Ethics in Finance
Foundations of Business Ethics
Series editors: W. Michael Hoffman and Robert E. Frederick
Written by an assembly of the most distinguished figures in business ethics,
the Foundations of Business Ethics series aims to explain and assess the
fundamental issues that motivate interest in each of the main subjects of
contemporary research. In addition to a general introduction to business
ethics, individual volumes cover key ethical issues in management, marketing,
finance, accounting, and computing. The books, which are complementary yet
complete in themselves, allow instructors maximum flexibility in the design
and presentation of course materials without sacrificing either depth of coverage or the discipline-based focus of many business courses. The volumes can
be used separately or in combination with anthologies and case studies,
depending on the needs and interests of the instructors and students.
1 John R. Boatright, Ethics in Finance, third edition
2 Ronald Duska, Brenda Shay Duska, and Julie Ragatz, Accounting Ethics,
second edition
3 Richard T. De George, The Ethics of Information Technology and Business
4 Patricia H. Werhane and Tara J. Radin with Norman E. Bowie, Employment
and Employee Rights
5 Norman E. Bowie with Patricia H. Werhane, Management Ethics
6 Lisa H. Newton, Business Ethics and the Natural Environment
7 Kenneth E. Goodpaster, Conscience and Corporate Culture
8 George G. Brenkert, Marketing Ethics
9 Al Gini and Ronald M. Green, Ten Virtues of Outstanding Leaders: Leadership and Character
Forthcoming
Denis Arnold, Ethics of Global Business
Ethics in Finance
THIRD EDITION
John R. Boatright
This edition first published 2014
© 2014 John Wiley & Sons, Inc
Registered Office
John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, UK
Editorial Offices
350 Main Street, Malden, MA 02148-5020, USA
9600 Garsington Road, Oxford, OX4 2DQ, UK
The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, UK
For details of our global editorial offices, for customer services, and for information about how to
apply for permission to reuse the copyright material in this book please see our website at www
.wiley.com/wiley-blackwell.
The right of John R. Boatright to be identified as the author of this work has been asserted in
accordance with the UK Copyright, Designs and Patents Act 1988.
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or
transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or
otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the
prior permission of the publisher.
Wiley also publishes its books in a variety of electronic formats. Some content that appears in print
may not be available in electronic books.
Designations used by companies to distinguish their products are often claimed as trademarks. All
brand names and product names used in this book are trade names, service marks, trademarks or
registered trademarks of their respective owners. The publisher is not associated with any product
or vendor mentioned in this book.
Limit of Liability/Disclaimer of Warranty: While the publisher and author(s) have used their best
efforts in preparing this book, they make no representations or warranties with respect to the
accuracy or completeness of the contents of this book and specifically disclaim any implied
warranties of merchantability or fitness for a particular purpose. It is sold on the understanding that
the publisher is not engaged in rendering professional services and neither the publisher nor the
author shall be liable for damages arising herefrom. If professional advice or other expert assistance
is required, the services of a competent professional should be sought.
Library of Congress Cataloging-in-Publication Data applied for
Paperback ISBN: 978-1-118-61582-9
A catalogue record for this book is available from the British Library.
Cover image: © Getty Images / pepifoto.
Cover design by Cyan Design.
Set in 10.5/12.5 pt Minion by Toppan Best-set Premedia Limited
1
2014
Contents
Preface
Acknowledgments
Abbreviations
vii
ix
x
1
Finance Ethics: An Overview
The Need for Ethics in Finance
The Field of Finance Ethics
1
2
13
2
Fundamentals of Finance Ethics
A Framework for Ethics
Agents, Fiduciaries, and Professionals
Conflict of Interest
26
27
40
45
3
Ethics and the Retail Customer
Sales Practices
Credit Cards
Mortgage Lending
Arbitration
63
64
78
96
108
4
Ethics in Investment
Mutual Funds
Relationship Investing
Socially Responsible Investing
Microfinance
120
121
141
148
155
5
Ethics in Financial Markets
Fairness in Markets
Insider Trading
Hostile Takeovers
Financial Engineering
171
172
182
189
201
vi
Contents
6
Ethics in Financial Management
The Corporate Objective
Risk Management
Ethics of Bankruptcy
Corporate Governance
Index
223
224
234
243
254
273
Preface
Writing a book on ethics in finance poses a special challenge. The difficulty
does not arise from a lack of subject matter, despite the cynical view that there
is no ethics in finance. To the contrary, finance is infused with ethics and could
not exist without it. Financial activity is governed by detailed rules, and a high
level of integrity is expected of people who bear great responsibility. As a field
of study, however, finance ethics is barely formed, and so the first task for a
writer in this area is to define the subject, frame the main issues, and identify
the relevant ethical principles. Whereas most textbooks present standard
material, this one is forced by necessity to be original. Hopefully, Ethics in
Finance, Third Edition, will continue to advance the important task of creating
the field of finance ethics.
Not only is the field of finance ethics still being formed, but it is also highly
diverse. People trained in finance enter many different lines of work, in which
they encounter a variety of ethical situations and issues. The situation of a
stockbroker is different from that of a mutual fund manager, a market regulator, or a corporate financial officer. In addition, finance ethics encompasses
broader ethical issues in financial markets, financial services, and financial
management, which are addressed by both industry leaders and government
regulators. A book on finance ethics must also identify the relevant ethical
principles for resolving many different kinds of questions. Some of these
involve dilemmas of individual conduct, but the most perplexing and significant issues are related to the operation of financial services providers and
financial markets and institutions.
Many ethical issues in finance have already been addressed by legal regulation, as well by firm and industry self-regulation. The role of ethics in such a
highly regulated environment is problematic. Why is it not sufficient merely
to obey the applicable rules? One answer to this question is that ethical principles lie at the heart of much regulation, and issues not yet settled by law or
self-regulation are debated, in part, as matters of ethics. Much of this book is
viii Preface
devoted, therefore, to an examination of existing regulation and proposals for
regulatory reform. In addition, regulation, whether it is by government or
industry, is a rather ineffective, uncertain guide, and so a commitment to high
ethical standards, and not merely to legal compliance, is essential.
Since the publication of the first two editions of this book, much has
changed and much has remained the same. In particular, the financial crisis
that began in 2007 has renewed interest in finance ethics and led to calls for
greater attention to the subject. However, this crisis, for all of the misconduct
involved and damage done, raises few novel issues in finance ethics and
presents mostly familiar issues in new guises. Still, the third edition of this
book devotes considerable space to the ethical aspects of the greatest financial
crisis since the Great Depression.
Readers of the first two editions will find the third one extensively revised
and expanded. Although the number of chapters remains the same, the material has been substantially reorganized for greater clarity and orderliness.
Chapter 2 now offers a more explicit framework for approaching ethics, which
presents, first, ethics in markets and, second, the ethics of roles and relationships, including those of agents and fiduciaries. The remaining material is
organized around the areas of financial services, financial markets, and financial management. Subjects that are new to this third edition include ethical
issues in credit cards, subprime mortgages, microfinance, derivatives, highfrequency trading, and risk management.
As with the first two editions, I am indebted to W. Michael Hoffman and
Robert E. Frederick of Bentley University, the editors of the series Foundations
of Business Ethics, and my editor at Blackwell, Jeffrey Dean. The Quinlan
School of Business at Loyola University Chicago has provided critical support
for the preparation of the third edition. I am especially grateful for the
resources of the Raymond C. Baumhart, S.J., Chair in Business Ethics, which
was created to honor a former president of Loyola University Chicago and a
pioneer in the field of business ethics. To Ray Baumhart I owe a special debt
of gratitude. I also wish to express my appreciation to Kathleen A. Getz, dean
of the Quinlan School of Business for her enthusiastic support. As always, I
am indebted to my wife Claudia, whose affection, patience, and encouragement have been essential for my work.
John R. Boatright
Acknowledgments
The following material is used in the third edition of Ethics in Finance with
permission from the copyright holders.
John R. Boatright, “Financial Services,” in Michael Davis and Andrew Stark,
Conflict of Interest in the Professions (New York: Oxford University Press,
1999), copyright 1999 by John R. Boatright.
John R. Boatright, “Fiduciary Duty,” “Soft Dollar Brokerage,” and “Bankruptcy,” in Robert W. Kolb (ed.), Encyclopedia of Business Ethics and Society
(Thousand Oaks, CA: Sage Publications, 2007), by permission of the
publisher.
John R. Boatright, “Ethics in Finance” in John R. Boatright (ed.), Finance
Ethics: Critical Issues in Theory and Practice (New York: John Wiley & Sons,
Inc., 2010), by permission of the publisher.
John R. Boatright, “The Ethics of Risk Management: A Post-Crisis Perspective,” Ethics and Values for the 21st Century (Madrid: BBVA, 2011), copyright
2011 by John R. Boatright.
John R. Boatright, “Why Financial Innovation Seems to be Associated with
Scandals, Crises, Mischief, and other Mayhem,” in Risks and Rewards of Financial Innovation (Chicago: Loyola University Chicago School of Business
Administration, 2010), copyright 2010 by John R. Boatright.
John R. Boatright, “Corporate Governance,” in Encyclopedia of Applied Ethics,
Ruth Chadwick (ed.) (Amsterdam: Elsevier, 2011), by permission of the
publisher.
Abbreviations
ABS
ARM
ATR
CalPERS
CAPM
CARD
CDO
CDS
CEO
CFO
CRO
CSR
ENE
ERISA
ERM
ESG
ETI
Eurosif
EVA
FINRA
FTC
GAAP
GDP
GSE
HFT
ICA
ICI
IPO
ISS
asset-backed security
adjustable-rate mortgage
annualized turnover ratio
California Public Employees’ Retirement System
capital asset pricing model
Credit Card Accountability, Responsibility, and Disclosure Act
collateralized debt obligation
credit default swap
chief executive officer
chief financial officer
chief risk officer
corporate social responsibility
early neutral evaluation
Employee Retirement Income Security Act
enterprise risk management
environmental, social, governance
economically targeted investment
European Sustainable Investment Forum
economic value added
Financial Industry Regulatory Authority
Federal Trade Commission
generally accepted accounting principles
gross domestic product
government-sponsored enterprise
high-frequency trading
Investment Company Act
Investment Company Institute
initial public offering
Institutional Shareholder Services
Abbreviations xi
LDC
LIBOR
M&E
MBS
NASD
NASDAQ
NPV
OPM
OTC
PDAA
REIT
RI
SEC
SME
SRI
SRO
SWM
VaR
VWAP
less-developed country
London Interbank Offered Rate
mortality and expense risk
mortgage-backed security
National Association of Securities Dealers (now FINRA)
National Association of Securities Dealers Automated Quotations
net present value
other people’s money
over the counter
predispute arbitration agreements
real estate investment trust
relationship investing
Securities and Exchange Commission
small and medium enterprise
socially responsible investing
self-regulating organization
shareholder wealth maximization
value at risk
volume weighted average price
Chapter One
Finance Ethics: An Overview
Some cynics jokingly deny that there is any ethics in finance, especially
on Wall Street. This view is expressed in a thin volume, The Complete Book of
Wall Street Ethics, which claims to fill “an empty space on financial bookshelves where a consideration of ethics should be.”1 Of course, the pages are
all blank! However, a moment’s reflection reveals that finance would be impossible without ethics. The very act of placing our assets in the hands of other
people requires immense trust. An untrustworthy stockbroker or insurance
agent, like an untrustworthy physician or attorney, finds few takers for the
services offered. Financial scandals shock us precisely because they involve
individuals and institutions that we should be able to trust.
Trust is essential in finance, but finance ethics is about far more than trust.
Finance consists of an array of activities that involve the handling of financial
assets—usually those of other people. Not only does the welfare of everyone
depend on the safeguarding and deployment of these assets, but billions of
financial transactions take place each day with a high level of integrity. With
this large volume of financial activities, there are ample opportunities for some
people to gain at other’s expense. Simply put, finance concerns other people’s
money (OPM), and OPM invites misconduct. Individuals in the financial
services industry, such as stockbrokers, bankers, financial advisers, mutual
fund and pension managers, and insurance agents, have a responsibility to the
customers and clients they serve. Financial managers in corporations, government, and other organizations have an obligation to manage the financial
assets of these institutions well. It is important that everyone else involved in
Ethics in Finance, Third Edition. John R. Boatright.
© 2014 John Wiley & Sons, Inc. Published 2014 by John Wiley & Sons, Inc.
2
Finance Ethics: An Overview
finance, in whatever role, conduct themselves with the utmost attention to
ethics.
The ethics of an occupation or a profession is best understood not by
examining the worst conduct of its members but by attending to the conduct
that is commonly expected and generally found. In finance, as in other
areas of life, three questions of ethics are critical: What are our ethical obligations or duties? What rights are at stake? And what is fair or just? Beyond these
more specific questions lies the ultimate ethical question: How should we live?
In the case of finance, this question goes to the heart of the purpose of financial
activity: What role should finance play in our individual lives and in the
development of a good society?2 These four fundamental questions are not
easily answered, but an attempt to answer them—or at least the first three—is
the main task of this book.
This chapter lays the groundwork for the ones that follow by providing an
overview of the need for ethics in finance and the main areas of finance ethics.
A comprehensive treatment of ethics in finance is, of necessity, long and
involved because of the diversity of financial activities and the range of ethical
issues they raise. However, there is little that is unique to finance ethics. The
ethics of finance has counterparts in other areas of business and in the professions, such as medicine and law. Thus, our discussion of ethics in finance can
be facilitated by drawing on the well-developed fields of business and professional ethics.
The Need for Ethics in Finance
Although the need for ethics in finance should be obvious, it is useful to
understand both the misconduct that occurs all too frequently and its causes.
Most people in finance are decent, dedicated individuals, but, unlike the professions, which involve a strong commitment to service, finance relies mainly
on the search for gain, which can easily become greed. Moreover, individuals
operate within and through organizations, institutions, and systems, including
markets, which may be faulty. Consequently, scandals may occur that were
part of no one person’s intentions and for which no one bears responsibility.
Many scandals result not from deliberate misconduct—doing what one knows
to be wrong—but from rational actors following incentives in situations with
complex interactions. Ethical misconduct is not always a matter of bad people
doing bad things, but often of good people who stumble unwittingly into
wrongdoing. This section describes some of the scandals of recent years, which
have created an image of finance as an activity devoid of ethics, and it also
explores some of the causes for these scandals.
Finance Ethics: An Overview 3
Financial scandals
Wall Street was shaken in the late 1980s by the insider trading and market
manipulation of Dennis Levine, Martin Siegel, Ivan Boesky, Michael Milken,
and others. In 1990, Mr Milken pleaded guilty to six felonies and was sentenced to 10 years in prison. Previously, his firm, Drexel Burnham Lambert,
collapsed after admitting to six felonies and agreeing to pay $650 million.
James B. Stewart, the author of Den of Thieves, calls their activities “the greatest
criminal conspiracy the financial world has ever known.”3 Insider trading
continues to be not only a frequent occurrence but also a source of controversy. Although the domestic maven Martha Stewart was convicted in 2004
for lying to investigators about a suspicious transaction, questions remain
about whether she had actually committed insider trading. However, the
investigation of Raj Rajaratnam, head of the Galleon Group—who was convicted of insider trading in 2011 and sentenced to 11 years in prison—also
ensnared many members of the circle of informants that he had built over
many years, including a respected director of Goldman Sachs and Procter
& Gamble. This conviction exposed the extent to which insider trading
had become organized in the hedge fund world through so-called expert
networks.
The investment bank Salomon Brothers was nearly destroyed in 1991 by
charges that traders in the government securities division had attempted to
execute a “squeeze” by rigging several auctions of US Treasury notes. The total
cost of this scandal—including legal expenses and lost business, on top of a
$290 million fine—has been estimated at $1 billion. The firm dismissed the
people responsible for the bid-rigging, as well as CEO John Gutfreund, who
was unaware of the activity at the time. (Gutfreund’s offense was that he sat
on the news for more than three months before reporting it to the Treasury
Department.) Also ensnared in this scandal was vice-chairman John Meriwether, who went on to head Long-Term Capital Management, a hedge
fund that collapsed at great loss in 1998. The name of this venerable firm,
founded in 1910, was eventually abandoned in 2003, after a new owner, Citigroup, was itself involved in a series of scandals. At that time, the reputational
value of the Salomon Brothers franchise was apparently deemed to be worth
little.
After losing $1.6 billion on derivative transactions in 1994, Orange County
in California sued its financial adviser Merrill Lynch for concealing the amount
of risk that was involved in its investments. In 1998, Merrill Lynch settled the
suit for more than $400 million. In 1996, Procter & Gamble (P&G) settled
with Bankers Trust after the bank agreed to forgive $200 million that P&G
owed on failed derivative transactions. P&G’s charge that Bankers Trust had
4
Finance Ethics: An Overview
misrepresented the investments was bolstered by damaging audio tapes,
including some in which bank employees were recorded using the acronym
ROF for “rip-off factor” to describe one method for fleecing customers.
Although derivative securities continue to be a source of considerable abuse,
efforts to regulate them have been largely unsuccessful. Both Merrill Lynch
and Bankers Trust were eventually saved from collapse by absorption into
larger banks (Bank of America and Deutsche Bank respectively).
Unauthorized trading by individuals has caused great losses at several
banks and trading firms. Nick Leeson, a 28-year-old trader in the Singapore
office of Barings Bank, destroyed this venerable British firm in 1995 by losing
more than $1 billion on futures contracts that bet the wrong way on the direction of the Japanese stock market. (The final blow to his precarious position
came from an unpredictable event, the Kobe earthquake.) In 1996, the
acknowledged king of copper trading was fired by Sumitomo Corporation for
losing an estimated $2.6 billion, and Sumitomo also sued a number of banks
for issuing derivative securities that enabled the trader to hide the losses.
Between 2006 and 2008, Jérôme Kerviel, a trader at the French bank Société
Générale, managed to lose 4.9 billion euros in unauthorized activity. UBS
incurred losses of $2.3 billion in 2011 that had been hidden by a young trader
named Kweku Adoboli. In most of these cases, the rogue traders exploited
flaws in reporting systems and benefited from lax management supervision,
which may have also been weakened by a reluctance to interfere in these
traders’ apparent money-making ability. Returns that are “too good to be true”
often are, but who wants to point this out?
The usually staid mutual fund industry was roiled in 2003 when New York
State attorney general Eliot Spitzer brought charges against a number of
mutual fund sponsors, including Bank of America, Putnam Investments,
Janus Funds, and Strong Capital Management. These companies had allowed
favored traders to operate after the close of the business day and also to make
rapid, market-timing trades. Late trading is illegal, and most funds discourage
market timing with rules that prevent the practice by ordinary investors. In
the case of Strong Capital Management, the founder, Richard S. Strong, not
only permitted a favored investor, Canary Capital, to engage in market-timing
trades but also engaged in the practice himself. He made 1400 quick trades
between 1998 and 2003 in violation of a fiduciary duty that he, as the manager
of the Strong family of funds, had to the funds’ investors.
Also in 2003, 10 major investment firms paid $1.4 billion to settle charges
that their analysis of securities had been slanted in order to curry favor with
client companies. At the height of the Internet and telecommunications boom,
the firms’ securities analysts had issued favorable reports of companies such
as WorldCom and Global Crossing that subsequently collapsed. These biased
Finance Ethics: An Overview 5
reports induced thousands of people to invest millions of dollars, much of
which was lost when the market bubble burst. The analysts were, in many
cases, compensated for their ability to bring in investment banking business,
which created a conflict of interest with their duty to offer objective evaluations of companies. Two analysts, Jack B. Grubman at Salomon Smith Barney,
then a part of Citigroup, and Henry Blodget of Merrill Lynch, paid large fines
and agreed to lifetime bans from the securities industry for their roles in
pushing companies that they knew were troubled. William H. Donaldson,
then chairman of the Securities and Exchange Commission, commented,
“These cases reflect a sad chapter in the history of American business—a
chapter in which those who reaped enormous benefits based on the trust of
investors profoundly betrayed that trust.”4
The fall of Enron in 2001 and WorldCom in 2002 involved many ethical
lapses. An important part of the Enron story involved off-balance-sheet partnerships that generated phantom profits and concealed massive debts. These
partnerships were formed by Enron’s chief financial officer (CFO) Andrew
Fastow. For Fastow to be both the CFO of the company and the general
manager of the partnerships, and thus to negotiate for both sides in deals,
constituted an enormous conflict of interest—a conflict that he used to reward
himself handsomely. Shockingly, the Enron board of directors waived the
prohibition on such conflicts in the company’s code of ethics to allow Fastow’s
dual role. Aside from the fact that many of the partnerships violated accounting rules and should have been consolidated on the company’s books, Enron
guaranteed some of the partnerships against losses with a commitment to
infuse them with more stock in the event they lost value. Because the partnerships were capitalized with Enron stock to begin with, a decline in the price
of the stock triggered massive new debt obligations. The end for Enron came
quickly when investors realized the extent of the company’s indebtedness—
and the faulty accounting that had hidden it.
By contrast, the accounting fraud at WorldCom was alarmingly simple: the
company reported as revenue accruals that were supposed to be set aside for
payments, and some large expenses were recorded as capital investments. Both
kinds of entries are violations of generally accepted accounting principles
(GAAP). WorldCom’s end also came quickly when the head of internal auditing unraveled the fraud and courageously reported it to the board of directors.
CEO Bernie Ebbers and CFO Scott Sullivan were convicted and sentenced to
prison terms of 25 and 5 years respectively. The internal auditor, Cynthia
Cooper, was later featured on the cover of Time as one of three women whistleblowers who were recognized with the magazine’s 2002 Persons of the Year
award. (Another awardee was Sherron Watkins, who blew the whistle on
Enron’s perilous financial structure.)
6
Finance Ethics: An Overview
In the financial crisis that began in 2007, the most obvious target of ethical
criticism was the mortgage origination process in which unsuitable loans were
made without adequate determination and documentation of creditworthiness. Lax mortgage origination practices contributed, in part, to a bubble in
housing prices, which precipitated the crisis and left many borrowers “under
water,” owing more on their mortgage than the house was worth. Mortgage
originators were often heedless about suitability or creditworthiness because
they could quickly sell the loans to major banks, which would combine many
mortgages into securities that were sold to investors. Woefully inadequate
documentation of mortgages (called “robo-signing”) has also proven to be a
serious problem as banks, which often lacked clear title to the property, sought
to foreclose on borrowers, who, in some cases, did not owe the amounts
charged.
Although the securitization of mortgages and other debt obligations has
many benefits, the risks of default, which were increased by the housing
bubble and uncreditworthy borrowers, tended to be overlooked by both the
securitizers and investors. When the bubble burst, the banks that held many
of the mortgage-backed securities and financed their holdings by short-term
borrowing found themselves unable to obtain funding, and because of their
high leverage and assets of questionable value, they faced the threat of
insolvency. Since many of these banks were considered “too big to fail,” their
collapse threatened the whole economy, which prompted a vigorous government response. A failure on the part of rating agencies to accurately gauge the
risk of the mortgage-backed securities and government policies supporting
home ownership were also blamed for the crisis. In particular, the federally
chartered, for-profit mortgage holders, Fannie Mae and Freddie Mac, were
major factors in the financial crisis. Given the many factors in the crisis,
controversy remains about which were more important and which of these
involved distinctively ethical failings as opposed to poor judgment, failed
systems, and plain bad luck.
Since the financial crisis, questions of ethics have been raised in such cases
as the collapse of MF Global, in which about $1 billion in clients’ money
disappeared in a frantic effort to meet the firm’s own obligations after the
failure of risky bets on European sovereign debt. MF Global violated a fundamental requirement in their business of derivative trading to segregate client
funds from those of the firm. The “flash crash” of May 6, 2010, and the $440
million loss at Knight Capital Group in 2012, both due to malfunctioning
software programs, have focused attention on the dangers of high-frequency
trading, which some charge is a predatory practice that provides little benefit
to investors. Confidence in financial institutions was further imperiled by
charges that major banks had intentionally manipulated the widely used
Finance Ethics: An Overview 7
London Interbank Offered Rate (LIBOR) by submitting false information to
the rate-setting organization. Banks have also been under investigation for
aiding in illegal tax evasion and for deliberately circumventing rules to prevent
money laundering for clients in countries under international sanctions, such
as Iran.
These scandals not only undermine the public’s confidence in financial
markets, financial institutions, and indeed the whole financial system but also
fuel popular perceptions of the financial world as one of personal greed
without any concern by finance people for the impact of their activities on
others. A 2011 Harris poll revealed that 67 percent of respondents agreed that
“Most people on Wall Street would be willing to break the law if they believed
they could make a lot of money and get away with it.”5 In addition, 70 percent
believed that people on Wall Street are not as “honest and moral as other
people.” Only 31 percent of people agreed with the statements “In general,
what is good for Wall Street is good for the country” and “Most successful
people on Wall Street deserve to make the kind of money they earn.” In 2006,
60 percent of respondents polled believed that “Wall Street only cares about
making money and absolutely nothing else.” These results are virtually
unchanged from polls conducted annually by Harris since 1996.
The public’s dim view of ethics in finance is shared by industry insiders. A
2012 survey of 500 financial services professionals in both the United States
and the United Kingdom found that 26 percent of Wall Street and Fleet Street
professionals had personally witnessed unethical conduct in the workplace.6
In addition, 24 percent of the respondents believed that getting ahead requires
people to engage in unethical and illegal behavior. Only 41 percent of respondents were sure that no one in their firm had “definitely not” engaged in such
behavior, while 12 percent thought that it was likely that people in their firm
had done so. Thirty percent of respondents in the United States and the United
Kingdom also agreed that the compensation system in their firms created
pressure to violate ethical and legal standards.
This image of the financial world as mired in misconduct is not entirely
undeserved, of course. Ivan Boesky delighted a commencement audience of
business school students at the University of California at Berkeley with the
assurance that greed is “all right.” “I think greed is healthy,” he said. “You can
be greedy and still feel good about yourself.”7
Causes of wrongdoing
Although scandals cannot be prevented entirely, it is important to understand
why they occur and to undertake reasonable preventive measures. At the same
time, we should aim not merely at the prevention of scandals but also at
8
Finance Ethics: An Overview
achieving the highest possible level of exemplary ethical conduct. The goal
should be not only to prevent the worst but also to achieve the best. Success
in meeting this challenge depends on a complex interplay of the personal
integrity of individuals, supportive organizations and institutions, and ethical
leadership by people in positions of responsibility.
Pressure and culture
Some of the most difficult dilemmas of business life occur when individuals
become aware of questionable behavior by others or are pressured to engage
in it themselves. In a survey of 30 recent Harvard University MBA graduates,
many of the young managers reported that they had received “explicit instructions from their middle-manager bosses or felt strong organizational pressures
to do things that they believed were sleazy, unethical, or sometimes illegal.”8
A survey of more than one thousand graduates of the Columbia University
business school revealed that more than 40 percent of the respondents had
been rewarded for taking some action they considered to be “ethically troubling,” and 31 percent of those who refused to act in ways they considered to
be unethical believed that they were penalized for their choice, compared to less
than 20 percent who felt they had been rewarded.9 The Harvard graduates did
not believe that their superiors or their organizations were corrupt. The cause
is rather intense pressure to get a job done and to gain approval. Ethical and
even legal restraints can get lost when the overriding message is “Just do it!”
Unethical behavior can also be fostered by the culture of an organization.
In Liar’s Poker, an amusing exposé of the author’s brief stint as a trader at
Salomon Brothers, Michael Lewis describes the coarse pranks of a group who
occupied the back row of his training class.
There was a single trait common to denizens of the back row, though I doubt it
occurred to anyone. They sensed that they needed to shed whatever refinements
of personality and intellect they had brought with them to Salomon Brothers.
This was not a conscious act, more a reflex. They were the victims of the myth,
especially popular at Salomon Brothers, that a trader is a savage, and a great
trader is a great savage.10
In the culture that Lewis describes, ethical behavior is not readily fostered.
He continues, “As a Salomon Brothers trainee, of course, you didn’t worry too
much about ethics. You were just trying to stay alive. You felt flattered to be
on the same team with the people who kicked everyone’s ass all the time.”11
Organizational factors
Although wrongdoing is sometimes attributable to a lone individual or rogue
employee, some of the most common misdeeds are committed by organiza-
Finance Ethics: An Overview 9
tions in which many people contribute to an outcome that no one intends or
even foresees. Wrongdoing also occurs in large organizations when responsibility is diffused among many individuals and no one person is “really”
responsible. In some cases, it is difficult to identify any one person or decision
as the source of an act, and the wrongdoing can be attributed only to
the organization as a whole. Such organizational wrongdoing is often due
to the fragmented nature of decision making in which a number of individuals
make separate decisions about different matters, often on the basis of diverse,
sometimes conflicting, information. Typically, these decisions are not made
all at once but incrementally over a long period of time in a series of small
steps, so that their full scope is not readily apparent.
Virtually all organizations seek to direct and motivate members by means
of incentives, which may produce unintended outcomes. Poorly designed
incentive plans may either move people in the wrong direction (when incentives are misdirected) or too far in the right direction (when incentives are
simply too strong). Perverted or overly powerful incentives are the root cause
of many financial scandals. Another kind of incentive problem develops when
individuals or organizations acquire interests that interfere with their ability
to serve the interests of others when they have a duty to do so. When a broker,
for example, is obligated to recommend only suitable investments for a client
but is compensated more for some investments than others, a personal interest
in more pay may lead the broker to fail in the duty to serve the client. The
very existence of such an incentive to violate an obligation to serve the interest
of another is a wrong that is known as a conflict of interest. Conflict of interest
is a particularly prominent incentive problem in all areas of finance ethics.
These organizational factors are evident in the case of E.F. Hutton, a nowdefunct brokerage firm, which was convicted in 1985 on 2000 counts of fraud
for a check-kiting scheme. The firm obtained interest-free use of more than
$1 billion over a 20-month period by systematically overdrafting checking
accounts at more than 400 banks. This illegal scheme began as an attempt to
squeeze a little more interest from the “float” that occurs when checks are
written on one interest-bearing account and deposited in another. Until a
check clears, the same dollars earn interest in two different accounts. No one
person created or orchestrated the practice, and yet the firm, through the
actions of many individuals, defrauded banks of millions. When the checkkiting scheme began, few people were aware of the extent of the activity, and
it continued, no doubt, because anyone who intervened would have had to
acknowledge the existence of the fraud and take responsibility for the loss of
the extra income it generated. In addition, the participants could assure themselves that their own actions did no significant harm since each transaction
seemed minor.
10 Finance Ethics: An Overview
In another example, Marsh Inc., which called itself “the world’s leading
risk and insurance services firm,” was accused in 2004 by the New York
State attorney general of cheating its insurance brokerage clients by rigging
bids and accepting undisclosed payments from insurance companies that it
recommended. As an insurance broker, Marsh advises clients on the choice
of insurance companies and policies. By accepting so-called contingency
commissions—which are fees of 5 to 7.5 percent of the annual premium on
top of a typical 15 percent standard commission—Marsh placed itself in a
conflict of interest that potentially hampered its ability to offer its clients
unbiased service. This added cost of companies’ insurance policies, which is
arguably exorbitant for the services provided, is passed along to the public in
the form of higher prices. Although contingency commissions appear to be
questionable, they have gone largely unquestioned by industry leaders. Jeffrey
W. Greenberg, chairman and CEO of Marsh at the time, issued a statement
calling them a “longstanding, common industry practice.”12 Nevertheless,
Marsh paid $850 million in 2005 to settle the charges, agreed to forgo the
payments permanently, and issued an apology for engaging in the practice.
More ethically aware leadership might have recognized the inappropriateness
of contingency commissions and ended their use much earlier.
Organizational factors are also impacted by leadership. Leaders of firms
have a responsibility for the environment in which unethical conduct takes
place. In a Harvard Business Review article, Lynn Sharp Paine writes:
Rarely do the character flaws of a lone actor fully explain corporate misconduct.
More typically, unethical business practice involves the tacit, if not explicit,
cooperation of others and reflects the value, attitudes, beliefs, language, and
behavioral patterns that define an organization’s operating culture. . . . Managers
who fail to provide proper leadership and to institute systems that facilitate
ethical conduct share responsibility with those who conceive, execute, and
knowingly benefit from corporate misdeeds.13
The bond-trading scandal at Salomon Brothers, for example, was not due
merely to the willingness of the head of the government bond-trading department to violate Treasury auction rules. It resulted, in large measure, from the
aggressive trading culture of the firm, from a poorly designed compensation
system, and from a lack of internal controls. At Salomon Brothers, some units
had negotiated compensation systems in which members shared a bonus pool
equal to a percentage of the total profits, while managers in other units received
lesser amounts that were based mostly on the overall performance of the firm.
This system placed no cap on the bonuses of some traders and encouraged
them to maximize profits without regard for the profitability of the whole firm.
Finance Ethics: An Overview 11
In addition, there were few controls to detect irregular trading by the managers of the most profitable units. The task for the new leadership of Salomon
Brothers included a thorough overhaul of the whole organization, which was
led by major shareholder Warren Buffett, whose reputation for integrity
was instrumental in regaining the trust of clients and regulators.
Leadership failures were abundant in the years leading to the financial crisis
that began in 2007. The heads of large mortgage origination companies created
a climate in which loan officers were actively encouraged, indeed forced, to
abandon prudent standards in order to meet the insatiable demand from the
packagers of mortgage-backed securities. Further, these companies created
new types of mortgages with low teaser rates and generous repayment plans,
such as interest-only and even negative amortization loans, in which unpaid
interest was added to the principal. While praising these inventive mortgages
in public, the founder of one of the largest origination companies, Countrywide, was more candid. About one of these products (a mortgage with no
down payment), Angelo Mozilo wrote, “In all my years in the business, I have
never seen a more toxic product.”14 Yet the sales went on.
Innovation
Although financial innovation has brought many benefits, its value has been
questioned in the public mind and among some finance experts for the
destructive consequences that sometimes follow. Economist and New York
Times columnist Paul Krugman quipped that it is “hard to think of any major
recent financial innovations that actually aided society, as opposed to being
new, improved ways to blow bubbles, evade regulations and implement de
facto Ponzi schemes.”15 Former Fed chairman Paul Volcker claimed that the
only really useful recent innovation was the ATM machine.16 Even good innovations, such as the credit card, have some socially destructive consequences.
Robert Manning convincingly shows in Credit Card Nation that America’s
“addiction to credit,” as he calls it, has brought misfortune to many.17
The dangers of innovation are inevitable and may be inseparable from the
benefits.
First, innovation creates new situations in which the rules for proper
conduct, as well as for safe practice, are uncertain and slow to develop. In the
changed world wrought by innovation, the old rules may no longer apply, and,
eventually, new rules will be developed, but in the meantime, there are
windows of opportunity for misconduct. For example, in the early days of the
Internet, there was great uncertainty about how to value dot.com businesses
and, in particular, about how to recognize income for start-ups that were not
making any money but had great potential. Many investment decisions were
made on the basis of pro forma statements that presented hypothetical future
12 Finance Ethics: An Overview
income and expenses that, in many cases, turned out to be wildly optimistic.
The result was the Internet or dot.com bubble.
Second, new situations sometimes involve a change of incentives and a shift
of risk and responsibility. This was certainly true of mortgage lending during
the current financial crisis. In the old originate-to-hold model of mortgage
lending, issuing banks had an incentive, and the responsibility, to ascertain
and verify the creditworthiness of potential borrowers, inasmuch as they held
the loans on their books and hence bore the full risk of default. With the shift
to an originate-to-distribute model, in which mortgages were securitized and
sold to investors, neither the originating banks nor the ones packaging the
securities (which were sometimes the same) had an incentive to ensure borrowers’ creditworthiness. The responsibility for this function was shifted to
the ultimate investors, who, in many cases, were ordinary people, who were
utterly unaware of the risk shift taking place and, in any event, had neither
the information nor the ability to assess the quality of the underlying
mortgages.
Third, innovation is inherently complex and opaque, and the dangers are
difficult to perceive. Innovation takes place on the cutting edge of finance or
any other domain and may be understood, at first, by only a few involved in
the creative process, if at all. History is replete with examples of how inventions had profound and unexpected consequences. Moreover, some financial
innovations are deliberately designed to be complex and opaque precisely in
order to gain an advantage by deceiving or confusing others. In the recent
financial crisis, the role of credit default swaps (CDSs) was a crucial factor
inasmuch as many banks took greater risk in holding risky mortgage-backed
securities, called collateralized debt obligation (CDOs), because they believed
their positions were adequately hedged with the insurance-like credit default
swaps. What they failed to see was that the insurers who issued these swaps
would be unable to honor claims in a general crisis that would result from a
collapse of the mortgage market. The two securities, CDOs and CDSs, turned
out to be closely linked.
Fourth, given that the dangers of innovation are difficult to perceive,
everyone is held captive to the least perceptive—or the most daring. Innovation is subject to a classic collective action problem in which no one individual
can affect an outcome that can be avoided only if everyone cooperates. In Fool’s
Gold, Gillian Tett describes how the bankers at J.P. Morgan who developed
the derivative called CDO squared (or synthetic CDO) foresaw the dangers
of using their discovery to make bets on mortgage-backed securities.18 In her
account, the J.P. Morgan bankers looked on in horror as less cautious firms,
who did not perceive the unique risks posed by using mortgages in these
securities, proceeded to do exactly that. As long as a few banks and enough
Finance Ethics: An Overview 13
investors failed to see the dangers, these securities would continue to be produced and purchased with the disastrous consequences that occurred. This
dilemma was illustrated by Charles Prince, the CEO of Citigroup, who was
aware of the dangers in financing long-term assets with short-term debt. Yet,
he said, “But as long as the music is playing, you’ve got to get up and dance.”
This remark shows that his restraint would have had little effect unless all
parties involved perceived the dangers and acted in concert to stop dancing
to the music.
The causes of major scandals in finance involve more than individual
conduct and range over many organizational and systemic factors. However,
the field of finance ethics is concerned with more than these scandals, which
are merely the most visible and troubling evidence of the need for ethics in
finance. Ethics is probably most needed in the everyday activities that constitute the world of finance, in which individuals and firms work to spend, save,
invest, produce, and, in general, secure our economic welfare. Scandals may
be thought of as a malfunction in an otherwise smoothly operating machine,
and ethics is not only the sand in these malfunctions but also the oil that
maintains the machine’s ordinarily smooth operation. Much of this book is
concerned with specific ethical problems and issues in the financial sector—
with securing a high level of ethical conduct in everyday financial activities—
and not with the different challenge of preventing scandals.
The Field of Finance Ethics
Finance is concerned broadly with the generation, allocation, and management of monetary resources for any purpose. It includes personal finance,
whereby individuals save, spend, invest, and borrow money in order to
conduct their lives; corporate finance, whereby organizations, both businesses
and not-for-profits, raise capital, mainly through loans or the issue of
stocks and bonds, and manage it in order to engage in their activities; and
public finance, whereby governments raise revenue by means of taxes and fees
and spend it to provide services and other benefits for their citizens. This
financial activity is facilitated by financial markets, in which money and financial instruments are traded, and by financial institutions, such as banks and
other financial services providers, which facilitate financial transactions
and offer various kinds of products and services. Both markets and institutions are also important means for managing risk, which is another important
service needed by individuals, corporations, and governments. In addition,
financial activity takes place within an economic system, which in most developed countries can be characterized as capitalism. Thus, financial markets and
14 Finance Ethics: An Overview
institutions assume very different forms in socialist or planned economies
with state-owned enterprises, as in China.
Defining the field
Ethics in finance consists of the moral norms that apply to financial activity
broadly conceived. Moral norms, in this context, may be understood as prescribed guides for behavior or conduct about what is right or wrong or about
what ought to be done, using such concepts as duty or obligation, rights, and
fairness or justice. That finance be conducted according to moral norms is of
great importance, not only because of the crucial role that financial activity
plays in the personal, economic, political, and social realms but also because
of the opportunities for large financial gains that may tempt people to act
unethically.
Many of the moral norms in finance are embodied in laws and regulations,
which are enforced by prosecutors and regulators. Ethics plays a vital role in
these matters, however, first, by shaping laws and regulations and, second, by
guiding conduct in areas not governed by laws and regulations. In countries
with well-developed legal systems, much of what is unethical is also illegal,
and the law is constantly expanding to align ethics and law more closely. Thus,
ethics is a major factor in the development of existing legislation and regulation and also a major source of new legislation and regulation. That is, ethics
explains why we have the laws and regulations we do and guides their creation.
However, in finance and other areas of life, some matters are not suited to
legal control, and there ethics alone holds sway.
The moral norms that apply to financial activities are diverse and vary to
some extent among societies or cultures. This is most marked in the case of
Islamic finance, the moral norms of which contrast sharply with those of the
United States and Europe. These norms are expressed in Islamic law, known
as Shariah, and derive from the Qur’an, the sacred text of Islam, and the
sayings of Muhammad, the prophet. In the Islamic view, all economic activity
should aim at human well-being, which includes justice, equality, harmony,
moderation, and a balance of material and spiritual needs. The main principles
of Islamic finance are that wealth should come from legitimate trade and
investment activity that has some social benefit, so interest or riba is forbidden
as an unproductive activity; all harmful activities (haram) should be avoided,
so investment should not be made in such prohibited activities as drugs,
gambling or pornography; and risk should be limited and fairly shared, which
rules out speculation (which is also gambling) and one-sided, sure-bet trades
based on superior information (which describes a lot of arbitrage). Because
so many financial instruments, such as conventional loans, options, futures,
Finance Ethics: An Overview 15
and other derivatives, are forbidden, Islamic finance requires the creation
of inventive means of achieving the same ends. For example, the purchase of
business equipment might be accomplished without an interest-bearing loan
through Ijara, in which the bank owns the equipment and leases it back to the
user at an agreed-upon mark-up, which substitutes for interest.
A complete account of financial activity is not possible in a few words. First,
finance is not a distinct, identifiable occupation or profession. Like medicine,
law, engineering, and accounting, finance involves a highly technical body of
knowledge, but people who are trained in finance engage in a much wider
range of activities. Accountants, by contrast, do much the same work in every
setting, and the different accounting functions—public and management
accounting or external and internal auditing—raise similar ethical problems
that can be identified and addressed in a code of professional ethics. Thus,
accounting ethics, like the ethics of medicine, law, and engineering, focuses
on the ethical problems of a relatively uniform activity. Although codes of
ethics exist for many specific fields in finance—such as financial advisers,
financial analysts, actuaries, and insurance underwriters—the idea of a single
code of ethics for everyone in finance is impractical since the range of activities is so diverse.
Second, the ethics of finance is concerned not solely with the ethical
problems of individuals in a specific occupation or profession but also
with problems in financial markets and financial institutions, as well as the
financial function of corporations and governments. Because market regulation is concerned, in part, with fairness (orderliness and efficiency are the
other main aims), financial ethics must address such questions as what is a
fair trading practice or the fair treatment of customers or clients. Finance is
also a function in every business enterprise and in most nonprofit organizations and governmental units. Corporate financial managers are responsible
for myriad decisions, from how best to raise and invest capital to the planning
of mergers and acquisitions. Nonprofit organizations typically raise money
from donors and apply it to public service causes. Public finance, on the other
hand, is concerned largely with raising and disbursing funds for governmental
purposes. These tasks raise ethical dilemmas of personal conduct, as well as
broad questions of organizational or institutional practice, especially when
important financial decisions affect society.
