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The current Chinese or ethical wall established on Wall Street to ...


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The current Chinese or ethical wall established on Wall Street to ...

  1. 1. The Ethical Wall By Bambi Francisco May 2003 For the class on Christian Ethics Prof. Edgar 1
  2. 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 2
  3. 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 3
  4. 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 constructive message. 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 quality. 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 4
  5. 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 of capitalism. 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 5
  6. 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 Pg. 84]. 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 6
  7. 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. 92] 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. 7
  8. 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 bank. 8
  9. 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 Soros] 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 9
  10. 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 observes. 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 10
  11. 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. Locke] Renaissance needed 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 11
  12. 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. Locke] 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. 12
  13. 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 momentum game? 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, 13
  14. 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 individuals. 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. 14