bubbles in the tub.

*Mr. Bubble is a registered trademark of Ascendia Brands.