Ethics and law
The close connection of ethics with law and regulation raises the question of
why these more formal mechanisms are not enough. Why is ethics needed in
finance in addition to legislation and regulation? Finance is perhaps the most
16 Finance Ethics: An Overview
heavily regulated area of business. Not only is the basic framework of regulation established by major legislative enactments but legislatures on various
levels have also created innumerable regulatory bodies with the power to
create and enforce rules. The financial services industry in the US is now
subject to oversight from the federal Consumer Financial Protection Bureau,
and some parts of the industry engage in self-regulation through, for example,
the Financial Industry Regulatory Authority (FINRA). Many questionable
industry practices are challenged in court, so that the judiciary—which consists of prosecutors and judges—plays a prominent role in determining the
boundaries of acceptable conduct. Most organized exchanges, such as the New
York Stock Exchange and the Chicago Board of Trade, have their own private
rule-setting and rule-enforcement bodies.
In view of this extensive body of law and regulation, people in finance
might well assume that this is the only guide needed. Their motto might be:
“If it’s legal, then it’s morally okay.” However, this motto is inadequate for many
reasons.
First, the law is a rather crude instrument that is not suited for regulating
all aspects of financial activities, especially those that cannot be easily anticipated, reduced to precise rules, and enforced by appropriate and effective
sanctions. The relationship between a broker and a client, for example, involves
repeated interactions, and some of these are one-of-a-kind situations for
which legal rules may not have been developed. In such situations, what constitutes fair treatment may be obvious, but a rule mandating a specific action
may not be easy to formulate. Consequently, a moral rule “Be fair!” or a standard of suitability may be more effective than a precise legal rule of the form
“Do such-and-such.” Moreover, precise rules can often be “gamed” to produce
results that may be considered unfair, and legal sanctions for violations of a
rule may be difficult to devise and apply.
The example of conflicts of interest is illustrative. Because of the variety of
conflicts, a law barring them would be difficult to draft, and such a law would
be subject to difficulties of interpretation and enforcement. Conflicts of interest are often a matter of perception so that a strict legal definition would be
elusive, and proving a conflict would be similarly difficult. Rules designed to
prevent conflicts could be effective only if individuals obeyed the spirit as well
as the letter of these rules. The difficulty of bringing legal action against some
figures involved in the recent financial crisis also shows the limited use of
the law in complex financial cases where it is difficult to prove individual
culpability.
Second, the law often develops as a reaction to activities that are considered
to be unethical. It would be perverse to encourage people in finance to do
anything that they want until the law tells them otherwise. Besides, the law is
Finance Ethics: An Overview 17
not always settled, and many people who thought that their actions were legal,
though perhaps immoral, have ruefully discovered otherwise. For example,
the law prohibits abusive tax shelters but offers no precise standards for
judging such abuse. Consequently, some accounting firms have offered tax
shelters that they believed to be within the law and that no court or tax ruling
has declared to be illegal. Nevertheless, in 2005, one of these firms, KPMG,
paid $456 million to settle charges of selling illegal tax shelters, and heavy
fines and stiff prison sentences were imposed on two convicted KPMG partners and one lawyer. Their belief that the tax shelters were legal turned out to
be grievously mistaken.
Third, merely obeying the law is insufficient for managing an organization
or for conducting business because employees, customers, and other groups
expect, indeed demand, ethical treatment. The law is a relatively low standard
of a minimally acceptable level of conduct that is generally below not only
public expectations but also the higher plane that companies themselves
profess and practice. As a former Securities and Exchange (SEC) chairman
observed, “It is not an adequate ethical standard to aspire to get through the
day without being indicted.”19 The attitude that only the law applies to financial
activities invites even more legislation, litigation, and regulatory attention.
Self-regulation—by individuals, organizations, and markets—is not only a
more effective means for securing ethical conduct on some matters but also
a shrewd strategy for avoiding more onerous legal regulation. A certain
amount of self-regulation is necessary, not only as a replacement for legal
regulation but also as a supplement for areas that the law cannot easily reach.
Financial markets
Despite the complexity of finance ethics, an examination of this field can
be organized in three broad areas: financial markets, financial services, and
financial management. Financial markets involve transactions such as onetime trades that take place in organized exchanges, such as stock markets,
commodities markets, futures or options markets, currency markets, and
the like. Furthermore, financial activity includes long-term contractual relationships, which are also formed in markets and are a kind of exchange or
transaction. Thus, a mortgage or an insurance policy, which are products
bought and sold in markets, commits two parties to act in certain ways over
an extended period of time. Financial markets, in which these exchanges or
transactions take place, presuppose certain moral rules and expectations of
moral behavior.
The first obligation or duty in any market exchange is to abide by the agreements made. Every transaction in a market is a kind of agreement or contract,
18 Finance Ethics: An Overview
which creates an ethical obligation to act in certain ways. Market trades take
the form “I will give you this in exchange for you giving me that.” Markets
could not work if the parties to an exchange did not perform as they have
agreed or contracted to do. Simply put, a market transaction is a kind of
promise, and we have a basic moral duty to keep all promises made. Failing
to abide by an agreement made in a market exchange may also be described
as a breach of contract, which, too, is a kind of failure to keep a promise.
Failures to abide by agreements or contracts in market exchanges are not
always simple matters of nonperformance or breach. The required conduct
may not be clear or may be understood differently by the two parties. Consequently, disagreements can arise about whether one or both of the parties has
acted appropriately. The parties can also take advantage of any ambiguity or
omission in an agreement or contract to advance their own interests. These
kinds of abuse often end up in court where a judge must interpret a contract’s
meaning. Agreements also require monitoring to ensure that both parties
abide by them, and since it may often be difficult to determine compliance,
there are abundant opportunities in contracting to take advantage of any
inability to monitor adequately. Such problems are described as cases of information asymmetry, in which one party knows more than the other about
his or her performance, and the outcome is commonly described as opportunism or shirking, which is taking advantage of an opportunity to breach a
contract without consequences or avoiding the need to comply with the terms.
Second, all market exchanges are governed by a general prohibition against
force and fraud. The prohibition against force follows from the necessary
assumption that all transactions in a market are entered into voluntarily.
Giving up a wallet to a gunman in an alley in return for not being harmed is
not a market exchange due to the wrongful threat. So any forced transfer is a
kind of theft and, of course, theft is wrong. In market transactions, where each
party gives up something in order to obtain something that is valued more,
full information about what is given up and gained in return is critical. So a
misrepresentation by one or other party affects the value created by the
exchange. Thus, fraud, which is willful misrepresentation of some fact made
with the intent to deceive the other party, interferes with the crucial feature
of markets to make both parties to an exchange better off. In simple terms,
fraud is a kind of lie, and, of course, lying is wrong. Manipulation, which is
also a wrong in a market exchange, is a kind of fraud inasmuch as it misleads
or deceives the other party about some relevant fact in the transaction.
Third, many of the rules and expectations for markets are concerned with
fairness, which is often expressed as a level playing field. The playing field in
financial markets can become “tilted” by many factors, including unequal
information, bargaining power, and resources. Many market regulations aim
Finance Ethics: An Overview 19
to correct various kinds of differences or asymmetries between the parties to
an exchange that creates an unlevel playing field. In addition to making onetime economic exchanges, participants in markets also engage in financial
contracting whereby they enter into long-term relationships. These contractual relationships typically involve the roles of agents and fiduciaries, which
are subject to unethical conduct because of the possibility for opportunistic
behavior to benefit at another’s expense. Indeed, the roles of agent and fiduciary are ubiquitous in finance, and the responsibilities of these roles—that is,
agency and fiduciary duties—constitute much of finance ethics.
Finally, market exchanges between two parties often have third-party
effects, which is to say that they affect others who are not parties to a transaction. Third-party effects are especially common in investment decisions by
corporations and financial institutions, which have wide-ranging consequences for people’s welfare and the well-being of society. Many of these
third-party effects are externalities, which are costs of production that are not
borne by the producer but are passed along to others. Pollution is a common
externality from manufacturing, but financial activities are also capable of
producing externalities. Consider, for example, the impact that bank lending practices have on community development. Insofar as banks engage in
redlining—the alleged practice of denying mortgages and home-improvement
loans for properties in deteriorating neighborhoods, which are figuratively
outlined in red on a map—they actively contribute to the process of urban
decay (which becomes an externality). On an international scale, the lending
practices of multinational banks and global financial institutions such as the
World Bank have an enormous impact on less-developed countries and thus
are subject to ethical evaluation.
Consequently, ethics in financial markets includes some consideration of
the social impact of financial activity and the responsibility of financial decision makers to consider these impacts. The extent of this responsibility to
consider social impacts, however, is open to question. If the primary obligation of a corporate finance officer, for example, is to serve the interests of
shareholders, then should the fact that a decision will result in layoffs or plant
closures be taken into account? It is tempting for financial managers to make
purely financial judgments and leave the more difficult task of social impacts
to others, but such a neat division of responsibility is not always possible.
Furthermore, financial institutions serve many publics and wield immense
power in our society. Shouldn’t they use this power responsibly?
Although the moral rules that govern markets may be complex in their
application, they may be expressed simply: don’t steal, tell the truth, keep your
promises, be fair, avoid harm, and be a faithful agent or fiduciary. The complexity lies in the details.
20 Finance Ethics: An Overview
Financial services
The financial services industry is the most visible face of finance and the aspect
that affects ordinary people most directly. This industry consists of major
financial institutions, such as commercial banks, investment banks, savings
and loan associations, credit unions, mutual funds and pension funds, financial planners, and insurance companies. Private partnerships, such as hedge
funds, and publicly traded investment management firms, such as Warren
Buffet’s Berkshire Hathaway, further expand the definition of the financial
services industry.
Financial services firms fulfill many useful, often essential, functions. They
enable individuals, organizations, and governments to save and borrow, to
invest for a return, to have access to capital, to insure against misfortune, and
to effect major changes, such as mergers and acquisitions. These benefits are
made possible by specialized services, such as the research of stock analysts,
the guidance of investment planners, the risk assessment of actuaries, and the
investment ability of a mutual fund, pension fund or hedge fund manager. The
financial services industry also provides benefits through the creation of innovative products. Thus, insurance serves to reduce risk by pooling assets;
money-market funds allow small investors to invest in large-denomination
commercial paper; mutual stock funds enable people of limited means to hold
a diversified portfolio; and home equity loans turn an otherwise illiquid asset
into available funds. In recent years, securities that bundle or securitize a
group of assets, such as a pool of mortgages, and derivatives, which are securities whose value is “derived” from some underlying asset, have created new
opportunities, as well as some dangers. Thus, financial services are both
diverse in form and critically important for individual and social well-being.
The financial products that firms offer should meet certain standards of
integrity. These products should fit people’s needs, be financially sound, and
be marketed in a responsible manner. Not only should they be accurately
represented—which is to say that firms should avoid false, misleading, or
deceptive claims and disclose relevant information, including the level of
risk—but they should also be fairly priced, offer good value, and be suitable
for the buyer. In recent years, some mortgage originators acted irresponsibly
by selling inappropriate mortgages using misleading tactics. In addition,
financial services firms often act as a custodian of people’s assets and an executor of their transactions. In serving these roles, a bank, for example, has a duty
to safeguard customers’ deposits and execute their payments faithfully. Further,
financial services providers typically owe certain duties to clients that arise
from offering to put special skills and knowledge to work for their benefit. The
people who make such offers often become fiduciaries or agents who have a
Finance Ethics: An Overview 21
duty to subordinate their own interests to those of the clients. Some financial
services providers may even be characterized as professionals who have stringent professional duties like those of physicians and lawyers.
Agents and fiduciaries, as well as professionals, have opportunities to abuse
the trust invested in them by pursuing their own interest, especially in cases
known as conflicts of interest, where the agent, fiduciary or professional has an
interest that may interfere in the ability to serve the other party faithfully. In
finance, however, it is sometimes difficult to determine when an individual or
a firm is acting as an agent or fiduciary and when that party is acting in a
purely market capacity in which there is no duty or obligation to serve the
other party’s interest. For example, both Goldman Sachs and Citigroup have
been accused of betraying customers by betting against securities that they
had created and sold to them. Both banks argued, however, that the investors
were merely trading partners or counterparties (“sophisticated investors”) and
not trusting clients to whom some duty was owed.
In addition to offering financial products and services, which involves
sometimes becoming agents or fiduciaries, financial services providers also
serve as intermediaries for market transactions. These two roles of product
provider and intermediary are often linked, as when, for example, a bank
offers checking accounts (a product) and also serves as an intermediary in
making payments and in linking savers with borrowers, thereby providing
loans (another product) as well as in enabling savers to gain interest on their
deposits. Similarly, an insurer is able to offer a product (an insurance policy)
by acting as an intermediary in managing risk, whereby the policy holders
essentially pool their premiums through an insurer to pay those with claims.
(Thus, insurance is essentially a system by which policy holders agree to compensate each others’ losses with the company acting merely as a facilitator or
intermediary.) When an investment bank sells an option to a client—such as
an interest-rate or currency swap—it not only provides a requested product
(the swap) but may also take the other side of a bet on, say, interest rates or
exchange rates and thus become a counterparty. An investment bank that
underwrites a bond or stock offering may also invest in the same issue. Such
dual roles are inherent in the investment banking business, and managing the
conflicts is a necessity.
Some of the products that the financial services industry provides may not
merely fit people’s needs but may also contribute to important social goals,
such as increasing the social responsibility of corporations and reducing
poverty. Many mutual and pension funds practice socially responsible investing, in which securities are selected not only for their financial return but also
on the basis of the company’s social performance. Such funds originated from
the demand of religious and socially concerned investors to avoid so-called
22 Finance Ethics: An Overview
“sin stocks,” but they now appeal to investors who take a long-term view of
value creation that includes sustainability and social desirability. A creative
example of using finance to address poverty in less-developed countries is
microfinance, which consists of loans in very small amounts to people who are
among the “unbankable.” With these small amounts, poor people have an
opportunity to start or expand a business that would be impossible within the
traditional banking system. The contribution of microfinance to poverty alleviation was recognized by the awarding of the 2006 Nobel Peace Prize to
Muhammad Yunus for his founding of the Grameen Bank in Bangladesh.
Financial management
Financial managers, especially chief financial officers, or CFOs, have the task
of raising and allocating capital, managing a company’s revenues, payments,
and cash flows, and overseeing most financial reports and communications
with investors. In a sense, a CFO is like an investment manager in making
investment decisions and developing a portfolio, but these decisions are not
about which securities to hold but about what business opportunities to
pursue. Because these investment decisions are so closely linked to strategy, a
CFO is typically involved in high-level management planning and is often an
ex officio member of the board of directors. A CFO is also responsible for
managing the risks of a corporation, although many large firms now have a
separate chief risk officer (CRO).
In carrying out these tasks, financial managers are agents and fiduciaries
with a duty to manage the assets of a corporation prudently, avoiding the use
of these assets for personal benefit, and acting in all matters in the interest
of the corporation and its shareholders. Specifically, this duty prohibits
unauthorized self-dealing and conflicts of interest, as well as fraud and manipulation in connection with a company’s financial reporting and securities
transactions. In many recent scandals, most notably those at Enron and
WorldCom, the CFO was convicted along with the CEO, since accounting
fraud, which was central to these cases, generally requires the acquiescence,
if not the active involvement, of individuals in the financial management
function.
Every firm must have a capital structure in which its total capital is divided
between equity, debt, and other types of obligations. Corporate finance is
concerned mainly with determining the optimal capital structure and, if necessary, how best to raise additional capital. Most large corporations today have
a very complex financial structure with on- and off-balance sheet entities and
extensive holdings in derivatives. All of these decisions are guided by a single
Finance Ethics: An Overview 23
corporate objective: to maximize shareholder wealth. This objective has been
criticized by some who hold that it unjustly neglects the interests of other
corporate constituencies. Therefore the ethics of financial management must
address not only the obligations or duties of a financial manager but also the
justification of shareholder wealth maximization as the objective of the firm.
The duties of financial managers are often the subject of special codes of
ethics. The major exchanges, the New York Stock Exchange and NASDAQ, as
well as the Securities and Exchange Commission (SEC), require publicly held
companies to have a code of ethics for their senior financial officers. Section
406 of the 2002 Sarbanes–Oxley Act specifies that companies adopt a code of
ethics for senior financial officers with standards that are “reasonably necessary to promote (1) honest and ethical conduct, including the ethical handling
of actual or apparent conflicts of interest between personal and professional
relationships; (2) full, fair, accurate, timely, and understandable disclosure in
the periodic reports required to be filed by the issuer; and (3) compliance with
applicable governmental rules and regulations.”
Fraud, accurate accounting and reporting, conflict of interest, and insider
trading are the main ethical (and legal) matters that arise for CFOs and other
financial managers, but more specific and subtle problems occur in earnings
management and in investor communications, which may involve no legal
violation. Accountants have considerable leeway within the rules to report
earnings, and many techniques exist for managing earnings that may violate
the spirit, but not the letter, of these rules. Similarly, communications with
investors may contain omissions and interpretations that give a misleading
picture of a corporation’s financial health. Both the flow and the content of
information released to investors can powerfully affect investors’ perceptions—
and consequently a firm’s stock price. One practice, the release of information
to favored analysts, which served to encourage favorable analysis, is now
illegal due to the SEC rule FD (for “fair disclosure”). Some major events in a
corporation’s life, such as bankruptcy and mergers and acquisitions, including
hostile takeovers, confront CFOs with difficult ethical challenges.
Conclusion
Although the cynical view that there is no ethics in finance is easy to refute,
the financial scandals that occur with depressing regularity impress upon
us the challenge of maintaining—and restoring when necessary—the level of
ethics needed for a functioning, flourishing financial system. Addressing this
challenge requires not only doing what is right when this is known but also
knowing what is the right conduct, which may be unclear. Financial activity,
24 Finance Ethics: An Overview
which takes place in financial markets, financial services firms, and the financial management function of corporations, raises an immense number of
difficult ethical issues. At bottom, these issues are about right and wrong,
about what ought to be done, about obligations or duties, about the rights of
various parties, and about fairness or justice. The remaining chapters in this
book address these ethical issues in finance, first, by identifying them in
finance practice and, then, by seeking to resolve these issues through an
examination of the main positions that can be taken on them and the arguments for these positions. The ultimate aim of this book is to enable people
in the world of finance, as well as everyone affected by this world—which is,
indeed, all of us—to address the inevitable ethical issues in a reflective and
effective manner.
Notes
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
Jay L. Walker [pseudonym], The Complete Book of Wall Street Ethics (New York:
William Morrow, 1987).
This question is addressed in Robert J. Shiller, Finance and the Good Society
(Princeton, NJ: Princeton University Press, 2012).
James B. Stewart, Den of Thieves (New York: Simon & Schuster, 1991), p. 15.
Stephen Labaton, “Wall Street Settlement,” New York Times, April 29, 2003.
http://www.harrisinteractive.com/NewsRoom/HarrisPolls/tabid/447/ctl/
ReadCustom%20Default/mid/1508/ArticleId/783/Default.aspx.
Labaton Sucharow, Wall Street, Fleet Street, Main Street: Corporate Integrity at
the Crossroads; United States and United Kingdom Financial Services Industry
Survey, July 2012.
Quoted in Stewart, Den of Thieves, p. 223.
Joseph L. Badaracco Jr and Allen P. Webb, “Business Ethics: A View from the
Trenches,” California Management Review, 37 (Winter 1995), 8–28, 8.
“Doing the ‘Right’ Thing Has Its Repercussions,” Wall Street Journal, January 25,
1990.
Michael Lewis, Liar’s Poker: Rising Through the Wreckage on Wall Street (New
York: W.W. Norton, 1989), p. 41.
Lewis, Liar’s Poker, p.70.
Gretchen Morgenson, “Hat Trick: A 3rd Unit of Marsh under Fire,” New York
Times, May 2, 2004.
Lynn Sharp Paine, “Managing for Organizational Integrity,” Harvard Business
Review, March–April 1994, 106–107, 106.
Gretchen Morgenson, “Lending Magnate Settles Fraud Case,” New York Times,
October 15, 2010.
Paul Krugman, “Money for Nothing,” New York Times, April 26, 2009.
Paul Volcker, “Think More Boldly,” Wall Street Journal, December 4, 2009.
Finance Ethics: An Overview 25
17.
18.
19.
Robert Manning, Credit Card Nation: The Consequences of America’s Addiction
to Credit (New York: Basic Books, 2000).
Gillian Tett, Fool’s Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was
Corrupted by Wall Street Greed and Unleashed a Catastrophe (New York: Free
Press, 2009).
The remark is by former SEC Chairman Richard Breeden, which is quoted in
Kevin V. Salwen, “SEC Chiefs Criticism of Ex-Managers of Salomon Suggests
Civil Action Is Likely,” Wall Street Journal, November 20, 1991.
Chapter Two
Fundamentals of Finance Ethics
Ethics is concerned, in large measure, with conduct—by both individuals and
organizations. Ethical conduct involves doing what is right and not doing
wrong, fulfilling one’s duties or obligations (these mean the same), respecting
people’s rights, acting fairly or justly, and treating others with dignity. In addition to what we do, ethics is also about who we are, about our character and
about having integrity or virtue. Further, ethics deals with the evaluation
and justification of practices, states of affairs, institutions, and systems. For
example, is insider trading wrong? Is income inequality fair? Should corporations aim solely at shareholder wealth? Is capitalism the best economic system?
The language of ethics is rich and varied because of all that ethics attempts:
to prescribe, to evaluate, and to justify.
In approaching finance from an ethical point of view, it is necessary to have
some understanding not only of the language of ethical discourse but also of
the principles of ethical reasoning. At a minimum, we need to be able to
determine what is ethical conduct in finance and how financial activity ought
to be conducted. This is a matter not merely of identifying rules—which are
often contained in law and regulation, as well as in codes of conduct—but also
of understanding the reasons for these rules, the reasoning behind them. We
need to know, for example, what makes right conduct right? Unfortunately,
the desirable understanding of ethics for approaching finance is not easily
obtained, but a useful framework for ethics is available that should be sufficient for the discussion in the remainder of this book.
This framework considers, first, the ethics that governs market activity
when parties are merely in buyer–seller situations. A second part in this
Ethics in Finance, Third Edition. John R. Boatright.
© 2014 John Wiley & Sons, Inc. Published 2014 by John Wiley & Sons, Inc.
Fundamentals of Finance Ethics
27
framework addresses ethics when people and organizations are in certain roles
and relationships, which constitutes a substantial portion of financial activity.
One of the most common ethical problems in roles and relationships is conflict of interest, and so this chapter also contains an explanation of what are
conflicts of interest, what is wrong with them, why they occur, and how they
can be managed.
A Framework for Ethics
No framework can possibly provide all that is needed for ethical understanding, but it is possible to approach ethics in finance, as well as ethics generally,
with a few key elements of ethical reasoning. Indeed, an understanding of
ethics and the ability to engage in ethical reasoning is part of human development; it is something that everyone learns by growing up in a culture. Ideally,
an ethical framework should simply express explicitly what we all understand,
at least implicitly. However, ethical reasoning can be done with greater or
lesser degrees of depth and validity. The first step in applying any framework
is recognizing the presence of an ethical issue and, then, identifying the ethical
element in this issue. This first step can be achieved with a checklist of six key
elements that indicate the presence of an ethical issue. This discussion is followed with a division of ethics into, first, the ethics of the market and, second,
the ethics of roles and relationships.
The elements of ethics
Although ethics is complex, its main elements can be broadly sketched. Virtually the whole of ethics can be easily understood by means of six familiar
concepts. Identifying these elements may be only the beginning of a long,
difficult ethical inquiry, but at least they are useful starting points.
First, ethics invariably involves some impact on people’s welfare. We generally feel that it is a moral matter to avoid inflicting harm on others, as well as
to relieve suffering when it occurs; we also believe that morality is related
somehow to the promotion of people’s welfare by providing some benefit,
which is the opposite of harm. Indeed, the moral theory of utilitarianism is
often expressed as “the greatest good for the greatest number,” with “good”
understood in terms of pleasure and pain. Although the infliction of harm is
not always wrong, it often is, and, in any event, it always requires some justification. So whenever a course of action or a state of affairs bears on people’s
welfare, one should be alert for the presence of ethical issues.
28 Fundamentals of Finance Ethics
Second, much of ethics consists of having a duty or an obligation to act in
certain ways (these concepts are generally interchangeable). Whenever one
recognizes a duty or an obligation, or is in situations in which is it appropriate
to speak of what ought to be done or what it is right to do, ethics is somehow
involved. Of course, it may be difficult to determine what duty requires or
what one is obligated to do, but the presence of ethics is usually undeniable.
Third, the concept of rights is prominent in ethics. We often speak of human
rights, which are fundamental moral requirements, and we decry their violation. The United Nations Universal Declaration of Human Rights and the Bill
of Rights in the US constitution are familiar examples. Also commonly recognized are employee rights, customer rights, shareholder rights, and so on.
Rights are also conferred by agreements and contracts, for example, as when
a lender claims a right that a borrower repay a loan. Rights are thought by
many to be correlated with duties so that they are two sides of the same coin.
Thus, if people have a right of free speech, for example, then others have a
duty not to interfere with people’s speech. One especially important right is
freedom or liberty, which might deserve to be treated separately as a basic
moral concept.
Fourth, the concepts of fairness or justice are often at issue in matters of
ethics. In finance, we often speak of fairness in market exchanges, of fair
competition, of the fair treatment of investors, and the like. Not only may
individual actions be assessed for fairness or justice, but the concepts are also
used to evaluate practices and institutional arrangements, such as the fairness
of high executive compensation or the justice of the tax system. Equality is
also an important concept in ethics that is closely related to fairness or justice
inasmuch as we often consider unequal treatment to be unfair or unjust. There
is much discussion in economics and finance of the equity/efficiency trade-off,
in which equality and welfare come into conflict.
Fifth, honesty might be regarded as a duty or obligation—we ought to tell
the truth, for example—but it is important enough, especially in finance
ethics, to be recognized separately. Honesty is essential in market exchanges
when a buyer and a seller each make representations to the other, and much
of finance involves the reporting of information, which should be accurate,
complete, and reliable. Honesty is important in developing the kind of relationships that are essential in financial activity, and it is lost when fraud or
bribery occurs. Being honest is a basic moral requirement in finance as well
as other spheres of life.
Sixth, the concept of dignity expresses the fundamental moral requirement
that all people be treated with respect as human beings. This concept, too,
might be reduced to another, in this case rights: to respect the dignity of
others is to respect their rights. However, in addition to having rights, people
Fundamentals of Finance Ethics
29
should be recognized as autonomous moral agents with the freedom to pursue
their own ends. This autonomy is violated when people are subjected to
humiliation, violence, coercion, degradation, or enslavement. Less serious
violations of people’s dignity occur when they are treated merely as means to
our own ends.
With these six concepts in mind, we can identify and address the ethical
issues in any situation. The key elements of ethics can be expressed as six
questions:
1.
2.
3.
Welfare: Is anyone being harmed, and if so, can the harm be justified?
Duty: What is my duty or obligation in this situation?
Rights: Are anyone’s rights being violated, and if so, can the violation be
justified?
4. Justice: Is everyone being treated fairly or justly?
5. Honesty: Am I being entirely honest in my actions?
6. Dignity: Am I showing respect for all persons involved?
These six questions express the basic elements of ethics in general, no matter
the area of application. These elements need to be specified in greater detail
to apply to the ethical issues in finance.
One distinctive feature of financial activity is that it is conducted in markets
between buyers and sellers, as well as in firms. Markets and firms are the two
main venues for financial activity. Market participants make exchanges at
arm’s-length, solely with a view to their own interests. Although markets often
have a win–win outcome, they can also create large winners and losers.
Markets of all kinds create opportunities for gain at other’s expense by exploiting any mistakes or merely by making winning bets. Firms, by contrast, are
cooperative ventures, in which people are organized for productive activity by
means of hierarchies, which are structured orders of roles and relationships.
In firms, people act not as traders—entering into exchanges or transactions
with a view to maximizing their own gain—but as role players with responsibilities, performing their assigned tasks and submitting to the authority of a
superior.
Despite the occasional ruthlessness of market activity, there is still an
ethics of the market that is binding on all participants. Not all is ethical in
market transactions, and market actors are prohibited, by both ethics and
law, from engaging in certain practices. When people occupy roles and enter
into relationships, they have removed themselves from markets and assume
yet other ethical obligations. This is especially true when people operate
in firms, although roles and relationships exist outside of firms as well as
within them.
30 Fundamentals of Finance Ethics
Markets and firms
The next step in developing a framework for ethics in finance is understanding
the ethics of the market that governs the activities of mere buyers and sellers,
followed by a discussion of firms.
Markets
Markets are exceedingly useful mechanisms that also have a substantial moral
justification. In a typical market exchange between a buyer and a seller, each
party gives up something of value in return for something that he or she values
more. In theory, both traders leave a market better off than they came—or
at least no worse off—because of the voluntary character of the exchange.
That is, market participants make exchanges voluntarily, without any force
or coercion, and, by assumption, no traders would voluntarily make themselves worse off. (Of course, market exchanges are based on each party’s
judgment of value at the time, which may later change or not meet expectations.) In market exchanges, the participants act solely out of self-interest,
each seeking to get the best deal or the greatest advantage for themselves.
However, any gain to one party is achieved with the voluntary consent of
the other, who is similarly self-interested and who may also benefit from the
transaction.
The moral justification of markets is based on the twin considerations of
welfare and rights. First, the welfare enhancing feature of market exchanges is
assured when not only individuals but the whole of society benefits from a
system of voluntary transactions. In economic terms, every market exchange
is a Pareto improvement—in which at least one party is better off and no
one is worse off—and eventually free trading should lead to a Pareto optimum—
which is a state in which no trades remain that will make anyone better off
without making at least one person worse off.1 (These terms were developed
by the Italian economist Vilfredo Pareto, who lived 1848–1923.) Furthermore,
in the larger economy, when business decisions are made in a market with
accurate prices, the result is maximal efficiency (which may be defined as the
greatest output for the least input). Maximal efficiency also leads to increased
welfare in society since all resources are put to their most productive uses,
leading to an abundance of goods and services.
Second, markets are further justified because they enhance freedom or
liberty. Market exchange presupposes property rights inasmuch as each party
in an exchange gives up the ownership of something of value and transfers
right of ownership to the other party. Property rights themselves are of moral
importance because they secure the use of resources for our own welfare. For
example, a farmer who owns a plot of land can cultivate it and thereby feed a
Fundamentals of Finance Ethics
31
family—and the farmer can also sell some of the produce in exchange for other
goods. Ownership rights confer freedom or liberty not only by enabling
people to provide for their own needs without dependence on others but
also by giving them power to counter that of the state. Historically, the
development of private property has been instrumental in the creation of
free, democratic societies, which consist of citizens with independent power
instead of powerless subjects, like serfs under feudalism.2 In addition, part of
the value of owning property is the freedom or liberty to exchange it advantageously for other property in order to increase one’s welfare. The feature of
property whereby it can be sold or transferred is alienability. Not all property
has this feature, but the alienability of property clearly adds greatly to its
owner’s freedom or liberty.
Firms
A business firm or corporation is an organization that brings together many
different groups—most notably managers, employees, suppliers, customers,
and, of course, investors—for the purpose of providing some product or
service. The nature of this entity, the firm or business corporation, can be
understood from many different perspectives, including economics and law.3
In economics, neoclassical marginal analysis regards the firm as a profitmaximizing unit, and for the purposes of economics there is no need to
inquire into its internal workings. It might as well be viewed like the sole
proprietor of a business. As the entry on the theory of the firm in the New
Palgrave dictionary of economics observes: “If firms maximize, how they do
it is not of great interest or at least relevant to economics.” The marginalist
theory has been challenged in economics, however, by behavioral and
managerial theories of the firm, which are based on the operation of actual
corporations, in which the functioning parts must be considered.4
Legal theorists have also developed theories of the firm in order to answer
the many puzzling questions that arise in corporate law. Debate rages to this
day over the nature of the corporation: Is the corporation the private property
of the stockholders who chose to do business in the corporate form, or is the
corporation a public institution that is sanctioned by the state in order to
achieve some social good?5 On the former view (which may be called the
property rights theory), the right to incorporate is an extension of the property
rights and the right of contract that belong to everyone. Because the right to
incorporate is alleged to “inhere” in the right to own property and to contract
with others, this view is also known as the inherence theory. The latter view
(let us call it the social institution theory) holds that the right to incorporate
is a privilege granted by the state and that corporate property has an inherent
public aspect. The view that incorporation is a privilege “conceded” by the
32 Fundamentals of Finance Ethics
state in order to achieve some social good is also known as the concession
theory.
The original form of the modern corporation was the joint-stock company,
in which a small group of wealthy individuals pooled their money for some
undertaking that they could not finance alone. The property rights theory
would view this corporate form of business organization as an extension of
the property rights and the right of contract enjoyed by everyone. Just as
individuals are entitled to conduct business with their own assets, so too have
they a right to contract with others for the same purpose. Because they jointly
own the common enterprise, they are entitled to receive the full proceeds, as
though it were a business conducted by one person alone. However, the fact
that the earliest joint-stock companies were also special grants that kings
bestowed on favored subjects for specific purposes fits the social institution
theory. Incorporation is possible today only because the state allows this form
of business organization to exist, in part because of its contribution to the
public welfare. Further, the right of the state to regulate business for the public
benefit is based, partially, on a view that corporate property is “affected with
a public interest.”6 Thus, corporations are not wholly private; they fill some
public role.
However, the premise of the property rights argument that shareholders
are the owners of a corporation was challenged in 1932 in a book that profoundly changed all thinking about corporate governance. That book was
The Modern Corporation and Private Property, by Adolf A. Berle Jr and Gardiner C. Means, which documented a dramatic shift that had occurred in
American business.7 The dispersion of stock ownership in large corporations
among numerous investors with little involvement in corporate affairs, combined with the rise of a professional managerial class that exercised actual
control, had resulted in a separation of ownership and control, with farreaching implications. In particular, the separation of ownership and control
changed the nature of corporate property as well as the ownership rights of
shareholders.
Strictly speaking, property is not a tangible thing like land but a bundle of
rights that defines what an owner can and cannot do with a thing, such as a
piece of land. Shareholders provide capital to a corporation in return for
certain rights, such as the right to vote and to receive dividends. However, full
ownership involves control over property and an assumption of responsibility,
both of which shareholders have relinquished. By doing so, shareholders of
large, publicly held corporations have ceased to be owners in the full sense
and have become one among many providers of the resources needed by a
corporation. Because of the separation of ownership and control, managers
have assumed the position of trustee for the immense resources of a modern
Fundamentals of Finance Ethics
33
corporation, and in this new position, they face the question: For whom are
corporate managers trustees? Managers, they observe, “have placed the community in a position to demand that the modern corporation serve not alone
the owners . . . but all society.”8
Although the separation of ownership and control documented by Berle
and Means undermined the property rights theory, a fully developed social
institution theory did not replace it. Instead, a conception of the corporation
as a quasi-public institution emerged, in which managers have limited
discretion to use the resources at their command for the good of employees,
customers, and the larger society. In a world of giant corporations, managers
are called upon to balance the interests of competing corporate constituencies,
and in order to fill this role, they developed a sense of management as a
profession with public responsibilities. Managers ceased being the exclusive
servants of the stockholders and assumed the mantle of public-spirited leaders.
The theory of the firm that is prevalent in modern finance is the contractual
theory, according to which a firm is viewed as a nexus of contracts among all
corporate constituencies. On this theory, different groups, including investors,
employees, suppliers, and customers, each contract with a firm to supply some
needed resource in return for some benefit. The manager’s role in the nexusof-contracts firm is to coordinate the vast web of mutual agreements. The
contractual theory of the firm stands in sharp contrast to the social institution
theory, in which the corporation is sanctioned by the state to serve the general
welfare. In contrast to the property rights theory, which it more closely resembles, the contractual theory does not hold that the firm is the private property
of the shareholders. Rather, shareholders, along with other investors, employees, and the like, each own assets that they make available to the firm. Thus,
the firm results from the property rights and the right of contract of every
corporate constituency and not from those of shareholders alone.
The contractual theory of the firm originated in the work of the economist
Ronald Coase.9 One of Coase’s many insights is that firms exist as less costly
alternatives to market transactions. In a world where market transactions
could occur without any costs (what economists call transaction costs), economic activity would be achieved entirely by means of contracting among
individuals in a free market. In the actual world, the transaction costs involved
in negotiating and enforcing contracts can be quite high, and some coordination can be achieved more cheaply by organizing economic activity in firms
through hierarchies. Thus, there are two forms of economic coordination—
markets and firms, which operate by exchange and hierarchy respectively—and
the choice between them is determined by transaction costs.
In the Coasean view, the firm is a market writ small in which parties with
economic assets contract with the firm to deploy these assets in productive
34 Fundamentals of Finance Ethics
activity. Generally, an individual’s assets are more productive when they are
combined with the assets of others in joint or team production. Individuals
will choose to deploy their assets in a firm instead of the market when the
lower transaction costs of a firm combined with the benefits of team production yield them a higher return. Deploying assets in a firm involves some risks,
however, when those assets are firm-specific, which to say that they cannot
easily be withdrawn and redeployed elsewhere. Firm-specific assets enable any
group—including employees, customers, suppliers, and investors—to gain
greater wealth, but this wealth can also be appropriated by the firm itself. Thus,
these groups will make their firm-specific assets available to a firm only with
adequate safeguards against misappropriation. A major challenge in a nexusof-contracts firm, then, is forming contracts that provide not only a return
but also adequate protection for it.
Market ethics
Since all market exchanges occur, at least in theory, with the voluntary consent
of two parties, one might ask how it is possible for one party in a transaction
to wrong the other, or indeed anyone. It has been argued that a world in which
all activity took place in perfect markets—with everyone interacting solely by
means of mutual consent—would have no need of morality. Such a world
would be a “morally free zone.”10 Valid or not, this argument rests on the critical assumption of perfect markets, and so certainly one role for morality is to
provide guidance when markets are imperfect—as they often are.11
Force and fraud
In a perfect market, there is no place for force or coercion since, by definition,
each party freely consents to every exchange. Any forced exchange, where
a person is threatened with violence for not making a trade, is not really a
market transaction at all but a case of theft or expropriation, which is a moral
wrong in any context. (A gunman in an alley who says “Your money or your
life” is not engaging in market activity despite the offered trade, and the same
is true for making the proverbial “offer that cannot be refused.”) Of course, a
person can obtain goods without force by merely stealing unawares, but this,
too, is a moral wrong that scarcely constitutes market activity.
Coercion is commonly defined as inducing a person to choose an undesirable alternative under some threat, and such an action is not necessarily wrong
as long as no right is violated.12 For example, a bank that threatens to foreclose
on a loan unless payment is made may force a borrower to seek funds elsewhere, but the bank is within its rights to make this threat. The borrower may
be coerced into repayment, but no right is being violated. Wrongful coercion,
Fundamentals of Finance Ethics
35
which, on this analysis, involves some violation of a right, is like theft in being
a recognized moral wrong. Thus, one rule of market ethics, addressing both
force and coercion, is “Do not steal!”
Every market exchange involves the making of a promise or an agreement
or a contract to act in certain ways, and so both parties in a transaction
have a duty or obligation to act as promised or agreed. For a seller, this
includes the delivery of the promised good, while the buyer is committed to
making the agreed-upon payment. Failure to do either is a moral wrong that
violates the common norms “keep your promises” and “abide by agreements
made.” Since every market exchange can be viewed as a kind of contract,
failure to act as required may be called a breach of contract, which is also a
moral wrong. All of these wrongs can be addressed by the simple moral rule
“Keep your promises.”
In a perfect market, no party would lie to the other about what is being
given up or offered in an exchange. Such lying may consist of concealment or
a failure to disclose certain facts that are relevant to an exchange or, worse,
misrepresenting these facts. Lying of this kind in a market transaction is commonly called fraud, which may be defined as a material misrepresentation that
is made with an intent to deceive and that causes harm to a party who reasonably relies on it. For example, when the seller of a house cleans up the sawdust
from termite activity, fails to disclose the problem, and, further, denies the
existence of any infestation, the result may be a bad deal for the buyer, who
may then own a house that is worth less than expected. When lying occurs in
market exchanges, not only may a trade fail to produce an overall benefit for
both parties (which is an important virtue of markets), but one party commits
a wrong against the other because of the common moral prohibition against
lying. As everyone knows, it is wrong to tell a lie.
Of course, difficult questions arise about what information each party to
an exchange is morally obligated to disclose and what constitutes a falsehood
or a material misrepresentation. A seller of a home has an obligation to disclose important defects that are not readily apparent, but the buyer may also
be reasonably expected to exercise some level of care in discovering other
problems with the property, perhaps by engaging his or her own inspector.
Moral blame and legal guilt for fraud may also hinge on whether a person
knew that a statement was false and had an intent to deceive, and also on
whether the other party relied on the information and suffered a loss as a
result.
Closely related to fraud is manipulation. This occurs most commonly in
securities trading when investors attempt to move the price of a stock in order
to profit from the change. For example, in a classic “pump and dump” scheme,
investors boost the price of a stock by aggressive buying and then selling when
36 Fundamentals of Finance Ethics
other investors jump in, after being deceived by the inflated price. Manipulation differs from fraud in that there is no misrepresentation of a material
fact; rather, investors are deceived by the manipulated appearance of the facts.
The sharp dealings that occur in finance, especially in securities trading, constantly test the boundaries of moral and legal permissibility, and accusations
of fraud and manipulation are frequent. Nevertheless, there are lines in both
ethics and law about the disclosure and representation of information that
ought to be observed. The simple moral rule in such matters is “Tell the truth”
or “Don’t lie!”
Wrongful harms
Market actors are prohibited, both morally and legally, from harming others
in violation of their rights. The three cases considered so far all involve rights,
which are violated in market exchanges when force is applied, promises are
not kept, and lying occurs. Legally, these are matters of contract law. Market
participants have many other rights, including protection from defective
products, hazardous working conditions, racial and sexual discrimination,
invasion of privacy, and so on. Violations of these other rights are generally
the subject of tort law, which is concerned with compensation for wrongful
harms—that is, when people are harmed by the wrongful acts of others. Not
all harm is wrongly inflicted; what makes a harm wrongful is usually the violation of some right.
For example, when a bank sells a product, such as a loan, it has the same
moral duty as a manufacturer to exercise due care to ensure that the product
is not defective in any way. (On this duty, the law is less stringent, as Elizabeth
Warren complained in observing that it is impossible to buy a toaster that
might burst into flames and burn down a house, while one can buy a mortgage
with the same chance of putting a family out on the street.13 The newly created
Consumer Financial Protection Bureau is intended to remedy this defect in
the law.) Arguably, a mortgage that can cause great loss to a homeowner is a
defective product for which a bank should be held responsible, both morally
and legally. Similarly, cases in which banks failed to maintain proper records,
which has caused great hardship to mortgage holders in foreclosure proceedings, are examples of negligence or a failure of due care that violated people’s
rights. The moral rule that is applicable to cases of wrongful harm is “Respect
people’s rights!”
Market failures
The final area where wrongs can occur in markets involves market failure. This
encompasses a broad set of factors, much studied in economics, which prevents markets from functioning with maximum efficiency. Because of market
Fundamentals of Finance Ethics
37
failures, the ability of markets to secure welfare and rights may also be
impaired. Some market failures result when the conditions of perfect markets
are lacking, such as perfect information and perfect rationality. If buyers
and sellers are poorly informed about the goods being exchanged or cannot
process the information they have, then a market outcome may not increase
either welfare or rights. Similar results may obtain if markets lack perfect
competition, which occurs, for example, in the presence of monopolies and
anticompetitive trading practices.
