1. The Ethical Wall
For the class on Christian Ethics
2. Inherent in any ethical wall are the underlying conflicts that exist between two
parties that can, when brought together, nullify the objectivity and integrity both parties
must uphold. There is temptation towards aligning one’s duty and moral obligation
against what is more beneficial to his client, and more enriching to himself.
But the Chinese or ethical wall established on Wall Street to separate investment
banking and analyst research had many cracks, if not big gaping holes.
The problem has been exposed as Wall Street investment banks announced an
historic $1.4 billion settlement with securities regulators for allegedly selling “bias”
research to an unsuspecting investing public to further lucrative investment banking
deals. On Dec. 20, 2002, the SEC, the New York Stock Exchange, the NASD, the New
York Attorney General’s Office and the North American Securities Administrators
Association and its member states reached an agreement in principle.
The goal of the settlement: To erect a thicker, stronger and theoretically
impenetrable ethical wall in order to rebuild trust in Wall Street’s research.
But without the establishment of a moral code whereby reputations are exalted based
on integrity and not the bottom line, the proposed changes, which include new incentive
structures, and the enumeration of trivial alongside non-trivial rules, will not be effective.
That’s because the main crux of the problem is that investment banks and their
employees promoted an internal agenda of profit optimization, to the exclusion of long-
term market stability. Bankers banked deals while analysts promoted them to investors in
order that the investment banks could profit.
These longstanding goals of profit maximization are still very much in place. To see
why this is the case, one has to look only at the details of the proposed rules and
3. government regulations.
The landmark agreement is the most comprehensive of rule changes, and explicitly
prohibits interaction between bankers and analysts. The agreement is designed to “ensure
that research analysts are insulated from undue pressure by a securities firm’s investment
banking department. Analysts won’t report to investment banking; won’t be compensated
based on a firm’s investment banking; won’t be evaluated by investment banking
personnel; won’t solicit or sell investment banking business; won’t attend road shows;
and, won’t be permitted to communicate with investment banking personnel except in
narrowly circumscribed and limited situations.”
The agreement will also “enhance required disclosures so that customers understand,
clearly and plainly, that research reports they read are produced by firms that do
investment banking business with the companies they cover.” Besides this landmark
agreement, there are a number of new rules already mandated by the government. For
instance, the Sarbanes-Oxley legislation, the most sweeping reform bill since the Great
Depression, requires the SEC to enforce mandatory disclosure requirements and prohibit
brokers and dealers from “threatening” analysts who choose to release unfavorable
reports about a client or prospective client.
In the private sector, Wall Street trade groups, like the Securities Industry Assoc.
and the Assoc. for Investment Management and Research, also known as AIMR, have
compiled best practices that extend beyond Wall Street. For instance, one suggestion is
directed to the media, suggesting that journalists be required to disclose all pertinent
information about an analyst and his stock selection.
These new standards and best practices are already being instituted. Yet there is not
4. one statement in any of these proposed rules by regulators, trade groups or within the
companies’ revamped internal policies that suggest that the investment banks have the
best interest of their clients in mind.
Instead, companies are going beyond the mandatory or suggested changes, and
instituting burdensome and superfluous rules to the point at which they dilute any
For instance, Thomas Weisel Partners stopped sending analysts research to the
media to avoid having it be misconstrued by less-market savvy journalists and individual
investors. Yet, this hardly prevents conflict between bankers and analysts. This rule fails
to address the problem, which is that research analysts promoted the internal agenda of
the investment bank.
In another example, one firm, Legg Mason, requires its analysts to certify that the
“views expressed “accurately” reflect the analysts’ “personal views.” It also states in the
new disclosure requirement accompanying research reports that the analysts’
compensation is not “directly or indirectly related to the specific recommendation or
views contained” in the report. This disclosure also fails to address the problem as well.
Analysts were not conflicted because compensation was tied to their recommendations.
Analysts are conflicted because they share the same roof over their heads as investment
banks, and therefore can be tempted to be promoters of stock, rather than arbiters of
Merrill Lynch, one of the bulge-bracket firms with arguably the most incriminating
evidence of securities fraud, goes so far as to enumerate a number of ways an employee
is prohibited to act. An employee cannot promise, imply, offer or communicate in any
5. way a stock change in exchange for the awarding of an investment-banking client.
For the most part, the rules make explicit prohibitions against practices, which were
arguably perceived to be the guiding principles by those outside of the established
investment community. Or, the rules of the game, as it were.
