Chapter 4
Regulation And Ethics
®1999 South-Western College Publishing
1
History Of Regulations
• October 11, 1929
– Appropriate Environment
• Need for Information
– Shareholders
– Financial institutions
– Standard accounting practices
– Disclosure requirements
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What Are The Major Securities
Laws That Protect Investors?
• Securities Act of 1933
• Glass-Steagall Banking Act of 1933
• Securities Exchange Act of 1934
• Public Utilities Holding Co. Act of 1935
• The Maloney Act of 1938
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Securities Law And
Financial Innovation
• Regulators
– Concerned about the rights of security
holders
• Financial Innovators a step ahead of regulators
– Design
– Sell
Complex Securities
– Trade
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4
Corporate Governance
• System of Controlling the Corporation
• Rests with the Board of Directors
– Elected by shareholders
– Appoint senior management
– Determines CEO’s compensation
• Legal Compliance
• Establishes Appropriate Ethical Conduct
• Institutional Investors
– Priority of clients interests?
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5
Ethics And Fraud
• Three Levels of Applying Ethics
– Corporate mission
– Constituency relations
– Corporate policies and practices
• Code of Ethics
– Establish acceptable activities and
behaviors
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Ethics
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•
•
•
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Integrity
Dignity
Competence
Proper Care
Independent Professional Judgement
Don’t do anything that you couldn’t live with on the
front page of the local newspaper!
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Exercising Independent
Judgement
• Cornerstone of the AIMR’s Code of Ethics
• Influenced by Outside Pressures
• Exercise
– Diligence
– Thoroughness
• Present Their Own opinion
• Credible Basis for Recommendation
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8
Insider Trading
• Base Investment Decisions on
– Information not publicly available
– Inappropriately acquired information
• Insider Trading Sanctions Act of 1984
– Enforced by the SEC
• Insider Trading and Securities Fraud
Enforcement Act of 1988
– Increases jail terms and fines
– Cash bounties
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9
Commission Brokers And
Churning
• Churning
– Buying and selling excessive amounts
– Trading excessively for the primary
purpose of generating commissions
– Difficult to prove
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How Can You Prove Excessive
Trading?
• Courts Use 3 Tests for Excessive Trading
– Analyze turnover ratio
• How frequently securities are traded
– Ratio of commissions to invested equity
– Compare commissions in all accounts
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Commission Brokers And
IPO’s
Firm Issuing Securities
Wants the highest price
Broker
The broker has to sell
the securities, whether
they are what the client
needs or not!
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Broker’s Client
Wants the lowest price
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Financial Planners
Advise Investors
Financial Planners
The investor is
dealing with a
salesperson
Compensated From
Commission
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CEO’s Compensation
• Indexed to Firm’s Performance
• Excessive Compensation
– Increased compensation as firm loses
money
• Unethical
– Interlocking board membership
• CEO’s on other boards
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Improving Investment
Manager’s Conduct
• Incentive structures
– That foster ethical markets
– That are satisfactory to investors
– That correspond with clients’ desires
– That reward independent judgement
– Based on serving the client
– Linked to earnings
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