Another kind of market failure is the well-known feature of markets to
neglect public goods and to favor private over public consumption. By definition, a public good is one that can be consumed by everyone with no one
excluded. Examples of public goods include roads and parks, which are open
to everyone and from which no one can be easily excluded. If an attempt were
made to charge for public goods, those who could not be excluded would
become free riders, benefitting unfairly from other’s payment. Since public
goods cannot be packaged and sold for exclusive use by one person, like
toothpaste, there is no profit to be gained, and so these goods are ignored by
markets and usually left for government to provide, if indeed they are provided at all.
A major source of market failure is the presence of externalities or spillover
effects, which are costs to society that result from economic production.
Pollution is a classic example. In economic theory, all costs of production are
assumed to be borne by the producer and factored into the price of a product.
When a resource, such as clean air or water, is used in production without
any cost to the producer and returned in a polluted state, the cost of the
damage is left to be borne by society. The result is not only a misallocation of
resources that would otherwise be corrected by the price system but also a
distortion in the distribution of costs and benefits of production. If the cost
of using air or water were internalized by being factored into the price of a
product, then producers would consume these resources more cautiously,
and the cost would be borne by those who benefit and not shifted (unfairly)
to others.
Finally, market failures occur in cases of collective choice. In a market
system, many choices for the whole of society result from the aggregation of
all the choices made by individuals in discrete market exchanges. Economic
theory assumes that when individuals make choices that are rational for themselves, the outcome of all these choices is always a rational social choice. The
falsity of this assumption is illustrated by an example known as “the tragedy
of the commons.”14 It may be rational for individual herders to graze as many
sheep as they can on pasture that is owned by everyone (a commons) since
any effort by one or a few herders to limit their own use of the land would be
38 Fundamentals of Finance Ethics
offset by other herders, who simply would put more sheep into the vacated
portion of the pasture. The rational collective choice would be for each herder
to limit the number of sheep that herder grazes on the commons. However,
if a collective choice is made only by individual herders considering what is
rational for themselves without any ability to control the choices of others,
then the commons will be destroyed, which is an irrational collective choice.
Market failures can be addressed by many means. Much of the legal regulation of business is concerned with these defects or imperfections in markets.
For example, disclosure laws of various kinds and antitrust and fair competition laws attempt to secure the conditions of perfect information and perfect
competition respectively. Ethics also has a role to play, although it is difficult
to formulate simple rules like those for other components of market ethics.
The best that can be done is perhaps “Contribute to efficient markets and do
not take undue advantage of the opportunities provided by market failures.”
Finance consists of more than buying and selling in markets. People
engaged in financial activity also enter into roles and relationships that entail
specific duties or obligations and also confer some rights. Despite the importance of markets in finance, finance ethics is, to a great extent, the ethics
of roles and relationships with their corresponding duties and rights. Two of
the most important roles and relationships in finance are those of agent and
fiduciary, and these moral categories constitute a large part of finance ethics,
along with the ethics of the market. A framework for ethics in finance consists, then, of two parts: an ethics of the market and an ethics of roles and
relationships.
Roles and relationships
When a person or an organization is in a purely market situation, dealing with
another party merely as an arm’s-length buyer or seller, self-interest holds
sway, and tough bargaining and sharp dealing are ethically and legally
permissible—within the limits of market ethics. However, much financial
activity involves individuals and organizations assuming roles and entering
into relationships in which market ethics still applies but which entail further
duties or obligations that limit and often preclude self-interest. These roles and
relationships are essential for finance inasmuch as many goals could not be
achieved solely in markets but require a high degree of cooperation and
coordination.
Much of the skill and knowledge possessed by people in finance can be put
to productive use only by serving others. A financial adviser, for example,
would make a poor living without clients to advise. Many of the financial
functions served by banks, mutual funds, insurance companies, and the like
Fundamentals of Finance Ethics
39
require large organizations that could not function merely through market
activity. Indeed, a bank, for example, can be understood as a complex of roles
embedded in relationships. When a bank agrees to make payments from a
customer’s checking account, it becomes an agent for the customer, and in
safeguarding deposits in a savings account, the bank serves as a fiduciary. A
bank also serves an important intermediary function by channeling customers’ deposits into loans for borrowers.
One feature of roles and relationships is that they are voluntarily assumed:
one typically occupies a role or enters into a relationship by making an agreement, often in a market. For example, when a financial adviser agrees to serve
a client, both parties cease to be merely market participants, dealing with each
other in a pure buyer–seller situation. The adviser becomes a trusted counselor
with a duty to serve that client’s interests without regard for his or her own—
within the limits of the agreement, of course. For this selfless service, the
financial adviser is compensated, and part of this compensation is to induce
the adviser to act on the client’s behalf. Furthermore, the agreement to become
an adviser is itself made in a market in which the adviser may rightly consider
his or her self-interest.
The key point about roles and relationships is that by making an agreement
in a market, the parties in question take themselves out of the market and now
conduct their activities not merely on the basis of the ethics of the market but
in accord with a new set of duties or obligations that belong to—indeed, are
created by—these new roles and relationships. In general, the duties or obligations of roles and relationships are whatever the two parties have agreed on.
Thus, a financial adviser agrees to provide certain services to a client, which
may vary considerably. No financial adviser would be ethically permitted to
steal from a client; this would violate a rule of market ethics. However, the
amount of time spent and the level of care exercised may rightly depend on
the agreement made—on how much service the client is “buying” from the
adviser.
As an illustration, some financial advisers are compensated solely by a
fee, while others depend on commissions from the client’s investments. Feefor-service advisers are free from conflicts—they derive no benefit from
recommending one investment over another—while commission-based advisers have an incentive to recommend investments with higher commissions,
which might not be in the client’s best interests. Either compensation system
is ethical as long as the method of compensation is understood and accepted
by both parties. Further, the choice between the two methods can be left to
the choice of the two parties. That is, it is subject to their agreement.
The two most common roles in finance and business generally are those of
agent and fiduciary, which each carry certain duties or obligations. Some
40 Fundamentals of Finance Ethics
people in finance are also professionals, who, like physicians and attorneys,
have special duties that belong to these roles. Although there are some standard duties or obligations of agents, fiduciaries, and professionals, there is also
a great deal of variation and context-specificity to the ethics of roles and
relationships.
Agents, Fiduciaries, and Professionals
An agent is a party that has been engaged to act on behalf of another, called
the principal. Typically, an agent is engaged by a principal to act in place
of the principal at the principal’s direction. The agent may be an individual,
such as a real estate agent, or an organization, such as a real estate agency.
Employees are generally agents of an employer. A fiduciary is a person
or organization that has been entrusted with the care of another’s property or
assets and that has a responsibility to exercise discretionary judgment in this
capacity solely in this other person’s interest. The other person in a fiduciary
relationship is described as the beneficiary. Common examples of fiduciaries
are trustees, guardians, executors, and, in business, officers and directors
of corporations. Both agency and fiduciary relationships are ubiquitous in
finance because of the need to employ specialized services and to safeguard
people’s assets.
The concepts of agent and fiduciary are very closely related and often
overlap. Thus, directors are often held to be fiduciaries for the corporation and
its shareholder and also their agents. In general, the duty of an agent to act in
the interest of a principal is not as inclusive as the duty of a fiduciary. For
example, the duty of a broker who is acting merely as an agent in the sale of
securities is usually narrower than that of a broker who is acting as a fiduciary
in managing a client’s portfolio. Thus, an agent-broker may not have an obligation to advise against an unwise trade that he or she is asked only to execute,
but a broker-adviser, acting as a fiduciary, would have such an obligation. The
difference between the two cases is the scope of the engagement—which is
to say, the range of services that the client seeks and the broker has agreed to
provide.
Moreover, the duty of a fiduciary is usually more stringent than that of an
agent. Generally, failure in the performance of a fiduciary duty is considered
to be a greater moral wrong than the failure to fulfill the duty of an agent or
of a mere participant in a market exchange. As Justice Benjamin Cardozo
famously observed “Many forms of conduct permissible in a workaday world
for those acting at arm’s length, are forbidden to those bound by fiduciary ties.
A trustee is held to something stricter than the morals of the marketplace. Not
Fundamentals of Finance Ethics
41
honesty alone, but the punctilio of an honor the most sensitive, is the standard
of behavior.”15
Need for agents and fiduciaries
Agency relationships arise from the need to rely on others for specialized
knowledge and skills. For example, selling a house requires considerable
knowledge and skill, as well as time, and so a seller may engage a real estate
agent to act on the seller’s behalf, doing what the seller would do if that person
had that person’s knowledge and skills. An agent thus becomes an extension
of the principal, acting in the principal’s place, with a duty to use his or her
abilities solely for the principal’s benefit. An agent can also be authorized to
affect a principal’s legal relationships. For example, an authorized agent may
enter into contracts that bind a principal. An insurance agent, for example, is
an agent of an insurance company, not of the client, and sellers of policies
(who are often independent contractors rather than employees of the insurer)
become agents of the insurance company because of their legal power to
commit the company in selling a policy. A person may also become an agent
because of the potential to expose another to legal liability. Thus, a truck driver
for a company is made an agent, subject to the employer’s direction, because
the employer might be held liable for the cost of an accident.
Fiduciaries provide a valuable service for individuals who are unable for
some reason to manage their own property or assets. Thus, a person saving
for retirement might prefer that the assets in a pension fund be managed by
a professional manager, who assumes the role of fiduciary. The executor of an
estate, who is a fiduciary, distributes property and assets in accord with a will
that the deceased person wrote but is unable to implement. Similarly, the
trustee of a trust for a minor child manages the trust in place of the person
who created it but can no longer exercise control. Shareholders elect directors
as their representatives with a fiduciary duty to manage a corporation in their
interest when they choose not to manage the corporation themselves (which
is typically the case in the modern corporation that features a separation of
ownership and control). In all these cases, control over property or assets is
delegated to a trusted party who has a duty to exercise this control for the
benefit of others.
Duties of agents and fiduciaries
Broadly, the duty of an agent is to act as directed by the principal with competence, diligence, and care. For example, employees as agents of employers
have assigned tasks with a duty to complete these tasks as directed. Often, it
42 Fundamentals of Finance Ethics
is not possible for a principal to specify in detail the expectations for an agent.
Indeed, agents are typically engaged because they know better than the principal what should be done and how it should be done. The duties of an agent,
as well as of a fiduciary, tend to be open-ended. That is, the specific acts that
are to be performed are not fully specified in advance, and agents and fiduciaries have wide latitude or discretion in the choice of means to advance the
interests of others. Agency and fiduciary duties serve as means to ensure that
this discretion is properly exercised.
Aside from a positive duty of an agent to act in the interest of another, there
is a negative duty to avoid advancing personal interests in the relationship. It
would generally be a violation of an agent’s duty, for example, to use the principal’s property or information for personal gain. An example of personal
advantage-taking in an agency or a fiduciary relationship is self-dealing, as
when a director or executive buys some asset from the company or sells something to it, unless it can be shown that the transaction is fair and would have
occurred at arm’s-length. Insider trading or other personal use of confidential
information gained in an agency or a fiduciary relationship is another violation of a duty. It is also wrong for a fiduciary to gain some personal benefit,
even if the beneficiary is not harmed, because the fiduciary would no longer
have an undivided loyalty. In general, the duty of a fiduciary is to act solely in
the interest of the beneficiary within the scope of the relationship without
gaining any material benefit except with the knowledge and consent of the
beneficiary.
A fiduciary relationship has two elements: trust and confidence. Something
is entrusted to the care of a person with the confidence that proper care will be
taken. A fiduciary relationship can be created by a contract, as when one person
(called a trustor) creates a trust and another agrees to be a trustee who manages
the trust. However, a fiduciary relationship, with its attendant duties, can be
imposed by legislation. For example, the law governing pensions makes any
pension fund manager a fiduciary for the intended beneficiaries, and corporate law makes officers and directors fiduciaries of the corporation and its
shareholders. More specifically, the elements of fiduciary duty are candor, care,
and loyalty.
1. Candor. In a market, everyone has an obligation of honesty or
truth-telling. It is wrong to say something false or to make a material
misrepresentation. However, market actors are not required to disclose all
information that others might want to know. A fiduciary, on the other
hand, has a duty of candor—that is, a more extensive obligation to disclose
information that the beneficiary would consider relevant to the relationship. Thus, it would be violation of a fiduciary duty for an attorney or an
investment banker to conceal important, material information from a
Fundamentals of Finance Ethics
43
client (unless doing so would violate a duty to another party). Similarly,
the director of a company would fail in a fiduciary duty by remaining
silent about a matter that is critical to a decision under discussion.
2. Care. When property or assets are entrusted to a fiduciary—the trustee
of a trust, for example—that person should manage what is entrusted with
due care, which is the care that a reasonable, prudent person would
exercise. Although an extraordinary level of care may not be required, a
fiduciary is expected not to act negligently. Although market actors also
have a duty of due care with respect to certain matters, this obligation
governs only how the party conducts a chosen activity and not the activities that are chosen. For example, a manufacturer should exercise due care
in the design and assembly of its products, but it has no responsibility of
due care in the products it chooses to manufacture. A fiduciary, by contrast, has a duty to act in all matters with a high level of care.
3. Loyalty. A duty of loyalty has two aspects: it requires a fiduciary to act in
the interest of the beneficiary and to avoid taking any personal advantage
of the relationship. In a market transaction, there is generally no obligation to serve the interests of another except to make good faith efforts to
abide by the contracts made; gaining some personal advantage is the
whole point of entering into a market transaction. In general, acting in
the interest of a beneficiary is acting as the beneficiary would if that
person had the knowledge and skills of the fiduciary. Taking personal
advantage, by contrast, is deriving any benefit from the relationship
without the knowledge and consent of the beneficiary.
Another important duty of both agents and fiduciaries is to maintain confidentiality. The need for confidentiality arises from the fact that in order to
serve another’s interest, agents and fiduciaries must often have access to sensitive, privileged information, and this kind of information will generally be
revealed by those who have it only under a pledge of confidentiality, in which
the agent or fiduciary provides assurances that the information will be held
in confidence and used only for the purpose for which it was provided. Finally,
agents and fiduciaries, by virtue of their commitment to act in the interest of
some other parties, have a duty to avoid conflict of interest, since a conflicting
interest would interfere with their ability to serve this other interest.
The role of professionals
The conduct of physicians, lawyers, engineers, and other professionals is
governed by special professional ethics. Which occupations are professions
and which are not is a subject of much dispute. Historically, the three main
44 Fundamentals of Finance Ethics
recognized professions have been law, medicine, and the clergy, although in
recent years engineers, architects, healthcare providers, social workers, journalists, and realtors, among many other occupational groups, have claimed
professional status. Certainly, not all people in finance are professionals, but
some might rightly claim this status, especially those that provide specialized
services to clients, such as financial advisers and insurance underwriters.
Before we can determine whether anyone in finance is a professional, we need
to understand the criteria for a profession.
Three features of a profession are commonly cited:
1. A specialized body of knowledge. Professionals do not merely have valuable skills, like those of a plumber, but they possess a highly developed,
technical body of knowledge that requires years of training to acquire.
2. A high degree of organization and self-regulation. Professionals have considerable control over their own work, and, largely through professional
organizations, they are able to set standards for practice and to discipline
members who violate them.
3. A commitment to public service. The knowledge possessed by professionals serves some important social need, and professionals are committed
to using their knowledge for the benefit of all.
These three features are closely related and mutually reinforcing. It is
because professionals possess a specialized body of knowledge that they
are given a high degree of control over their work. For the same reason, we
leave it to professionals to determine what persons need to know to enter a
profession and whether they know it. There is a danger in giving so much
independence and power to professionals, but we have little choice if we are
to enjoy the benefit of their valuable specialized knowledge. Consequently,
professionals enter into an implicit agreement with society. In return for being
granted a high degree of control over their work and the opportunity to organize as a profession, they pledge that they will use their knowledge for the
benefit of all. Without this guarantee, society would not long tolerate a group
with such independent power.
The standards of a profession include both technical standards of competence and ethical standards. Ethical standards are generally presented in
a code of professional ethics, which is not only a mechanism for the
self-regulation of a profession but also a visible sign of the profession’s commitment to public service. A code of ethics is not an option for professionals
but something that is required by the nature of professionalism itself. Developing a code of ethics is often the first step taken by an occupational group that
is seeking recognition as a profession.
Fundamentals of Finance Ethics
45
Is finance a profession? Merely proclaiming an occupation to be a profession does not make it so, and so any group that lays claim to professional status
must provide a convincing rationale. The best case is made by financial planners and insurance underwriters, who provide highly technical services that
meet some important needs. Organizations such as the Institute for Certified
Financial Planners (which bestows the designation of Certified Financial
Planner on those who meet its standards) and the International Association
for Financial Planning have developed codes of ethics that include enforcement procedures. Members of each organization are required to subscribe to
the organization’s code of ethics, and they can be reprimanded, suspended, or
removed from membership for infractions. Organizations in the insurance
industry confer the designation Chartered Property Casualty Underwriter,
Chartered Life Underwriter, and Chartered Financial Consultant on their
members and have detailed codes of ethics. All of the codes stress the commitment of the profession to public service and profess such ideals as integrity,
objectivity, competence, diligence, and confidentiality, and they also address
the problem of conflict of interest.16
Conflict of Interest
Mark S. Ferber, a politically well-connected partner in the investment bank
Lazard Fréres, was selected to oversee the financing of a $6 billion project to
clean up Boston harbor with the power to recommend the firms that would
raise the money. In a secret agreement, Merrill Lynch, which obtained much
of the business, agreed to share the underwriting fees with Lazard Fréres, and
over a four-year period, the two firms split $6 million. In addition, Mr Ferber
received $2.6 million in retainer payments, while Merrill Lynch garnered millions more from other clients of Mr Ferber who were steered to the firm. An
SEC commissioner described the fee-splitting arrangement as outrageous and
declared, “I hire an investment adviser to give me prudent objective advice
and they have a financial incentive to skew the business to a particular party?
That’s troubling, and if I were a client, I’d have a fit.”17
Merrill Lynch and Lazard Fréres denied that the secret agreement was
improper or that they had any obligation to reveal it. Mr Ferber said, “I’m
not telling you it’s pretty. But there is no violation of my fiduciary responsibilities.”18 A federal judge disagreed and sentenced Ferber to 33 months in
prison, in addition to a $1 million fine and a lifetime ban from the securities
industry. Merrill Lynch and Lazard Fréres each paid $12 million to settle
charges brought by the SEC. In a parting shot, the judge chastised the firms
and their lawyers for creating an environment that fostered rampant graft and
46 Fundamentals of Finance Ethics
corruption. As for the obligation to disclose conflicts of interest, the judge
concluded, “And if this sorry lot of municipal bond attorneys do not understand it, let me spell it out: it is required that every potential conflict of interest
be disclosed in writing and in detail.”19
Financial services could scarcely be provided without raising conflicts of
interest. In acting as intermediaries for people’s financial transactions and as
custodians of their financial assets, financial services providers are often forced
to choose among the competing interests of others—and weigh those interests
against their own. Although personal interest plays some role, the conflicts of
interest in financial services arise primarily from attempts to provide many
different kinds of services to a number of different parties, often at the same
time. Conflicts of interest are built into the structure of our financial institutions and could be avoided only with great difficulty. As one person noted,
“The biblical observation that no man can serve two masters, if strictly followed, would make many of Wall Street’s present activities impossible.”20 In
addition, the inhabitants of Wall Street are motivated primarily by self-interest
and can be induced to serve any master only within limits. The challenge,
therefore, is not to prevent conflicts of interest in financial services but to
manage them in a workable financial system.
Defining conflict of interest
Although much has been written about the definition of conflict of interest,
the issues in the controversy over various definitions have little bearing on the
understanding of conflicts in the financial services industry.21 As a working
definition, the following is sufficient: “A conflict of interest occurs when a
personal or institutional interest interferes with the ability of an individual or
institution to act in the interest of another party, when the individual or institution has an ethical or legal obligation to act in that other party’s interest.”22
Conflicts of interest are inherent in financial services because of the ubiquitous
roles of agent and fiduciary, with their attendant duties to serve the interests
of others with whom another interest conflicts or interferes.
Three distinctions commonly made among conflicts of interest generally
are especially relevant to conflicts in the financial services industry. First is
the distinction between actual and potential conflicts of interest. An actual
conflict of interest occurs when an individual or institution acts against the
interest of a party whose interest that individual or institution is pledged to
serve, whereas a potential conflict of interest is a situation in which an actual
conflict of interest is likely to occur. Actual conflicts of interest generally constitute misconduct, but potential conflicts, while perhaps are best avoided,
may need to be tolerated as unavoidable features of certain situations.
Fundamentals of Finance Ethics
47
Second, a distinction is made between personal and impersonal conflicts of
interest. A conflict of interest is personal when the interest that actually or
potentially interferes with the performance of an obligation to serve the interest of another is some gain to an individual or an institution. Thus, a lawyer
who stands to benefit personally by acting against the interest of a client is in
a personal conflict of interest. However, the interfering interest may also be
another person’s interest that an individual or institution is duty bound to
serve. For example, a lawyer who has two clients with opposed interests also
faces a conflict of interest, which may be described as impersonal.23 This is the
classic “two masters” problem.24
Impersonal conflicts are more common in the financial services industry,
where firms have large numbers of clients. For example, if a broker, in managing a discretionary account, selects an inferior security because it generates
a higher commission, the broker is acting in a personal conflict of interest
by putting self-interest ahead of the client’s interest. However, a broker who
manages accounts for multiple clients may be forced to choose among the
interests of these different parties when he or she decides how to allocate a
security in short supply. Trust officers who manage multiple trust accounts
face similar conflicts. This kind of conflict also occurs for brokers and trust
officers in the utilization of market-moving information. Which accounts
receive the benefit of this information, and in what order? Mutual fund advisers may be forced to decide how to allocate investment opportunities between
various funds. The individuals who manage multiple accounts and funds have
an incentive to favor those that are more important to them personally or to
the firm, because these accounts belong to large customers, for example, or
because they generate higher fees and commissions. A mutual fund adviser
may allocate an especially profitable investment that is in short supply to a
lagging fund in order to boost its performance or to a high-performing fund
in order to gain even greater publicity.
In many situations, the obligations that are owed to different parties (who
may have competing interests) cannot all be fulfilled, in which case some
priority must be followed in allocating gains and losses. Not every account or
fund can receive a firm’s undivided loyalty of the kind we expect from individual lawyers, for example. Moreover, the standard solution for a lawyer with
an impersonal conflict of interest, namely to sever the relation with at least
one of two competing clients, is not available to a broker or trust officer, who,
of necessity, manages dozens, if not hundreds, of accounts, or to a mutual fund
company, which generally offers a variety of funds.
Third, a conflict of interest may be either individual or organizational.
Organizations as well as individuals act as agents and assume fiduciary
duties, and an organization can fail to serve the interests of a principal or the
48 Fundamentals of Finance Ethics
beneficiary of a trust even when no individual is at fault. For example, if a
trust officer in the trust department of a commercial bank learns that a corporate customer of the commercial bank is in financial difficulty, should he
or she be permitted or required to use that information in managing trust
accounts? On the one hand, a failure to use the information could result in
avoidable losses for the beneficiaries of those accounts, but, on the other hand,
use of the information would violate the confidentiality that the bank owes to
the corporate customer. One solution is to separate the trust and commercial
functions by implementing policies on information use or by constructing
“Chinese walls” to prevent the flow of information.
Because financial services are delivered primarily by institutions that
offer a multitude of services to multiple customers or clients, most of the
conflicts of interest in this area are potential, impersonal, and organizational.
They result from the deliberate design of our financial institutions and pose a
problem for those responsible for creating, regulating, and managing these
institutions.
Why conflicts occur in finance
Conflicts of interest are ubiquitous in finance because people and institutions
in this field so often act as agents and fiduciaries or otherwise commit themselves to act in the interest of other parties. Absent any such commitment a
conflict of interest cannot occur. Thus, parties in a purely buyer–seller relationship, who have no obligation to serve any interest but their own, cannot,
by definition, have a conflict of interest. For example, a trader for a hedge fund
cannot be in a conflict of interest situation in dealing with a trading partner
whose interest the trader has no duty to serve. However, a conflict of interest
could be present inasmuch as such a trader is acting on behalf of the hedge
fund itself and could acquire an interest that would interfere with the ability
to serve the interest of the fund and its investors. With respect to the fund,
but not the trading partner, the hedge fund trader is acting as an agent, with
an attendant duty to serve the fund’s interest.
In determining whether a conflict of interest is present, it is critical to
ascertain the role or relationship involved. Does one party indeed have an
obligation or duty to act in the interest of another? In the professions, such as
medicine and law, the answer to this question is easily answered because of
the nature of a profession. To be a physician or an attorney is to occupy a
professional role in which service to others is central. Once a physician accepts
a patient or an attorney accepts a client, there is a commitment to serve that
party’s interest exclusively. Since people in finance are usually not profession-
Fundamentals of Finance Ethics
49
als, and since the role or relationship is established by a contract, rather than
by the nature of a profession, the question about what is owed is more difficult
to answer. The duties of a physician are derived from what it means to practice
medicine, and similarly for the duties of an attorney. By contrast, the obligations or duties of people in finance are founded in a specific contract between
them to perform certain agreed-upon services. As a result, we cannot make
many generalizations about what constitutes conflicts of interest for financial
services providers, as we can for professionals. Judgments must be made on a
case-by-case basis.
With respect to an obligation or duty to serve the interests of another,
which is essential for the presence of a conflict of interest, there is another
difference between finance and the professions, such as medicine and law. In
finance, self-interest plays a large and legitimate role. Professionals typically
forgo all right to pursue their self-interest in the offering of their services; once
committed to a patient or a client, a professional ought to consider only that
other interest. (Of course, such professionals are well compensated for their
selfless service, and they may consider their self-interest in deciding whether
to assume a professional role.) Thus, people in finance typically operate at all
times as self-interested economic agents who legitimately engage in financial
activity on their own behalf, often while they are also serving as an agent or
a fiduciary.
For example, a commercial bank with a trust department may be a fiduciary
in the management of a corporation’s pension fund at the same time that it is
acting as a seller in making a commercial loan to the corporation. Similarly,
an investment bank might be an investor in a takeover for which it is also
raising the capital and thus be both an agent (in its financing activities on
behalf of the raider) and a principal (by being an investor on its own behalf).
Portfolio managers for mutual and pension funds are generally permitted to
trade for their own accounts, and in so doing they are not only fiduciaries for
the fund’s shareholders but also active traders, competing against them. The
potential for abuse in such situations is obvious.
In each instance, we might be able to separate the functions and require
those who are agents and fiduciaries to forgo all self-interested activities.
Some have suggested removing trust departments from commercial banks,
for example, or prohibiting fund managers from trading for their own account,
but such proposals for change are generally rejected on grounds of efficiency.
Since people in finance primarily enable others to make money, they cannot
easily be induced to employ their special money-making skills solely for other
people’s benefit. Persuading them to combine self-interested and altruistic
activities is perhaps the best that can be achieved.
50 Fundamentals of Finance Ethics
Examples of conflict of interest
The conflicts of interest in financial services are too numerous to list exhaustively, and they are even difficult to classify because of the range of activities.
However, a typology of conflicts of interest in finance might be obtained by
imagining a world of pure market transactions, where no conflicts of interest
can occur, and identifying the need for agents and fiduciaries and other roles
that involve a commitment to serve the interests of others, which creates the
conditions for conflicts to occur. If individuals conducted their financial affairs
as rational economic agents in a free market, there would be no conflicts of
interest because, by definition, each person in a market is legitimately pursuing his or her self-interest. No one has any obligation in a free market to serve
the interests of anyone else. There are plenty of competing interests in a free
market but no conflicts of interest. However, this world would be unsatisfactory for many reasons, and insofar as rational economic agents are free to form
contracts that advance their interests, they would do so. It is from this kind
of contracting in a free market that the conditions for conflicts of interest arise,
and from examining what contracts would be formed, the types of conflicts
can be determined.
In a free market, participants would create an array of financial instruments that impose obligations on both parties. For example, few people have
enough money saved to buy a home. Thus, instead of exchanging money for
a house in a single transaction, the buyer and seller might draft a mortgage,
which is a secured long-term loan. Similarly, a farmer and a mill owner might
seek to reduce the risk inherent in the grain market. A glut of grain at harvest
time would depress prices and possibly ruin the farmer, whereas a shortage
would raise prices to the detriment of the mill owner. Instead of waiting until
harvest time and exchanging at the market price, which is risky for both
parties, they might agree in advance to a futures contract for the delivery of
grain at a predetermined price. Mortgages and futures contracts solve two
critical problems at once, namely how to create long-term financial relationships and how to manage the risks that result from our lack of knowledge of
the future.
Financial instruments also create the need for a variety of financial intermediaries to handle the complex transactions between contracting parties.
More important, intermediaries are necessary because the parties may not be
able to contract face to face but may require the services of a third party. For
example, when a savings bank collects deposits from customers and lends
the funds to home buyers, the two parties never meet; their “transaction” is
mediated by the bank, which combines the functions of saving and lending.
Similarly, the farmer and the mill owner might act independently to protect
Fundamentals of Finance Ethics
51
themselves by operating through a futures market. Investment banks, serving
as underwriters, handle the many different tasks that are involved when a
corporation issues new securities, including the task of finding buyers for the
securities. Insurance companies enable large numbers of people to protect
themselves from risk by pooling premiums, which are then used to satisfy
claims.
In all these cases, financial intermediaries act as agents, performing transactions and other activities that require specialized skills that are employed
for the benefit of others. In so doing, they have an obligation to act in the
principal’s best interest. Thus, a broker has an obligation to achieve the best
execution of a trade, and a fund manager has an obligation to select brokers
who will provide the best execution. Both can be swayed by a personal or an
institutional interest to make decisions that result in less than the best execution. For example, if the trust department of a commercial bank allocates the
commissions for trades in trust accounts to brokerage firms that maintain a
customer relation with the bank—a practice known as reciprocation, or “recip”
for short—then the quality of the brokerage service might be compromised.
Even if a broker-customer provides the best execution, the bank has still used
its power to allocate brokerage commissions, which ought to be exercised
solely for the interest of the beneficiaries of the trust funds, in order to advance
the bank’s commercial interests. The bank might have been able to use this
power in some other way that would secure a benefit to the trust beneficiaries
instead of the bank itself.
Insofar as an intermediary is the custodian of funds, such as uninvested
cash in a trust or brokerage account, the intermediary is also a fiduciary.
Individual accounts often contain positive cash balances from the sale of
securities that have not been reinvested and from funds deposited in anticipation of purchases. Although the amount in each account is often small, the
aggregate amount is usually quite large. If the trust department of a commercial bank leaves uninvested cash in noninterest bank accounts, then the bank,
not the individual trust beneficiary, is benefited. Brokerage firms can also
deposit uninvested cash in interest-bearing accounts and claim the interest for
themselves, or they can leave it in noninterest accounts in order to gain some
other benefit from a bank. SEC Rule 15c-3 stipulates that uninvested cash can
be used only to provide some benefit to customers, such as providing funds
for purchases on margin and for short sales. However, trust departments and
brokerage firms need not credit accounts for any interest or other benefits
that they derive from invested cash. Brokerage firms defend these cash management practices on two grounds. First, funds left on deposit are for the
convenience of the customer and not the firm, which, in any event, could
derive greater income from the commissions generated by new investments.
52 Fundamentals of Finance Ethics
Second, the benefits they derive help keep their fees low, so that customers are
credited with the income, albeit indirectly.
Trust departments are in a position to advance the interests of the parent
bank in many other ways. For example, in managing trust accounts, a trust
department may buy the stock of important bank clients and hold it when it
would be prudent to sell. Trust departments may also cooperate with the
management of bank clients by voting proxies in favor of management and
by helping management defend against hostile takeovers. Such practices are
known as “customer accommodation.” In their other trust activities, such as
disposing of assets during probate, banks can serve or accommodate their
customers’ interests (and perhaps their own) in the sale of property or other
valuable assets. For example, a trust department may be required, in the
probate of an estate, to sell controlling interest in a company that had been a
bank customer. By selling the controlling interest to another bank customer,
a continued relationship is assured.
In addition to financial instruments, free-market participants would seek
to build financial markets, in which financial instruments could be issued and
traded. Securities, such as stocks and bonds, are sold first in a primary market
and then traded in a secondary market. A bond, for example, can be held to
maturity, but a holder may also wish to cash out of this investment, in which
case another buyer must be found. Mortgages can be exchanged between
institutions and even pooled to form mortgage-backed securities that trade in
markets. The liquidity of a financial instrument, which is the ease with which
it can be traded, adds to its value and reduces the risk of holding it—hence
the benefit of secondary markets. Many aspects of primary and secondary
markets, including the obligations of the various participants, are a matter of law,
specifically the Securities Act (1933) and the Securities Exchange Act (1934).
Securities markets are regulated by the Securities and Exchange Commission
(SEC). However, within the legal framework established by law, the obligations
of participants in financial markets are flexible and subject to negotiation.
Primary and secondary markets create many different specialized roles. A
major source of business for investment banks is the underwriting of new
issues of securities, including not only corporate stocks and bonds but also
initial public offerings (IPOs) of formerly private companies. Underwriting
itself consists of several distinct roles with accompanying obligations. An
underwriter serves as adviser, analyst, and distributor. As an adviser, the
investment bank is an agent, providing advice on how to structure and
price the offering. As an analyst, the bank serves its own customers and the
investing public by certifying the value of the securities. As a distributor,
the underwriter also buys the securities for sale to its customers or, at least,
conducts the sale, and it may pledge to buy any unsold portion of the offering.
Fundamentals of Finance Ethics
53
The commitment to sell the securities underwritten by an investment bank
creates an incentive to sell the stocks or bonds to customers, regardless of
suitability, and there is also a temptation to place any unsold securities in
accounts that the firm manages. Because any unsold securities have been
judged a poor value by informed market participants, placing them in individual accounts, without the clients’ knowledge and consent, would appear to
be a violation of a firm’s fiduciary duty.
The underwriting role has a built-in conflict of interest. As an adviser to a
corporate client, the bank should seek to obtain the highest price for the
securities, but it serves its investment customers by obtaining the lowest price.
However, this is a “virtuous” conflict of interest because the outcome is usually
fairly priced securities. The investment bank must act like an auctioneer,
seeking to obtain the highest price for the corporate client consistent with
selling the whole offering to the bank’s customers. The price, therefore, must
be fair to both parties. A “vicious” conflict of interest may result, though, from
the fact that the underwriter is compensated, in part, by the spread between
the amount paid to the issuer and the public offering price. Thus, an underwriter has an incentive to “buy low” from the corporate client and to “sell
high” to their customers.
Conflicts of interest also arise for organized markets and exchanges. In the
United States, there is one major national stock exchange, the New York Stock
Exchange, as well as smaller regional exchanges. The stocks of many smaller
companies trade through NASDAQ, which was founded as an over-the-counter
market by the National Association of Securities Dealers (NASD, now the
Financial Industry Regulatory Authority, FINRA). Other exchanges exist for
bonds, commodities, futures, and other financial instruments. These organizations serve multiple constituencies and must balance various competing interests. For example, the NASD recognized a conflict between its role as an
association of securities dealers and as an operator of a market and so divested
itself of NASDAQ.25
Particular roles within organized markets and exchanges give rise to rolespecific conflicts. For example, floor traders in commodities and futures
exchanges are privy to market-moving information that they can exploit by
timely trading on behalf of themselves or others. Such trading constitutes a
misappropriation of confidential or proprietary information and is strictly
prohibited. A floor trader operates in an auction market, which is characterized by large numbers of buyers and sellers trading small lots. In an auction
market, prices are known to all, and the trader operates purely as an agent in
the execution of trades. By contrast, in a dealer market, in which large blocks
of securities are traded between a few parties, trades are brokered by a dealer,
known as a block positioner. In a dealer market, both prices and commissions
54 Fundamentals of Finance Ethics
are generally hidden and subject to negotiation, and the dealer may be acting
as both an agent for other parties and as a principal for the firm. These conditions create potential conflicts of interest.
One market role worth noting is the market specialist, who has responsibility for maintaining a fair and orderly market in one or more stocks. Whenever
the numbers of buyers and sellers in a stock market are mismatched, the specialist is expected to buy or sell, using his or her own inventory, in ways that
approximate a market with a sufficient number of buyers and sellers. A specialist also holds a “book,” which is information about calls and puts and limit
orders. Because of the specialist’s privileged access to the market and to sensitive information, the possibility exists for abuse. Not only can a specialist
manipulate the price of stocks but he or she is able to engage in trading as a
principal with virtually no risk in so-called “riskless principal transactions.”
For example, a specialist with an order to buy a stock when it drops to a certain
price can buy the stock just above that price, with the assurance that if the
price drops further the stock can be sold to the customer who placed the order.
As long as the commission for the sale exceeds the loss on the transaction, the
specialist takes no risk.
Active trading of securities in markets and the holding of diverse portfolios
would lead free-market participants to seek an investment adviser and perhaps
a professional manager for an investment portfolio. For example, a broker acts
not only as an intermediary by executing trades but also as an investment
adviser, recommending suitable securities, and as a portfolio manager if the
customer has given the broker discretionary authority to trade for the customer’s account. If a broker is compensated only for executing trades, then he
or she has an incentive to recommend frequent trading of (possibly) unsuitable securities, and especially to engage in excessive trading in discretionary
accounts, a practice known as “churning.” Similar practices occur in banking,
when loan customers are urged to replace one loan with another, and in insurance, when agents persuade customers to replace one policy with another, in
order to generate extra fees and commissions. These abuses are called “flipping” and “twisting,” respectively.
Investment advisers, who must register with the SEC under the Investment
Advisers Act of 1940, offer investment advice to the public. Because a conflict
of interest is created when investment advisers are paid a commission on the
investments selected by the client, some advisers attempt to remove this source
of conflict by charging a flat fee. Investment banks derive a large portion of
their income from advising corporate clients on a wide range of matters,
including financial restructurings, mergers and acquisitions, and hostile takeovers. Because investment banks offer other services to the same clients
Fundamentals of Finance Ethics
55
and also have clients with competing interests, their advisery activities create
multiple conflicts of interest. Finally, mutual funds, pension funds, and
insurance companies provide professional management for large portfolios
of securities. Two potential conflicts of interest for portfolio managers arise
when they engage in personal trading for their own accounts and when they
allocate commissions to brokers for the execution of trades in return for
research and other nonmonetary benefits in the form of “soft dollars.”
Finally, because of the complexity of providing financial services and
the problem of marshaling vast resources, free-market participants create
large organizations, which create conflicts of interest in the governance of
these organizations. Just as corporate law specifies the form of governance
for business corporations, so other pieces of legislation create governance
structures for financial organizations. The Investment Company Act of 1940
sets forth the framework for investment companies, including mutual funds,
and most private pension plans are regulated by the Employee Retirement
Income Security Act of 1974 (ERISA). Each of these acts requires the fund to
be under the control of trustees with a fiduciary duty to the shareholders (of
a mutual fund) or the beneficiaries (of a pension fund).
The governance structure of any organization creates potential conflicts
of interest, not only because of the personal interests of the responsible
persons but because of the multiple roles that these persons fill. An investment
banker, for example, who is a director of a corporation or a trustee of an
endowment fund is offered a plethora of opportunities to advance the interests
of one group to the detriment of another group’s interests. Individuals who
wear two or more hats may be able to compartmentalize their roles and
their attendant obligations. A more difficult challenge faces institutions that
attempt to fill multiple roles, in which legitimate interests are continually
competing.
For example, mutual fund trustees are obligated to represent the interests
of the shareholder-investors of a fund. However, some are people with a close
association with management who also do business with the fund in various
ways. Critics have accused these trustees of paying insufficient attention to
fund fees and other investor concerns and have called for a greater number
of independent trustees on fund boards. Real estate investment trusts (REITs)
raise special governance problems, not only because of a lack of independence
among the trustees, who are often associated with the sponsoring institution,
but also because of the prevalence of outside management of REITs. Unlike
mutual funds, REITs can assume debt and leverage their assets, and when
management fees are based on total assets of the trust, the managers have an
incentive to assume more debt than may be beneficial to the investors. Because
56 Fundamentals of Finance Ethics
of the externalized management structure of REITs, shareholders are usually
unable to evaluate the fees, which are not stated separately from REIT returns.
As a result, the governance structure of REITs does not provide the degree of
accountability that is present in other financial institutions.
Managing conflict of interest
Despite the prevalence of potential conflicts of interest in financial services,
the occurrence of actual conflicts has been minimized by relatively effective
preventive strategies. These strategies are embodied in much of the regulation
of the financial services industry and in accepted industry practices. They can
be conveniently classified under the headings of competition, disclosure, rules
and policies, and structural changes.
Competition
Fierce competition among financial services providers for customers and
clients provides a powerful incentive to avoid actual conflicts of interest
and even the appearance of conflicts. Because results are critical in this competition, any source of inefficiency must be eliminated. For example, “recip”
in commercial banks with a trust department has been virtually eliminated
because of the need for returns on trust accounts to compare favorably
with those of other trust departments and mutual funds. The allocation of
brokerage commissions must be based on “best execution” rather than other
institutional interests. In competing for customers by keeping fees low, trust
department and brokerage firms must also employ responsible cash management practices. It has been argued that competition prevents the abuse of soft
dollars, because fund managers who misallocate them will pay a price in the
marketplace.26 Competition is still limited in some areas of the financial services industry, and perhaps conflicts could be further reduced by eliminating
these barriers, for example, by increasing the kinds of firms that could serve
as trustees of pension funds.
However, competition also contributes to conflicts of interest. It is because
of competitive pressures that firms branch out into related services and
combine with other service providers. A bank that makes real estate mortgage
loans might be tempted to sponsor a REIT, for example, despite the increased
risk of conflicts. The entry of retail brokerage firms into underwriting
puts them in direct competition with investment banks, thereby increasing
competition, but the move also creates conflicts with their retail customer
business. The mergers of retail brokerage firms with investment banks, which
have been prompted by competitive pressures, give rise to even more conflicts.
Furthermore, competition depends for its force on other factors, most notably
Fundamentals of Finance Ethics
57
disclosure. For example, unless fund earnings are properly disclosed, competition cannot exert pressure on firms to reduce conflicts of interest.
Disclosure
Disclosure as a strategy for managing conflicts of interest is generally understood as the disclosure of adverse interests, as when politicians disclose their
investment holdings. This kind of disclosure is important in financial services.
For example, a broker who is acting as a principal in a transaction is required
by SEC Rule 10b-10 to disclose this fact to a customer. Section 17 of the Investment Company Act requires detailed disclosure of transactions involving
“affiliated persons” who stand to gain personally from a mutual fund’s activities. Under the Securities Act, the prospectus for a security must include a
description of any material conflicts of interest held by the issuing parties.
However, disclosure in finance includes much more than disclosure of
adverse interests. It has been noted that disclosure of performance data of all
kinds, including levels of risk, facilitates competition, which in turn reduces
conflicts of interest. In addition, conflicts of interest can be avoided by making
known a firm’s policies and procedures for dealing with conflicts. For example,
if a trust department discloses its policies concerning the priority given to
accounts or the treatment of uninvested cash, there need be no violation of
fiduciary duty because the terms of the contract that create this duty have
presumably been accepted by the trust beneficiaries. In this case, an informed
beneficiary has no justified complaint if an account receives less attention than
that of a corporate pension fund. Similarly, an investment bank can reduce
conflicts of interest by announcing its policies in advance should two clients
be involved in a hostile takeover.