The intent of much of these changes is to realign analysts’ incentives, for it is the
compensation tied to banking that had been a motivating factor driving analysts to
promote stocks, or be subconsciously optimistic. In the last decade, investment-banking
deals drove sales, and, therefore, it was in this type of deal-making that research analysts
could be paid.
While the set forth rules surely applies far more rigor to the incentive structure, there
is not one bank that has yet to completely split the two units.
Defense of capitalism
Notwithstanding the new government-enforced rules, the free market system is
largely intact with self-regulation raised to higher standards in order to maintain the spirit
It is a free market system that requires analysts and bankers and their employer to
bear the responsibility of ethical oversight. By doing this, companies in the investment
banking community are free to pursue profits, since research is at best a break-even
business, and, more often than not funded by other units within the investment bank.
The maintaining of the free market is in itself more desirable than a socialist or
totalitarian system, which deliberately seek to control what cannot be controlled, and seek
to repress freedom of any kind. There are countless examples showing the superiority of
capitalism over other ideologies. For example, the embrace of capitalism by South East
6. Asian countries enabled them to defeat poverty at an amazing rate. [K.E. Grubbs, author]
A capitalist society builds upon the principles set forth by economist and philosopher
Adam Smith, who espoused that self-interest, more than government-imposed rules,
guides the most efficient use of resources in a nation’s economy. If this theory holds true,
by allowing the investment bank to pursue its self-interest, it should produce the most
efficient means of creating wealth.
The capital system also brings out virtuous qualities in man, such as diligence,
dedication and hard work since inherent in a capitalist market is a competitive structure
that motivates men to attain the highest productivity. For man to labor and bear fruit is a
divine ordinance. As stated in Genesis 2:15, the Lord put Adam to work in the garden to
“work it and take care of it.” And, idleness is indicted as impiety in the bible. Paul
enjoins the Thessalonians to withdraw themselves from idle men, those who are “busy
bodies.” For Paul says, “if any provides not for his own, and specifically for his own
household, he has denied the faith, and is worse than an infidel.” [Principles of Conduct
We can surmise then that idleness is not part of the Christian ethical structure. Sloth
and laziness are also two vices that are borne out of a society that has become too
comfortable with leisure to the exclusion of laboring for it. The result of laziness is forced
labor, which is exactly what freedom from Egypt meant to abolish. [Prov. 12:24]
A capital market system is a meritocracy system where men enjoy the fruits of their
own labor, or endure the adverse consequences of their idleness. This is in line with
scripture. God did not ordain that wealth be equally distributed. Scripture cited by Douma
in his book The Ten Commandments supports this. The general rule is that one who
refuses to work shall not eat, I Thess. 4:11-12, or in Prov. 12:24, which states that the
7. sluggard falls into slavery, but the hand of the diligent will rule.
Some people are indeed more able, more provident and prodigious. Murray, author
of Principles of Conduct, contends that we are not to engage in a “leveling process that
will secure uniformity.” This he calls absurd because equality is not in God’s providence,
and it is not a rule to be practiced in the order he has instituted. “Unequal distribution of
wealth is indigenous to the order that God has established.” [Principles of Conduct Pg.
Where new rules and proposals fail
So what are we to make of all these new laws and standards as constructed under the
capital market system? Already one can see that some rules are vague. For instance, in
Merrill’s new guidelines it says that analysts can accept compensation for involvement in
investment banking “to the extent that such participation is intended to benefit investor
clients.” Here there is reliance on the individuals to make the right judgment call. If it is
open to interpretation then it also leaves room for misjudgment. Notwithstanding the
rigid rules, what is clear is that the incentive, and thus temptation for analysts to promote
investment-banking clients is still very real. “If the analyst endeavors to win the banking
business, the firm profits, and the analyst profits,” noted StarMine, a firm that measures
the performance of analysts’ stock recommendations.
There are also new models being formed to create so-called “independent “ research
paid by the amount of commissions based on trading volume the research generates. But
herein lies yet another incentive that could lead to analysts to produce research that leads
to higher trading volume.
This structure is also, in many ways, similar to how real estate brokers are paid.
8. They receive commissions upon the sale of a property. Arguably real estate brokers are
biased since their goal is to make all the properties look attractive in order to make a sale.
(The only purely independent real estate broker is one who is paid upfront no matter if he
makes a sale or not.) This commission-based business model may work fine in the real-
estate context perhaps because the homebuyer is almost always cognizant of the broker’s
biases. This was not the case on Wall Street when the public was not aware that some
analysts, found to be true in the case of Merrill Lynch’s Internet analysts, acted as
promoters of companies rather than arbiters of quality.
