Side Payments

When two parties involved in a transaction exchange money that is not part of the transaction itself, the exchange is a side payment. It is typically made to induce the recipient to take part in the transaction. The most notorious side payments are kickbacks and other types of bribes, but side payments can take many forms, some perfectly legitimate. For example, if several countries join a pact to reduce air pollution, a downwind country that has the most to gain from clean air may make a side payment to an upwind country to give it some incentive to participate in what would otherwise be a losing proposition.

Side Payments———1923 Kickbacks and Commissions Side payments raise ethical questions when they create conflicts of interest or provide incentives to break the rules. The classic example is a purchasing agent for a firm who receives a kickback from a vendor selected by the agent. The vendor “kicks back” to the agent some of the profits gained from the purchasing contract. This normally creates a conflict of interest, because it is in the firm’s interest to award the contract to the most attractive bidder, while it is in the agent’s personal interest to award it to the firm that will provide a kickback.

Kickbacks should not be confused with commissions. Someone who hires an agent, a broker, or a salesperson may pay that person a commission for services rendered. The purchasing agent’s kickback is not a commission because it is paid by someone other than the party that hired the agent. Commissions normally do not create conflicts of interest but can do so in some circumstances. Real estate agents, for example, typically receive a fixed percentage of the sales price as commission. This may create a conflict of interest for an agent hired by the buyer, since it provides an incentive to negotiate a higher price than necessary.

There are several related types of payments that may or may not create conflicts of interest. An attorney who refers a potential client to a second lawyer may receive a referral fee from the second lawyer. This is not a side payment because it is not external to another transaction involving the lawyers, and there is no obvious conflict of interest. Financial advisers (or, more frequently, the banks that employ them) may receive a retrocession payment from a mutual fund when the adviser’s client buys shares of that fund. This is a side payment but is not identical to a kickback since it normally goes to the bank rather than an individual. It can create a conflict of interest, however, since the bank may give its advisers incentives to recommend funds that pay retrocession.

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