Disclosure is a frequently recommended and employed remedy for conflicts of interest, but it has shortcomings. First, since it is easy to disclose
conflicts and requires little else, it does not threaten existing arrangements,
which may be in need of reform. As New Yorker columnist James Surowiecki
has observed, “It has become a truism on Wall Street that conflicts of interest
are unavoidable. In fact, most of them only seem so, because avoiding them
makes it harder to get rich. That’s why full disclosure is suddenly so popular:
it requires little substantive change.”27
Second, disclosure may worsen conflicts of interest by affecting both the
disclosing party and the party being warned. The effectiveness of disclosure
as a remedy rests on the assumption that, once warned, a party likely to be
harmed by a conflict will take protective measures, such as discounting possibly biased advice or seeking additional information. However, psychological
research suggests that the warning provided by disclosure is often not heeded
sufficiently to provide adequate protection.28 Moreover, this research also
58 Fundamentals of Finance Ethics
shows that people who have made disclosures may be emboldened to take
even greater advantage of an opportunity with the rationalization that the
other party has been warned. The result might be greater harm than would
occur without any disclosure at all.
Rules and policies
Specific rules and policies serve to reduce conflicts of interest by prohibiting
conduct that constitutes or facilitates conflicts. These rules and policies may
address conflicts of interest directly by requiring people to avoid conflicts of
interest or by prohibiting the kinds of conduct that would constitute conflicts
of interest. Other rules and policies may operate indirectly by creating conditions that reduce the possibility of conflicts of interest. For example, policies
on the flow of information in any financial services firm, such as who has
access to what information, are vital for many reasons, including the prevention of conflicts of interest. Some commercial banks require that only the
securities of sound, creditworthy corporations be selected for trust accounts.
Not only is such a policy a good practice for a trust department but it also
prevents the possibility of conflict if, for example, the bank is also a creditor
of a corporation in danger of bankruptcy. In such a case, the sale of the stock
by the trust department might endanger the bank’s commercial loans, which
creates a conflict of interest.
Rules and policies have many sources, including legislatures, regulatory
agencies, industry associations, exchanges, and financial services firms themselves. These rules and policies need to mesh with each other and be mutually
supporting. However, the prevention of conflicts of interest is probably best
achieved by financial services institutions themselves: that is, an employee’s
own firm provides a strong first line of oversight. Every firm is different, and
each one can provide better oversight if it has the flexibility to tailor measures
to its own circumstances. Also, whether any given action constitutes a conflict
of interest is not always easy to determine, and judgment is required for
carefully evaluating each case. Thus, broad rules and policies for the whole
industry are likely to be less effective than finely crafted ones from individual
companies.
Structural changes
Because so many conflicts of interest in financial services result from combining different functions in one firm, these conflicts could be reduced by structural changes that separate these functions. The once-firm separation of
commercial and investment banks, mutual funds, and insurance companies
serves, among other purposes, to avoid conflicts. Many conflicts could be
eliminated by separating the functions of trust management and commercial
Fundamentals of Finance Ethics
59
banking, of underwriting and investment advising, of retail brokerage and
principal trading, and so on. Addressing the problem of conflict of interest
by such radical structural changes is probably unwarranted, however, because
of the many advantages of such combinations. For example, underwriting a
corporation’s securities requires an investment bank with substantial sales
capability as well as personnel with analytical skills. The trend in the financial
services industry is toward more rather than less integration.
Even within multifunction institutions, many structural changes are
possible and perhaps advisable. One such change is strengthening the independence and integrity of functional units. In particular, steps can be taken
to strengthen the autonomy of trust departments in commercial banks and
research departments in investment banks by increasing the sense of professionalism among trust officers and research analysts. Managing the flow of
information is an important factor in creating autonomy. This is done, in part,
by building “Chinese walls,” which create impermeable barriers between functional units. Chinese walls can also be built by policies that prohibit personnel
from acting on restricted information, even if it is known. There are some
drawbacks to Chinese walls, however. They take away some of the gains from
integrating different functions in one firm, and firms may also lose the confidence of customers, who fear, for example, that investment advice does not
represent all the information possessed by a firm. However, a customer may
also benefit, by being assured that a broker’s investment advice is not biased
by the need to place unsold stocks in an underwriting. One significant benefit
of Chinese walls to firms is increased protection against charges of insider
trading.
Finally, financial services providers avoid conflicts of interest by seeking
parties with independent judgment in situations in which their own judgment
is compromised. Examples of such independent parties include independent
trustees on the boards of mutual funds, independent appraisers in determining the value of assets in cases of self-dealing, independent actuaries in the
operation of corporate pension funds, and independent proxy advisory services in deciding how to vote on shares held by trusts and funds.
Conclusion
This chapter presents a framework for approaching ethics in finance. Using
this framework, one should always ask, first, am I acting solely in a market
situation? If so, then the rules of market ethics apply. If not, then one should
ask, second, what role or relationship am I in, and what is ethically required
of me in this role or relationship? While market ethics permits a considerable
amount of aggressive, self-interested behavior in the pursuit of gain, not
60 Fundamentals of Finance Ethics
everything is permitted. In particular, prohibitions against fraud and manipulation, the need to respect the rights of others, and responsible conduct in
cases of market failure present considerable constraints on what may be rightly
done. Roles and relationships, especially those of agents and fiduciaries,
constitute much of financial activity, and very definite duties or obligations
accompany them. One notable duty of agents and fiduciaries is to avoid conflict of interest, which is shown in this chapter to be a particularly challenging
ethical concern.
Notes
1.
2.
3.
4.
5.
6.
7.
An economy may have many possible Pareto optimal states, most of which would
produce less than the total amount of welfare possible. Moreover, any of these
states may be faulted for distributing welfare in unequal ways (which is called
distributional equity). These points are commonly used to argue that markets
alone may not lead to a just and prosperous society and that some government
interventions may be necessary to achieve these (desirable) ends.
Because markets require property rights, which in turn facilitate democracy,
some have argued that the use of markets in socialist planned economies, as in
present-day China, will eventually lead to some degree of democracy in such
societies. Experience shows that the link between markets and democracy is not
secured merely by property rights but requires other conditions as well.
See G. C. Archibald, “Firm, Theory of,” The New Palgrave (London: Macmillan,
1987); Richard M. Cyert and Charles L. Hedrick, “Theory of the Firm: Past,
Present, and Future; An Interpretation,” Journal of Economic Literature, 10
(1972), 398–412; Fritz Machlup, “Theories of the Firm: Marginalist, Behavioral,
Managerial,” American Economic Review, 62 (1967), 1–33; and Philip L. Williams, The Emergence of the Theory of the Firm (New York: St Martin’s Press,
1979).
William J. Baumol, Business Behavior, Value, and Growth (New York: Macmillan,
1959); Richard M. Cyert and James G. March, A Behavioral Theory of the Firm
(Englewood Cliffs, NJ: Prentice Hall, 1963); Robin Marris, The Economic Theory
of Managerial Capitalism (New York: Free Press, 1964); and Oliver E. Williamson, The Economics of Discretionary Behavior: Managerial Objectives in a Theory
of the Firm (Englewood Cliffs, NJ: Prentice Hall, 1964).
The distinction between the property rights and the social institution conceptions
of the corporation is due to William T. Allen, “Our Schizophrenic Conception of the Business Corporation,” Cardozo Law Review, 14 (1992), 261–281. See
also William T. Allen, “Contracts and Communities in Corporate Law,” Washington and Lee Law Review, 50 (1993), 1395–1407.
Munn v. Illinois, 94 U.S. 113; 24 L. Ed. 77 (1876).
Adolf A. Berle Jr and Gardiner C. Means, The Modern Corporation and Private
Property (New York: Macmillan, 1932).
Fundamentals of Finance Ethics
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
61
Berle and Means, The Modern Corporation and Private Property, p. 355.
Ronald H. Coase, “The Nature of the Firm,” Economica, NS, 4 (1937), 386–405.
The contractual theory has been developed by economists using an agency or
transaction cost perspective. See Armen A. Alchian and Harold Demsetz, “Production, Information Costs, and Economic Organization,” American Economic
Review, 62 (1972), 777–795; Benjamin Klein, Robert A. Crawford, and Armen
A. Alchian, “Vertical Integration, Appropriable Rents, and the Competitive Contracting Process,” Journal of Law and Economics, 21(1978), 297–326; Michael C.
Jensen and William H. Meckling, “Theory of the Firm: Managerial Behavior,
Agency Costs, and Ownership Structure,” Journal of Financial Economics, 3
(1983), 305–360; Eugene F. Fama and Michael C. Jensen, “Separation of Ownership and Control,” Journal of Law and Economics, 26 (1983), 301–325; Steven N. S.
Cheung, “The Contractual Theory of the Firm,” Journal of Law and Economics,
26 (1983), 1–22; and Oliver E. Williamson, The Economic Institutions of Capitalism (New York: The Free Press, 1985). An authoritative development of the
theory of the firm in corporate law is Frank H. Easterbrook and Daniel R. Fischel,
The Economic Structure of Corporate Law (Cambridge, MA: Harvard University
Press, 1991). See also William A. Klein, “The Modern Business Organization:
Bargaining under Constraints,” Yale Law Journal, 91 (1982), 1521–1564; Oliver
Hart, “An Economist’s Perspective on the Theory of the Firm,” Columbia Law
Review, 89 (1989), 1757–1773; and Henry N. Butler, “The Contractual Theory of
the Firm,” George Mason Law Review, 11 (1989), 99–123.
David Gauthier, Morals by Agreement (Oxford: Oxford University Press, 1986).
For criticism of this argument, see Daniel M. Hausman, “Are Markets Morally
Free Zones?” Philosophy and Public Affairs, 18 (1989), 317–333.
For a development of this point, see Joseph Heath, “A Market Failure Approach
to Business Ethics,” Studies in Economic Ethics and Philosophy, 9 (2004), 69–89.
Robert Nozick, “Coercion,” in Sidney Morgenbesser, Patrick Suppes, and Morton
White (eds), Philosophy, Science and Method (New York: St. Martin’s Press, 1969),
440–472.
Elizabeth Warren, “Unsafe at Any Rate,” Democracy: A Journal of Ideas, Issue 5,
Summer 2007.
Garrett Hardin,“The Tragedy of the Commons,” Science, 162 (1968), 1243–1248.
Meinhard v. Salmon, 164 N.E. 545, 546 (1928).
For further discussion see Julie A. Ragatz and Ronald F. Duska, “Financial Codes
of Ethics,” in John R. Boatright (ed.), Finance Ethics: Critical Issues in Theory and
Practice (New York: John Wiley & Sons, Inc., 2010).
SEC commissioner Richard Y. Roberts, quoted in Leslie Wayne, “A Side Deal and
a Wizard’s Undoing,” New York Times, May 15, 1994.
Wayne, “A Side Deal and a Wizard’s Undoing.”
Quoted in Craig T. Ferris, “Ferber Judge’s Words Are Chilling Indictment of
Muni Industry,” The Bond Buyer, January 21, 1997, p. 27.
Warren A. Law, “Wall Street and the Public Interest,” in Samuel L. Hayes III (ed.),
Wall Street and Regulation (Boston, MA: Harvard Business School Press, 1987),
p. 169.
62 Fundamentals of Finance Ethics
21.
22.
23.
24.
25.
26.
27.
28.
Michael Davis, “Conflict of Interest,” Business and Professional Ethics Journal, 1
(1982), 17–27; Neil R. Luebke, “Conflict of Interest as a Moral Category,” Business
and Professional Ethics Journal, 6 (1987), 66–81; and John R. Boatright, “Conflict
of Interest: An Agency Analysis,” in Norman E. Bowie and R. Edward Freeman
(eds), Ethics and Agency Theory: An Introduction (New York: Oxford University
Press, 1992), 187–203. For criticism of these works, see Thomas L. Carson,
“Conflict of Interest,” Business and Professional Ethics Journal, 13 (1994), 387–
404; Michael Davis, “Conflict of Interest Revisited,” Business and Professional
Ethics Journal, 12 (1993), 21–41, with replies by John R. Boatright and Neil R.
Luebke.
This definition is adapted from John R. Boatright, “Financial Services,” in Michael
Davis and Andrew Stark (eds), Conflict of Interest in the Professions (New York:
Oxford University Press, 2001).
Rule 1.7(a) of the American Bar Association’s Model Rules of Professional Conduct
labels a situation in which a lawyer represents clients with opposing interests a
conflict of interest.
Matthew 6:24. “No man can serve two masters: for either he will hate the one
and love the other, or else he will hold to the one, and despise the other.”
Speech by Mary L. Shapiro, president, NASD Regulation, Inc., Vanderbilt University, Nashville, TN, April 3, 1996.
D. Bruce Johnsen, “Property Rights to Investment Research: The Agency Costs
of Soft Dollar Brokerage,” Yale Journal on Regulation, 11 (1994), 75–113.
James Surowiecki, “Financial Page: The Talking Cure,” New Yorker, December 9,
2002, p. 54.
Daylian M. Cain, George Lowenstein, and Don A. Moore, “Coming Clean but
Playing Dirtier: The Shortcomings of Disclosure as a Solution to Conflicts of
Interest,” in Don A. Moore, Daylian M. Cain, George Lowenstein, and Max H.
Bazerman (eds), Conflicts of Interest: Challenges, Solutions in Business, Law,
Medicine, and Public Policy (New York: Cambridge University Press, 2005).
Chapter Three
Ethics and the Retail Customer
Virtually everyone is a retail customer of the financial services industry.
Banking provides essential services that are needed by most people, and many
use credit and debit cards, obtain loans, secure insurance policies, make
investments, save for retirement, seek financial planning, and otherwise
consume financial services. For much of the financial services industry, retail
customers are the main focus of their business, which requires providers to
develop and sell products that satisfy their customers’ needs and gain their
loyalty.
In serving retail customers, the financial services industry relies heavily on
personal selling. Although more and more customers are dealing with banks
via cash machines and websites, sending their money in envelopes to faceless
mutual funds, and saving for retirement through employer withholding, many
people still know their local banker, buy and sell securities through a broker
whom they know personally, and deal with insurance agents, financial planners, tax advisers, and other finance professionals face to face. Personal selling
creates innumerable opportunities for abuse, and although finance professionals take pride in the level of integrity in the industry, misconduct still occurs.
However, customers who are unhappy over failed investments or rejected
insurance claims, for example, are quick to blame the seller of the product,
sometimes unfairly.
In addition to abuses in the selling of financial products, criticism can be
leveled at the products themselves. Payday loans, for example, are suspect for
exploiting the poor with high rates and practices that often create a vicious
cycle of indebtedness. Banks make much of their profit from overdraft fees
on debit cards, which can be inflated by certain methods for calculating
the charges, while the opportunity to decline overdraft has not been readily
Ethics in Finance, Third Edition. John R. Boatright.
© 2014 John Wiley & Sons, Inc. Published 2014 by John Wiley & Sons, Inc.
64 Ethics and the Retail Customer
disclosed. Subprime mortgages have been a particular target of criticism
during the recent financial crisis for being sold with inducements and without
documentation to unwary borrowers who frequently end up “underwater,”
owing more on a mortgage than the house is worth. Some of the mortgagebacked securities into which these loans were bundled were described at the
time as “toxic waste.”
There are “bad apples” in every business, of course, but many critics fault
the industry itself. They cite the need for better training of sales personnel,
more stringent rules and procedures, more aggressive oversight, more disclosure to investors, and changes in the compensation system. The full-service
brokerage business, for example, is facing a crisis as wary customers, who have
felt vulnerable relying on individual brokers, now have many options for their
investment dollars. Mutual funds and even banks now offer investors the
opportunity to invest without the fear of being “ripped off ” by a broker.
The new Consumer Financial Protection Bureau, which was created by the
Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010, has
the central mission “to make markets for financial products and services work
for Americans.”
This chapter examines four issues facing the financial services industry in
meeting customer needs, treating customers fairly, building customer confidence, and ensuring a high level of integrity in all aspects of the business.
A section on unethical sales practices considers deception, manipulation,
and concealment, as well as churning by brokers and similar abuses by insurance agents and loan officers. Credit and debit cards, while generally beneficial,
may be problematic for many users because of many abusive practices, which
may result, in part, from a lack of disclosure and consumer education by the
issuing banks. Mortgage lending, which is critical to home ownership, raises
many problems, including discrimination in mortgage lending, called “redlining,” which has contributed to urban blight and is the subject of an important
piece of legislation, the Community Reinvestment Act. The problem considered here is that of subprime loans, which have not only damaged the lives of
many unwary borrowers but played a major role in the recent financial crisis.
Finally, many financial products and services require retail customers to
submit disputes to arbitration, and this requirement, along with alleged abuses
in the arbitration process, has prompted a controversy that is also covered in
this chapter.
Sales Practices
Two real estate limited partnerships launched by Merrill Lynch & Co. in 1987
and 1989 lost close to $440 million for 42 000 investor-clients.1 Known as
Ethics and the Retail Customer 65
Arvida I and Arvida II, these highly speculative investment vehicles projected
double-digit returns on residential developments in Florida and California,
but both stopped payments to investors in 1990. At the end of 1993, each
$1000 unit of Arvida I was worth $125 and each $1000 unit of Arvida II, a
mere $6.
Not every investment is a success, of course, and aggressive investors reap
higher rewards for assuming greater risk. However, the Arvida partnerships
were offered by the Merrill Lynch sales force to many retirees of modest means
as safe investments with good income potential. The brokers themselves were
told by the firm that Arvida I entailed only “moderate risk,” and companyproduced sales material said little about risk, while emphasizing the projected
performance. Merrill Lynch advised its own brokers that the Arvida funds
were appropriate for investors with $30 000 in income and a $30 000 net worth,
or with a $75 000 net worth—which is to say, most of the brokers’ clients.
Left out of the material was the fact that the projections included a return of
some of the investors’ own capital, that the track record of the real estate
company was based on commercial, not residential, projects, and that eight
of the top nine managers of the company had left just before Arvida I was
offered to the public.
Merrill Lynch (now part of Bank of America) insists that the brokers
acted properly in selling the Arvida limited partnerships to clients, but several
questions can be raised about the firm’s sales practices. First, were some investors deceived by the brokers’ sales pitches? The prospectus for an offering
is typically scrutinized by the Securities and Exchange Commission (SEC)
and the issuing firm’s legal staff in order to ensure full disclosure of all
legally required information. However, investors seldom read all of the fine
print and do not always understand what they do read. Much of their understanding of an investment comes from conversations with brokers, and here
there is ample opportunity for deception. Second, did the Merrill Lynch
brokers have a responsibility to protect the interests of their clients? At one
extreme, brokers can be viewed as sellers of a product whose obligations do
not extend beyond those of any seller, which include, of course, a prohibition
on deception. The other extreme is to view brokers as agents who are pledged
to advance the interests of clients to the best of their abilities. However, the
responsibilities of brokers lie at neither extreme and vary with the client and
circumstances.
What is ethical and unethical in sales practices is difficult to determine in
detail because of the many kinds of sellers in the financial services industry.
The situation of stockbrokers is different from that of insurance agents or
financial planners, for example. Selling is done both by person-to-person
contact (including cold calling) and by more anonymous mass-media advertising and direct-mail promotion. However, two issues are ever present,
66 Ethics and the Retail Customer
namely whether a sales practice is deceptive and the extent of a seller’s responsibility to protect the buyer.
Deception and concealment
The ethical treatment of retail customers requires that salespeople explain all
of the relevant information truthfully and in an understandable and nonmisleading manner. One observer complains that brokers, insurance agents, and
other salespeople have developed a new vocabulary that obfuscates rather than
reveals:
Walk into a broker’s office these days. You won’t be sold a product. You won’t even
find a broker. Instead, a “financial adviser” will “help you select” an “appropriate
planning vehicle,” or “offer” a menu of “investment choices” or “options” among
which to “allocate your money.” . . . [Insurance agents] peddle such euphemisms
as “private retirement accounts,” “college savings plans,” and “charitable remainder trusts.” . . . Among other linguistic sleights of hand in common usage these
days: saying tax-free when, in fact, it’s only tax-deferred; high yield when it’s
downright risky; and projected returns when it’s more likely in your dreams.2
Salespeople avoid speaking of commissions, even though they are the
source of their remuneration. Commissions on mutual funds are “front-end” or
“back-end loads”; and insurance agents, whose commission can approach 100
percent of the first year’s premium, are not legally required to disclose this
fact—and they rarely do. The agents of one insurance company represented
life insurance policies as “retirement plans” and referred to the premiums as
“deposits.”3
Deception is a broad term without clear boundaries. The Federal Trade
Commission (FTC) was charged by Congress in 1914 with the task of protecting consumers from deceptive advertising, and the Commission struggles to
this day in developing an adequate definition. Federal securities law prohibits
practices that would “operate as a fraud or deceit” on a person; the Investment
Company Act, which regulates mutual funds, contains similar language; and
state insurance laws also prohibit fraud and deception in the sale of insurance.
Most legal action has focused on fraud, with the result that the concept of
deception in finance lacks a clear legal definition.
Despite the vagueness of the term, some guidelines have been developed
for identifying deception. In general, a person is deceived when that person
holds a false belief as a result of some claim made by another. That claim may
be either a false or misleading statement or a statement that is incomplete in
some crucial way. Even if every claim made by Merrill Lynch brokers is literally true, deception is still possible if the clients formed mistaken beliefs
because of statements made or not made. Indeed, some investors in the Arvida
Ethics and the Retail Customer 67
limited partnerships claimed that the distinction between return on capital
and a return of capital was not clearly explained to them, and that, as a result,
they misunderstood the cash-flow projections. In short, the investors complained that the brokers’ sales pitch was deceptive.
In addition to defining deception, it is necessary to determine when it is
morally objectionable and falls afoul of the law. The FTC, the SEC, and other
regulators employ a three-factor test: (1) How reasonable is the person who
is deceived? (2) How easily could a person avoid being deceived? (3) How
significantly is the person harmed by the deception?
First, some people are more easily deceived than others, and some claims
could mislead only a few, rather gullible individuals. Regulations that seek to
protect even the most ignorant consumer would prohibit all but the most
straightforward of claims and would severely hamper advertising and promotion. Regulators have generally employed a reasonable person standard that
asks whether a customer or client of ordinary intelligence and knowledge
would draw a mistaken conclusion from a claim. For example, advertising for
credit cards and bank loans often features a low “teaser” rate that applies
for an initial period. Even though the attractive rate is featured prominently
in advertisements, a reasonable person, it is assumed, can read the fine print
and compare the various offers. On the other hand, a misleading comparison
of mutual fund performance that would lead even careful readers to conclude
that a poorly performing fund is superior to the competition is arguably
deceptive.
Second, potentially deceptive claims that can be easily countered by readily
accessible information are less objectionable than claims that most people can
accept only at face value. Information on mutual fund performance is so
widely available—albeit in confusing abundance—that a single misleading
comparison is not as serious as a misstatement of the fees for a particular fund,
since this is information that an investor can obtain only from a company’s
own material.
Third, deception that would lead a person to suffer a significant financial
loss or some other grave harm is of greater concern to regulators than a misleading statement that leads to a trivial loss. For this reason, claims about
finance and healthcare receive more scrutiny than claims about, say, clothing
or perfumes, and misleading claims for home equity loans, where a person’s
home is at risk, are more likely to be considered deceptive than equally misleading claims for credit cards or installment loans. False and misleading
claims are morally objectionable because they are forms of dishonesty. More
problematical is the concealment of information, because whether a claim is
false or misleading is a matter of fact, whereas what information ought to be
revealed involves a value judgment. Furthermore, the moral objection to
68 Ethics and the Retail Customer
concealment is not that concealing certain information is dishonest but that it
is unfair. Whether a sales practice is deceptive due to concealment cannot
easily be determined, therefore, without considering the conditions for fair
market transactions (which are discussed in Chapter 5).
Economic exchanges are generally considered to be fair if each party makes
a rational choice—or at least has the opportunity to make a rational choice.
Consequently, sales practices in finance are unfair, and hence deceptive, when
they substantially interfere with the ability of people to make rational choices
about financial matters. The concept of rational choice in economics is complicated, but the details need not concern us here. It is sufficient to note that
economic theory assumes that in any economic transaction each party gives
up something (a cost) and receives something in return (a benefit). In addition, economic actors make choices that produce (or are expected to produce)
the greatest net return for themselves. In short, economic actors are assumed
to be egoistic utility maximizers.
This concept of economic rationality further presupposes that:
1.
2.
Both the buyer and the seller are capable of making a rational choice.
Both the buyer and the seller have sufficient information to make a
rational choice.
3. Neither the buyer nor the seller is denied the opportunity to make a
rational choice (this condition excludes coercion, for example).
All three of these conditions are fraught with difficulties. A misleading claim
may constitute manipulation, and thus cross a line between legitimate persuasion and illegitimate coercion. But where should that line be drawn? The
capacity for rational choice is an uncertain standard, not only because many
people are unsophisticated about financial matters but also because even experienced investors may not understand complex transactions. This condition
does not specify how people who are unable to make a rational choice should
be treated. Who is responsible for protecting vulnerable investors? Should
they be barred from certain markets? Should some education be required?
Finally, what is sufficient information? Who has an obligation to ensure that
an investor is sufficiently informed?
Examples for analysis
In order to examine some of the difficulties in the conditions for fair market
exchanges that bear on whether claims are deceptive, consider the following
situations:
1.
A brokerage firm buys a block of stock prior to issuing a research report
that contains a “buy” recommendation in order to ensure that enough
Ethics and the Retail Customer 69
shares are available to fill customer orders. However, customers are not
told that they are buying stock from the firm’s own holding, and they are
charged the current market price plus the standard commission for a
trade even though no trade takes place.
2. A broker assures a client that an initial public offering (IPO) of a closedend fund is sold without a commission and encourages quick action by
saying that after the IPO is sold, subsequent buyers will have to pay a 7
percent commission. In fact, a 7 percent commission is built into the price
of the IPO, and this charge is revealed in the prospectus but will not
appear on the settlement statement for the purchase.
3. The names of some mutual funds do not accurately reflect the fund’s true
investment objectives. One study showed that fewer than two-thirds of
the funds classified as “growth and income” performed in a manner that
is consistent with that investing style. However, the investment objectives
of any fund are stated in the prospectus, and the current portfolios of all
active funds are available for inspection.4
4. Insurance companies that sell variable annuities are permitted by the SEC
to advertise with charts that project hypothetical returns that do not
include “mortality and expense risk” (M&E) charges for insurance coverage.5 These charges, which range from 1.27 to 1.4 percent annually, must
be disclosed in the text of all advertising. The insurance industry contends
that omitting M&E charges from the hypothetical returns is necessary
in order for investors to compare their variable annuities with those
offered by mutual fund companies, which do not contain any insurance
coverage.
First, we can ask whether the information in question would have a significant bearing on an investor’s purchasing decision. That is, is the information
material? If an investor decides to purchase shares of stock in response to a
“buy” recommendation, it matters little whether the shares are bought on the
open market or from a brokerage firm’s holdings. The price is the same. An
investor might appreciate the opportunity to share any profit that is realized
by the firm (because of lower trading costs and perhaps a lower stock price
before the recommendation is released), but the firm is under no obligation
to share its profit with clients. To do so, moreover, would invite the charge of
favoring some clients over others. (However, the practice of amassing holdings
in advance of a “buy” recommendation is criticized as a form of insider
trading because a firm buys stock with knowledge of a not-yet-released analysts’ report.)
On the other hand, a client might be induced to buy an initial offering
of a closed-end mutual fund in the mistaken belief that the purchase would
avoid a commission charge. The fact that the commission charge is disclosed
70 Ethics and the Retail Customer
in the prospectus might ordinarily exonerate the broker from a charge of
deception, except that the false belief is created by the broker’s claim, which,
at best, skirts the edge of honesty. Arguably, the broker made the claim with
an intent to deceive, and a typical prudent investor is apt to feel that there
was an attempt to deceive.
Second, information about the investment objective of a mutual fund is
material by any reasonable standard, but has the threshold for full disclosure
been achieved by statements in the prospectus? The name of a fund conveys
some information, but unless the description is highly inaccurate (such as a
speculative junk-bond fund called “The Widow and Orphan Secure Income
Fund”), it is questionable whether investors are seriously harmed. Investment
objectives are difficult to state in a name, and so it is not unreasonable to
expect investors to read the prospectus for this information.
Fund-tracking firms, such as Lipper Analytical, Morningstar, and Value
Line, classify mutual funds, so that some of the responsibility for any deception and part of any remedy rests with the classifying by these firms. The SEC
and the National Association of Securities Dealers (NASD) examined the situation and concluded that the benefits of greater regulation for investors do not
outweigh the costs, especially given the practical difficulties of devising adequate guidelines. (For example, nondescriptive fund names would deprive
investors of one form of communication about investment objectives.) The
debate on whether fund names are deceptive revolves around utilitarian considerations, namely the seriousness of the harm, the ease of avoidance, and
the costs and benefits of the proposed remedies.
Third, the question of whether insurance companies should be permitted
to use charts that omit M&E charges is debated mainly in terms of fair competition with mutual funds. Variable pension annuities are essentially mutual
funds with tax-deferred contributions. One SEC official explained: “For purposes of understanding what the tax effect would be, you have to show the
returns [of both insurance company and mutual fund variable annuities] net
of all charges. It levels the playing field.”6 Critics complain that some M&E
charges are ordinary fund management expenses that mutual funds must
reflect in charting hypothetical returns. If so, then omitting M&E charges tilts
the playing field in favor of the insurance companies. However, both sides
agree on the proposition that disclosure rules should promote fair competition
between variable-annuity providers and enable consumers to compare the
products of these providers in easily understood presentations.
Responsibility to protect
What is the obligation of brokers, agents, or other salespersons in finance to
protect the interests of those who buy financial products? Certainly, a broker,
Ethics and the Retail Customer 71
for example, should not exploit a naive or inexperienced client, but does a
broker have a strong positive obligation, like that of a physician or a lawyer,
to disclose fully and to act solely for the benefit of others? The responsibility
of a broker to protect may not extend this far, but neither is a broker merely
a salesperson. A broker may not be a shepherd protecting a flock, but the
broker’s role is not just to shear the sheep.
The responsibility of any salesperson can range from caveat emptor to
paternalism. However, caveat emptor (“let the buyer beware”) is not the rule
of the modern marketplace because every seller is bound by a substantial
body of law, including the Uniform Commercial Code, which requires
“honesty in fact and the observance of reasonable commercial standards of
fair dealing in trade.” According to the Uniform Commercial Code, sellers
also warrant that their products are of an acceptable level of quality and fit for
the purpose for which they are ordinarily used. The underlying assumption is
that a seller generally has superior knowledge, so that it is more cost effective
to place the burden of consumer protection on sellers rather than buyers of
products. If a sales clerk at a hardware store has a legal obligation to protect
consumers in the sale of a wrench, then it is not unreasonable to expect at
least as high a level of conduct from a broker selling limited partnerships.
However, the focus of a seller’s obligations is on the product itself and on
the way in which it is represented. The decision to buy is left to the buyer,
and the typical seller has no obligation to ensure that the buyer makes a wise
choice. An underlying assumption of the market system is that buyers are the
best judge of their own interests and should be free to make their own decisions once they are fully informed. The alternative is paternalism, which is
generally deplored as an unjustified limitation on people’s freedom. However,
a responsibility to protect clients—and hence some paternalism—is supported
by two considerations. One is that the broker is more than a seller when he
or she is serving as an adviser because an agency relationship is thereby
created by a kind of contract. The other consideration is that people are generally more vulnerable in making investment decisions than in making typical
consumer purchases, so that a failure to protect their interests may be regarded
as abuse or unfair advantage-taking. These two considerations raise the questions: What is the nature of the relationship between a salesperson and a client
or customer? What constitutes abuse?
Unfortunately, these questions are difficult to answer without examining
specific cases because each one is different. Aside from the responsibility of
all sellers in a buyer–seller situation, some responsibilities are imposed as a
matter of market efficiency or public policy. Thus, there is concern that pushing
unprepared investors into stock mutual funds endangers the market if they
are not prepared to withstand a long downturn. Perhaps the main basis of the
72 Ethics and the Retail Customer
responsibility of any seller of financial products and services is the “shingle
theory.” Under this theory, many different relationships are possible, but any seller
should be held to whatever level of responsibility he or she offers in “hanging
out a shingle” and thereby opening up a business. Thus, to call oneself a broker
is to create a certain expectation of competent and fair treatment.
For example, investment advisers represent themselves to clients as
objective, independent consultants who will offer, for compensation, sound
investment advice. Some advisers are “fee-only,” which is to say that they seek
to gain further client confidence by advertising that they do not accept commissions or other compensation for investments made on behalf of clients.
Whether investment advisers who are not “fee-only” have an obligation to
reveal commissions and other compensation is more problematical.
Churning, twisting, and flipping
The variety of abuses in the financial services industry has spawned a colorful
vocabulary that is more appropriate to con artists than dedicated professionals.
No one in the industry defends these practices, and firms diligently guard
against them. Nevertheless, rogue employees and occasionally whole organizations are guilty of these unsavory tactics, and the record of the industry
in punishing the perpetrators and compensating the victims has not been
exemplary. The offending individuals often switch jobs and continue their misconduct, and firms generally fight complaints vigorously rather than settle
them justly. Churning, twisting, flipping, and other abusive practices stain the
reputation of the financial services industry and undermine public confidence.
Given that these practices are unethical and sometimes illegal, the main
ethical questions are what constitutes churning, twisting, and so on, and what
ought to be done to prevent them. Churning is wrong by definition, but there
may be honest differences of opinion on whether losses in a portfolio are due
to churning by the broker or to the client’s own mistakes or inattention.
Brokers and their firms may be victimized by disgruntled investors who seek
to recover their losses by falsely charging that their accounts were churned.7
Similar problems attend twisting and flipping. What separates these unethical
practices from aggressive but ethical selling of insurance policies or consumer
loans?
The ethical issues
First, some definitions. Churning is defined as excessive or inappropriate
trading for a client’s account by a broker who has control over the account,
with the intent to generate commissions rather than to benefit the client.
Twisting refers to the practice by insurance agents of persuading a policy-
Ethics and the Retail Customer 73
holder to replace an older policy with a newer one that provides little if any
additional benefit, but generates a commission for the agent. Typically, in
twisting, the cash value of an old ordinary or straight life insurance policy is
used to finance the new policy. The corresponding tactic in the consumer loan
business is called flipping. A loan officer who “flips” a customer manages to
replace an existing loan with a new one that usually provides the customer
with some additional cash. Since new loans are accompanied by numerous
fees, flipped loan customers may end up paying as much in fees as they receive
in loan proceeds. In one case, an illiterate retiree with equity in a home was
flipped 10 times in a four-year period as an original $1250 loan grew to
$45 000.8 The victim paid $19 000 in loan fees for the privilege of borrowing $23 000, so that fees constituted a whopping 83 percent of the loan
proceeds.
The poor are frequent targets of other abuses by loan providers. In 1989,
ITT Consumer Financial Corporation settled suits in many states for pressuring loan customers to add on various “options,” including credit, property,
and term life insurance and membership in the ITT Consumer Thrift
Club.9 In 1997, Sears, Roebuck & Co. was charged with unfair credit card
collection practices for persuading customers whose debts had been legally
wiped out by personal bankruptcy to pay the outstanding balances anyway.10
Sears admitted that it had used “flawed legal judgment” in not filing the documents (called “reaffirmation agreements”) with the bankruptcy court, as
required by law.
Although churning occurs, there is disagreement on the frequency or the
rate of detection. The brokerage industry contends that churning is a rare
occurrence and is easily detected by firms as well as clients. No statistics are
kept on churning, but complaints to the SEC and various exchanges about
unauthorized trading and other abuses have risen sharply in recent years. In
1995, SEC chairman Arthur Levitt, who has been especially critical of the
compensation system in the securities industry, commissioned a report on
compensation practices which concluded that churning was “at the heart of
many of the concerns” that the commission heard over the past year.11 The
report identified some “best practices” in the industry that might prevent
churning, including ending the practice of paying a higher commission for a
company’s own products, prohibiting sales contests for specific products, and
tying a portion of compensation to the size of a client’s account, regardless of
the number of transactions. Some critics of the industry cite May 1, 1975, as
a major turning point in the treatment of small investors because on that
day (called “Mayday” by worried brokers) the industry changed from fixed
commissions to variable, negotiated commissions. The 1995 SEC report on
compensation in the securities industry concluded that the commission
74 Ethics and the Retail Customer
system “is too deeply rooted” to be significantly changed and recommended
better training and oversight by brokerage firms.12
The ethical objection to churning is straightforward. It is a breach of a
fiduciary duty to trade in ways that are not in a client’s best interests. Churning, as distinct from unauthorized trading, occurs only when a client turns
over control of an account to a broker, and, by taking control, a broker assumes
a responsibility to serve the client’s interests. An insurance agent or a loan
officer, like a broker who merely recommends a trade, is not acting necessarily
on behalf of a client or customer and is more akin to a traditional seller. The
ethical fault with twisting and flipping, then, is that they violate the ethics of
the buyer–seller relationship. Typically, these practices involve deception or
unfair advantage-taking or both, and they are often facilitated by building a
relationship of trust that is then abused. The courts have generally refused to
enforce grossly one-sided contracts by employing a test of conscionableness.
An unconscionable agreement may be defined loosely as one that no person
in a right frame of mind would accept and no honest person would offer.
What is churning?
Despite clear-cut instances of churning, the concept is difficult to define. Some
legal definitions offered in court decisions are: “excessive trading by a broker
disproportionate to the size of the account involved, in order to generate commissions,”13 and a situation in which “brokers, exercising control over the
frequency and volume of trading in the customer’s account initiates transactions that are excessive in view of the character of the account.”14 Federal suits
under Section 10(b) of the Securities Exchange Act of 1934 have raised the
question of the need to establish that a broker traded with the intention of
generating commissions rather than benefiting the client. The legal term is
scienter, which is “a mental state embracing intent to deceive, manipulate, or
defraud.”15 In Ernst & Ernst v. Hochfelder (1976), the Supreme Court held that
scienter is a necessary element of churning. The legal definition of churning
contains three elements: (1) the broker controls the account; (2) the trading
is excessive for the character of the account; and (3) the broker acted with
intent (scienter).
Whether a broker has control of an account or is trading at the direction
of the client is often a source of dispute. A broker is not authorized to control
an account and to trade without explicit directions unless the client has signed
a statement giving approval. However, many brokers who have the authority
to control an account still consult with the client and seek approval for specific
trades. Thus, a broker may claim that the questionable trades were made with
the knowledge and consent of the client. Some brokerage firms seek to cover
themselves by sending “comfort” or “happiness” letters when a broker’s
Ethics and the Retail Customer 75
manager notes unusual trading activity. These letters typically thank the client
for doing business with the firm, express the hope that the client is satisfied,
and specifically solicit suggestions for improvement. Although clients often
discard these letters as junk mail, the firm may use them to show that any
excessive trading was approved by the client and that the broker did not have
control.
The most difficult issue in the definition of churning is the meaning of
“excessive trading.” First, whether trading is excessive depends on the character of the account. A client who is a more speculative investor, willing to
assume higher risk for a greater return, should expect a higher trading volume.
Second, high volume is not the only factor; pointless trades might be considered churning even if the volume is relatively low. Examples are “in-and-out”
trading or “switching,” in which one stock is replaced by another with similar
characteristics, and cross trading, in which blocks of stock are transferred
between two similar accounts. In addition, a broker who does not cancel a
customer’s call at its expiration but exercises the option and then immediately
sells the stock could garner two commissions while making no change in a
client’s portfolio. Third, churning might be indicated by a pattern of trading
that consistently favors trades that yield higher commissions. Common to
these three points is the question of whether the trades make sense from an
investment point of view. High-volume trading that loses money might still
be defended as an intelligent but unsuccessful investment strategy, whereas
investments that represent no strategy beyond generating commissions are
objectionable, no matter the amount gained or lost.
Several attempts have been made to quantify excessive trading on the basis
of the annualized turnover ratio (ATR) of a portfolio.16 An often-cited measure
is the 2–4–6 rule, whereby a turnover during any period that is proportionate
to buying and selling twice the value of a portfolio during a year (ATR = 2)
is considered to be possible churning. When there is a fourfold annualized
turnover ratio (ATR = 4), churning is presumed, and an ATR of 6 is conclusive
proof of churning. The 2–4–6 rule takes no account of the variation in turnover that is due to the character of the account. An alternative that considers
this factor is a measure based on the mean annualized turnover rate of mutual
funds with investment objectives that match those of the investor.17 Specifically, the proposal is that churning occurs when the ATR is equal to the mean
for the appropriate category of mutual funds plus twice the standard deviation.
If aggressive growth mutual funds have a mean ATR of 0.9 and a standard
deviation of 1.3, then the ATR of the portfolio of a client who wants aggressive
growth should not exceed 3.5 [ATR = 0.9 + (2 × 1.3)].
Neither of these quantitative measures serves to define churning.18 First,
the measures are arbitrary. Although 2–4–6 is plausible, why not 1–3–5, or
76 Ethics and the Retail Customer
any other similar sequence of numbers? Second, churning could conceivably
occur when the turnover ratio is substantially less than any given figure,
and not occur when the turnover ratio is substantially higher. In short, the
reasonableness of the trades must be taken into account. Third, the use of
any numerical measure is potentially dangerous because it might encourage
commission-driven trading up to any permissible limit. At the same time, a
rigid numerical measure might discourage legitimate, potentially profitable
trading in a client’s account for fear of being charged with churning. For these
reasons, a court declared in one important case, “Churning cannot and need
not be established by any one precise rule or formula.”19
Suitability
Churning, twisting, flipping, and other abusive practices are indicated not
merely by the volume of transactions but also by their suitability. A brokerage
account with a high volume of suitable trades might not be considered a case
of churning, whereas an account with a lower volume of unsuitable trades
might be. Of course, a single recommendation, in which churning is not
alleged, can also be unsuitable. In general, brokers, insurance agents, and other
salespeople have an obligation to recommend only suitable securities and
financial products. However, suitability, like churning, is difficult to define
precisely.
The rules of the NASD include the following: “In recommending to a customer the purchase, sale, or exchange of any security, a member shall have
reasonable grounds for believing that the recommendation is suitable for such
customer upon the basis of the facts, if any, disclosed by such customer as to
his other security holding and as to his financial situation and needs.”20 A legal
suit alleging unsuitability must meet three tests: (1) the broker has made a
recommendation; (2) the security in question is unsuitable; and (3) the broker
has acted knowingly (with scienter).
The NASD rule and the legal test it contains raise several difficulties. First,
when has a broker made a recommendation? After discussing an investment
with a customer, a broker may believe that the customer has made a choice,
despite attempts by the broker to warn the customer of risks, while the customer may believe that he or she is acting at the urging of the broker. The
conversation between a broker and customer is obviously subject to misunderstanding. Second, the rule expresses an obligation to seek information
from the customer about his or her financial means and objectives. However,
how far should a broker probe? How can a broker be assured that the information is sufficient and accurate? The frequently offered refrain, “Know your
customer,” requires a broker to use due diligence in learning the essential facts
about a customer. However, the standards for due diligence in this context are
Ethics and the Retail Customer 77
not always easy to determine. Third, scienter is difficult to prove because it
involves the broker’s knowledge of both the customer’s financial means and
objectives and the nature of the security, and the broker can claim inadequate
knowledge of one or both. The recommendation of an unsuitable security can
be made out of incompetence or negligence rather than with fraudulent intent,
and the distinction between the two types of cases may be difficult to draw.
However, reckless conduct in which a competent broker should know that the
security is unsuitable is often sufficient to establish scienter.
Of course, the most difficult question is: When is a security unsuitable?
Rarely is a single security unsuitable except in the context of an investor’s total
portfolio. Investments are most often deemed to be unsuitable because they
involve excessive risk, but a few risky investments may be appropriate in a
well-balanced, generally conservative portfolio. Furthermore, even an aggressive, risk-taking portfolio may include unsuitable securities if the risk is not
compensated by the expected return.