Therefore by keeping investment banking and research units under one roof, there is,
a greater temptation for analysts’ research to be bias. This temptation becomes harder to
resist because many analysts formed their modes of conduct in a banking-driven
environment. It is not pure research, but research driven to sell a particular product. In
fact, the research criticized were those mostly in the technology, technology-related or
communications industries. These were growth industries filled with companies most
inclined to seek money-raising services from the investment banks. In comparison, there
were fewer, if any at all, bias-research incidents within other areas of research that
covered industries that did not seek banking services. A StarMine study surveying more
than 4,000 companies that went public between ’94 and 2000 showed that analysts at the
banks that brought companies public were typically more bullish than other analysts
outside the bank. When measured by the performance of stock recommendations, the
bank-affiliated analysts showed lackluster results compared to analysts outside of the
9. Where capitalist system fails
The analyst and banking conflict is just one example of the shortcomings in a free
market system. At its root, a capitalist system is predicated on man pursuing self-interests
within an economic framework designed to achieve efficiencies in both cost and benefits
for the greater good. There are two challenges with this thinking. First, it is simply
impossible to predict the decisions made by an individual, much less the outcome of
those decisions. Second, the goal of the individual is to make decisions that produce the
most efficient economic outcome, while taking social values as a given, which in effect
create a disregard for what is virtuous, and what is just. [The Capitalist Threat, George
Touching on the first point of why it is hard to predict man’s actions: The evolution
of economic theory has shown that it is impossible to obtain the necessary information
regarding the benefits and costs from each human action. “This premise of modern
economics is based on the innate creative capacity of the human being, who is
continually discovering new ends and means, thus giving rise to new flow of
information.” [The ethics of Capitalism, Jesus Huerta de Soto].
Moreover, especially within the financial markets, the notion of imperfect
knowledge is often ignored. Buyers and sellers seek to discount a future based on
expectations that are ultimately imperfect because new information arises between the
present and the future. Therefore the theory that free and competitive markets bring
supply and demand into equilibrium and thereby assure the best allocation of resources is
flawed. [The Capitalist Threat. George Soros].
On the second point, it becomes even more difficult to make predictions about the
10. well being of society when the social values are subjective and not standard. In the
current economic framework, the objective goal of the rational person is to pursue profits,
while social values are subjective. Without a standard moral code, it is not easy to
determine a person’s actions. At the time of Adam Smith when economic theory was
born, having grounded morals was a reasonable assumption, billionaire financier George
Soros contends, because “people did in fact, have firmly established values. Adam Smith
himself combined a moral philosophy with his economic theory.” [The Capitalist Threat
by George Soros Feb. ‘97] The world has change a great deal since then as conflicts arise
between market values and other traditional values. “Society has lost its anchor… Unsure
of what they stand for, people increasingly rely on money as the criterion,” Soros
To be sure, there is a plethora of sin, imperfection and inconsistency among
believers that it would be foolish to believe that an absolute governing moral code would
result in an economic utopia. But as history has shown, the alternative system, which is
complete separation of social principles from economic efficiency, can be fiercely
destabilizing to the economy and society.
Re-establishment of moral standards
The integration of justice and integrity as end goals that override, or at least
considered alongside the profit objective would surely alter the decision-making process,
and, may reinforce the free-market system. This brings the economic model closer to the
Christian ethical framework, which weds one’s theory of obligation with one’s theory of
value. [Christian Ethics Lesson XI, Grier].
Taking economist Israel Kirzner’s revised concept of distributive justice for market
11. economies as a starting point, one theory posits that efficiency and justice are two sides
of the same coin. In other words, considerations relative to moral principles and
economic efficiency mutually strengthen each other. If efficiency is defined as
coordination of market participants, then efficiency is possible if people used a standard
series of guides or moral principles to coordinate human interaction. From a free market
standpoint, efficiency understood as coordination arises from behavior of human beings
when they act on the basis of specific moral guidelines. [The Ethics of Capitalism, Jesus
Huerta de Soto]
Viewed in another way, it is not in man’s self-interest to not have integrity, or to be
dishonest. The result of that path can lead to loss of credibility, bankruptcy, lawsuits and
even incarceration. This is hardly limited to a biblical understanding as the secular
Objectivism view espouses honesty as a virtue and dishonesty as self-destructive.
[Congressional Hysteria Will Not Make Every Businessman Honest. July/02 Edwin A.