Modern portfolio theory provides a suitability test for portfolios by means
of the concept of the efficient frontier.21 The efficient frontier is a curve on a
graph that plots portfolios with the maximum return for each level of risk.
Possible portfolios far from the frontier consist of demonstrably unsuitable
securities because an investor could gain a higher return for the same risk or
assume less risk for the same return. A portfolio at or near the frontier contains unsuitable securities only if the degree of risk is not that desired by the
investor. In that case, suitability can be achieved by moving up or down
the curve that marks the efficient frontier. Securities are unsuitable, then,
when the risk is excessive with respect either to the preferences of the investor
or to the expected return.
The most common causes of unsuitability are: (1) unsuitable types of
securities—recommending stocks, for example, when bonds would better fit
the investor’s objectives; (2) unsuitable grades of securities, such as selecting
lower rated bonds when higher-rated ones are more appropriate; (3) unsuitable diversification, which leaves the portfolio vulnerable to changes in the
markets; (4) unsuitable trading techniques, including the use of margin or
options, which can leverage an account and create greater volatility and risk;
and (5) unsuitable liquidity, which involves the ease with which a security can
be sold or liquidated. Limited partnerships, for example, are not very marketable and are thus unsuitable for customers who may need funds soon.
Ensuring that a recommended security is suitable for a given investor
involves many factors, but people in the financial services industry offer to
put their specialized knowledge and skills to work for us. We expect suitable
recommendations from physicians, lawyers, and accountants. Why should we
expect anything less from finance professionals?
78 Ethics and the Retail Customer
Credit Cards
Credit cards are greatly valued by both users and issuers.22 For the millions
who use them, these ubiquitous pieces of plastic are not only a convenient
form of payment but also a ready source of credit—for purchases both planned
and spontaneous, essential and frivolous. The issuing banks also depend
heavily on credit cards—and their cousin, debit cards—as carefully cultivated
sources of revenue. When a customer presents either kind of card for a purchase, the selling business pays a “swipe fee” that compensates the issuer for
its services. When users of credit cards allow balances to develop, they pay
interest at very high rates, and when payments are late, credit limits are
exceeded or overdrafts occur, cardholders are charged very hefty fees, which
greatly enrich the issuers.
The value of credit cards to users is demonstrated by the extent of cardholder reliance on them. In 2012, 68 percent of US households possessed at
least one card, and although 40 percent of these cardholders carried no revolving balance, the total indebtedness on credit cards of the remaining 60 percent
was $854 billion.23 (This amount is down from a peak of more than $1 trillion
in 2007–2008.) Moreover, 40 percent of cardholders use this form of debt to
finance basic living expenses because they lack sufficient funds in checking
and savings accounts.24 The average credit card debt for this low- and middleincome group in 2012 was slightly over $7000, the main contributors to their
debt load being unemployment and medical bills. Without access to credit
card debt, these credit-reliant households would suffer deprivation or else be
forced to turn to payday loans and other, more onerous forms of debt. Millions
of people depend on a plastic safety net.
Although reliable figures on the profitability of credit cards for issuers are
not available, one estimate is that the total earnings of the industry in 2011
were $18.5 billion, which is an increase over the $13.6 billion earned in 2010.25
This increase occurred despite predictions that profitability would fall in the
wake of the Credit Card Accountability, Responsibility, and Disclosure Act
of 2009 (CARD Act), which contained many needed reforms.26 The magnitude
of issuer profits is also reflected in the 2012 annual report by the Federal
Reserve on the profitability of credit card operations. According to this report,
the return on assets for large credit card banks was 5.37 percent, while the
return for all commercial banks was only 1.18 percent.27 The difference
between these two figures dramatically illustrates the value of credit cards for
the issuers’ bottom lines.
The reliance of users on cards and the dependency of issuers on the profits
they generate create many opportunities and incentives for abuse. Needy users
Ethics and the Retail Customer 79
can be subjected to high rates and fees without much resistance or fear of
competitors with lower costs, while issuers search aggressively for creative new
ways to increase revenue within the limits set by the evolving law. The mindset
of the issuers was described by one former CEO of a credit card company in
a candid interview: “Bankers will figure it out to comply and say, ‘As long as
I’m in compliance with what the government says, it’s none of anybody’s business to tell me what to do’. . . . Yeah, I mean, because you guys are none of you
smart enough. You make the stupid laws, I’ll comply and I’ll make money.”28
The pricing strategies of credit card issuers take advantage of consumers’
inattention to certain matters, lack of financial knowledge, limited ability to
understand, and well-known behavioral biases, such as excessive optimism
about their ability to repay.29 In addition to the direct losses incurred by credit
card users from excessive rates and fees and the significant human costs of
heavy indebtedness, inefficient pricing imposes a burden on the whole
economy when the amounts paid are not proportional to the actual costs of
extending credit and assuming risk. From an economic point of view, distorted prices impede the operation of market mechanisms, which has the
effect, in the case of credit cards, of leading consumers to underestimate
the cost of credit—and, hence, perhaps, to engage in overconsumption—and
of causing banks to misallocate credit and mismanage risk. Ethical concerns
about credit cards are not confined to the possible abuse of users but extend
to the health of the economy at large. When credit card abuse occurs, everyone
suffers, the banks included.
Ethical concerns
Ethical concerns with credit cards, as well as debit cards, are unusually broad.
First, as with any financial product, these cards should be made available to
consumers with full, accurate disclosure of relevant information without
deception, concealment, or guile. Whatever the terms—in this case about
interest rates, service or penalty fees, payment requirements, liability for unauthorized use, resolution of disputes, notification of changes, and the like—they
should be clearly disclosed in ways that can be easily known and understood
by card applicants. The ethical principle at issue is transparency.
Because of legal requirements for issuing cards, as well as legal protections
for issuers, all necessary details are usually expressed fully in the standard
credit or debit card contract. The main problem is readability: the ability of
consumers to fully understand the terms—indeed, to have even a rudimentary
understanding—is impeded by the use of incomprehensible legal language,
often in small, faint type. The average American reads at a ninth-grade level,
while the typical credit card agreement is written on a twelfth-grade reading
80 Ethics and the Retail Customer
level, thereby making it inaccessible to four out of five adults.30 This lack of
readability is probably no accident: card issuers certainly benefit from befuddled, ignorant consumers. However, the industry replies that both the legal
wording and the extensive content of agreements are necessary to comply with
the law. However, the US Consumer Financial Products Bureau has developed
a two-page form in accessible language that it believes is adequate. In any
event, a simple explanation of terms could always be provided to applicants
in addition to the formal agreement.
In addition to ensuring that the terms of a card agreement are transparent—
that is, clearly known and understood—a second requirement is that the terms
be fair. Although fairness is unexceptional as a general requirement, it is
problematic in application for many reasons. For one, the terms of credit card
agreements address many different matters, including rates and fees, payments, dispute resolution, notification of changes, and the like. What is a fair
interest rate is obviously different from the fairness of a late-payment fee or
the resolution of a billing error. Second, fairness itself may be judged in different ways. In particular, a distinction is commonly made between fairness
in process or procedure and fairness in outcome or substance. A fair process
may produce an unfair outcome, and vice versa, and standards for a fair
process and a fair outcome may differ.
The typical credit or debit card agreement raises questions of fair process
since they are presented to the applicant on a take-it-or-leave-it basis, with
little difference between issuers. (In legal terms, these are contracts of adhesion.) Because of an imbalance of power and some collusion among issuers,
an applicant has virtually no opportunity to bargain or seek better terms
elsewhere. Hence, they cannot be said to have consented to the terms of a card
agreement in any meaningful sense. Put another way, the card industry falls
short of an ideal free market since one party, the buyer in this case, has few
options and the sellers refuse to compete by offering more attractive terms.
Under such conditions, one virtue of markets—that their outcomes are justified by consent—is not fully realized. Even if applicants fully understand a
card agreement, its terms are unlikely to be the ones they would prefer, nor
the ones they could likely obtain in a perfectly free market.
Issues of fairness of the terms in card agreements arise mainly in the area
of outcome or substance, especially about interest rates and fees. Not only are
very high interest rates often charged, but the methods for calculating them
are unduly complicated and easily manipulated for the issuer’s gain. For
example, different portions of a cardholder’s balance often have different interest rates, and payments may be credited first to reduce the amount owed on
portions that carry the lowest interest rate regardless of when this balance was
incurred. This method of crediting payments obviously benefits the issuer at
Ethics and the Retail Customer 81
the expense of the user. Is this fair? Also, issuers have been accused of setting
rules for fees in ways that trigger them more often and increase the total
amounts owed. Are such rules fair?
A third factor that raises ethical concerns about credit and debit cards
is their impact on social welfare. The marketing of credit cards to people
who cannot handle debt responsibly may lead to individual health problems,
such as anxiety and depression, to family discord resulting in divorce and
child neglect, and to lifelong financial instability from impaired credit history
and lack of savings. Special attention has been directed to credit card marketing to students, whose irresponsible use may cause them to leave school
or hamper them for years to come. More broadly, the vast expansion of consumer credit that cards have facilitated has profound consequences for how
people spend, save, and invest and how the economy and society grow and
develop.31
Of the numerous ethical concerns with credit and debit cards related to
transparency, fairness, and social welfare, two of the most controversial ones
are examined in the remainder of this section, namely the marketing of credit
cards to students and the rates and fees associated with cards.
Marketing to students
An all-too-familiar phase of many students’ college experience is the initial
euphoria of acquiring that first credit card, soon followed by overwhelming
feelings of hopelessness and desperation as debts mount and the demands for
repayment become more insistent. Irresponsible credit card use by students is
known to impair academic performance from anxiety and, for many, from
longer hours spent working. The resulting indebtedness may also have destructive life-long consequences when students are forced to drop out of school or
find it difficult, upon graduation, to rent or buy housing or to obtain a desired
job because of a damaged credit record. Schools suffer as well when they lose
students to credit card debt, and the loss to society from the failure of students
to complete their education or participate fully in the economy is also substantial. The human cost of marketing credit cards to students is a problem of
social welfare that has drawn a considerable amount of attention from the
general public, as well as government.
Balanced against this undeniable problem of social welfare are the convenience of credit cards for payments and the benefit of access to credit, especially
in emergency situations. In addition, the vast majority of students who handle
cards responsibility not only acquire useful financial management skills in
college but also begin to develop a credit history, which is essential for adult
life. Furthermore, students over the age of 18 are legally adults, and many of
82 Ethics and the Retail Customer
them, as well as most college-age youth who are not in school, are financially
independent of their parents and have as much need for credit as anyone else
in society. Is it fair that students should be deprived of the use of credit cards
merely because they are in school? Or is it fair that nonstudents of college age
should be deprived of credit in order to protect those still in school? These
are questions of fairness.
The ethical concerns over the marketing of credit cards to students are
directed mainly at credit card issuers, who solicit applications from students,
approve students for credit cards, and service their credit card accounts.
However, the marketing is often done on campuses, typically in accord with
some agreement with the college or university. These agreements usually
commit the school to provide space for on-campus solicitation and also disclose names and addresses for direct mailings. Issuers further benefit from the
school connection when students believe—mistakenly in most instances—
that the card companies on campus have been screened for reliability. In
return for their services, the schools receive some compensation, which, for
some, amount to a not insignificant source of revenue. Critics allege that colleges and universities not only fail to protect the young people in their charge
but are profiting from the harm that is done. So the marketing of credit cards
to students also brings into question the responsibility of the schools that
facilitate, and perhaps even benefit from, the problems of indebtedness.
However, students themselves and, to some extent, their parents also bear
some responsibility.
The main abuses in the marketing of credit cards to students and others of
college age were addressed in the Credit Card Accountability, Responsibility,
and Disclosure Act of 2009 in Title III—Protection of Young Consumers.32
The unethical practices that were commonplace before the passage of the
CARD Act can be described, but they may no longer raise ethical concerns if,
indeed, this legislation succeeds in its aims. These practices are still worth
examining, however, in order to understand what constitutes responsible marketing in this case, as well as to assess the adequacy of the CARD Act itself.
That is, does this act accurately reflect the ethical principles that should guide
the marketing of credit cards to students? Also, does it effectively implement
these principles?
Two areas in which credit card issuers have been criticized with regard to
ethics are the extension of credit to young people with questionable ability
to make payments and the marketing of cards on campus by such means as
prescreened mail offers and gifts for making an application. These questionable means have been facilitated by agreements between the credit card
companies and colleges and universities, which have also received criticism.
Ethics and the Retail Customer 83
Assessing creditworthiness
Since most students study full time or hold part-time jobs at best, they are
unlikely to have sufficient income to support payments on any significant
credit card balance. For this reason, college students as a group would not
seem to be a promising target market for credit cards, and, certainly, credit
card applications should be approved for students only with a careful assessment of their creditworthiness. Applications from students should be held, at
least, to the same standards of creditworthiness as those of older adults, if not
higher ones. The information submitted should be verified with the same
rigor, and the initial credit limits should also be determined by the same criteria. Unfortunately, these commonsense prescriptions have been widely
disregarded by credit card companies in the stiff competition for student
customers.
The college student market is attractive for issuers because it is largely
untapped, and it is restocked each year with new entering classes. Credit card
users tend to show great loyalty, so the first card received will often lead to
life-long use, along with future business for the issuing company. The longterm value of a student customer is perhaps greater than the revenue gained
in the short run—which may still be substantial. Although significant losses
occur in this market, especially when debts must be written off because
they are uncollectable or discharged in bankruptcy, the fees and interest that
student users incur still make the business profitable for the issuers. Moreover,
students without income are not without money, and they spend it quite liberally. Allowances from parents are typical, and parents often stand ready to
make up shortfalls and may be induced to pay their children’s debts, even
when they are not legally required to do so. In this way, parents become de
facto co-signers. For all these reasons, credit card companies have strong
incentives to target this market aggressively and to extend credit without
strong, verified evidence of ability to pay.
The ability of credit card companies to verify information is limited, even
if they make the effort, and students who are eager to obtain a card can often
do so by subterfuge. Applicants sometimes list scholarship and student loan
funds as income and even use them to pay credit card bills. Issuers are often
unaware that applicants possess several credit cards, which may already have
high balances, although a cursory credit check might reveal such facts. The
ability to pay is relative not only to income but also to the amount owed, and
an applicant may be judged capable of handling a small credit line but not the
large balance that is actually owed. Once cards are acquired, users can disguise
payment problems by using an advance on one card to make a minimum
84 Ethics and the Retail Customer
payment on another, so that an issuer may be unaware when a user is having
difficulty making payments. A good payment history by such means may lead
the issuer to raise the credit limit, often without being requested, which could
compound the user’s problems with payments.
In the typical loan process, it is unnecessary to insist that the lender assess
the creditworthiness of the borrower. Since the lender bears the preponderance of the risk—which is mainly that of default—it is generally in the lender’s
interest to ensure that a borrower does not become overly indebted. Without
any urging, a lender is likely to set standards for the ability to repay that are
higher than those needed to protect the borrower. Consequently, the harm to
the borrower ordinarily need not be considered by the lender since the borrower is automatically protected by the lender’s caution. Credit cards generally
and student users in particular constitute exceptions to this usual state of
affairs. (Payday loans are another.) Under such conditions, the incentives have
changed. It is now in the lender’s interest to permit a borrower to assume more
debt than is prudent.
This analysis of the situation raises the questions, first, of whether any
wrong is being done and, second, what, if anything, should be done to correct
the wrong. One answer to the first question is, yes, a wrong is done if a failure
to assess creditworthiness in extending credit to college students has the
impacts that are commonly claimed. The wrongness in this case is little different from the problem of defective products that injure consumers or pollution that damages the environment. The ethical principle is the prevention
of harm. However, the harm in any case needs to be balanced against the
benefits, which, in the case of credit card use by college students, are substantial. The marketing of credit cards has the additional element of unfair
advantage-taking of a vulnerable population that stands in need of protection.
Although 18-year-olds are legally adults, their financial illiteracy and impulsive
financial behavior are well documented.33 If this group is, indeed, vulnerable to
unfair advantage-taking, then it should be protected in some way.
The judgment of the US Congress in passing the CARD Act was that the
harm is great enough and young people are sufficiently vulnerable to warrant
legislative protection. The main means Congress chose for providing this
protection is a prohibition on issuing credit cards to anyone under the age of
21 without a parent or other responsible adult as a co-signer. However, an
exception is provided for anyone who can demonstrate “an independent
means of repaying any obligation arising from the proposed extension of
credit.” Obviously, what counts as an “independent” means of repayment is
critical, and no assessment is required of the reliability of any source of
income, so that a temporary job might be sufficient. More importantly, if the
“obligation” in question is to make merely the minimum payment, then an
Ethics and the Retail Customer 85
applicant need not have enough income to pay the full balance and could, over
time, acquire considerable unpayable debts.34
Marketing on campus
According to one observer, credit card companies “swoop down every fall on
American college campuses, looking for freshman or ‘fresh meat’.” This account
continues, “In a ‘carnival atmosphere’ of blaring music and free food, the credit
card companies set up tables spread with glossy promotional brochures and
loaded with free t-shirts, frisbees, and other gifts to lure students into applying
for credit cards.”35
The tables are only the beginning of an assault. Applications are stuffed into
bookstore bags, hung on bulletin boards, and mailed to campus addresses.
Entering freshmen have reported receiving an average of eight credit card
applications in the first week alone.36 In one sample, 69 percent of students
reported receiving at least one credit card offer in the mail during the past
week,37 and other studies found that students had received between 25 and 50
solicitations a semester.38 Schools are complicit not only by allowing representatives on campus but also by providing names and addresses for mailings.
The agreements between credit card companies and colleges and universities
often give exclusive rights in return for payments.
Some critics charge that this aggressive marketing is deceptive since the
representatives at tables and the materials distributed stress the benefits of
credit card use but not the burdens of carrying the debt and the harm from
overindebtedness. The kind of information commonly presented in card
agreements is usually lacking in promotional materials. Campus representatives are usually independent contractors, who have strong incentives to sign
up students with regard to the means used, and the credit card companies are
often lax is monitoring their activities. Issuers also rely on students’ lack of
knowledge about credit card use, inattention to available information, and,
about some matters, false beliefs. Although credit card marketing may not
involve false or misleading information—which are the usual elements of
deception—students cannot always be said to make informed decisions, and
neither the issuers nor the schools do much to enable better decision making.
Whether students are actually deceived by aggressive marketing, the result is
often the same.
The more common objection is that students are victims of manipulation
insofar as the sheer volume of prescreened mail offers combined with the
excitement of a “carnival atmosphere” and the enticement of free gifts may
prove irresistible—at least to some students. One study concluded: “The
majority of college students who own credit cards do not actively seek them
out, but are aggressively pursued through the mail and on-campus by credit
86 Ethics and the Retail Customer
card issuers.”39 In addition, research shows that students who are financially
at risk, including those who carry larger debts relative to income, are more
likely than others to obtain credit cards on campus from a table or through a
mail solicitation.40 The manipulation in credit card marketing might not be
objectionable in itself, though, but for the high level of indebtedness that
results from it.
The colleges and universities that permit solicitation on campus are open
to criticism not only for failing to protect students from the perils of credit
cards but also for profiting from the harm that is done. Robert Manning
blames the emphasis on revenue generation over educational concerns to
explain the willingness of school administrators “to sacrifice the long-term
interests of their students and their institutions for the short-term financial
inducements of the credit card industry.”41 Given the amount of revenue
that schools receive from students’ credit card use, they now have a vested
interest in increasing students’ debt load.42 This interest creates a conflict
of interest in policy decision making insofar as schools have a duty to protect
the students in their care.
The CARD Act addresses these ethical problems with the marketing of
credit cards on campus by various means. The most direct remedy for unsolicited prescreened credit card offers would be to legally prohibit them to
people under the age of 21. However, the CARD Act approaches the problem
indirectly by prohibiting credit bureaus from providing names and addresses
of college-age persons without their consent. This measure restricts a critical
source of information for credit card issuers, but it still allows them to mail
offers if they can obtain names and addresses in other ways or obtain consent.
With this restriction, the willingness of schools to provide this information
becomes more significant.
Issuers are also prohibited by the CARD Act from offering any “tangible
item” on or near campus to any student, regardless of age, in return for completing a credit card application. This restriction is undermined, however, by
exceptions that permit gifts without requiring a completed application—free
pizza may be offered to anyone passing a table, for example—and that allow
nontangible rewards, such as discounts on purchases or promotional credit
terms. Further, the CARD Act requires that all agreements between schools
and credit card companies be disclosed to the public. This provision assumes
that no college or university would sacrifice the welfare of students for the
sake of a monetary benefit if this became known. This rationale follows
the adage “Sunlight is the best disinfectant.” However, an examination of the
disclosures that have been made pursuant to this act indicate that initial fears
about the amount of money received by schools and the business generated
for issuers had been overestimated. Although some agreements are highly
Ethics and the Retail Customer 87
lucrative for a select few schools, the median payment reported is less than
$6000, and 87 percent of the agreements generated less than 100 new credit
cards accounts.43
Rates and fees
On August 25, 2009, Jessica Duval used her Citizens Bank debit card for a
$178.20 purchase from JCS Fashion. Since two purchases earlier that day totaling $139.05 would have reduced her beginning balance of $229.68 to $90.63,
the last purchase of the day would have produced an overdraft with an accompanying $39 fee.44 However, the bank followed its standard practice of debiting
the largest amount first, regardless of the chronological order of card use,
with the result that the two earlier purchases each triggered a separate overdraft fee. So Ms Duval paid $78 in fees for the privilege of spending $87.57
more than she held in her account that day.
If Ms Duval had read the Deposit Agreement carefully, she would have
noted that Citizens Bank reserved the right to record transactions “in any
order determined by us.” That wording did not reveal, though, that the bank’s
computers were programed to enter transactions so as to maximize the
number of overdrafts. Thus, transactions were always entered from the highest
amount to the lowest in order to multiply the number of fees—and hence
maximize the bank’s revenues. Transactions were sometimes withheld for days
so that they could be processed in a batch, further increasing the number of
overdrafts. The provision in the agreement permitting this practice was inconsistent with one, six paragraphs before, which stated, “We will not permit
withdrawals from your account unless there are sufficient funds in your
account.” However, the Deposit Agreement also provided for automatic overdraft protection with no mention of any possibility of opting out. In effect,
users got overdraft protection whether they wanted it or not—or were even
aware of it. In addition, the schedule of overdraft fees was contained only in
a separate pamphlet, which was not signed by the cardholder.
A class action lawsuit with Jessica Duval as the lead plaintiff resulted in a
$137.5 million settlement, and some of the abusive fee-generating practices
engaged in by Citizens Bank are now illegal under the CARD Act.45 In particular, holders of debit cards in the US must now explicitly accept overdraft
protection under an opt-in system rather than a system that requires them to
opt out if they do not want the bank to cover transactions in accounts with
insufficient funds. Still, ethical questions remain about the ways in which
issuers treat card users in a wide range of matters, including not only the
numbers and amounts of the rates and fees themselves but also the factors
that determine them and the manner in which they are imposed and
88 Ethics and the Retail Customer
disclosed. The possibilities for generating revenue from cards are enormous,
and issuers devote considerable effort and ingenuity in exploiting these
possibilities.
Some practices may be criticized as deceptive, due to false, misleading, or
inadequate disclosure. In this respect, abuses with debit and credit cards are
little different from ethically objectionable practices with other financial products that have the potential to harm consumers. Other practices, however, may
be considered ethically unacceptable even if they are completely and truthfully
disclosed to, and even known and accepted by, users. The processing of debit
card transactions from highest to lowest may be an example since it is contrary
to reasonable expectations and seems to be designed solely to maximize the
revenue from overdraft fees with little or no benefit to users. This is, arguably,
something a bank ought not to do even if the card user knowingly consents,
especially given that users have little choice since agreements are offered on a
take-it-or-leave-it basis with little difference among issuers. Another example
is that for centuries limits on rates of interests have been imposed by both
ethics and law in the belief that charging excessively high rates—called usury—
is morally wrong and ought to be legally forbidden. The wrongness persists
even if a borrower is willing to accept a usurious loan.
The ethical issues with rates and fees, deception aside, fall into two categories. First are questions about whether card users are being treated fairly by
the various actions that issuers take in their aggressive efforts to maximize
revenues. Can users be said to be abused by certain practices even when banks
act within the rights accorded by the agreements users sign? Second, certain
practices may be criticized for their impact on social welfare, which may
extend beyond the well-being of individual users to the whole of society. This
impact includes the deadweight loss to the economy that occurs not only when
people waste precious income on unnecessary fees and additional interest
payments but also when the cost of credit is unnecessarily high. For reasons
of economic efficiency, prices should reflect that actual costs to the issuers of
extending credit and servicing card use, which include compensation for the
risks taken as well as ordinary expenses. When economic goods are mispriced
in a market, the resulting inefficiency imposes a cost that is borne by everyone
in society. Virtually all questionable practices with respect to debit and credit
cards raise both kind of issues—of fairness and social welfare. Since these
practices are numerous, the following discussion focuses only on what constitutes fairness in card servicing and on whether interest rates should be
restricted in an effort to prevent usury.
Fairness with cards
There are many ways in which card issuers could protect users and even
benefit them—if they choose to do so. However, as with all products and
Ethics and the Retail Customer 89
services, the ethical obligations of sellers are limited, and consumers bear
some responsibility for protecting themselves and deciding what to buy.
Consumer beware—that is, caveat emptor—should not be the rule of the
marketplace, but neither should the other extreme of seller beware, caveat
venditor. Finding an ethical division of responsibility is a difficult but necessary task.
Issuers could help debit card users, for example, by notifying them when a
transaction would cause an overdraft. Most swipes of a card are transmitted
instantly to the issuing bank, and when accounts without overdraft protection
have insufficient funds, the transaction is usually denied at the point of sale.
In the same manner, users with this protection could easily be notified that a
purchase being made will cause an overdraft. This notification would allow
the user the option of paying in some other way, deciding against the purchase
or incurring the fee willingly. In helping users in this way, however, banks
would forgo the revenue that inadvertent overdrafts create. Another example
with credit cards is that different portions of the total balance owed are often
subject to different interest rates. In such cases, payments are invariably credited to portions of the balance with the lowest rate without regard for when
the debts were incurred, leaving the portions with higher rates to continue
earning interest for the issuer.
Other examples of practice that are not addressed by the CARD Act and
continue to persist include charging an inactivity fee for customers who do
not use a card within a certain period of time, and levying a minimum finance
charge when a lesser amount is technically due.46 The calculation of variable
interest rates is generally complex and opaque, and although rates can rise
from the initial one, that rate often constitutes a floor below which the variable
rate cannot drop. New fees are imposed or old ones are increased for balance
transfers, cash advances, and other transactions that were formerly free or low
cost. Although issuers may prominently display a low late-payment fee, the
actual amount charged may vary by the size of the balance (called “tiered late
fees”), with the largest fee applied to more common low balances. This method
enables the issuer to gain the benefit from the prominent display of a low fee,
while increasing revenue by actually employing higher ones on the majority
of balances.
These examples are but a few of the many that could be cited. What is ethically objectionable about these examples if the practices are disclosed and the
user agrees to them? The adequacy of the disclosure may be questioned when
the terms appear in faint, small print near the end of a long agreement that is
full of dense legal language. The typical agreement seems designed to hide
more than it reveals. For starters, the issuer holds most of the power in
the buyer–seller relationship, which enables it to dictate the terms with no
possibility of negotiation except for the refusal to sign. Such contracts of
90 Ethics and the Retail Customer
adhesion are ethically problematic insofar as they permit the imposition of
highly favorable terms for the stronger party. Are there reasons to believe,
though, that issuers have exploited their superior position to impose highly
favorable terms for themselves?
First, many of the terms in card agreements seem designed merely to
maximize revenue with little or no benefit to users. Banks have argued that
processing the largest transaction on a debit card first is a benefit since it is
likely to be a more important one—a rent payment, for example—that a user
would want honored. However, this order for processing transactions is of
benefit only to users without overdraft protection because all transactions
of a protected user will be approved anyway. All that a user with overdraft
protection receives is more fees. If this method of processing really is of benefit
to a user, then they might well choose to opt in when opting out is the default
option (which provides greater consumer protection). Late fees also benefit
users by providing an incentive for prompt payment, but this beneficial motivating effect could be achieved without such complications as a tiered schedule, which makes estimation of costs virtually impossible and serves mainly
to mislead. In general, the more that card agreement terms provide genuine
benefits to users, the less issuers can be said to abuse their superior position.
Second, card agreements and monthly statements seem designed to increase
the difficulty with which users can protect themselves and make the best use
of this important payment and credit system. Protection involves not only
avoidance of higher interest rates and more frequent fees but also an ability
to accurately estimate costs in advance. Even if users bear a large share of the
responsibility for protecting themselves, the task should not be made unnecessarily difficult, especially when alternatives are readily available. The main
alternative in this case would be a simplified interest rate and fee structure
that could be easily understood by a typical user. Such a structure could be
easily developed by an issuer to satisfy its legitimate needs to generate sufficient revenues to cover its costs, which include compensation for risk. It would
not, however, enable an issuer to realize outsized returns from cards, which
brings into question the extent of its “legitimate needs.”
Third, the various practices of card issuers take advantage of—some might
say exploit—the vulnerabilities of human psychology. People are apt to pay
less attention to a number of small fees rather than one big one, even when
the total amounts are the same. Hence the multiplicity of small fees. People’s
attention is limited and is drawn more to some matters than others. Complexity in the determination of interest rates, for example, is less likely not
only to be understood but also even to attract attention in the first place
because of the complexity. The minimum payment option on a credit card
statement involves subtle psychological considerations. The prominent place-
Ethics and the Retail Customer 91
ment reminds users that they need make only this minimum payment and
provides a certain amount of respectability. It sends the message, “Paying only
the minimum is okay.” Also, the amount listed (which is typically quite modest)
provides what psychologists call an “anchor” from which to decide how much
to pay. Studies show that the minimum repayment amount has a causal effect
on the amounts actually paid: the lower the stated minimum payment the less
people pay.47
Fourth, when rates and fees bear little relation to an issuer’s actual costs,
an expectation of reasonableness is violated. A user should expect to pay an
overdraft fee since a bank is, in effect, making a small loan, which involves
administrative costs as well as the right for a certain return. However, one
study found overdraft fees ranged from $10 to $38, with the median being
$27.48 A card user who is charged a $27 fee on an overdraft of $20 and
who repays the amount loaned within two weeks would incur an annual
interest rate of 3520 percent. This does not fit easily into any definition of
reasonable.
The power of expectations of reasonableness was vividly displayed when
outraged customers forced Bank of America in 2011 to rescind an announced
$5 per month fee on debit cards.49 This outrage occurred despite the fact that
the fee was intended merely to recover revenue that was lost due to changes
in the law, which removed charges that customers had long been paying. Not
only is a $5 per month fee for debit cards similar to the annual fee charged
for many credit cards but debit card users would not be paying any more in
total fees than before. So understood, the proposed $5 charge is, arguably, not
unreasonable. However, it touched a nerve with customers that forced the
bank to abandon this plan—probably to find other sources of revenue that
would be less noticeable and disturbing.
Capping rates
Laws that impose a cap or a maximum rate on the interest that can be charged
for credit card and other consumer debt have long been present in most
countries of the world, and proposals for yet more stringent rate ceilings are
occasionally advanced in the US and elsewhere, though usually without much
success. Not only is limiting interest rates a popular idea today, but the practice
of even charging interest on money lent has been considered morally suspect
throughout history in virtually all cultures and religions. Under the label
of usury, charging interest on loans was condemned in ancient Greece by
Plato and Aristotle; in Judaism, usury is forbidden in the five books of
the Torah, which are attributed to Moses; and Thomas Aquinas provided
authority for the opposition to usury in the medieval Catholic Church.50 Some
of the earliest prohibitions on usury occurred in Vedic texts and Buddhist
92 Ethics and the Retail Customer
teachings originating in India, and Islamic thought firmly condemns usury to
the present day.
Absolute prohibitions on charging any interest have abated in modern
times with the rise of capitalism, which recognizes the importance of capital
formation in economic growth, as well as the necessity of credit in a consumer
economy. Some historians attribute this critical transition to the Protestant
Reformation.51 Today, usury is commonly regarded as charging excessive or
exorbitant interest. Thus, charging interest is in itself morally acceptable—this
is not usury in present-day usage—but to avoid the charge of usury, the rate
should be kept below some ceiling. Determining an acceptable, nonusurious
rate of interest is difficult, but the arguments for capping interest at some rate
closely resemble the traditional objections to charging any interest at all. The
arguments against capping interest rates on credit cards or any consumer debt
consist not only of responses to traditional objections but also of appeals to
more contemporary economic-based considerations.
Despite the near-universal existence of laws limiting interest rates, they
have little effect on the actual interest rates charged today due to the high rate
levels that are legally permitted and the many means of evasion that are
available. In the United States, where interest rate regulation is currently the
province of the states, the ability of states to cap rates for credit cards was
virtually eliminated by a 1978 court decision. The decision in Marquette
National Bank of Minneapolis v. First of Omaha Service Corp. (known as “Marquette”) essentially deregulated credit card interest rates by permitting issuers
to charge the highest rate permitted in its home state without regard for the
laws of the state where the customer resides.52 Not surprising, credit card
companies are now located in states with little or no interest rate regulation,
and these states compete with each other to offer an attractive home. Another
court decision declared that late fees are a kind of interest, so these also enjoy
the same favored treatment.53 The ineffectiveness of state interest rate regulation has prompted initiatives for uniform national regulation in the US, but
they have had little effect to date.
Arguments for caps. In ancient times, the argument against usury as any
lending of money with interest was based, in part, on a narrow view of money
as merely a medium of exchange that is an alternative to bartering, in which
goods are exchanged for other goods. If money is essentially “sterile,” as Aristotle claimed, then to make money off money is an unnatural act that is
contrary to the natural use of money. Lending money with interest is not
productive commerce, like trading goods for other goods or for money, but
it is rather unearned income, more akin to the gain of thieves and pimps,
whose activities add nothing of value. This view gained plausibility from the
Ethics and the Retail Customer 93
fact that money lending at the time was a nefarious activity conducted out of
the public eye.
Although this argument, based on a conception of the natural use of money,
was influential into medieval times, the main argument, which was central
to the condemnation of usury in Judaism, Islam, and other traditions, is
that lending money with interest involves an exploitation of those who are
economically weak by the economically strong. Not only does this kind of
unfair advantage-taking harm the poor, but it also unjustly enriches the
well-to-do and further increases inequality in society. In the process, usury
corrupts the lender by encouraging the vice of greed or avarice and discouraging the virtue of charity. This point is especially prominent in Islam, which
places a high value on aiding to the poor: a person in need should be given
money without any reciprocal obligation. Usury (or riba in Arabic) thus
undermines the very basis of a society built on benevolence and selflessness
that is central to Islam.
In sum, the traditional argument is threefold: (1) interest is unearned
income that involves no productive activity; (2) interest involves the exploitation of the needy and encourages greed or avarice; and (3) interest produces
socially undesirable outcomes by transferring wealth from the poor to the rich
and thereby increasing inequality. The first of these objections no longer has
force, since the ancients were unaware of the productive power of money in
investment, as well as the role of interest as compensation for the risk taken
by a lender and for the loss of opportunity to use money in other ways (which,
in finance theory, is the time value of money). However, the remaining two
points are of legitimate ethical concern. Exploitation and inequality ought to
be addressed in any just society.54
In addressing these two ethical concerns, two questions must be answered.
First, what level of exploitation and inequality are morally unacceptable?
Exploitation, in particular, is a morally freighted concept that implies unfair
advantage-taking, but it is unclear whether a lender, in charging interest, is
taking advantage at all, and, if so, when—at what level of interest—the
advantage-taking becomes unfair. This question is especially difficult when a
borrower willingly accepts a loan at a high rate of interest. Any prohibition,
either ethical or legal, might seem to constitute a form of paternalism that
seeks to protect people from their own bad judgment. Inequality is generally
accepted as a consequence of a market economy, and it is a phenomenon that
has many causes, with high interest rates a minor one at best. So the issues of
how much inequality ought to be tolerated and how much of it is caused by
high interest rates remain controversial.
Second, even if high interest rates involve exploitation and produce (some)
inequality, the question remains: Is capping interest rates the best way of
94 Ethics and the Retail Customer
addressing these ethical concerns? More generally, are prohibitions on usury,
either ethical or legal, effective means for preventing exploitation and reducing inequality? Given the justification for lending with interest at reasonable
rates, attempts to identify the level at which rates become unreasonable and
to enforce the resulting limits are justifiable only if better means are not available. This is especially true if laws capping interest rates have economic costs,
which is claimed in the arguments against such legislation. A similar question
can be raised about executive compensation, which many consider excessive.
Attempts to place legal caps on CEO pay have proven to be not only ineffective
but also counterproductive,55 and some have argued that more transparency
and shareholder voice might provide better means for addressing this matter.
Perhaps the same is true of high credit card interest rates.
Arguments against caps. Opponents of proposals for caps on credit card interest rates offer three arguments. First, rates for credit of all kinds are set by a
competitive market in ways that reflect the costs to the lender, and so high
rates are justified because they merely reflect high costs. Credit card interest
is high due to the risk of default to unsecured borrowers (who, in many cases,
have been extended credit without adequate assessment of creditworthiness).
The costs of extending and servicing short-term loans for small amounts are
also high (although these costs are also covered by charges to retailers who
accept credit cards and by fees for late payment and exceeding credit limits).
If the interest charged by issuers were not justified by the costs, competitors
would surely step in and take business away from those with exorbitant rates—
or so the argument goes.
Second, this appeal to the virtues of a market in setting a price for credit
is further enhanced by the idea of free choice. Consumers willingly accept
high interest rates in return for access to convenient credit. For them, the high
interest of credit card debt must still represent a good value. As long as
both issuers and users find this arrangement acceptable, why should the law
intervene to prevent a mutually agreed-upon transaction? Doing so would
constitute a form of paternalism designed to protect people from harm caused
by their own actions.
Third, caps on interest rates are likely to impact the welfare of credit card
users, with the heaviest toll on those who are already disadvantaged. If the
legally permissible interest rates reduce the revenue from credit cards below
their costs or below the return from other investments, then issuers will
respond by increasing revenues, cutting costs or shifting investments—or
perhaps some combination of all three. The results are unpredictable, but a
Federal Reserve study of the consequences of caps on credit card interest rates
Ethics and the Retail Customer 95
identifies the most likely ones.56 To cuts costs, issuers might tighten eligibility
requirements, which would deny credit to lower-income families. In response,
those unable to obtain credit cards would turn to even more costly forms of
credit such a payday lenders, pawn shops, and rent-to-own stores (the so-called
“substitution hypothesis”).57 Revenues could be increased by raising fees and
adding new ones, which might affect even users who maintain no balance.
Charges to retailers might be increased, which would affect all consumers,
including those who pay with cash, if prices are raised on the goods sold. The
total cost paid by users would be the same in the end, but the distribution of
benefits and burdens of credit card use would change as a result of regulatory
interference in the market.
These arguments against capping credit card interest rates have been challenged. Some proponents of caps question the extent to which the credit card
market is competitive enough to ensure that rates align with costs. One study
finds that returns in the credit card business are three to five times that of
other areas of the banking business and attributes these outsized profits to
consumer irrationality, especially about the size of balances.58 The possible
lack of competitiveness in the credit card market may also be the result of
collusion among issuers, who follow a tacit agreement not to compete on
interest rates. Factors like these, which reduce competitiveness in markets, are
commonly addressed by government regulation, such as interest rates caps.
Others dispute these claims and argue that the credit card market is quite
competitive and that users’ apparent insensitivity to interest rates may be
rational, in part because of the low balances that many carry.59 Other work
indicates that low-income families are very rational in their use of credit.
However, one consequence of this finding is that the substitution thesis—that
they would be forced to use higher-cost forms of credit—is not borne out by
the evidence, which suggests that the harm caps might impose on the poor is
overstated.60
If the credit card market is not sufficiently competitive to justify the rates
charged on the basis of costs, the remedy need not be caps or ceilings. The
National Commission on Consumer Finance recommends in a 1972 report
that the first priority should be on policies designed to promote competition.
One focus of such policies should be on greater transparency so that users can
easily comparison shop among the available offers. The report concludes, “As
the development of workably competitive markets decreases the need for rate
ceilings to combat market power in concentrated markets, such ceilings may
be raised or removed.”61 In this event, some caps or ceilings may still be necessary in credit markets, but only to prevent the most egregious gouging of
vulnerable borrowers.
96 Ethics and the Retail Customer
Mortgage Lending
After a Lehman Brothers executive visited a prospective client, a mortgage
company in California named First Alliance, he wrote of his experience, “It is
a requirement to leave your ethics at the door.”62 The inside, which he described
as a sweatshop, housed salespeople, most of them from the automobile
industry, who were pitching home loans, largely to unsophisticated elderly
customers. He also wrote that, in the case of some loans, “the borrower has
no real capacity for repayment” and that First Alliance was “the used car
salesperson” of the subprime credit market. Despite these warnings and
numerous pending suits from disgruntled customers, Lehman Brothers was
convinced that the company had cleaned up its act and, in any event, that it
had been doing nothing illegal. Subsequently, Lehman loaned the mortgage
company around $500 million to continue its operations and underwrote $700
million in securities from loans originated by First Alliance.
Like many banks during this period, Lehman Brothers was deeply involved
with subprime mortgages, which led not only to much distress among borrowers, including personal bankruptcy and loss of homes, but also to the
near-collapse of the banking system from losses in mortgage-backed securities. Lehman itself disappeared in a spectacular bankruptcy in September
2008, which was a key event in the financial crisis. A main cause of Lehman’s
collapse was the firm’s large holding of shaky mortgage-backed securities. In
June 2003, a jury in California found Lehman guilty of “substantially assisting”
First Alliance in defrauding homeowners by using high-pressure sales tactics
that induced customers to refinance with loans in which high fees and interest
rates were concealed or misrepresented. In some instances, fees up to 24
percent of the loan amount were imposed. One woman, who had sought to
refinance a $14 000 credit card debt ended up with two mortgages, for which
she was charged $18,000 in fees. By the time of the legal action against Lehman,
First Alliance had gone out of business, after agreeing to a $60 million settlement in March 2002 with the Federal Trade Commission over allegations of
consumer fraud.
Rise and fall of subprime
The decade leading up to the financial crisis was marked by a vast increase in
the number of subprime mortgages issued to American homeowners. From
1996 to 2006, subprime mortgages as a percentage of all mortgages made rose
from 9.5 to 23.5.63 However, in 2008, the percentage of subprime mortgages
dropped to 1.7, and the figure subsequently remained low due to tightened
Ethics and the Retail Customer 97
lending standards and a shortage of credit. Most of the independent loan
origination companies that issued huge volumes of subprime mortgages have
gone out of business or been absorbed by major banks. The mortgage brokerage business, which played a large role, has also largely disappeared. Although
the damage done by this temporary rise and sudden fall of subprime mortgages
lives on, this brief episode might seem to be of little significance for the present
except that it dramatically illustrates the ways in which a potentially beneficial
innovation can be abused, especially when it is combined with larger forces.
A case can be made that the advent of subprime mortgage lending had the
potential for great social benefit. Prior to 1970, mortgage loans were available
only for “prime” borrowers, who had the three critical features: a high credit
rating, sufficient income to make payments easily, and a downpayment of
at least 20 percent of the sale price. The only products generally available
were conventional 15-year and 30-year fixed-rate mortgages. The reasons for
the restriction of the market to prime borrowers were many, but, for one, the
ability of banks (which were the major lenders) to extend mortgage loans was
limited by their own deposits, which generally provided the funds. Since the
loans were usually kept on a bank’s own books, great caution was exercised to
accept only the most creditworthy borrowers and to insist on good collateral
that could be seized in the event of default. In addition, property appraisals
were conservative in order to reduce the lender’s risk. Furthermore, the market
for selling loans, which was mainly the government-sponsored enterprises
(GSEs) Fannie Mae and (after 1970) Freddie Mac, required so-called “conforming mortgages.” These were 15-year and 30-year fixed-rate mortgages that
met certain standards with regard to credit quality, loan-to-value ratios, and
dollar amounts.
With home mortgage financing available only to prime borrowers, and with
such a limited range of products, home ownership stood in 1970 at slightly
less than 63 percent of American households, according to the US Census
Bureau. Excluded from the ranks of homeowners were potential buyers who
had sufficient income to make payments, though perhaps with some effort,
and those who lacked sufficient time to build up enough savings. In addition,
people with varied sources of income that fluctuated typically did not qualify
for prime mortgages. More importantly, the requirements for a prime mortgage took no account of people’s income growth potential. From an economic
point of view, an efficient capital market should enable people to consume
based on their lifetime wealth and not just their current level of income and
savings. The removal of such time constraints is an important function of
credit in an efficient market.
Since many of the people who were excluded from the home mortgage
market were members of racial minorities, these restrictions on lending
98 Ethics and the Retail Customer
tended to exacerbate the deep-seated problem of discrimination. Moreover,
homeownership is critical for most families in building wealth, and so many
of those excluded from the mortgage market, which were predominantly
low-income groups, increased the problems of poverty and inequality. Homeownership is also linked to the development of strong families and communities, and so it is an important social goal that has been encouraged in the US
and elsewhere for decades by government policy.
Beginning in 1970, innovations in mortgage lending greatly expanded
the opportunities for people previously excluded to enter the ranks of homeowners. These new products included adjustable-rate mortgages (ARMs),
mortgages with balloon payments and low initial payments (so-called “teaser
rates” that re-set after two or three years), no-money-down loans, second
mortgages (often providing the needed downpayment), and home equity lines
of credit. A study by the National Bureau of Economic Research found that
the development of unconventional loans from 1970 to 2000 greatly increased
home ownership, especially among the young and racial minorities, without
significantly impairing loan quality.64 By 2000, the homeownership rate had
increased to 66.2 percent and had greatly boosted participation by racial
minority groups, which had often suffered discrimination in mortgage lending.
Furthermore, the default rate on subprime mortgages was consistently low, in
single digits, in the 1970 to 2000 period. It was less than 11 percent as late as
2005, although that sector had been weakening, unnoticed, for some time.
The social benefits of subprime mortgage lending make a compelling case:
many people who would otherwise be unable to purchase a suitable home
have been able to do so, and, at the same time, a number of pressing social
problems in society have been addressed. Subprime mortgages pose greater
risks not only to lenders, because of higher default rates, but also to borrowers,
who may lose money in foreclosure if they are unable to make the payments.
However, the higher default rate can be factored into the interest charged and
also offset by mortgage insurance (which was generally required on subprime
loans). The risk to borrowers is also limited if a home can be sold or easily
refinanced in the event of financial distress, and if housing prices rise
significantly. More importantly, the main factors that limited credit to prime
borrowers, which were limited funds and bank risk, were overcome by a new
development—the securitization of home mortgages. In one fell swoop, this
innovation opened the world’s credit supply for home mortgages and transferred the risk to the world’s investors.
Securitization
Securitization is the process by which financial instruments are created by
combining multiple assets of any kind into a common pool, dividing this pool
Ethics and the Retail Customer 99
into parts with different features, and selling the rights in each part to investors. The most common assets in securitization are expected payments from
home mortgages, auto loans, student loans, and credit card debt. The simplest
form of securitization is an asset-backed security (ABS) or, when the assets
backing the security are mortgages, a mortgage-backed security (MBS). In an
ABS or MBS, the pool of loans serves as collateral for a security that offers
investors a right to all future payments, minus a fee to the arranger or securitizer. More common is a complex security called a collateralized debt obligation
(CDO) in which the common pool is divided in parts or tranches that carry
different rates of return and levels of risk. The risks in different tranches result
from the order of payment, since investors in less risky tranches with the
lowest rates are paid first, while the most risky tranches with the highest rate
suffer the losses from the first defaults.
In the financial crisis, the production of CDOs was deeply entwined with
the origination of subprime mortgages, since the enormous fees to the securitizers (which were mostly large investment banks) led them to demand an
ever increasing supply of home mortgages. These fees were possible, in turn,
because of the heavy demand from investors worldwide for CDOs because of
their high return. Although the resulting deterioration of credit quality in
home mortgages—prime as well as subprime—led to the crisis, securitization
itself has many benefits.
First, by shifting the risk of loan defaults to holders of CDOs, securitization
removes the risk from local banks, which are relatively undiversified and
hence more risk averse, and places the risk on investors around the world,
who are more willing and able to bear the risk. This ability to bear risk more
efficiently also reduces the cost of risk bearing in making loans, which reduces
interest rates. Second, this transfer of risk also enables banks to make more
home loans, not only because they do not bear the risk but also because loan
funds are available from investors worldwide and not merely from a bank’s
own depositors. Although less creditworthy borrowers may default at higher
rates, many can successfully repay loans, and as long as default rates are
known, a higher interest rate can be charged to compensate for the greater
risk. Moreover, the risk of loaning to less creditworthy borrowers is not excessive under certain assumptions. As long as housing prices continue to rise,
borrowers who are unable to make payments can refinance or sell their properties, and if the loans are well collateralized, then the risks to the lender are
relatively small. (Needless to say, these conditions ceased to prevail during the
financial crisis.)
Finally, securitization provides an ample supply of high-earning, high-rated
securities to meet investor demand. (This demand, too, quickly dried up in
the crisis.) The seemingly magical power to turn risky subprime mortgages
into AAA-rated securities is perhaps the most remarkable feature of CDOs.
100 Ethics and the Retail Customer
The key to this power is the point that in a pool of mortgages, each one of
which would alone receive a low rating, only some percentage will default. If
the highest tranches are paid first from nondefaulting mortgages, then almost
all the mortgages in a pool would have to default before the losses affected
these highest tranches. Since such a high default rate is unlikely to occur, even
among a pool of all subprime mortgages, these tranches are very safe and
hence deserving of a triple-A rating.
The flaws in this seemingly magical transformation of dross into gold are
that, first, the lowest tranches, which are affected by the first defaults, are very
risky; second, defaults were far in excess of predictions and thus affected
higher tranches; and, third, the highest tranches became difficult to value, so
they became worthless as collateral for loans since no one knew what they
were worth. In the crisis, many CDOs retained their value and their AAA
rating but they became illiquid.
What went wrong?
Despite the great potential for social benefit, America’s brief boom in
subprime mortgage lending turned into a bust. What went wrong? The subprime mortgage bust has many causes, some of which arise from the loans
themselves and how they were marketed, while others involve larger forces,
including a house price bubble, problems with securitization, and the risks
taken by banks. The recent financial crisis, too, had many causes, of which
subprime mortgages was only one. The whole crisis is a story of complex
interactions among many factors. The focus here is confined to the question
of how subprime mortgage lending failed to realize its promise and instead
resulted in millions of people losing their homes to foreclosure, often with a
loss of their whole savings, or else ending up “underwater,” owing more on
a mortgage than their house was worth. Only some of these causes involve
ethical faults, but these are significant failings from which some important
lessons can be learned.
Predatory lending
The most obvious but perhaps least consequential cause of the subprime bust
was predatory lending of the kind practiced by First Alliance and aided by
Lehman Brothers. The harm that predatory lending can do to victimized borrowers may be substantial, especially when it is done on a large scale, and the
harm is all the more egregious when it is done deliberately with loans that
the lender knows cannot be repaid and will likely ruin the borrower. However,
predatory lending has been prevalent in most economies with loans of all
Ethics and the Retail Customer
101
kinds without causing the extensive devastation experienced recently. The
consequences of predatory lending are usually confined to the victims with
little or no systemic impact, such as the collapse in housing prices, which
affected almost everyone in the economy. Moreover, many homeowners have
been trapped by mortgages, both subprime and prime, which were entirely
free of any predation, and it is likely that the subprime bust would have
occurred anyway without any predatory lending.
Predatory lending lacks a precise definition, but roughly a loan is predatory
when the lender uses unscrupulous means to induce a borrower to take a loan
that the lender knows or should know will likely inflict harm on the borrower.
The harm in this case may result from loss due to foreclosure when payments
cannot be made, or else from a loss of an opportunity to be better off, as when
qualified borrowers are steered toward loans with higher interest rates. The
means used may be unscrupulous not only in cases of outright fraud but also
when high-pressure sales tactics are used. Determining when a loan is predatory is difficult, especially in the case of subprime borrowers who must take
greater risks in order to obtain a loan. A subprime mortgage is already risky
for a borrower, so when is the risk so great that it ought not to be undertaken?
Who is to make this judgment? Furthermore, a lender may be the victim of
predatory borrowing when a loan applicant misrepresents certain facts.
Federal regulators have identified three elements in predatory or abusive
subprime lending.65 First, it occurs when important terms of a loan are
concealed or disguised or otherwise not made known, especially to an unsuspecting or unsophisticated borrower. Such actions generally constitute fraud,
which is compounded when the terms involve unconscionably high interest
rates, exorbitant points or fees, or onerous restrictions, including high prepayment penalties. Second, it is predatory to induce borrowers to refinance
unnecessarily into new loans repeatedly in order to collect additional fees,
which is a process known as “flipping.” A third element of predatory lending
is judging creditworthiness on the basis not of a borrower’s ability to repay
but of the value of the collateral. This practice is considered predatory because
the lender is making a loan with the intent of seizing the property in question
when the borrower, as expected, defaults. Such loans are merely devious ways
of acquiring property by stealth.
The first of these elements—concealing or misrepresenting crucial
information—raises questions about what a lender ought to disclose and
perhaps ensure that a borrower understands. Among such information are
balloon payments; payments that may be increased due to interest-rate resets
on adjustable-rate mortgages or mortgages with low initial “teaser rates”;
fees or penalties that may be incurred, especially for prepayment of loans
and up-front, single-premium mortgage insurance; and the costs of taxes and
102 Ethics and the Retail Customer
insurance, especially if these are not escrowed and included in monthly payments. Information about such matters is crucial to ensure that borrowers are
prepared to pay the full costs of homeownership and are not surprised by the
amounts required. In addition, the failure to disclose that the borrower may
qualify for mortgages with more favorable terms, including prime loans, is a
form of predatory lending known as “steering,” which is often done when less
suitable loans generate more fees for the originator.
Predatory lending is generally illegal, and so one factor in the subprime
bust is ineffective enforcement of existing regulation. In the United States
there are many laws, both federal and state, that forbid certain abusive practices, as well as many regulatory agencies with responsibility for enforcing
these laws. Victims of predatory lending are also able to sue in court, as many
have. A major cause of the subprime bust was the failure of regulatory agencies
to effectively enforce laws already on the books. The Federal Reserve Board
explicitly declined to take action in the belief that it lacked sufficient resources
to prevent abuses.66 The fragmentation of the American banking regulation
system further impeded enforcement, and state regulators who took aggressive action were ordered, in some instances, to desist by federal bodies, which
claimed jurisdiction. In addition, much of the origination of subprime mortgages was done by nonbank institutions that were beyond the reach of bank
regulators. This lack of supervision in the subprime sector, where it was
needed most, was described by Edward M. Gramlich as “like a city with
murder laws but no cops on the beat.”67
Toxic products
In 2006, Angelo Mozilo, the CEO of Countrywide—a notorious subprime
mortgage originator, now part of Bank of America—wrote a memo describing
a new mortgage for the full value of a home as “the most dangerous product
in existence and there can be nothing more toxic.”68 In context, Mozilo was
urging great care in the sale of this product,69 but he still recognized the danger
inherent in one of his company’s best sellers. Subprime mortgage lending,
which had great potential for good, was made possible only by the development of innovative products, but these same products became the gunpowder
that blew up the market. There are, perhaps, some financial products that
are inherently “toxic” and should not be sold to anyone, but the main problems with subprime mortgages were not only how they were sold (that is a
matter of predatory lending) but also to whom they were sold (which is
a problem of suitability) and in what quantity. All three of these factors were
crucial in the subprime mortgage bust.
Probably no single mortgage product deserves the label “toxic,” even Countrywide’s 100 percent, no-money-down loan, which may be appropriate for
Ethics and the Retail Customer
103
some people. Indeed, most of the subprime innovations were designed to fit
the needs of specific, often prime, borrowers. For example, so-called option
ARMs, which allowed borrowers to pay less than the stated interest, with the
shortfall added to the principal (negative amortization), were created originally for wealthy homeowners who wanted the benefit of low immediate
payments.70 Such a product may also be of benefit to cash-strapped prospective homeowners who expect to increase their wealth over time. Furthermore,
the available subprime mortgages made sense under certain assumptions,
including rising home prices. (Had they ever fallen? Well, yes, but not in living
memory.) Other assumptions include access to refinancing and/or ease of sale.
Under the conditions that prevailed up to 2006, both borrowers and lenders
saw limited downside risk in even the most unconventional mortgages.
Some of the risk involved in subprime mortgages could not have been easily
foreseen, but some borrowers were undeniably careless in assessing their
ability to pay, and lenders were only too eager to assist them. Both originators
and mortgage brokers pitched unnecessarily complex products that would
befuddle even sophisticated customers. However, the inescapable conclusion
is that mortgages were sold to people who should not have been homebuyers
in the first place. The problem was not lack of suitability (getting the right
mortgage) but of qualification (obtaining any mortgage at all). Lenders were
qualifying applicants for mortgages either by relaxing standards or, in some
cases, by falsifying information. The latter, of course, is a form of fraud.
Relaxed underwriting standards can turn good products toxic by putting
them in the wrong hands—of people who should not have them at all. This
lowering of standards can take many forms that are not easily detected. One
form is failing to adequately document information that, if correct, would be
qualifying. Such “low-doc,” “no-doc,” or “stated income” loans may formally
meet underwriting standards but disguise the falsity of the information.
These types of loans were developed to accommodate people with erratic and
difficult-to-verify sources of income, such as self-employed professionals, but
their use was eventually extended, improperly, to ordinary wage earners,
whose income could be exaggerated.
Second, borrowers may be qualified for mortgages with low initial payments but not for the costs later when the rate resets, or for mortgages alone
without considering the other costs of ownership, such as taxes, insurance,
and maintenance. A third form of relaxed standards is “risk layering,” in which
numerous small risk factors combine to produce a large risk. Thus, a borrower
may have no single disqualifying risk characteristic, but if enough small ones
are ignored, then creditworthiness may be significantly misjudged. Similarly,
a borrower may qualify for a loan with one kind of risk feature, but if multiple
risks are “layered,” then the loan may be too risky for this borrower.
104 Ethics and the Retail Customer
Perverse incentives
The subprime bust cannot be understood without some mention of the
incentives that led mortgage originators to engage in predatory lending
and offer toxic products.71 The main cause of these perverse incentives is,
in a word, securitization. Like subprime mortgages themselves, securitization
is a potentially beneficial innovation that is not without its dangers when
wrongly used.
When banks originate mortgages and hold them on their books, they have
very strong incentives to select only the most creditworthy borrowers and
verify information about both the borrower and the property being bought.
This system, which prevailed before 1970, may be called originate-to-hold. In
securitization, pools of loans are bundled together and sold as securities to
investors. When this became common in the 1990s, the link between origination and holding was broken: the originator no longer held the resulting
mortgages; rather they were now held by investors worldwide. The result is
the originate-to-distribute system. In the transition from originate-to-hold to
originate-to-distribute, the incentives for lenders were fundamentally transformed. Furthermore, securitization introduces many new parties, including
the securitizers and the ultimate investors, which each have their own
incentives.
In the originate-to-distribute system, one incentive for originators is to
focus on volume. Since originators are paid a fee by the securitizers for each
mortgage sold to them and are able to collect fees from borrowers as well, the
number of loans originated is critical. Banks that hold mortgages need to
make some loans, but the number is limited by their available funds; therefore
more is not necessarily better. Since originate-to-hold lenders have little need
to attract borrowers—indeed, they are often turned away—loans are made to
people who are likely to be more creditworthy than are potential borrowers
who must be persuaded to refinance or become a first-time homeowner. The
different situation of mortgage originators who sell their loans to securitizers
explains their aggressive search during the peak years to find more and more
borrowers, often through direct-mail marketing and cold-calling. Few prospects would be turned away.
Under the originate-to-distribute system, the creditworthiness of borrowers is inconsequential as long as it is accurately represented. Loans of any
quality can be securitized if the risk is known and correctly priced. Indeed,
risky subprime mortgages with high interest rates were in great demand for
securitization during the peak years because of the greater return. Although
accuracy in the representation of risk is important in selling mortgages to
securitizers, it is less urgent to the originators than to banks that keep loans
Ethics and the Retail Customer
105
on their own books, because once loans are sold, any inaccuracy is the problem
of the buyer. Moreover, the responsibility for ensuring accuracy is split in the
originate-to-distribute system between the buyer (the securitizer and ultimately investors) and the seller (the originator), which reduces the strength
of the incentive for each.
Although the value of the property being financed is important for all
lenders, the incentives vary between the two systems. A bank that originatesto-hold has an interest in ensuring that the property is worth the amount
claimed because that is the collateral for the loan, and it typically engages a
reliable appraiser to determine the value. Furthermore, the appraiser would
be urged by the bank to estimate conservatively, so that in the event of default,
the amount loaned could be recovered by seizing the collateral. When a bank
is unwilling to loan more than 80 percent of the appraised value, the loan
amount will be low with a conservative appraisal and more than 20 percent
of the actual sale price may be required for a down payment.
When loans are originated to be distributed, however, the lender is less
concerned with an accurate appraisal for the same reason that accuracy about
creditworthiness of the borrower is relatively unimportant. More importantly,
the originate-to-distribute lender has in interest in inflating the value of the
property so that the face amount of the loan is higher, since that amount is
the basis for the fee obtained from the securitizer. A higher face value can also
be achieved by lowering the amount of the downpayment, which raises the
principal of the loan. Thus, a 100 percent mortgage on a house with an inflated
appraisal is very attractive to a lender in the originate-to-distribute system but
anathema in the originate-to-hold system.
Under both systems, the lender has incentives to make mortgages with the
highest possible interest rate and the most fees, since these are the main
sources of income. Income can also be increased by designing loans that may
need to be refinanced. However, if onerous terms lead to default, then a bank
that holds the loan suffers, but the originate-to-distribute lender is unaffected.
So the former lender has an incentive the latter lacks to avoid onerous terms.
Also, banks that hold mortgages are more rooted in communities and have a
reputation to protect, which create additional incentives to moderate their
conduct.
Moreover, the type of loan—prime or subprime, conforming or not—is of
greater interest to a lender when loans are sold to securitizers. Banks that hold
mortgages generally have little interest in subprime loans, but when these are
in greater demand by securitizers, originate-to-distribute lenders would seek
to obtain more of them, perhaps by steering prime borrowers into subprime
loans. Nonconforming loans, in fact, were demanded by securitizers during
the peak years because they were seeking to take market share away from the
106 Ethics and the Retail Customer
GSEs (Fannie Mae and Freddie Mac), which, at least initially, would buy only
conforming loans.
Although securitization impacted mainly the incentives for lenders, borrowers, too, were affected. Since securitization greatly lowered the costs of
obtaining a mortgage and expanded the supply of credit, that fact, combined
with escalating house prices, drew many speculators into the market for
investment properties that could be quickly “flipped” for a tidy profit. The
same factors also induced many homeowners to take out home equity loans
or to refinance into higher-principal loans in order to obtain ready cash,
thereby using the home as a “piggy bank.” Thus, predatory lenders were joined
by predatory borrowers, who would use deception and misrepresentation to
obtain loans for which, in some case, they were not qualified.
The originate-to-distribute system also created a new role—the mortgage
broker, who mediated between borrowers and the originators. Their role in
mortgage origination was negligible as late as 1960, but at the peak of the
market in the 2000s, brokers originated approximately two-thirds of all mortgages.72 Today, mortgage brokers have virtually disappeared.73 Contrary to the
belief of many borrowers, mortgage brokers are responsible only to themselves; they are solely intermediaries between borrowers and lenders, with no
fiduciary duty to either. Since they are paid by originators, their incentives are
largely aligned with them—“Get ‘em what they want!”—but their main interest lies in getting the deal closed on any terms, because only then do they get
paid. However, the opportunity also exists for brokers to conspire with borrowers to misrepresent or conceal information when that is necessary for
obtaining a mortgage, or to broker loans that benefit neither borrower nor
lender but enrich themselves.
The aftermath
Although the subprime mortgage market is now largely in the past, the effects
linger. After the major banks bought up the main independent mortgage
companies in order to secure a steady supply of mortgages to securitize, the
subprime mortgage business collapsed during the financial crisis. The misdeeds of these mortgage companies now haunt their buyers, the major banks,
as homeowners, investors, and governments bring suits against them. The
ethical problems with subprime mortgages have shifted from origination to
foreclosure, as questions are raised about the obligations of the banks in
helping distressed homeowners to cope with their desperate situations.
Although money was allocated by the US government to finance foreclosures, little has been done by the major banks, which have benefited greatly
from the infusion of taxpayers’ money to avert their collapse. Homeowners
Ethics and the Retail Customer
107
complain, “The banks got bailed out, while we got sold out!” However, efforts
to address issues in foreclosure are hampered by two legitimate ethical concerns. For one, the public perceives the plight of some homeowners as due to
their own greed. Many agree with the ungrammatical rant of the television
personality Rick Santelli, who asked on the air, “How many people want to
pay for your neighbor’s mortgages that has an extra bathroom and can’t pay
their bills?” In addition, many of the mortgages in question have been sliced
and diced into countless securities owned by people all over the world, in
which the return owed is guaranteed by contract. Many homeowners may
have been wronged, but correcting these wrongs might violate the property
rights of these contract holders, which would also be a wrong.
A final ethical issue in the aftermath of the subprime bust is the ethics of
homeowners defaulting on mortgages when they are able to make payments.
This has become known as “jingle mail,” because of the sound that an envelope
full of keys makes when it is sent by a homeowner to the mortgage servicer
(It’s yours now!). In nonrecourse jurisdictions, where creditors cannot seize
more than the asset held as collateral (a house in the case of a mortgage), it
may make economic sense for an “underwater” homeowner who owes more
on a mortgage than a house is worth to simply walk away and let the bank
take possession. The fact that few “underwater” homeowners have actually
done this is in need of explanation. One possibility is that some combination
of shame, guilt, and fear deter them from doing what is otherwise rational.74
Others argue that walking away or “jingle mail” is not as economically rational,
nor as morally permissible, as may first appear.75
Although the banking industry argues vigorously that a homeowner has
promised to repay a loan—and, of course, promises should be kept—this
industry also argues that a contract is a contract and ought to be followed,
regardless of moral considerations. (This is why contracts should not be
modified in foreclosure, for example.) Is the banking industry guilty of
inconsistency in this stand? Moreover, the contract in question, the mortgage
document, provides for a remedy in the event of default, which is generally
limited to bank seizure of the property. It may be argued that the bank has,
in effect, sold the homeowner a put option to sell back the property, and that
the homeowner is merely exercising this option. Would a bank say that it had
an obligation to decline the right to exercise an option due to moral concerns?
After all, it is exercising an option in proceeding with foreclosure without
regard for the human cost, and some homeowners’ distress, it may be argued,
was caused by the banks in the first place. So, do they have a right to compound this harm by foreclosing on properties when mortgage modification is
also possible? The aftermath of the subprime bust leaves many ethical questions unanswered.
108 Ethics and the Retail Customer
Arbitration
The American humorist Alexander Woollcott once quipped that a broker is
“a man who runs your fortune into a shoestring.” Unfortunately, not a few
investors have entrusted their life savings to a broker only to discover their
once-large nest egg consumed by churning, unauthorized trading, or the
failure of a broker to follow orders—or simply by a broker’s incompetence.
The problem is not confined to brokers. Bank customers, credit card holders,
mutual fund investors, insurance policy holders, and a wide variety of other
ordinary people find that they have suffered losses from possible misconduct
by financial services providers.
Justice requires that the victims of abuse or incompetence be compensated
for their losses and perhaps that the wrongdoers be punished. Of course,
customers or clients may attempt to blame financial services providers for
their own failures and misfortunes, and so a method for settling disputes is
required, lest an injustice be done to either party. The court system is designed
to handle disputes of this kind in a just manner, but costly and lengthy legal
battles often do not serve anyone’s interests. Individuals who have few resources
or whose losses are minor would be deterred from seeking compensation if a
court fight were their only recourse, while financial services firms would face
constant litigation if every disgruntled customer or client were to sue.
Arbitration, instead of litigation, appears to be a quick, low-cost method of
dispute resolution that serves the interests of all concerned. Most labor contracts, for example, provide for binding arbitration because of the advantages
over court action. Similarly, in the securities industry, predispute arbitration
agreements (PDAAs), which commit customers or clients (and often employees) to binding arbitration, are standard. Many investors are precluded,
therefore, from suing in court and are forced to submit disputes to a panel of
arbitrators. In addition, employees who might otherwise be able to sue for
discrimination or other illegal treatment are often forced into arbitration, and
credit card customers, insurance policy holders, and other users of financial
services are increasingly being required to arbitrate disputes. Despite the
virtues of arbitration, the process is open to abuse, and critics charge that
many injured parties have been denied justice. Arbitration, they say, is heavily
weighted in favor of the industry, so that people who have been wronged once
by dishonesty or incompetence are wronged yet again by a bullying firm. Some
of the most elemental principles of due process are not observed by arbitration
panels. In addition, the promise of quick, low-cost dispute resolution has not
always been realized because arbitration is sometimes as hard-fought as court
battles. The industry itself complains that unpredictable punitive damage
Ethics and the Retail Customer
109
awards expose firms to potentially heavy liability. All sides in the arbitration
controversy recognize the need for thoroughgoing reform.
In 1994, the NASD, which at the time handled 85 percent of all arbitration
claims in the securities industry, appointed an eight-member Arbitration
Policy Task Force under former SEC chairman David S. Ruder to make recommendations for an overhaul of the current system. The task force report,
Securities Arbitration Reform, which was issued in January 1996, contains
more than 70 recommendations that represent, according to a press release,
“the most comprehensive revamping of securities industry arbitration since it
was established to resolve investor disputes more than a century ago.”76 The
so-called Ruder Commission investigated four main areas of concern: the
requirement of compulsory arbitration through the use of PDAAs; the hardball legal tactics of securities firms; the competence and accountability of
arbitrators; and the permissibility of punitive damages.
Compulsory arbitration
Investors who open accounts with a brokerage firm are usually asked to sign
a PDAA. These agreements are required for virtually all margin or option
accounts and more than 60 percent of money management accounts, but not
commonly for cash trading accounts. Customers who refuse to waive the right
to sue will generally be told to go elsewhere, but they will find the same form
awaiting them at any other firm. Can investors be said to agree voluntarily to
compulsory arbitration if signing a PDAA is a condition of doing business
with a brokerage firm? One congressional critic of arbitration describes “fair
compulsion” as an oxymoron and contends, “Investors should not be forced
to make the Faustian bargain of signing away rights to litigate in order to invest
in our financial markets.”77
The law for self-regulating organizations (SROs), under which NASD is
organized, and the NASD code permit customers to insist that any dispute be
arbitrated, regardless of whether a PDAA has been signed, but legally customers have a right to litigate—unless, of course, they waive that right. However,
at least two questions must be asked about compulsory arbitration agreements. Should the law permit firms to require that investors sign a PDAA as
a condition of opening an account? In particular, should a PDAA be legally
enforceable if compulsory arbitration does not enable an investor to protect
rights granted by law?
In 1987, the US Supreme Court addressed these questions in Shearson/
American Express, Inc. v. McMahon.78 The court unanimously upheld the
right of the securities industry to require customers to submit claims to arbitration on the grounds that the law merely supports a federal policy favoring
110 Ethics and the Retail Customer
arbitration by SROs. In short, it is the judgment of Congress that the American
public is better served by arbitration, rather than litigation, in the securities
industry. The right to require a PDAA does not apply to an agreement that
results from fraud, but this exception aside, PDAAs are legally enforceable.
Investors also have a right under securities law not to be defrauded by brokers.
Do PDAAs require investors to forgo this legal protection? No, the court ruled
in the McMahon decision, as long as arbitration is reasonably effective in
enforcing investor rights in securities transactions. Whether arbitration provides sufficient protection is a matter for Congress, not the courts, to decide.
The bottom line, however, is that PDAAs are fair to investors only if they
effectively protect all investor rights.
Other ethical and legal issues are whether investors should be told that they
are agreeing to compulsory arbitration by opening an account, and whether
they should understand fully what signing a PDAA entails. Customers
complain that the agreement provisions are expressed in impenetrable legal
language buried deep inside the documents for opening an account. Many
people do not realize that the rules for arbitration are different from those
in the courts. The Ruder Commission report specifically recommends that
the PDAA be highlighted and that investors be required to acknowledge the
agreement in writing. Further, the following disclosures should be prominently displayed:
1.
2.
Arbitration is final and binding on the parties.
The parties are waiving their right to seek remedies in court, including
the right to a jury trial.
3. Discovery is generally more limited and different from discovery in judicial proceedings.
4. The arbitrator’s award is not required to include factual findings or legal
reasoning and any party’s right to appeal or to seek modification of the
arbitrator’s rulings is strictly limited.
5. The panel of arbitrators will typically include a minority of arbitrators who
were, or are, affiliated with the securities industry.79
Some states, most notably New York, do not permit punitive damages in
securities arbitration. Whether arbitration agreements involving customers
and firms in other states can include waivers of any right to punitive damages
is unclear, but in any event, some investors have signed PDAAs that preclude
punitive damages without being aware of having done so. Prior to 1995, many
brokerage firms inserted a clause in their PDAAs that specified that in arbitration the laws of New York State will prevail, without adding, of course, that
Ethics and the Retail Customer
111
these laws prohibit punitive damages. A college professor in Chicago named
Antonio C. Mastrobuono signed such an agreement with Shearson Lehmann
Hutton, Inc., little realizing the implications, and when he won punitive
damages from an arbitration panel, the brokerage firm filed suit to block the
award, contending that Mastrobuono had waived the right to punitive damages.
In a 1995 decision, the Supreme Court found in favor of Mastrobuono on the
grounds that the contract was not sufficiently explicit, although the high court
did not express an opinion on either the merit of awarding punitive damages
or the ethics of hiding a waiver in nonrevealing language. Professor Mastrobuono, a Dante scholar, was more forthcoming: “To allow Wall Street to
steal from customers and then limit what they can recover in a forum of its
choosing,” he said, “would be institutional immorality worthy of punishment
in Dante’s fourth circle of hell.”80
Hardball legal tactics
Although arbitration is intended to be less formal than a court trial, it has
become a legal battleground in which platoons of lawyers from both sides fight
tooth and nail over every aspect of the proceedings. Despite their professed
commitment to arbitration, brokerage firms have eagerly gone to court to get
their way in arbitration. Thus, investors who can seek justice only through
arbitration face a foe who can fight in two arenas at once.
The main points of contention in arbitration and litigation are: (1) the
eligibility of a claim for arbitration, especially whether the time limit for
making claims has expired; (2) the rules to be followed, especially those
governing the admissibility of evidence and the applicable law; and (3) the
documents that must be produced in discovery. Investors have accused brokerage firms of refusing to produce documents or delaying as long as possible,
and although arbitration panels have subpoena power, they rarely exercise it
or exact consequences for noncompliance. Many complaints are settled before
they reach an arbitration panel, some no doubt on generous terms, but brokerage firms have been known to take advantage of investors’ lack of resources
and uncertain prospects to settle cheaply. Virtually all settlements contain
confidentiality agreements that prevent unfavorable publicity about problem
brokers and their firms. In general, customers who enter arbitration can
expect a hardball legal approach from brokerage firms seeking to minimize
legal liability, no matter the cost to the industry’s reputation for fair treatment
of customers.
The Ruder Commission report addressed these problems with three main
recommendations.81
112 Ethics and the Retail Customer
(1) Bar collateral court litigation over procedural issues in arbitration until
after the arbitration award. The Commission recommends that the
parties seek to resolve procedural issues in the arbitration forum and
delay any court litigation until the arbitration panel has ruled.
(2) Suspend the six-year eligibility rules and resolve issues of whether an arbitration claim is time barred by more vigorously applying applicable state
and federal statutes of limitations. Under the current rule, claims must
be brought within six years of the alleged wrongdoing. Aside from the
fact that some investors might not discover fraudulent activity within
this period of time, the six-year rule is difficult to apply because of
uncertainty over the date of the alleged offence.
(3) Simplify document production and other discovery, and require early resolution of any discovery dispute. The Commission concluded from its
study that the process of obtaining documents from the opposing side
was a main obstacle to quick, low-cost arbitration and the source of
much collateral litigation. Discovery is also abused by lawyers who use
“vacuum-cleaner” tactics, common in civil litigation, that seek to gain
all available evidence and at the same time burden the opposing side
with heavy production requirements.
Problems with arbitrators
Critics of arbitration complain that some arbitrators are inattentive to the
proceedings, ignorant of the relevant law and of arbitration procedures, capricious and inconsistent in their rulings, and biased in favor of the industry.
Arbitrators, for their part, feel overburdened and undercompensated, and they
lament the lack of time and resources for more training. Some of the complaints about arbitrators are compounded by the rules for arbitration. For
example, at least one arbitrator on a panel must have ties to the industry, thus
creating an impression of a stacked deck. The limited number of arbitrators
and the limited opportunity of the parties to select among them reduce
confidence in the system. Arbitration panels typically do not explain their
reasoning, nor can their decisions be appealed. Thus, the parties are deprived
of any basis for judging the soundness of the decision-making process or the
competence of the decision makers.
The Ruder Commission report notes a tension between a traditional model
of arbitrators as peers, who draw upon their knowledge and experience, and
a more recent model of professional, full-time arbitrators, not unlike the judiciary.82 The traditional model may have served the securities industry well in
the past, but the report suggests that the time has come for the shift to the
professional model that prevails in labor relations and large commercial dis-
Ethics and the Retail Customer
113
putes. In addition to making numerous recommendations for improvements
in the training and compensation of arbitrators and an increase in their
number, the Ruder Commission report also proposes that complaints involving smaller amounts be arbitrated using simplified procedures. Also, greater
use should be made of mediation and “early neutral evaluation” (ENE).
Punitive damages
The Ruder Commission report observes, “No subject has generated more
controversy or so polarized opinion between the investor community and
the securities industry than the availability of punitive damages in securities
arbitration.”83 The industry has made the elimination of punitive damages its
main goal, while investors have sought to maintain the possibility of punitive
damage awards.
The industry view is that arbitration is intended to compensate investors
for actual losses, not to punish individuals and firms for past misconduct or
to deter them from future misconduct. If arbitration panels were to aim at
punishment and deterrence, then they would have to consider many factors
besides the case at hand. Moreover, punishment and deterrence are the province of the state and ought to be left to regulators acting to protect the public,
not to arbitrators who are settling private disputes. Because punitive damages
can be enormous, it is unfair that they be imposed in proceedings that lack
important procedural safeguards, such as the consideration of all relevant
information and the right of appeal. Finally, the possibility of punitive damages
raises the stakes for brokerage firms and induces them to take a hardball legal
approach.
Investors argue that punitive damages protect against predatory behavior
by brokerage firms. Since the McMahon decision permits brokerage firms to
require PDAAs as a condition of opening an account and to force customers
to settle disputes through arbitration, investors should not be further deprived
of a remedy that would otherwise be available in civil litigation. In short,
investors should have the same remedies in arbitration that they have in
court—especially since they have little say in the choice of venues. This principle is expressed, moreover, in SEC and NASD rules that prohibit the placing
of any restrictions on arbitrators with regard to the kind and amount of
awards.
The Ruder Commission concedes the merits of both views and does not
side with either one. Instead, the report offers a compromise position: that
punitive damages be retained subject to a cap. Specifically, the proposed cap
is the lesser of two times the compensatory damages, or $750 000. The main
benefit of a cap, whatever the amount, is to alleviate industry concern with
114 Ethics and the Retail Customer
the unlimited exposure that exists under the present system. The recommended amount is high enough that few investors would be affected. In
addition, the Ruder Commission report proposes that the availability of punitive damages in arbitration be determined by whether punitive damages
would be available in court for the same claim under the laws of the investor’s
state at the time that the claim was filed. “By this standard,” the report notes,
“investors will be no better or worse off than if they had brought their claim
to a judicial forum.”84
Disputes between investors and brokers are inevitable, and so some means
of just resolution must be available. However, the securities industry should
also aim to eliminate the causes of disputes, and not merely deal with them
as they arise. As a commentator in BusinessWeek observed, “The industry’s
proposals simply amount to a more efficient shovel brigade for the elephant
parade. Instead, the industry should work on the front end to prevent abuses
in the first place.”85
Conclusion
Retail customers of financial services are especially vulnerable since the providers of these services typically have great powers that can be easily abused,
and they also have strong incentives to do so. For their part, customers vary
greatly in their financial knowledge and sophistication, and given the importance of financial services to our lives, everyone should be able to utilize them
without fear of being abused. Although the market provides customers with
considerable protection—no bank, for example, can survive without great
trust and loyalty—substantial regulation is also necessary. This regulation is
often guided by ethics since questions often arise about the duties or obligations of financial services providers to customers, as well as about the rights
of consumers. In addition, the ethical treatment of customers goes beyond
what markets and regulation would impose. Providers must determine what
is ethical in their treatment of customers and how to implement ethical standards through their practices and policies. The main topics in this chapter—
sales practices, credit cards, mortgage lending, and arbitration—do not exhaust
those that affect retail customers, and, indeed, much of this book is relevant
to the vulnerability that we all feel in dealing with the world of finance.
Notes
1.
2.
“Burned by Merrill,” Business Week, April 25, 1994.
Ellen E. Schultz, “You Need a Translator for Latest Sales Pitch,” Wall Street
Journal, February 14, 1994.
Ethics and the Retail Customer
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
115
Michael Quint, “Met Life Shakes Up Its Ranks,” New York Times, October
29, 1994.
Penelope Wang, “Why Mutual Funds Investors Need a Truth-in-Labeling Law,”
Money Magazine, October 1995; John S. Longstaff, “Has Your Mutual Fund
Changed its Personality?” Money Magazine, January 1996.
Ellen E. Schultz, “SEC Staff Supports Limited Disclosure of Variable-Annuity
Fees in Ad Charts,” Wall Street Journal, November 7, 1995.
Schultz, “SEC Staff Supports Limited Disclosure of Variable-Annuity Fees in Ad
Charts.”
Stanley Luxenberg, “Who’s Churning Whom?” Forbes, December 1985.
Jeff Bailey, “A Man and His Loan: Why Bennie Roberts Refinanced 10 Times,”
Wall Street Journal, April 23, 1997.
Walt Bogdanish, “Irate Borrowers Accuse ITT’s Loan Companies of Deceptive
Practices,” Wall Street Journal, February 26, 1985; Charles McCoy, “ITT Unit
Settles Fraud Charges in California,” Wall Street Journal, September 22, 1989.
Robert Berner, “U.S. Files Suit Against Sears Roebuck Charging Unfair Card
Debt Collection,” Wall Street Journal, April 18, 1997.
Report of the Committee on Compensation Practices, issued by the Securities and
Exchange Commission, April 10, 1995.
Report of the Committee on Compensation Practices.
Marshak v. Blyth Eastman Dillon & Co. Inc., 413 F. Supp. 377, 379 (1975).
Kaufman v. Merrill Lynch, Pierce, Fenner & Smith, 464 F. Supp. 528, 534 (1978).
Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976); 96 S. Ct. 1375, 1381 (1976).
The formula is ATR = P/E × 365/D, where P = total cost of purchases made
during a given period, E = average equity in the account during the same period,
and D = number of days during the period.
Marion V. Heacock, Kendall P. Hill, and Seth C. Anderson, “Churning: An
Ethical Issue in Finance,” Business and Professional Ethics Journal, 6 (1987),
3–17.
For objections to these measures, see Robert F. Almeder and Milton Snoeyenbos,
“Churning: Ethical and Legal Issues,” Business and Professional Ethics Journal, 6
(1987), 22–3l.
Hecht v. Harris, Upham & Co., 238 F. Supp. 417, 435 (1968).
NASD Rules of Fair Practice, art. III, sec. 2.
Harry M. Markowitz, “Portfolio Selection,” Journal of Finance, 7 (1952), 77–91;
and Harry M. Markowitz, Portfolio Selection (New Haven, CT: Yale University
Press, 1959).
The issuers of credit cards are mainly banks or credit unions, although some large
retailers issue their own credit cards. Since banks are the dominant issuer of
credit cards, the terms “issuer” and “bank” are used here interchangeably. Credit
cards also require a payment system for processing transactions between customers and retailers. The two major payment systems are MasterCard and Visa,
but some issuers, such as American Express and Discover, provide their own
payment system. The role of payment systems is excluded from this discussion
of credit cards.
116 Ethics and the Retail Customer
23.
24.
25.
26.
27.
28.
29.
30.
31.
32.
33.
34.
35.
Board of Governors of the Federal Reserve System, Consumer Credit, Statistical
Release G.19, January 2013.
Amy Traub and Catherine Ruetschlin, The Plastic Safety Net: Findings from the
2012 National Survey on Credit Card Debt of Low- and Middle-Income Householders, www.demos.org, 2012.
BCS Alliance, Credit Card Profits, http://www.bcsalliance.com/creditcard
_profits.html.
Public Law Number 111-24, 123, United States Statutes at Large, 1734.
Board of Governors of the Federal Reserve System, Report to the Congress on the
Profitability of Credit Card Operations of Depository Institutions, June 2012.
Interview with Shailesh Mehta, former CEO of Providian, Frontline, The
Card Game, 2009, http://www.pbs.org/wgbh/pages/frontline/creditcards/etc/
script.html.
Joshua M. Frank, Dodging Reform: As Some Credit Card Abuses are Outlawed,
New Ones Proliferate, Center for Responsible Lending, December 10, 2009. See
also Sha Yang, Livia Markoczy, and Min Qi, “Unrealistic Optimism in Consumer
Credit Card Adoption,” Journal of Economic Psychology, 28 (2007), 170–185.
Connie Prater, “U.S. Credit Card Agreements Unreadable to 4 Out of 5 Adults:
Contracts Written at a Reading Level Most Can’t Understand,” Creditcards
.com, July 22, 2010, http://www.creditcards.com/credit card-news/credit card
-agreement-readability-1282.php.
See Robert D. Manning, Credit Card Nation: The Consequences of America’s
Addiction to Credit (New York: Basic Books, 2000).
For analyses of the CARD Act, see Jim Hawkins, “The CARD Act on Campus,”
Washington and Lee Law Review, 69 (2012), 1471–1534; Kathryn A. Wood,
“Credit Card Accountability, Responsibility and Disclosure Act of 2009: Protecting Young Consumers or Impinging on Their Financial Freedom?” Brooklyn
Journal of Corporate, Financial and Commercial Law, 5 (2010–2011), 159–183;
Regina L. Hinson, “Credit Card Reform Goes to College,” North Carolina Banking
Institute, 14 (2010), 287–308.