Unfortunately, laissez-faire ideology does not recognize a need for a world order, as
observed by Soros. An order is supposed to emerge from states’ pursuit of their self-
interest. But guided by the principle of the Darwin doctrine of the survival of the fittest,
states are increasingly preoccupied with their competitiveness and unwilling to make
sacrifices for the common good.
Deeply ingrained is the widely-held view that selfishness leads to profits, efficiency,
success, value and ultimately self-worth. Laura Nash illustrates this point in her
interviews with business executives. One executive viewed Christianity and faith in this
way: “You don’t get to the top in business unless you are willing to put your interests
12. first. I would be disturbed if people actually seriously tried to bring their religion into
work. When you make a business decision, it should be rational, not some touchy-feely
thing.” Another interviewee said this: “Business rewards the selfish and ruthless.”
[Church on Sunday, Work on Monday].
Some writers attribute this perverse thinking and lack of business ethics to the social
structure established a century ago by American philosopher John Dewey’s philosophy of
pragmatism. Dewey engrained the notion that ‘the truth is that which works at the
moment, and that which makes you feel better now.’
Dewey’s position that no absolute principles or standards exist was widely regarded
and taught in the educational system. Therefore to prevent business fraud there needs to
be a “philosophical renaissance that replaces pragmatism with an objective system of
morality that identifies what virtue is and how one should practice it.” Two diametrically
different types of moral absolutism exist: religion and Ayn Rand’s philosophy of
Objectivism, with a morality based on reason. Both advocate the virtue of honesty.
[Congressional Hysteria Will Not Make Every Businessman Honest. July/02 Edwin A.
To be sure, it is conceivable that the ethical awareness and attitudes rooted in
today’s mindset might not bear fruit for some time. “Social structures, types and attitudes
are coins that do not readily melt. Once they are formed they persist, possibly for
centuries, and since different structures and types display different degrees of this ability
to survive, we almost always find that actual group and national behavior more or less
departs from what we should expect it to be if we tried to infer it from the dominant
forms of the productive process.” [Schumpeter: Capitalism, Socialism, Democracy].
This said, there are many who do act honestly within the framework of their jobs.
13. This is what makes the ethical picture even messier on Wall Street. For instance, is an
analyst supposed to provide the best fundamental valuation call on a company? Or, is he
supposed to provide sentiment calls and advise his clients to jump in if sentiment is
changing such that more investors are willing to pay a higher price regardless of the
fundamental value of a stock? Should portfolio managers, having fiduciary responsibility
to his clients to make them money, provide instability in the market by playing the
To answer these questions one can look to Aristotle’s study of economic value,
which distinguishes between use value and exchange value. Use value relates to a good’s
intrinsic characteristics, and exchange value relates to how much a good can fetch in
return for other goods. Aristotle believed that the primary aim in purchasing goods is to
use them and have sufficient supply of them. But too often the aim is distorted into the
pursuit to make money. Aristotle looked down upon trade because professional traders
made a profit at the expense of others.
The overriding emphasis on exchange values to make a profit diminishes our ability
to recognize real worth. And, on Wall Street and in business, this goal undermines the
goal to seek virtues in life – like moderation and the well-being of society. [A measure of
justice, Mark Lovewell 2000]
But we cannot look down upon Wall Street, whose primary job is to raise capital for
a profit, just as we cannot condemn merchants for making a profit. The hagglers and
hustlers who seek egregious profits through trade, as described in Prov. 20:14 are
dishonest. In a civilized society, however, merchants play an integral role in being the
distributor of products to the masses. [The Ten Commandments]. In the same vein,
14. investment banks have democratized the money-raising functions, which were once the
sole jurisdiction of banks.
As the author Douma puts it: “Profit motive is not the same as greed. Just as narrow-
minded moralism brands the adventuresome spirit of a mountain climber as recklessness,
the same thing happens to the entrepreneurial spirit of the merchant.”
How does it look then?
Wall Street plays a significant role in the creation of wealth by raising capital for
new companies and distributing the investment opportunities to institutions and
But the rules and self-regulation being imposed will never truly be effective without
an individual ethic, a moral code within each of us that looks to a higher order and not the
immediate goals afforded to individuals in a free market system.
How would it look, therefore if we were to have a just system in place? We may
take the example of Warren Buffet, the CEO of Berkshire Hathaway. In his address to
shareholders in 2001, Buffett conceded that while he could not promise investors
“results,” he could “promise” that the return of Berkshire Hathaway stock would parallel
his. In effect, Buffett aligned his goals with shareholders. He would not take cash
compensation, restricted stock or option grants that would make his results superior to
theirs. The model that Buffett represents is one of integrity.