Haiyang Chen and Ronald P. Volpe, “An Analysis of Personal Financial Literacy
Among College Students,” Financial Services Review, 7 (1998), 107–128; James
A. Roberts and Eli Jones, “Money Attitudes, Credit Card Use, and Compulsive
Buying Among American College Students,” Journal of Consumer Affairs, 35
(2001), 213–240; Jacquelyn Warwick and Phylis Mansfield, “Credit Card
Consumers: College Students’ Knowledge and Attitude,” Journal of Consumer
Marketing, 17 (2000), 617–626.
The Federal Reserve Board clarified the CARD Act in Regulation Z, which states
that students may use any income or assets to demonstrate ability to repay
and that they need only the ability to pay the minimum amount due. Furthermore, the obligation of a cosigner extends only until the student’s twenty-first
birthday. Code of Federal Regulations §226.51 (2012).
Creola Johnson, “Maxed Out College Students: A Call to Limit Credit Card
Solicitation on College Campuses,” Legislation and Public Policy, 8 (2005), 191–
277, 191–192.
Ethics and the Retail Customer
36.
37.
38.
39.
40.
41.
42.
43.
44.
45.
46.
47.
48.
49.
50.
51.
52.
53.
54.
55.
117
Johnson, “Maxed Out College Students”, p. 193.
Jill M. Norvilitis, P. Bernard Szablicki, and Sandy D. Wilson, “Factors Influencing
Levels of Credit Card Debt in College Students,” Journal of Applied Social Psychology, 33 (2003), 935–947, 941.
Wood, “Credit Card Accountability, Responsibility and Disclosure Act of 2009,”
p. 163.
Warwick and Mansfield, “Credit Card Consumers,” p. 623.
Angela C. Lyons, “A Profile of Financially At-Risk College Students,” Journal of
Consumer Affairs, 38 (2004), 56–80, 63; and Norvilitis, Szablicki, and Wilson,
“Factors Influencing Levels of Credit Card Debt in College Students,” p. 941.
Manning, Credit Card Nation, p. 162.
Roberts and Jones, “Money Attitudes, Credit Card Use, and Compulsive Buying
Among American College Students,” p. 234.
Hawkins, “The CARD Act on Campus,” pp. 1504–1505.
In Re: Checking Account Overdrafting Litigation, United State District Court,
Southern District of Florida, Miami Division, Case No. 1:09-MD-02036-JLK.
Beth Healy and Todd Wallack, “Citizens in $137.5 M Overdraft Settlement,”
Boston Globe, April 25, 2012.
For examples, see Joshua M. Frank, Dodging Reform: As Some Credit Card Abuses
Are Outlawed, New Ones Proliferate, Center for Responsible Lending, December
10, 2009.
Neil Stewart, “The Cost of Anchoring on Credit Card Minimum Repayments,”
Psychological Science, 20:1 (2009), 39–41.
Federal Deposit Insurance Corporation, FDIC Study of Bank Overdraft Programs,
November 2008.
Tara Siegel Bernard, “In Retreat, Bank of America Cancels Debit Card Fee,” New
York Times, November 1, 2011.
Carl F. Taeusch, “The Concept of ‘Usury’: The History of an Idea,” Journal of the
History of Ideas, 3 (1942), 291–318.
Max Weber, The Protestant Ethic and the Spirit of Capitalism, trans. Talcott
Parsons (London: Unwin University Books, 1968 [first published in 1930]); and
R. H. Tawney, Religion and the Rise of Capitalism: A Historical Study (New York:
Harcourt Brace and Company, 1926).
Marquette National Bank of Minneapolis v. First of Omaha Service Corp., 439 U.S.
299 (1978).
Smiley v. Citibank, 517 U.S. 735 (1996).
For further development of these arguments, see Vincent D. Rougeau, “Rediscovering Usury: An Argument for Legal Controls on Credit Card Interest Rates,”
University of Colorado Law Review, 67 (1996), 1–46.
The Omnibus Budget Reconciliation Act of 1993 added Section 162(m) to the
Internal Revenue Code, which removed the unrestricted tax deductibility of
salary compensation over $1 million. Critics charge that the main effect of this
legislation was to make $1 million the base pay for CEOs and to encourage the
use of stock options as an alternative to cash compensation, thereby exacerbating
the problem of high executive compensation. See Nancy L. Rose and Catherine
118 Ethics and the Retail Customer
56.
57.
58.
59.
60.
61.
62.
63.
64.
65.
66.
Wolfram, “Has the ‘Million Dollar Cap’ Affected CEO Pay?” American Economic
Review, 90 (2000): 197–202; and Brian J. Hall and Jeffrey B. Liebman, “The Taxation of Executive Compensation,” in James Poterba (ed.), Tax Policy and the
Economy, vol. 14 (Cambridge: NBER & MIT Press, 2000).
“The Economic Effects of Proposed Ceilings on Credit Card Interest Rates,”
Federal Reserve Bulletin, 73 (January 1987), 1–13.
Todd J. Zywicki, “The Economics of Credit Cards,” Chapman Law Review, 3
(2000), 79–172.
Lawrence M. Ausubel, “The Failure of Competition in the Credit Card Market,”
American Economic Review, 81 (1991), 50–81. The period under study was
1983–1988.
Thomas F. Cargill and Jeanne Wendel, “Bank Credit Cards: Consumer Irrationality versus Market Forces,” Journal of Consumer Affairs, 30 (1996), 373–389. See
also Glenn B. Canner and Charles A. Luckett, “Developments in the Pricing of
Credit Card Services,” Federal Reserve Bulletin, 78 (1992), 652–666; and Zywicki,
“The Economics of Credit Cards.”
Angela Littwin, “Beyond Usury: A Study of Credit Card Use and Preference
among Low-Income Consumers,” Harvard Law School Faculty Scholarship Series,
Paper 8 (2007); and Angela Littwin, “Testing the Substitution Hypothesis: Would
Credit Card Regulation Force Low-Income Borrowers into Less Desirable
Lending Opportunities?” University of Illinois Law Review, 2009 (2009),
403–455.
National Commission on Consumer Finance, Report on Consumer Credit in the
United States (1972), p. 149.
Information on Lehman Brothers and First Alliance is taken from Monte Morin,
“Lehman Disputes Charges about First Alliance,” Los Angeles Times, February
19, 2003; E. Scott Reckard, “Lehman Aided Lender’s Fraud,” Los Angeles Times,
May 9, 2003; E. Scott Reckard, “Lehman Bros. Held Liable in Fraud Case,” Los
Angeles Times, June 17, 2003; Diana B. Henriques, “Lehman Aided in Loan
Fraud,” New York Times, June 17, 2003; and Michael Hudson, “Lending Hand:
How Wall Street Stoked the Mortgage Meltdown,” Wall Street Journal, June
27, 2007.
Financial Crisis Inquiry Commission Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States
(Washington, DC, January 2011), p. 70.
Kristopher Gerardi, Harvey S. Rosen, and Paul Willen, “Do Households Benefit
from Financial Deregulation and Innovation? The Case of the Mortgage Market,”
National Bureau of Economic Research, Working Paper 12967, March 2007.
Office of the Comptroller of the Currency, Board of Governors of the Federal
Reserve System, Federal Deposit Insurance Corporation, and Office of Thrift
Supervision, “Subprime Lending: Expanded Guidelines for Subprime Lending
Programs,” June 12, 2000.
See Edmund L. Andrews, “Fed Shrugged as Subprime Crisis Spread,” New York
Times, December 18, 2007; and Binyamin Appelbaum, “As Subprime Lending
Ethics and the Retail Customer
67.
68.
69.
70.
71.
72.
73.
74.
75.
76.
77.
78.
79.
80.
81.
82.
83.
84.
85.
119
Crisis Unfolded, Watchdog Fed Didn’t Bother Barking,” Washington Post, September 27, 2009.
Edward M. Gramlich, “Booms and Busts: The Case of Subprime Mortgages,”
Federal Reserve Bank of Kansas City, Economic Review, Fourth Quarter 2007,
pp. 105–113, 109.
Securities and Exchange Commission, “Excerpts of E-Mails from Angelo Mozilo,”
at http://www.sec.gov/news/press/2009/2009-129-email.htm.
The full text is: The 100% loan-to-value subprime product is “the most dangerous product in existence and there can be nothing more toxic and therefore
requires that no deviation from guidelines be permitted irrespective of the
circumstances.”
“Nightmare Mortgages,” Bloomberg Businessweek Magazine, September 10, 2006.
For a fuller discussion, see Robert W. Kolb, “Incentives in the Financial Crisis of
Our Time,” Journal of Economic Asymmetries, 7 (2010), 21–55.
Kolb, “Incentives in the Financial Crisis of Our Time,” p. 29.
Jeff Swiatek, “Mortgage Brokers Are Becoming a Vanishing Breed,” USA Today,
August 29, 2010.
This is argued in Brent T. White, “Underwater and Not Walking Away: Shame,
Fear, and the Social Management of the Housing Crisis,” Wake Forest Law Review,
45 (2010), 971–1023.
“The Morality of Jingle Mail: Moral Myths about Strategic Default,” Wake Forest
Law Review, 46 (2011), 123–153.
“Arbitration Task Force Issues 70 Recommendations in Largest Revamping of
Securities Arbitration Since Its Start More than a Century Ago,” NASD Press
Release, January 22, 1996.
Rep. Edward J. Markey of Massachusetts, quoted in Shirley Hobbs Scheibla, “See
You in Court,” Barron’s, June 5, 1989.
482 U.S. 220 (1987), cert. denied 483 U.S. 1056 (1987).
Securities Arbitration Reform: Report of the Arbitration Policy Task Force, January
1996, p. 15.
Margaret A. Jacobs and Michael Siconfolfi, “Investors Fare Poorly Fighting Wall
Street–And May Do Worse,” Wall Street Journal, February 8, 1995. The quotation
from the Wall Street Journal is a paraphrase of the speaker’s words.
NASD Press Release, January 22, 1996.
Securities Arbitration Reform, 88.
Securities Arbitration Reform, 10.
Securities Arbitration Reform, 45.
Michael Schroeder, “Wall Street Should Stop Playing the Bully,” BusinessWeek,
December 20, 1993.
Chapter Four
Ethics in Investment
The importance of financial services for our personal well-being is obvious,
but investment decisions by institutional investors, which manage large
volumes of capital, profoundly affect the quality of life in our communities
and the nation—indeed, the world. These decisions are critical to society
because they select from the opportunities that are available and determine
the direction of future growth. Some of this investment involves the management of individuals’ assets, especially in mutual funds and pension funds,
and thus affects people directly as retail customers. However, investment by
other institutional investors, such as endowments, insurance companies, trust
departments of banks, hedge funds, and sovereign wealth funds, affects
everyone indirectly and, ideally, promotes the welfare of all by allocating
capital to its most productive uses.
Investment decisions are typically based on objective calculations of risk
and return, not on considerations of the public good or social welfare. According to Adam Smith’s famous metaphor, though, an “invisible hand” hovers
over the marketplace and promotes an end that is not a part of anyone’s intention. So sound investment decisions tend to benefit everyone. However, the
marketplace is prone to many well-known failures, and the market mechanism
is not intended to promote some ends, such as equality in society. Thus, it is
questionable whether an ethical economy, as well as a prosperous one, can
permit investment decisions to be made without some attention to their
impact on the public good or social welfare.
Institutional investors, especially the managers of large pension funds, face
ethical challenges in exercising their responsibility as shareholders on behalf
of the people whose assets they manage. One response to these problems has
Ethics in Finance, Third Edition. John R. Boatright.
© 2014 John Wiley & Sons, Inc. Published 2014 by John Wiley & Sons, Inc.
Ethics in Investment 121
been the development of relationship investing, whereby institutional investors
take an active role in improving corporate performance. Their immediate aim
is typically to obtain a return, but in so doing they may also increase social
welfare. Some investors seek to make a positive social impact through the
investment process itself. This phenomenon, known as socially responsible
investing, raises some important ethical issues about how such investing
should be done and what benefit it can bring. A movement known as microfinance sees a potential in investment to alleviate poverty, especially in lessdeveloped countries. Whether microfinance can achieve this worthy goal and
constitutes a viable approach to poverty alleviation are important questions
to answer.
Mutual Funds
In 2011, mutual funds managed over $11 trillion for more than 53 million or
44 percent of American households, and the median of mutual fund assets for
these families was $120 000.1 These figures show that mutual funds are largely
the domain of individual investors of modest net worth who do not want to
manage a portfolio actively but seek returns that exceed bank savings accounts.
These funds combine convenience and flexibility with low levels of risk and
cost that would be difficult to achieve in relatively small portfolios.
Customer satisfaction with mutual funds is generally high, perhaps because
few opportunities exist for abuse or neglect, and also because dissatisfied
customers can so easily switch. Great care is taken by the industry to attract
and retain investors. However, some ethical issues have arisen in recent years
about certain practices within the industry, which fund shareholders may
not notice but which still have an impact on their returns. Most notable has
been a scandal involving market timing and late trading, which rocked the
industry beginning in 2003. A perennial ethical issue in mutual funds is
the conflict of interest that occurs when fund managers also invest for their
own accounts. Although it may be difficult, as well as undesirable, to prevent
such trading, it is a conflict that requires careful management. Finally, the
practice of soft-dollar brokerage is a practice that may be ethical, indeed even
beneficial, but that has nevertheless received considerable criticism. These
three topics are considered in this section on mutual funds.
Market timing
In 2003, reports surfaced that many mutual funds were allowing a few favored
clients, mostly investment funds, to engage in market timing. In this practice,
122 Ethics in Investment
large investments are made for short periods of time in order to benefit from
temporary changes in securities prices. Typically, it involves rapid “in-andout” trades (also called “round trips”) with purchases and redemptions within
a few days of each other. Although market timing of individual stocks is
common—indeed it is the main tactic of day traders—brokerage fees tend to
limit the gain, and market timing of individual stocks is not suitable for capitalizing on broad market movements. Rapid in-and-out trading in mutual
funds solves both of these problems: brokerage fees are avoided if the fund
has no up-front or back-end fees, and diversified funds generally reflect the
broader market. Market timing is especially attractive in international funds
due to the time lag in distant markets. When an international fund closes for
the day in New York, for example, the prices of Japanese stocks were set half
a day earlier, and European stock prices have been known for a few hours.
The resulting “stale” prices create opportunities for market timing (also called
“stale price arbitrage”).
The other practice that came to light in 2003 is late trading, in which orders
are placed after the close of trading in the United States, which is four o’clock
New York time. Late trading, which is strictly illegal in the US, enables investors to utilize information about the day’s activities and announcements made
after the markets’ close. In some instances, offsetting trades are entered during
the day, and then, after closing time, one trade is cancelled, leaving the desired
one to be executed. Whereas market timing still involves some judgment and
risk, late trading is a sure bet, rather like betting on a horse race after the
outcome is known.
In a 2003 SEC survey of the 88 largest mutual fund companies, more than
half admitted that they allowed market timing, and 25 percent admitted to
allowing late trading.2 According to another estimate, between 2001 and 2003,
over 90 percent of fund companies permitted market timing in at least one
fund, and late trading was permitted by 30 percent of them.3 During the same
period, market timing is estimated to have cost investors $5 billion per year4
and late trading $400 million.5 Although these amounts may be small for each
investor, the overall sums constitute a significant loss in returns.
Unlike late trading, which violates established trading rules, market timing
is legal as long as it is permitted by the mutual fund sponsor. Market
timing is ethically questionable, though, and possibly illegal when only a few
favored clients are permitted to engage in the practice to the detriment of
others who are discouraged or forbidden from trading on the same terms. Such
disparate treatment of a majority of investors is arguably a violation of a fund
sponsor’s fiduciary duty to serve the interests of all investors in accord with
stated policies. Thus, it might be ethical for a fund to openly permit market
timing for all shareholders, but not to secretly allow only a favored few in
Ethics in Investment 123
defiance of policies against this practice. The main ethical questions, then, are
what, if anything, is wrong with these two mutual fund trading practices, and
if they are wrong, what should be done to prevent them. Before these questions
are considered, more needs to be said about how market timing works.
How timing works
The abuses in mutual fund trading first became public in 2003 with an
investigation by Eliot Spitzer, the New York State attorney general, into the
activities of Canary Capital, headed by Edward J. (Eddie) Stern, which had
market-timing agreements with 30 mutual fund companies, including, most
notoriously, Bank of America and its Nations Funds family.6 Canary Capital
managed the Stern family fortune, which was based on the Hartz Mountain
pet food empire that was founded by the grandfather of Eddie Stern, who
arrived in the United States in 1926 with 5000 canaries to sell (hence the name
Canary Capital). Founded in 1998, Canary engaged in market timing from
the beginning, earning returns that greatly outpaced the market. In 1999,
when the S&P 500 index rose 20 percent, Canary earned 110 percent, and the
returns in 2000 and 2001 were 50 percent and almost 29 percent respectively,
when the market averages were down 9 percent and 13 percent in those same
years.
During the 1990s, market timing, which was practiced on a large scale
by perhaps a few hundred investors, was a mild irritant to mutual fund companies, which usually discouraged or, in some cases, banned the practice.
The prospectuses for most funds emphasized that they were intended as longterm investment vehicles, and investors were restricted to a few rapid trades
a year (most commonly four) and, in many cases, redemption fees were
imposed for short-term trades. Most fund companies had “timing police,” who
identified market timers and enforced the rules. By 2000, market timers,
who had previously managed to avoid detection by keeping a low profile and
moving from one fund to another, now found it more difficult to operate
without the cooperation of the mutual fund companies. Also, the increasingly
large investments (often tens of millions of dollars) made it more difficult to
operate undetected.
Although many mutual fund companies spurned the overtures of the
market timers—Fidelity, for example, firmly declined to do business with any
of them—others were receptive. This willingness of fund companies to permit
market timing of their funds to the detriment of ordinary investors was
prompted by the bear market that began in 2000, which reduced the assets
under management and the management fees that these assets generated.
Mutual fund companies were desperately looking for ways to maintain the
income levels of better times. Thus, some companies were interested when
124 Ethics in Investment
market timers like Eddie Stern offered to share some of the gains to be made
from rapid trading.
How did it work? As one writer explained:
Market-timing hedge funds—as well as brokers and other middlemen—
negotiated secret “capacity” arrangements in which they gained the right to run
a predetermined amount of money in and out of a fund and were exempted
from short-term redemption fees. In return, the market timer handled over a
second predetermined amount to the fund company—“sticky assets,” which sat
quietly and generated extra management fees for the fund complex. Often, the
sticky assets were placed in low-risk money-market or government bond funds.
But sometimes they’d end up in a hedge fund run by the fund managers, generating much juicier fees for both the portfolio managers and their firm.7
Canary Capital and some other market-timing funds also figured out how
to engage in short-selling with mutual funds. (Short-selling is profiting from
declining prices by selling borrowed shares and returning them later by buying
them back in the market after the price has dropped.) The method consisted
of developing a market instrument replicating holdings of a mutual fund that
could be shorted. However, developing this instrument required knowledge
of the holdings of the fund in question, which is information that is ordinarily
released only twice a year. Canary was able to strike deals in which fund
companies would provide a list of holdings at any given time, thus permitting
market timers, but not other investors, to short mutual funds.
Between 2000 and 2003, Canary Capital had market-timing agreements
with some of the major mutual fund companies, including Strong Capital
Management, Pimco Advisors, Janus Capital, Alliance Capital Management,
Bank One (now part of JPMorgan Chase), and Invesco. The reputation of
Putnam Investments was also badly tarnished for permitting other market
timers to trade in its funds. However, no mutual fund company went to greater
lengths to accommodate Canary than Bank of America, the sponsor of Nations
Funds (now a part of Columbia Management). In 2001, Bank of America
provided Canary with its own electronic trading terminal, installed in Canary’s
office, so that trades could be entered as late as 6:30 p.m. With direct access
to Bank of America’s trading system, Canary could disguise the origin of the
trades by mixing them with the bank’s own trading flow. Bank of America
provided Canary with a $300 million credit line to finance market timing in
its own funds, and the bank also revealed the portfolio holdings of funds so
that Canary could engage in short-selling.
Eventually, Bank of America settled all charges by agreeing to pay $125
million in penalties and $250 million in restitution to investors. Canary
Capital paid a fine of $40 million, and Eddie Stern agreed to cooperate with
Ethics in Investment 125
prosecutors in providing information about the mutual fund companies with
which he had market-timing agreements. Most of the other offending mutual
fund companies have entered into legal settlements and taken steps to compensate investors for their losses and restore their deeply tarnished reputations. In addition, a few individuals at the mutual fund companies have faced
criminal charges for their involvement in this scandal.
One individual, in particular, provides a striking example of the abuse in
mutual fund trading. Richard S. Strong was the founder, chairman, and chief
investment officer of Strong Capital Management (SCM), as well as chairman of
the board of directors of the 27 investment companies that managed the 71
SCM funds. When Mr Strong founded Strong Capital Management in 1974,
he wanted it to be “the Nordstrom’s of the financial industry,” believing that
this store provided the very best customer service. With this goal in mind, he
built SCM into an investment company that by 2004 managed $33.8 billion
in mutual fund and pension investments. In that year, though, SCM and
Richard Strong came under scrutiny for market timing, not only by outside
investors but by Mr Strong himself.
Despite the company’s policy on market timing, Richard Strong engaged
in market timing in SCM mutual funds, making 1400 quick trades between
1998 and 2003, including 22 round trips in 1998 in a fund for which he was
also a portfolio manager. In 2000, SCM’s timing police detected the chairman’s
trading activity, and the general counsel spoke to him, noting that his trading
was inconsistent with the company’s stated position on market timing and
its treatment of other market timers. After agreeing to quit, he increased his
activity, making a record 510 trades in 2001. In total, he netted $1.8 million
and obtained much higher returns than ordinary investors in the same SCM
funds. Richard Strong’s market timing was costly not only to SCM but also to
Mr Strong personally. The company agreed to pay $40 million in fines and
an additional $40 million in restitution, as well as reducing the fees on
SCM funds by a total of approximately $35 million over the next five years.
Mr Strong personally agreed to pay $30 million in fines and the same amount
in restitution, and to accept a lifetime ban from the financial services
industry.8
It was SCM’s involvement with Canary that eventually led to the downfall
of both companies. In 2001 and 2002, Canary was making so much money
and attracting so many new investors that it became more difficult to obtain
sufficient “capacity” in mutual funds that would permit market-timing trades.
In an effort to get the attention of Goldman Sachs, Canary hired a former
employee, Noreen Harrington. Goldman Sachs was uninterested, and Harriman left in dismay when she discovered how Canary’s money was made. She
was not intending to blow the whistle until her sister complained about how
126 Ethics in Investment
much money she was losing in her mutual fund and how she would never be
able to retire. “I didn’t think about this from the bottom up until then,” Harrington said.9 A telephone call to the New York State attorney general’s office
started the investigation that led not only to Canary but also to Richard Strong.
What is wrong with timing?
Although market timing, unlike late trading, does not violate an explicit legal
prohibition, it is morally objectionable and arguably illegal for several reasons.
First, it allows a few favored clients to trade under terms that are unavailable to the vast majority of ordinary investors. If a fund openly offers the
opportunity to engage in rapid in-and-out trading with few, if any, restrictions,
so that all investors can take equal advantage of market-timing opportunities,
then no one would be treated unfairly. Such a market-timing fund would have
transparency—that is, all investors would know the rules—and it would
provide equal treatment—that is, the same rules would apply to all. Market
timing under these conditions would be morally unobjectionable and perfectly legal. However, very few funds openly permit market timing, although
a few do. Most funds actively discourage short-term trading by advising
against it, placing restrictions on the number of round trips, and imposing
redemption fees on short-term investments. The objection to market timing
in most mutual funds, then, is that that some investors are subject to different,
more favorable rules (unequal treatment) of which other investors are not
aware (transparency).
For example, Strong Capital Management, like most mutual fund companies, encouraged long-term holding of five years or more and advised that
market timing does not work. Beginning in 1997, SCM warned shareholders
that frequent traders could be banned: “Since an excessive number of exchanges
may be detrimental to the Funds, each Fund reserves the right to discontinue
the exchange privilege of any shareholder who makes more than five exchanges
in a year or three exchanges in a calendar quarter.” Like most other mutual
fund companies, SCM also had timing police, who monitored trading activity
for frequent activity, and from 1998 through 2003, hundreds of market timers
were identified and barred from investing in Strong funds. When it was discovered that some SCM employees were market-timing in their own accounts,
the company issued a clear directive that the Strong funds were not to be used
for short-term trading and that violators could have their trading privileges
restricted. From these facts, a reasonable investor could assume that marketing timing does not take place in SCM mutual funds.
Second, allowing marketing timing hurts long-term mutual fund investors
by increasing a fund’s expense and reducing its returns. Large inflows and
outflows in short time periods add trading and other overhead costs. In addi-
Ethics in Investment 127
tion, the manager of a fund with active market timers may have to keep a
more liquid position in order to meet redemption orders or otherwise make
different investment decisions. The result may be the adoption of trading
strategies that are less than optimal for long-term investors. Also, frequent
sales of securities to meet redemption orders by market timers may produce
capital gains that result in higher taxes for all fund investors. Moreover, if
the value of a fund rises after a market timer’s investment was made, and
if the trader cashes out quickly before the fund purchases any new securities,
the effect is to dilute the earnings of a fund. Under such conditions, the earnings are due entirely to money provided by other investors and yet the market
timer shares in the returns. All of these possibilities involve losses to investors
without any corresponding gains—except for the market timers. In short,
market timers are able to impose costs on every fund investor for trading
activity from which only they benefit.
Third, insofar as market timing is unfair and harmful to ordinary investors,
it can be argued that the directors and executives of mutual fund companies
are violating a fiduciary duty to serve investors’ interests. Each mutual fund
is, legally, an independent company with a board of directors and a chairman
(although the same persons may be directors and chairmen of dozens, if not
hundreds, of funds offered by a single mutual fund company). The investors
are the shareholders of a mutual fund and the fund itself purchases and owns
the securities that comprise the fund’s assets. Although mutual funds are
sponsored by a mutual fund company, legally the board of directors selects
and contracts with the fund’s sponsor. A mutual fund company is simply an
agent hired by the directors of a fund to administer or advise the fund. Accordingly, the directors and executives of a mutual fund have the same kind of
fiduciary duty to its investors as the directors and executives of a publicly held
company have to its shareholders.
Indeed, all company personnel have an obligation to refrain from actions
that would harm a fund’s investors. In the SCM code of ethics, which was
distributed to all employees, Richard Strong summed up the “three most
important principles” for dealing with clients:
• You must deal with our clients fairly and in good faith.
• You must never put the interests of our firm ahead of the interests of our
clients.
• You must never compromise your personal ethics or integrity, or give the
appearance that you may have done so.
Thus, because of the fiduciary duty imposed by law on the directors and executives of mutual funds, as well the codes of ethics that mutual fund companies
128 Ethics in Investment
adopt and publish, investors have a right to expect that their interests will not
be harmed by capacity agreements with market timers, and especially not by
market timing by a company’s own personnel.
The wrongness of market timing, then, does not lie in the practice itself,
whether it is done by investors making frequent trades or by mutual fund
companies in allowing such trading. The wrongness consists rather in the
inconsistency of presenting mutual funds as safe, reliable investment vehicles
for relatively unsophisticated investors and at the same time collecting additional revenue from market timers who are allowed to benefit at the expense
of ordinary investors. By allowing market timers, mutual fund companies are
professing to play by one set of rules while secretly playing by another, which
is a kind of fraud. At bottom, mutual fund companies are betraying a trust
that is the cornerstone of their industry, and market timers are inducing fund
personnel to betray that trust.
What should be done
If market timing is wrong, then the obvious remedy is for all parties to refrain
from doing it. This solution overlooks the conditions that led to the scandal
in the first place. The failure is not a simple lack of recognition about what is
right and wrong but rather the result of a number of converging forces. When
an unethical practice occurs simultaneously in such a large number of financial institutions, including some of the most respected and successful mutual
fund companies, the underlying causes are likely to be complex.
In this case, the factors are easily recognized. The mutual fund industry is
relatively young, coming into existence after the passage of the Investment
Company Act of 1940. Only in recent years has institutional investing by
mutual funds, as well as pension funds, exceeded individual stock ownership.
The popularity of mutual funds increased significantly with the bull market
of the 1990s. Because of the small size of the industry through much of its
short history and its reputation for trust and integrity, it has been lightly regulated. Although mutual fund companies are not recognized as self-regulating
organizations like the major exchanges, such as the New York Stock Exchange
or NASDAQ, and are formally under the jurisdiction of the SEC, they operate
with little oversight, and neither Congress nor the SEC has seen a need for
extensive regulation. The mutual fund industry is supported by a large national
trade association, the Investment Company Institute, founded in 1940, which
aggressively advances the interest of its member companies and generally
opposes proposed additional regulation.
The market-timing scandal occurred between 2000 and 2003, which was
a difficult period of reduced returns due to the piercing of a bubble in the
economy. The decade prior saw a bull market in which the mutual fund indus-
Ethics in Investment 129
try experienced tremendous growth and record-setting revenues. However,
a few large mutual fund companies, including Fidelity and Vanguard, had
captured a large market share, leaving a multitude of small firms to compete
for the rest of the market. In 2001, the combination of too many mutual fund
companies and fewer, more wary investors created great pressure on mutual
fund companies to maintain the expected high earnings. Conditions in the
mutual fund industry made for a disaster waiting to happen.
In the wake of the mutual fund scandal, the following reforms have been
proposed:
1. Governance. Where were the directors of mutual funds when market
timers were allowed to engage in rapid in-and-out trading? Ultimately,
the board of directors of a fund is responsible for ensuring that investors’
interests are served. However, directors typically serve on dozens, if not
hundreds, of boards. In some mutual fund companies, every fund has the
same directors and chairman. Many of the directors and chairmen are
also company executives or else have close ties to the company, so that
they are not truly independent. Thus, they face a conflict of interest.
Various proposals have been advanced to limit the number of boards on
which directors serve, to increase the percentage of independent directors, and to require that the chairman of the board be an independent
party who is not otherwise connected with the mutual fund company.
2. Disclosure. If market timing harms investors, then the losses should be
reflected in the form of reduced returns, which, if detected, would enable
investors to avoid market-timing funds. In a market with perfect information, investors would be adequately protected. However, the lack of disclosure makes it difficult for investors to detect such losses or to assess
the costs of a fund and compare the returns with competing funds. Proposals have been advanced to require the disclosure of information about
a fund’s expenses that would enable investors to determine whether they
are receiving adequate value for the fees they pay and whether their return
is being reduced by market timing and other abuses in mutual fund
trading.
3. Pricing. Market timing, especially in international funds, is possible
because of the problem of stale prices. If the net value of a fund that is
reported at four o’clock New York time does not accurately reflect the
current prices of the securities in the fund’s portfolio, then an opportunity
for stale price arbitrage exists. Rather than prohibit or otherwise try to
protect against this practice—by changes in governance or disclosure
rules, for example—another strategy is to eliminate the opportunity. There
have been various proposals for mutual funds to implement what is called
130 Ethics in Investment
“fair-value pricing,” in which the net values of funds that are reported each
day at the close of the market incorporate any market-moving developments. Some critics of fair-value pricing argue, though, that it gives too
much discretion to fund managers and that uneven use could affect the
reporting of fund returns.10
Whatever reforms are eventually implemented, the mutual fund industry,
which had a relatively blemish-free reputation prior to 2003, has shown that
it is not immune to scandal and that greater oversight of some form—whether
it be industry self-regulation or government regulation—is necessary.
Personal trading
The explosive growth in mutual funds has brought Wall Street to Main Street.
The stock market, which was once the province of the very rich, is now easily
accessible to millions of ordinary investors. This revolutionary development
has drawn attention to the men and women who manage billion dollar portfolios and has even made celebrities of a few. When Jeffrey Vinik, the idolized
manager of Fidelity’s $54 billion Magellan Fund, touted Silicon Graphics in
1995, people took note and the share price rose—before it suddenly collapsed.
The financial writer Michael Lewis, who bought 500 shares of Silicon Graphics
on the way up, recalled, “As my money disappeared, my warm feelings toward
Jeff Vinik went with it.”11 This fund manager’s stock picks turned into an ethics
case when, as Lewis reports, “Vinik was quoted by journalists singing the
praises of two companies—Micron Technologies and Goodyear Tire and
Rubber—at virtually the same time that he was selling his own stake in these
companies.”12
Concern about personal trading was also sparked by John Kaweske, a
former money manager for Invesco Funds Group, who in 1995 paid $115 000
to settle an SEC complaint that he had not reported 57 personal trades for
himself and his wife, as required by the company’s rules. Although it is not
illegal for fund managers to trade, the SEC holds that they should not abuse
their position for personal gain. Mutual fund companies are required by law
to have policies and procedures on personal trading, although the details are
left to each company. Cases like this remind us that mutual fund managers
wear two hats: they manage money for others, but they often trade for their
own account. Even though most fund managers toil in obscurity and refrain
from giving stock tips, they still have immense opportunities to benefit personally from their privileged position.
The potential for abuse was recognized in 1940 by the drafters of the Investment Company Act (ICA), which governs mutual funds. In 1970, Congress
Ethics in Investment 131
added Section 17(j) to the original legislation, which gave the SEC the power
to set rules that require each investment company to adopt a code of ethics
and develop procedures for detecting and preventing abuse, including the
collection of information on employees’ personal trading activities. Because
of this long-standing regulation, personal trading in the mutual fund industry
has involved very little abuse, and the occasional instances have drawn a vigorous response.
News stories about Mr Kaweske’s failure to disclose personal trades as
required prompted Congress to ask the SEC to study the problem, and a
report, Personal Investment Activities of Investment Company Personnel, was
released in September 1994.13 In anticipation of the SEC report, the Investment Company Institute (ICI), the trade association of the mutual fund industry, issued its own report by a special Advisory Group on Personal Investing
on May 9, 1994.14 The two reports reach similar conclusions: that personal
trading should not be banned and that the current system of regulation works
well but can be improved.
There is very little controversy over personal trading except for the recognition of the potential for abuse and the need for regulation to prevent it.
The main ethical issues, therefore, concern the rationale for regulation
and the details of the appropriate regulatory system. The section examines,
first, the potential for abuse and the current regulatory framework; second,
the debate over whether personal trading should be banned; and, third,
remaining questions that need a closer look.
Scope of the problem
Investment companies, of which mutual funds are the best-known type, invest
their capital in other companies, usually by purchasing stock or other securities. Closed-end mutual funds have a fixed number of shares, which are commonly traded on a market, while open-ended mutual funds sell new shares to
the public and stand ready to redeem shares at any time. Like the managers
of a corporation, mutual fund managers have a fiduciary duty to act in all
matters solely in the interest of the shareholder-investors. Specifically, the
managers of mutual funds have an obligation to avoid conflicts of interest that
would lead them to put their own interests ahead of those they are duty bound
to serve. In addition, mutual funds serve the role of an investment adviser,
which also carries with it a fiduciary duty.
One aim of government regulation of investment companies is to ensure
that managers fulfill their fiduciary duty. Investment companies themselves
also have a strong interest in maintaining investor confidence. The SEC report
on personal trading notes:
132 Ethics in Investment
The success of the investment company industry is in no small measure
the result of the industry’s excellent record. . . . The industry’s continued
health, however, depends on its meeting the expectation of American investors, many of whom are new to the market. The industry will continue to be
trusted by investors only if it demonstrates that it maintains the highest possible
ethical standards and that it operates free from abusive and fraudulent
practices.15
Hence the concern in Congress and the industry when the Kaweske case
raised even the suggestion of improper personal trading by a fund manager.
Conflict of interest from personal trading is possible for so-called “access
people,” that is, investment company personnel such as portfolio managers,
analysts, and traders who have access to proprietary research and information
about pending transactions.16 Access people are in a position to use this information to trade ahead of a fund’s purchase (called frontrunning) and benefit
from any upward price movement. If frontrunning raises the price of a stock,
then the fund pays more for a security than it would otherwise. Similarly, an
access person with advance knowledge of a fund’s sale of a stock could capitalize on the information by selling the stock short. An access person might
be in a position to influence transactions that serve primarily to protect or
promote that person’s investment in a security. Conflicts of interest also arise
when a fund manager allocates a security that is in short supply, such as shares
in a “hot” initial public offering, or distributes gains and losses between different funds in ways that benefit the manager at the expense of some investors.
In addition, a fund manager who takes advantage of an opportunity, such as
a special placement, for his or her own portfolio rather than investing for the
fund is in a conflict of interest.
The SEC study, which examined data on personal and fund trading in 30
companies, found that relatively few managers actively buy and sell securities
for their own account. In 1993, 56.5 percent of the fund managers in the
groups studied engaged in any personal trading, and the median number of
personal transactions was two. Fewer than 5 percent of the personal transactions took place in a 10-day period prior to a transaction in the same security
held by another fund in the company, and only 2 percent of personal transactions were made within 10 days before a transaction in a fund for which the
manager selected securities.
The data analyzed in the SEC study may understate or overstate the frequency of matching transactions. Trading in the shares of large corporations,
for example, is unlikely to have any market moving effect, whereas the price
of thinly traded stock of small capitalization companies is easily moved. Of
course, the amount of personal trading and the number of matching trades
Ethics in Investment 133
reflects close regulatory oversight. No one can predict the consequences if the
current system of regulation were relaxed.
Several studies in the 1960s revealed substantial personal trading that
posed conflicts of interest, and so in 1970, Congress added Section 17(j) to
the 1940 ICA. This addition granted rule-making power to the SEC in order
to prohibit any fraudulent, deceptive, or manipulative act by an access person
in the purchase or sale of any security. Using its power, the SEC promulgated
Rule 17j-1 in 1980. In brief, the rule:
1.
Prohibits directors, officers, and employees of investment companies (and
the investment advisers and principal underwriters) from engaging in
fraudulent, manipulative or deceptive conduct in connection with their
personal trading of securities held or to be acquired by the investment
company.
2. Requires investment companies (and their investment advisers and principal underwriters) to adopt codes of ethics and procedures reasonably
designed to prevent trading prohibited by the rule.
3. Requires every “access person” to file reports with the firm concerning his
or her personal securities transactions, within ten days of the end of the
quarter in which the transaction was effected.
4. Requires investment companies (and their investment advisers and principal underwriters) to maintain records related to the implementation of
their procedures.17
Section 17(j) and Rule 17j-l reflect three important points in the approach
of Congress and the SEC toward personal trading.18 First, the regulation of
personal trading by investment company personnel is best done by the companies themselves. That is, an employee’s own firm provides a strong first line
of oversight. Second, every mutual fund is different, and they can provide
better oversight if they are given flexibility to develop a code of ethics and
specific procedures that fit their individual circumstances. Third, there is
the recognition that not all personal trading poses a conflict of interest and
that judgment is required for carefully evaluating each case. Thus, both a
complete ban on personal trading and rigid rules are inappropriate forms of
regulation.
Banning personal trading
Both the SEC and ICI reports contain lengthy sections on the question of a
complete ban on personal trading. This attention suggests that the issue is not
closed, despite the firm rejection of a ban in each report. Two points should
be noted at the outset. First, the question addressed in both reports is whether
134 Ethics in Investment
personal trading by access people in mutual fund companies ought to be
banned industry wide, not whether any given company should impose such
a ban on its own employees. The reports reject a mandatory ban for the industry but leaves open a voluntary ban by individual mutual fund companies.
Second, personal trading by access people is already subject to considerable
restrictions, and a complete ban is merely one end of a long continuum. As a
debate proposition, a complete ban is a red herring that diverts attention
from the critical question of how restrictive the regulation of personal trading
should be. Thus, the arguments for and against a complete ban are worth
examining, even if a complete ban is rejected, because the same considerations
enable us to determine the appropriate level of restrictiveness.
The arguments for a complete ban can be summarized as follows:
1. The image of the industry. Regardless of the seriousness of the actual
problem (which may be slight), the success of the mutual fund industry
depends on a “squeaky-clean” image that reassures investors, especially
those new to the market. Personal trading creates a perception of conflict
of interest that may be worse than the reality, and an unequivocal policy
is the only effective means for countering this perception.
2. The heavy responsibility of managing funds. The sheer volume of assets
under management by mutual funds and the importance of mutual
funds to the savings plans of so many people create a responsibility to
adhere to the highest level of ethics and to avoid even the remote possibility of harm to investors from mismanagement. Aside from any direct loss
to investors due to personal trading, there is a possible indirect loss if fund
managers devote their time and energies to their own portfolios rather
than attending to the work at hand.
3. The (in)effectiveness of regulation. Any regulation short of a complete ban
creates too many opportunities to take advantage of loopholes and fuzzy
lines. Fund managers, analysts, and other access people who are intent on
benefiting from their positions may be tempted to skirt the edge of ethical
and legal trading without overstepping the line. A simple complete ban
can be better understood and more easily enforced than complicated rules
and regulations.
4. Fairness to other investors. Access people are insiders who are privy
to information that other investors lack, so that personal trading may
constitute insider trading and be objectionable for this reason. Like proprietary corporate information, information about pending transactions
is provided to access people in order for them to perform a job. Trading
on the basis of this information is thus a misappropriation of company
property for personal use.
Ethics in Investment 135
The arguments against a complete ban include the following:
1. The lack of need. A complete ban is unnecessary for several reasons. First,
a multitude of funds compete fiercely with each other on the basis of
performance, and in this environment no company can succeed if it does
not put the interests of the customer first. In short, the market is a powerful force for motivating companies to protect investors against abuses
from personal trading. Second, fund managers compete against each
other and are judged by the returns that they achieve. Third, personal
trading is already stringently regulated, and the lack of apparent abuse
indicates that the current regulatory system works well.
2. No benefit to investors. A ban on personal trading would make it difficult
for mutual fund companies to attract and retain the best analysts, traders,
and fund managers. Competition for the most talented people is already
stiff, and a complete ban would put investment companies at a disadvantage with other financial institutions that permit personal trading. Mutual
fund customers would lose the benefit that they now derive from the skills
of top-performing professionals if a complete ban were imposed.
3. Unfairness to fund personnel. The opportunity to invest is vital to people’s
economic well-being, and so a ban on personal trading that would limit
people’s freedom on such an important matter requires weighty justification. In general, people’s freedom should not be restricted any more than
is necessary to achieve the desired ends. If the current regulatory system
works reasonably well, then would more stringent regulation compensate
for the loss of freedom?
In evaluating these arguments, the SEC considers three factors: “the prevalence of abusive securities transactions by access persons; the potential harm
to fund shareholders caused by access persons’ personal investment activities;
and the likelihood that a ban would curb abusive trading by access persons.”19
The available data suggest that abusive personal trading is not prevalent, that
it is not harmful to investors, and that any gains to investors from a complete
ban would be slight. The SEC also questions whether a complete ban would
deter more determined wrongdoers, some of whom are not deterred by
current regulation. Banning all personal trading in an attempt to prevent the
last vestiges of abuse is a misguided enterprise. The SEC report concludes that,
even though an industry-wide ban on personal trading is not warranted at
this time, the directors of mutual funds have a responsibility to assess the
benefits of personal trading for shareholders and adopt more effective rules
and procedures, or even a complete ban, if such steps are in the shareholders’
interests.
136 Ethics in Investment
Remaining questions
The current regulatory system on personal trading allows mutual fund companies great flexibility, and the rules and regulations of individual companies
vary widely. Any given question, therefore, may have already been answered
by one company and be completely unaddressed by another. The answers
that different companies give to these questions may be justifiably different.
However, some questions are at the forefront of discussion and have yet to
be firmly settled industry wide. Chief among these are questions concerning
codes of ethics and trading practices.
Although Rule 17j-1 requires investment companies to adopt a code of
ethics, the content of these codes is not legally mandated. The ICI Advisory
Group on Personal Investing recommends that every code of ethics incorporates certain general principles, which should, at a minimum, reflect the following: “(1) the duty at all times to place the interests of shareholders first; (2)
the requirement that all personal securities transactions be conducted consistent with the code of ethics and in such a manner as to avoid any actual or
potential conflict of interest or any abuse of an individual’s position of trust
and responsibility; and (3) the fundamental standard that investment company
personnel should not take inappropriate advantage of their positions.”20
The implementation of these general principles in specific rules and procedures raises many questions, including who is covered, what transactions
are prohibited, and what transactions must be reported. The term access people
covers a range of personnel who may not be easily identified, and some distinctions among them may be appropriate. Some codes of ethics employ a
tiered structure in which employees on different tiers are subject to different
regulations. The securities in question may need to be distinguished. Generally, codes of ethics exempt money market instruments, Treasury securities,
shares of mutual funds, or small blocks of stocks in large, actively traded
corporations on the grounds that fund trading in these securities is unlikely
to affect the price. Some argue that the definition of a security should be
broadened because of the development of new financial instruments such as
options, derivatives, and commodities futures.
Rule 17j-1 mandates that employees disclose all personal trading in quarterly reports. One loophole is that access people are not required by law to
disclose their portfolio holdings when they begin employment. Thus, quarterly transactions may not reveal a conflict of interest that involves an undisclosed pre-employment securities holding. Also, there is no legal obligation
to disclose a fund’s code of ethics to the public. The SEC and ICI reports each
recommend that mutual fund companies disclose their policy on personal
trading and provide an overview of their rules and procedures in the prospec-
Ethics in Investment 137
tus for each fund. The SEC has further proposed that investment companies
be legally required to include the full text of the code of ethics as an attachment to the company’s registration statement so that it will be publicly available, while the ICI Advisory Group’s only recommendation is that a company
may elect to include it at its discretion.
Generally, conflicts of interest are created by matching transactions in
which an access person makes personal trades in conjunction with fund
trades. Matching transactions can be addressed not only by disclosure—which
enables a company to analyze the pattern of trades—but also by blackout
periods during which all trading in a security is prohibited. Questions still
arise, however, about the length of the blackout period, whether it applies
before or after a fund transaction, or both, and whether there are different
blackout periods for different types of securities transactions. For example,
some codes of ethics create a longer blackout period for transactions over
which a fund manager has decision-making power. Other remaining questions about trading practices are: (1) the personal purchase of initial public
offerings (IPOs) and private placements; (2) short-term trading; and (3) shortselling stocks that are held by a company’s funds. Should any of these be
permitted?
IPOs raise the possibility of a conflict of interest because the intense interest
in certain “hot” new issues limits the number of investors who can participate.
Fund shareholders may rightly ask why a fund manager who had the opportunity to purchase shares did so for his or her personal account and not for
the fund. Private placements do not raise this concern because they generally
do not involve securities that could be purchased by a fund. Still, the opportunity to participate in a private placement may be regarded by fund shareholders as a conflict of interest if, for example, it was offered by a start-up firm
as an incentive for the manager to invest for the fund should the venture go
public in an IPO. Both IPOs and special placements are potentially profitable
opportunities that raise questions about the ability of a fund manager to exercise unbiased judgment in future transactions.
Short-term trading—which is generally interpreted as holding securities
for less than 90 days—is prohibited by some mutual fund companies for the
reason that quick profit taking is more likely to utilize information about fund
transactions. A rule against short-term trading is an especially effective precaution against frontrunning that, at the same time, does not prevent employees from realizing long-term gain in the stock market. Thus, the benefits to
the company and its shareholders are likely to outweigh any small losses
to fund managers and other access people.
Neither the SEC nor the ICI report addresses short-selling—which is the
practice of borrowing a stock and selling it in the hopes of replacing it later
138 Ethics in Investment
at a lower price—although shorting might fall under the category of shortterm trading. Short-selling is practiced by investors who believe that the price
of a stock will decline, which raises the question of why a prudent fund
manager does not reduce the fund’s holdings. Shorting evades restrictions on
matching transactions because there is no sale by the fund, and the conflict
of interest arises when a fund manager makes a biased decision not to sell in
order to short the stock for personal gain. Few companies have addressed the
issue of short-selling, although Fidelity Investments has announced a ban on
the shorting of stock held by its funds, saying that the practice could create
an appearance of a conflict of interest.21
Soft-dollar brokerage
Institutional investors, such as mutual funds and pension funds, pay a commission to brokerage firms to execute trades of securities. These commissions
are a highly valued source of revenue for brokerage firms, which lead them to
compete in gaining favor with funds to obtain and retain this lucrative tradeexecution business. One means for competing for this business is offering
rebates to institutional investors in the form of products and services other
than the execution of trades. These rebates, which are usually expressed in
dollar amounts of products and services, are called soft-dollar brokerage, or
simply soft dollars. The most common form of soft dollars are noncash credits
for propriety research offered by the brokerage firm itself or provided by third
party research firms.
Another means for obtaining and retaining the business of mutual funds
is for brokers to promote these funds to their own clients. This practice, which
was prohibited by the SEC in 1994, is known as directed brokerage. Brokerage
firms, which typically offer mutual funds to clients, can direct them to certain
funds through advising or prominent display. Such direction is a valuable
benefit to mutual funds in their competition for investors, which may lead a
fund to pay an above-market rate in commissions. With directed brokerage,
a brokerage firm becomes, in effect, a selling agent for a mutual fund, which
is a benefit worth paying for. However, in the SEC’s view, directed brokerage
creates an unacceptable conflict of interest since it might interfere with the
fiduciary duty of brokerage firms to recommend the best investment for a
client.22 The SEC rule still permitted brokerage firms to promote one mutual
fund over another as long as there was no quid pro quo arrangement in which
the promotion was offered in return for a fund’s trade-execution business.
Soft dollars and directed brokerage began in the 1950s with the growth of
institutional investors during a period of fixed commissions for securities
traded on the New York Stock Exchange. Barred from competing for volume
Ethics in Investment 139
customers by offering lower commissions, brokerage firms offered various
noncash benefits, including research services, in lieu of lower commission
rates. After the system of fixed commissions was abolished in May 1975, the
practices of soft dollars and directed brokerage continued. Although commission rates declined after that date and customers could pay for only the execution of trades, soft-dollar arrangements and directed brokerage continued to
be important forms of competition among brokerage firms and significant
resources for institutional investment funds.
The legislation ending fixed commissions, the Securities Act Amendments
of 1975,23 reiterated that fund managers have a fiduciary duty to secure the
“best execution” of trades, which includes paying low commissions. However,
Section 28(e) created a “safe harbor” that allows soft-dollar arrangements as
long as the managers believe in good faith that a higher-than-market commissions are “reasonable in relation to the value of the brokerage and research
services provided.” Thus, soft-dollar payments could continue as long as
mutual fund shareholders received benefits in the form of products and services that offset the higher commissions that fund managers were paying for
the execution of trades.
For such a little-known practice, soft dollars has received a surprising
amount of moral concern, with one observer claiming that it did not pass “the
smell test.”24 Soft dollars was the subject of a 1998 report by the Securities
and Exchange Commission,25 and in the same year the Association for
Investment Management Research issued extensive guidelines for soft-dollar
arrangements.26
Moral criticism of soft dollars has two sources. First, soft dollars is a virtually invisible process that appears to depart from the ideal of arm’s-length
economic transactions. In soft-dollar arrangements, the managers of institutional investment funds seem to be paying brokers more than is necessary
for the execution of trades and receiving other benefits in return. The costs of
execution and research are bundled together in ways that mutual fund investors may not be aware of and cannot easily evaluate. Expressed in the terms
of agency theory, investors (the principals) have the task of monitoring fund
managers (their agents). The lack of transparency and market forces makes
the monitoring of fund managers by investors more difficult. As a result, investors either suffer the agency costs of inadequate monitoring or else are forced
to incur additional monitoring costs. That transactions should be unbundled
and made transparent are key elements not only of sound financial practice
but of effective monitoring.
Second, investment fund managers, as fiduciaries, have a fiduciary duty
to act in the best interests of a fund’s investors. This duty includes obtaining
“best execution” and using any soft dollars solely for the benefit of a fund’s
140 Ethics in Investment
investors. However, soft dollars appear to create incentives for fund managers
to advance their own interests or the interests of a fund’s sponsor to the detriment of investors. This advancement of the manager’s interests would be not
only a violation of fiduciary duty but also an unacceptable conflict of interest.
Fund managers might unjustly enrich themselves through soft-dollar arrangements by engaging in excessive trading or churning designed merely to generate more soft dollars. They might also use soft dollars for purposes other than
research that benefits a fund’s investors. Finally, the benefit from soft dollars
may make managers less careful about monitoring the quality of a brokerage
firm’s execution. All of these possibilities would violate the safe harbor provision of Section 28(e).
Defenders of soft dollars argue that these moral concerns are misplaced
and that soft-dollar brokerage is not only morally justified but even economically sound.27 First, with regard to the difficulty that soft dollars may create in
monitoring fund manager performance, defenders contend that soft dollars,
in fact, align the interests of investors and fund managers because fund managers are in a better position than investors to monitor the execution of trades
by brokerage firms. Thus, instead of increasing the monitoring costs of investors, soft dollars reduce them.28 Second, to the criticism that the practice
tempts fund managers to violate their fiduciary duty to seek “best execution”
and to use any soft dollars in the investors’ interest, defenders respond that
the intense competition in institutional investing would punish fund managers who did not use all resources for the benefit of investors. This argument
suggests that funds using soft dollars would produce superior returns to those
that do not, and the evidence to date is that soft dollars have a slight positive
correlation with fund performance.29
Critics of soft dollars generally favor two measures: restricting the scope of
Section 28(e), thus giving fund managers less of a safe harbor, and mandating
greater disclosure of soft dollar practices. In particular, some critics urge that
the safe harbor provision be limited to research-related services provided
by the brokerage firm that are not readily available commercially, which would
exclude ordinary overhead expenses. Defenders of soft dollars would expand
the scope of Section 28(e), thus giving fund managers greater discretion in
making arrangements with brokerage firms. Although they are not opposed
to greater disclosure in principle, some defenders question the usefulness of
this information for investors and whether the cost would exceed the benefit.
A persistent problem with both soft dollars and directed brokerage is that
the regulations rely heavily on the judgment of fund managers—about the
reasonableness of the commissions paid in relation to the value of the soft
dollars received, and about the absence of any quid pro quo in a broker’s
promotion of a company’s mutual funds. How can the soundness of a fund
Ethics in Investment 141
manager’s judgment in these matters be determined? The recommendation of
the ICI is that these questions should be answered in terms of the adequacy
of rules and policies that mutual funds have in place about soft dollars and
directed brokerage.30
Relationship Investing
Within the past 50 years, a profound shift has occurred in the ownership of
stock in American corporations. In 1970, individuals held more than 72
percent of shares, while institutional investors (pensions, mutual funds, insurance companies, and private trusts and endowments) accounted for about 16
percent.31 By 1990, the holdings of institutions had risen to almost 50 percent,
and in 2009 the figure was 73 percent.32 This transformation has implications
not only for the responsibilities of institutional investors toward their beneficiaries but also for the role of institutional investors as shareholders in the
American system of corporate governance. In this changed environment, the
concept of relationship investing (RI) has emerged as one answer to the many
questions that institutional investors now face.
Because of the size of their holdings, institutional investors cannot behave
like individuals. They cannot easily sell an underperforming stock, for example,
but are generally locked into their investments. Instead of active portfolio
management that seeks out undervalued stocks, institutional investors passively manage large portions of their portfolios by indexing them to broad
market measures, such as the S&P 500. Because institutional investors are so
diversified, they can be said to “own the market” rather than specific companies. As such “universal owners,” they may have different interests than the
owners of single stocks, which may lead them to oppose, for example, corporate actions that impose externalities on society or impair long-term growth
in the whole economy.33 Institutions also have some opportunities that individual investors lack. In particular, they are in a position to pressure managers
of corporations for changes, and some argue that fund managers are not fulfilling their fiduciary duty if they do not exert this power. Individual investors
do not often take an active role in corporate governance, with the result that
some corporate managers have gotten by with lackluster performance.
In addition, taking an active role in corporate governance has also been
pursued as an investment strategy by some institutional investors, especially
hedge funds, as an effective way of increasing returns. By investing in underperforming companies and then pressing for changes designed to improve
corporate performance, these investors hope to realize a boost in stock price.
The ultimate cause of underperformance is usually a faulty strategy, but the
142 Ethics in Investment
immediate target of activist investors is more commonly a change in top
management or board composition or the correction of mistaken practices or
policies. Unlike traditional raiders in hostile takeovers, these investors do not
aim to take control of a company. However, they are also not mere critics, who
sometimes wage proxy fights; they want to be partners, who will work closely
with a company over a long period of time and offer valuable expertise.
Relationship investing is undertaken by institutional investors for diverse
reasons. Broadly speaking, the advocates of relationship investing cite three
grounds for engaging in it. First, relationship investing is an effective investment strategy that prudent investors may choose to adopt. Indeed, some
individual investors, most notably Warren Buffett, have used relationship
investing with great success. Second, the fiduciary duties of fund managers
may require them to take advantage of the opportunities offered by relationship investing. Third, relationship investing is a solution to a number of critical
problems in corporate governance, so that this approach ought to be encouraged. Each of these reasons is examined in turn.
RI as an investment strategy
Relationship investing may be defined as a situation in which an investor takes
an active interest in a corporation and attempts to influence the corporation’s
operations. As such, RI is not a new idea. It harks back to an earlier time when
stockholding was more concentrated and a few large investors exercised close
oversight. Today, venture capitalists and lenders to small businesses, who
watch their investments closely, could be called relationship investors. Similarly, the concept of relationship investing has been used to describe the close
working relation in Germany and Japan between corporations and large
banks, which are the major holders of corporate equity in those countries.
Among individual investors, Warren Buffett is known for his strategy of taking
large stakes in a few, well-chosen firms and working with them to increase
earnings when necessary. Other individual investors seek out troubled firms
with poor performance and seek to increase the value of their investment by
pressing for changes in leadership or strategic direction. In some instances,
the investors believe that they have expertise that can increase the value of
the firm.
Large institutional investors do not have the resources to establish a relationship with every corporation in their portfolio. For many years, CalPERS,
the pension fund for California state employees, compiled an annual “hit list”
of companies which had underperformed over the previous five-year period.34
CalPERS executives met with the CEOs of these companies in order to analyze
the causes of lagging performance and to develop plans for improvement. In
Ethics in Investment 143
situations where these efforts failed, CalPERS resorted to shareholder resolutions and even litigation. CalPERS’s efforts have borne fruit. One study
reported that 42 companies targeted by CalPERS for aggressive action between
1987 and 1994 lagged the S&P 500 by an average of 66 percent. After some
interventions, the returns of these companies averaged more than 41 percent
above the S&P 500.35 More recently, CalPERS and many other pension funds
have lobbied aggressively for regulation that improves corporate governance
and market operations.36
The ability of institutional investors to influence corporate managers is
enhanced when they can combine forces. In the past, SEC proxy rules have
made such concerted action difficult by requiring shareholders to file cumbersome statements, but in 1992 the SEC relaxed these rules, thereby increasing
the ease of communication among institutional investors. Traditional proxy
fights have required dissidents to educate large numbers of relatively uninformed shareholders about the issues, whereas, today, a handful of highly
sophisticated institutional investors are able to confer easily and agree on
changes quickly. Activist investors have formed several organizations in order
to exert joint pressure more effectively. One of these organizations, the Council
of Institutional Investors, currently represents 125 institutional investors with
assets that exceed $3 trillion. Its mission is “to educate its members, policymakers and the public about corporate governance, shareowner rights and
related investment issues.”
Generally, institutional investors have focused on major issues in corporate
governance and strategic direction and have avoided social issues. This choice
has been dictated both by a fiduciary duty to increase bottom-line value for
the funds’ beneficiaries and by the difficulty of articulating a position on social
issues that reflects the interests of all beneficiaries. Institutional investors have
pressured corporations to include more outside directors on boards, establish
independent compensation committees, separate the roles of CEO and chair
of the board of directors, and avoid poison pills and other defenses against
takeovers. In addition, institutional investors have supported regulatory
reforms, such as the changes in SEC proxy rules that facilitate communication,
promote greater transparency, and increase shareholder voice.
As an investment strategy, RI is forced upon institutional investors by the
size of their holdings. Institutional investors are not like traditional investors,
who can move in and out of the market freely; they are more like owners, who
are stuck with a stock. A former CalPERS CEO Dale M. Hanson used the
analogy: “If we buy an office building and the property manager isn’t properly
maintaining it, we don’t sell the building—we change the property manager.”37
The largest pension and mutual funds hold between 1 and 3 percent of
the largest American corporations. Positions of that size cannot be sold in the
144 Ethics in Investment
open market without depressing prices, and the only buyers are other institutional investors, who are apt to hold a similar evaluation of a stock.
Although the costs of relationship investing are high, they are typically less
than the expense involved in selling one stock and buying another. Albert O.
Hirschman, in his book Exit, Voice, and Loyalty, observes that dissatisfied
members of an organization who can easily leave (exit) do not attempt to
speak up for change (voice), but that members who cannot use the exit option
have no choice but to use voice.38 Thus, RI is a rational choice for institutional
investors who are locked in and have only the voice option to express their
dissatisfaction.
Many advocates of RI argue that not only shareholders but also managers
themselves benefit from more active, informed involvement. Institutional
investors provide patient capital, which is cited as a feature of the German and
Japanese systems that enables firms to develop long-term plans. Outsiders also
provide specialized skills and fresh perspectives that can help solve problems
and prevent costly mistakes. Corporate managers are advised to view relationship investors as a valuable resource. On the downside, more cautious critics
argue that relationship investing can lead to meddling by outsiders that distracts managers and diverts their focus. Institutional shareholders may be
pursuing agendas that run counter to the interests of the corporation and
other shareholders.
In particular, the change in the SEC rules that permits greater communication among institutional investors has been criticized for shifting the balance
of power away from individual shareholders.39 Although activist investors are
at a disadvantage when incumbent managers and board members can use
corporate resources to fight unwanted attention, the costs for a company to
fight activists may exceed the benefits and thus lead to unwise accommodation. Uncertainty about the fiduciary duty of managers and directors may also
cause them to accede to investors, even when they doubt the wisdom of their
demands.
RI and fiduciary duty
Individual shareholders are responsible to no one. Hence, they can pursue
investment strategies and exercise their shareholder rights as they choose.
However, institutional investors are typically both shareholders and fiduciaries, which creates the potential for conflicts between these two roles.
First, if RI is an effective investment strategy that is suited to the special
circumstances of institutional investors, then they may fail as fiduciaries if
they do not take advantage of the opportunity. Some have argued that the
decision to index a fund creates a fiduciary duty of active involvement with
Ethics in Investment 145
management, given the commitment not to sell an underperforming stock.40
As fiduciaries, institutional investors may also face conflicts of interest.
For example, investment management companies, which manage portions of
portfolios for large pension plans, are reluctant to offend corporations on
whom they depend for other business. Similarly, the managers of corporate
pension funds face numerous conflicts of interest. Should they invest heavily
in the company’s own stock or seek better diversification? How should they
vote when a management-sponsored proxy proposal is not in the employees’
interests? Managers of company pension funds often refrain from pressuring
the management of other corporations for fear of reciprocal action.41 In order
to avoid conflicts of interest, the managers of corporate pension funds must
be given greater independence to serve the interests of the employees exclusively, which might include the use of RI.
Second, since shareholders have a role to play in corporate governance,
institutional investors must decide how they will serve in this role. In particular, they are called upon to take positions on proxy proposals in every corporation in their portfolio. To do nothing or to vote routinely with management
is still to take a position. In the interpretation of the Employee Retirement
Income Security Act (ERISA) of 1974, which covers private pension plans,
the right to vote proxies is considered to be a plan asset and thus is subject
to the same strict fiduciary duties that apply to any other asset. Accordingly,
pension funds subject to ERISA are legally obligated to develop policies on
the voting of proxies that serve to promote the interests of a fund’s beneficiaries. A number of proxy voting services provide analyses and recommendations
on proxy proposals and handle the mechanics of submitting proxy votes. The
most prominent of these organizations is Institutional Shareholder Services
(ISS), which advises more than 1700 clients worldwide.
Third, the interests of the beneficiaries of pension funds and other institutional investments depend on the performance of the total portfolio. Because
these portfolios contain a cross-section of corporations and are heavily
indexed, their performance depends more on the health of the American
economy than on the success of any particular company. Consequently, a fund
manager with a fiduciary duty to serve the beneficiaries’ interests has a broader
perspective than an individual investor. For example, a merger or acquisition
that benefits the shareholders of one company but harms those of another,
or that benefits shareholders but harms bondholders, may be opposed by an
institutional investor that holds both stocks and bonds in each company.
Furthermore, a pension fund manager might best provide for the secure
retirement of a fund’s beneficiaries by making investments that create good
jobs, affordable housing, and an improved infrastructure. In 1989, the New
York State Pension Investment Task Force recommended that the state pension
146 Ethics in Investment
funds use their assets to promote long-term economic growth rather than
strict profit maximization. State pension funds have been urged to engage in
economically targeted investment (ETI) on the grounds that retirement security depends on the health of the state’s economy.42
A problem with ETI is that if it leads to reduced rates of return, then private
pension fund managers would violate their fiduciary duty under ERISA. To
meet this problem, the Clinton administration, which supported ETI, held
that this kind of investment is permissible under ERISA if it produces “collateral benefits” while also providing “commensurate returns.”43 Under this
ruling, an investment must produce at least a competitive rate of return, but
the choice among alternative investment may involve a consideration of the
social benefits. However, critics argue that ETI almost always offers a lesser
return adjusted for risk, because otherwise the investment would be made
without the need for special consideration.44 So the question becomes how
much return can rightly be sacrificed for the collateral benefits, especially
when the value of the collateral benefits is difficult to judge. Moreover, the
collateral benefits of an investment are difficult to identify, and, further, they
cannot easily be separated from the strictly financial return. Indeed, it has
been argued that investing for collateral benefits is little different from traditional investing, which considers all benefits.45
Public pension funds, which are not subject to ERISA, are especially vulnerable to political influence, and so managers must exercise considerable care
to resist unwise uses of fund assets. Experience shows that the managers of
public pension funds do not always make wise choices. For example, the Connecticut state pension fund lost $25 million in an unsuccessful attempt to save
the jobs provided by Colt Industries, a manufacturer of firearms that eventually declared bankruptcy.46 The Kansas pension fund invested in a local steel
mill and a savings and loan association in order to save jobs and lost more
than $100 million when both went bankrupt.47 Some consider any use of
public pension fund money for ETIs to be unsound public policy. If a project
benefits the people of a state, then it is worth supporting through the political
system with tax dollars that everyone provides. If the investments lower the
returns for retirees, then, in effect, they have been taxed to provide a benefit
for others.48
Improving corporate governance
One of the roles of shareholders in corporate governance is to exercise oversight and ensure accountability. In short, shareholders are important monitors
of corporations. In corporations without a separation of ownership and
control, shareholders are also the managers of an enterprise, and so their
Ethics in Investment 147
monitoring role is taken for granted. However, in large, publicly held corporations that have many shareholders with small holdings, the power of individual shareholders is diluted, and they have a decreased incentive to take any
action. The result has been the imperial CEO, backed by a complacent board
of directors. Without effective monitoring, corporations have engaged in
unwise expansion, avoided difficult but necessary changes, and provided
lavish compensation and other perquisites. Some companies languish because
of operational problems or mistaken strategic plans. The hostile takeover wave
of the 1980s was a financial remedy for excesses that were permitted, in part,
by inadequate monitoring. Relationship investing has been hailed by some
advocates as a political alternative that replaced hostile takeovers in the 1990s.
John Pound proclaimed, “This new form of governance based on politics
rather than finance will provide a means of oversight that is both far more
effective and far less expensive than the takeovers of the 1980s.”49
Traditionally, shareholders have monitored corporations by electing the
board of directors and voting on proposals for major changes that have been
submitted by management. For companies in distress, the main corrective has
been the board of directors, which has the authority to replace management
and set a new strategic direction. When boards do their job, this form of
corporate governance can be very effective. Shareholders have little recourse,
however, against an inattentive or incompetent board of directors since board
elections and proxy battles are generally too slow and unwieldy to bring about
the needed changes. In the 1980s, hostile takeovers provided a quick, albeit
ruthless, method for bringing about change. This form of corporate governance involves high transaction costs, however, because of the enormous fees
to investment bankers and lawyers, and it also imposes social costs as a result
of the dislocation that typically follows in takeovers.
Relationship investing enables present shareholders to bring about the
same kind of changes that a raider in a hostile takeover might make. Nell
Minow calls relationship investing a “nontakeover takeover.” She explains,
“Like the raiders, we [relationship investors] hope to realize value that’s buried
there. We’ve found a better, easier way to do it.”50 A number of factors limited
the use of hostile takeovers in the 1990s and beyond, including a lack of ready
financing and the advent of state antitakeover laws. At the same time, developments have been favorable to concerted action by institutional investors. John
Pound cites the further advantages that corporate governance through relationship investing is politically acceptable and consonant with basic American
values. He writes:
Americans have always had a deep distrust and political intolerance for pure
finance, and the transactions of the 1980s stirred the populist pot of suspicions
148 Ethics in Investment
to an unprecedented degree. LBOs [leveraged buyouts] and other takeover
transactions were based on secrecy, speed, and surprise. They eschewed due
process and public debate. . . . The new politics of corporate governance stands
in sharp contrast to the old ways of doing business. At the core of the new
movement is a substantive discussion and debate over corporate policies. The
new initiatives embrace due process and demand public debate. . . . [T]hey
create a system that holds corporate management accountable to the same kinds
of rules to which Americans hold their public officials accountable.51
RI raises some fears about its impact on corporate governance. Critics
predict that institutional investor demands for quarterly performance will lead
to more short-term emphasis instead of the patient capital that some have
predicted. Others warn that in a politicized environment, every corporate
decision will become a matter of public debate and that segments of the public
will attempt to influence corporate decision making. In addition, the relentless
effort to satisfy institutional investors has already led to restructurings and
other changes that have caused dislocation in the workforce. Some critics
contend that employees and other constituencies will lose additional power
to institutional investors as corporations continue to become “mean and lean.”
The danger is that greater accountability might be achieved by reducing the
responsiveness of corporations to social concerns. Thus, the question of
whether relationship investing is a beneficial reform in corporate governance
or a pernicious successor to hostile takeovers of the 1980s remains to be
decided.
Socially Responsible Investing
In picking stocks, some individuals consider values to be as important as P/E
ratios. These virtuous souls want to make sure that their dollars do not support
objectionable business activities. Similarly, charities, foundations, religious
groups, universities, and other nonprofit organizations have long sought
stocks that are compatible with their institutional values. By contrast, some
investors avidly pursue so-called “sin stocks.” Morgan Funshares, for example,
specializes in alcohol, tobacco, and gambling companies and finds support
among folks who take delight in profiting from the folly of others.52 The only
trouble with tainted profits, they say, is “there ‘taint enough of them.” For most
people, however, the stock market is merely a place to invest with no thought
to the uses that others make of their money. The advice of financial experts is
that if you care about the environment, civil rights, or public health, contribute
your gains to worthy causes or engage in political activity—but don’t mix
money and morals.53
Ethics in Investment 149
In recent years, investors who care about where their money goes have been
aided by mutual funds and pension funds that screen for social responsibility
factors. These funds identify themselves by many names: socially responsible
investing (SRI), ethical investing, sustainable investing, triple bottom-line
investing (financial, environmental, and social), and environment, social
issues, and governance investing (ESG).54 SRI is both a product and a practice.55
Therefore, in addition to SRI mutual and pension funds (products), which
appeal to socially concerned investors, the means employed by these funds to
be socially responsible are utilized by many other investment funds to seek
some of the same ends (practice). In addition, a whole industry of support
services has developed to aid funds that offer SRI products and engage in SRI
practices.
Because of the broad range of activities that might be characterized as SRI,
statistics are difficult to compile. However, a study by the Forum for Sustainable and Responsible Investment in 2012 found that in the United States $3.74
trillion is currently being managed according to SRI principles, which is
approximately 11 percent of investment assets under management and a 22
percent increase since 2009.56 In Europe, the corresponding figure for SRI
assets under management is in excess of 2.3 trillion euros.57 In both the US
and Europe, the increase in SRI funds has been quite rapid, with almost a
fivefold increase between 1995 and 2012.
Despite the admirable intent of socially responsible investors, some troubling questions surround the movement. In addition to the practical difficulty
of identifying socially responsible and irresponsible companies, critics challenge whether the effort makes any difference. Investors engage in SRI for
different reasons—some to feel good about making money in stocks, others
to bring about changes in corporate behavior—and whether SRI makes any
difference depends on the aim. Individual investors are free to buy stocks for
any reason they please and to pay the price if SRI produces lower returns.
Likewise, mutual fund and pension companies are at liberty to attract investors by offering to screen their holdings, as long as the commitment to SRI
is clearly stated and the investment is voluntary. More debatable, however, is
whether portfolio managers who have a fiduciary duty to seek the highest
return for investors have a right to consider nonfinancial factors in the selection of stocks—especially if SRI reduces overall results.
Defining SRI
SRI takes many forms. It can be as simple as a policy to avoid “sin stocks” or
companies engaged in unpopular causes or as complex as seeking out socially
responsible companies for investment and working with them to achieve
150 Ethics in Investment
socially worthy ends. Many active members of the SRI movement are motivated merely by a desire to feel good about their own investments, while others
are seeking to change the world through their investing activity.
The roots of SRI reach back to the eighteenth century in England, when
religious groups, especially Quakers and Methodists, believed that investing
was a value-laden activity with a religious dimension. However, the movement
really began in the 1960s as part of the political struggles against apartheid in
South Africa and the war in Vietnam. Frustrated activists used protests at
annual meetings, shareholder resolutions, and pressure on institutional investors, such as university endowment funds, to advance their causes. Similar
tactics were used by the activist Ralph Nader in his campaign against General
Motors to improve automobile safety, which spawned a larger consumer protection movement. In 1969, the Council on Economic Priorities was formed,
and their work resulted in a series of guides for investors and consumers with
such titles as Rating America’s Corporate Conscience: A Provocative Guide to
the Companies behind the Products You Buy Every Day58 and The Better World
Investment Guide. Religious groups eventually joined this movement, most
notably with the founding of the Interfaith Center for Corporate Responsibility in 1971. Further impetus was provided by the explosion of environmental
concerns in the 1990s.
Today, SRI has ceased to be the province of activists and has become mainstream, as well as global. Most SRI practitioners believe that screened funds
serve primarily to provide competitive returns, with the achievement of some
beneficial results as a secondary aim. SRI, they claim, is a viable investment
approach that takes advantage of the superior long-term performance of
socially responsible corporations. Corporations that pass SRI screens are generally well run and unlikely to face major crises and scandals. SRI may also
contribute to improved performance by increasing communication between
corporations and investors about social issues, and prompting corporations
to undertake socially responsible initiatives.
In this mainstream form, SRI has become prominent in Europe as well as
North America. European interest in SRI has been fostered by government
mandates for responsible investment by state pension funds (which are more
common in Europe than the US). The Oil Fund of Norway, which is the largest
holder of stock in Europe, with assets in 2012 of $654 billion, has been guided
since 2004 by an Advisory Council on Ethics, which enforces ethical guidelines for investments. The globalization of SRI has been facilitated by innovations in the reporting of social performance, as represented by the Global
Reporting Initiative, whose accounting standards for sustainability are used
worldwide. SRI practices have also been fostered by the Principles of Responsible Investment, which is an initiative launched by the United Nations in
2005. By 2012, its six basic principles have been subscribed to by more than
Ethics in Investment 151
1000 investment companies (not all SRI funds), which manage more than $30
trillion in assets.
Screened funds employ negative screens to exclude the stock of companies
that are engaged in particular businesses or that have objectionable records
of performance. Some also use positive screens that identify companies with
notable achievements in such areas as environmental protection, the promotion of women and minorities, family-friendly programs, charitable giving,
community outreach, customer and supplier relations, product quality and
safety, political activity, and responsiveness to public concerns. Many mainstream mutual fund and pension fund companies offer one or more SRI fund.
Support for SRI is provided by socially responsible investment advisory and
portfolio management companies and by organizations, most notably The
Forum for Sustainable and Responsible Investment in the US and the European Sustainable Investment Forum (Eurosif).
Proponents of SRI have diverse aims. Some investors apparently feel a
personal responsibility for the use that is made of their money. Many would
no doubt refuse to invest in a brothel in Nevada (where prostitution is legal)
on the grounds that they would be participating in an immoral activity, enabling others to act immorally or profiting from the immorality of others.
However, it is not evident that a shareholder in a brothel enterprise would
actually be participating in this activity or enabling others to do so. Obviously,
the responsibility of investors for the activities of the firms in which they invest
is a perplexing ethical issue. Much depends on whether investors’ decisions
have any substantial impact on corporate behavior, a question that is discussed
below.
The research to date has failed to find any statistically significant difference
in the returns of SRI funds.59 Their performance is, on the whole, no better
and no worse than comparable stock portfolios. However, these studies cover
a relatively brief period of time in which the stock market has risen steadily.
The returns must be adjusted for risk, and some researchers suggest that SRI
funds may be riskier, on the whole, because of less diversification and greater
holdings of small capitalization stocks.60 In addition, successful firms are able
to invest more in social responsibility, so that SRI screens may introduce a
bias in favor of corporations with strong past earnings records. Such a bias
would explain competitive short-term results but would be a poor predictor
of performance in the long run.
Can SRI make a difference?
Is socially responsible investing capable of producing superior results while
making the world a better place? If so, then the case for SRI could not be
stronger. Even if the returns are competitive or only slightly lower, then the
152 Ethics in Investment
beneficial consequences would still make SRI an attractive alternative for
investors who want to do good as they do well. Unfortunately, the prospects
for making the world a better place and making a profit at the same time are
not very bright. First, finance theory and, in particular, the efficient market
hypothesis challenge the claim that SRI can produce superior returns. Second,
the claim that SRI can change corporate investment policy lacks a basis in
finance theory.
SRI and fund performance
Finance theory suggests that screened funds should have a lower return
because of a lack of diversification and higher transaction costs. That is, reducing the universe of available stocks and adding the cost of screening are selfimposed restrictions that should hamper rather than enhance a fund’s
performance. The greatest theoretical challenge to the claimed benefits of SRI
is posed by the Efficient Market Hypothesis.61 The semi-strong form of the
hypothesis holds that all publicly available information is already reflected in
the price of stocks. As a result, the stock market is efficiently priced, and no
investor can expect to beat the market on a risk-adjusted basis. That is, investors can achieve superior returns only if they assume more risk (in which case
their risk-adjusted returns are still the same), or else they must possess information that has not yet been registered in stock prices (which requires that
the market be inefficient). The Efficient Market Hypothesis suggests, further,
that actively evaluating individual stocks by any criteria, financial or social,
is a waste of resources, and that investors should passively select a balanced
portfolio that mirrors the broader market.
The stock market is not perfectly efficient, however, and research can yield
some gains for any fund.62 However, this state of affairs provides little support
for SRI unless the information that is not reflected in prices involves a firm’s
social performance. The case for SRI, then, must be based on the claims that
the market is inefficient and that the source of this inefficiency is a failure to
recognize the significance of socially responsible activity in the evaluation of
stock price. The argument, in short, is that there is a link between social performance and financial performance that is generally ignored in the market,
and so SRI funds can beat the market by taking advantage of information that
other investors ignore.
That social and financial performance are linked is a reasonable claim that
has received some empirical support.63 That the market ignores information
about social responsibility is a more dubious proposition. A firm that has a
strong record on the environment, for example, may outperform less environmentally responsible firms because they are more likely to avoid the costs of
meeting new regulation and settling legal claims for environmental damage.
Ethics in Investment 153
The reason for this superior performance, however, may be due to a rational
calculation that an ounce of prevention is worth a pound of cure. If so, then
a higher stock price reflects the fact that the company has made an investment
in order to avoid future liabilities, and the lower stock price of a less responsible rival results from the lack of such an investment and a greater potential
for future liabilities.
The vulnerability of a corporation to adversity of any kind is information
that is ordinarily registered in the market and is not detected solely by social
responsibility screens. SRI funds avoid tobacco stocks for ethical reasons, but
these stocks are already discounted in the market because of uncertainty over
the industry’s potential liability. If tobacco companies were ever to collapse
from catastrophic liability judgments, then SRI firms would appear to be
vindicated in their exclusion of such a “sin” stock, but the long-term returns
of balanced portfolios that include tobacco stocks might be the same as the
returns of SRI funds because of the discounting. That is, tobacco stocks now
produce superior earnings relative to their (discounted) price, and so the
losses to possible future holders of worthless tobacco stocks would be offset
by these superior earnings.
The challenge of the Efficient Market Hypothesis, therefore, is that if the
market is efficient, then any information about socially responsible practices
that is relevant to financial performance will already be registered in the
market. SRI funds act on this information by excluding (negative screens) or
including (positive screens) the stock. By contrast, the market operates by
discounting the price of a stock on the basis of negative information and
placing a premium on a stock in the case of positive information. The difference between SRI and ordinary investing is the manner in which each responds
to information. SRI funds can produce superior returns, then, only if their
screens consistently reflect information that the market has somehow missed,
which is unlikely but still possible.
SRI and investment policy
Whether socially responsible investing is capable of making a better world
depends on the ability of investors to change corporate behavior by their
investment decisions. The law of supply and demand suggests that if the
demand for a stock is increased by socially concerned investors, then the price
of a stock in fixed supply will rise. Thus, socially responsible companies will
be rewarded by SRI investors with a higher stock price. However, if the price
of a stock rises above a level that is supported by its fundamentals, then other
investors will sell stock that they own or else cease their demand for the stock.
As a result, supply and demand will return to an equilibrium state and the
price of the stock will fall to its market value. In the long run, the price of the
154 Ethics in Investment
stock will be unaffected. The only difference will be that the stock of socially
responsible companies will be in the hands of socially concerned investors.
Since the price of the stock would be unaffected, under this analysis, there is
no reason to believe that SRI could affect corporate behavior.
This argument assumes that supply and demand are perfectly elastic, which
is true for larger, heavily traded stocks. SRI investors are more likely to affect
the stock price of smaller, relatively unknown firms, for whose stock the
demand is somewhat inelastic. However, can the willingness of SRI investors
to bid up the price of a stock influence the investment policy of a company?
Theoretically, the answer is yes.64 If a firm makes investment decisions by
selecting the opportunity with the highest net present value (NPV), then the
increased stock price that results from socially responsible investments would
lower the cost of equity for the firm and increase the expected rate of return.
In practical terms, however, the shareholders are subsidizing socially responsible activities through their willingness to pay a higher price for the company’s stock and accept lower financial performance, which runs counter to
the claim that SRI can produce superior returns.
Alternatively, SRI provides an opportunity for smaller companies to
compete in the crowded, noisy market for equity capital. Firms that operate
in a socially responsible manner have an opportunity to attract capital from
SRI funds. Much socially responsible activity is low-cost or cost-free, and a
reputation for social responsibility can be an asset, especially in marketing.
Smaller companies that market products like soaps and lotions (The Body
Shop), toothpaste (Tom’s of Maine), and ice cream (Ben & Jerry’s) are able to
compete in the mass market with industry giants by offering natural, environmentally friendly products to socially concerned consumers. Such socially
responsible companies are usually founded and led by value-driven entrepreneurs who want to do business in a different way. Although they might successfully raise capital in the general market on the basis of their balance sheets,
the existence of supportive, understanding SRI investors facilitates the task.
The conclusion to be drawn, then, is that SRI is unlikely to have any impact
on large, heavily traded corporations. It can alter the investment policy of a
firm only by raising the price of the firm’s stock significantly over a long period
of time, but the resulting increase in stock price represents a willingness of
investors to subsidize investment in social responsibility. Perhaps the most
enduring contribution of SRI is to provide a ready capital market for socially
responsible companies that would have difficulty raising capital otherwise.
These companies are often highly profitable, so that SRI investors need not
necessarily pay a price, but investors need to understand these companies and
seek them out in the first place. Socially responsible companies have an impact
on American business by pioneering practices that are later adopted by main-
Ethics in Investment 155
stream corporations. Because of this impact, then, socially concerned investors can perhaps, in the end, make a difference indirectly.
Microfinance
Investment is commonly made to obtain a return. However, this return usually
has some further aims, such as to secure one’s retirement (a pension fund),
support an institution (a university endowment, for example) or enable economic growth (such as development loans made by the World Bank). Socially
responsible investment seeks to promote good corporate behavior. Can investment also be used to alleviate poverty? Development loans to promote
economic growth achieve this end indirectly by creating jobs and increasing
productivity, but a more direct form of investment aimed at poverty alleviation consists of putting money into the hands of the poor themselves for the
purpose of starting or expanding a small enterprise. Loans in small amounts—
as low as $50 to $100—might enable budding entrepreneurs to escape grinding poverty and begin a climb toward modest prosperity.
This is the idea behind microfinance, which is also called microcredit and
microlending. This innovation in investment may be defined as the provision
of financial services—not only lending but also savings, insurance, and
payment systems—to low-income people who otherwise would not have
access to them. These are the “unbankables”—human beings whose needs for
credit and other financial services are not met by conventional financial institutions. This neglect is due mainly to the low income of the poor, which makes
servicing them unprofitable for existing banks, but other factors include their
distance from urban centers where banks are located, their lack of collateral
for ensuring loans, and the absence of any credit history, which makes creditworthiness difficult to assess. In addition, the poor can pay back loans only
if the funds are used productively and not merely for current consumption,
and the potential for productive use by the poor is open to question. How
much return can a poverty-stricken villager in Bangladesh, for example,
obtain from a small loan?
The answer turns out to be, quite a bit. In 2006, Muhammad Yunus, a
former Bangladeshi economics professor, and his creation, the Grameen Bank,
were awarded the Nobel Peace Prize for developing microfinance into “an ever
more important instrument in the struggle against poverty.”65 In his search for
the causes of the extreme privation that afflicts Bangladesh, Yunus discovered
that women who made bamboo stools cleared barely two cents a day, since
much of their income went to the middlemen who loaned them money to buy
the necessary bamboo and managed the sale of their products. Recognizing
156 Ethics in Investment
that the cause of the women’s poverty was not effort or skill but lack of credit,
he gave $27 of his own money to 42 women. These small amounts enabled
them to break free from the moneylenders and realize the full value of their
labors. After much experimentation, Yunus was ready in 1983 to found a bank
with the purpose of making small loans to the poor of Bangladesh, and the
bank has grown to serve more than 8.3 million members, almost all women,
in villages nationwide.66 Appropriately, the name Grameen means “of the
village.”
Lending small amounts to the poor is not a novel idea, and it can even be
profitable—as loan sharks and payday lenders have discovered. Subsidized
loans have long been a favored way for governments to help the poor. An early
practitioner of microfinance was Jonathan Swift, the noted Irish satirist and
dean of St Patrick’s cathedral in Dublin. In the 1720s, he developed a system
for making small interest-free loans to the poor, which led to numerous charitable societies that followed the Swift system. The first savings bank in England
developed from a Penny Bank for the poor that was founded in 1798 by Priscilla Wakefield, an English Quaker reformer. In slums and villages around the
world, communal mutual benefit associations, whereby members make contributions that they can draw upon as needs arise, have long been common.67
The challenge of microfinance is how to achieve three aims together: (1)
assuring high rates of repayment; (2) becoming self-sustaining, thereby avoiding a reliance on subsidies or contributions; and (3) actually alleviating poverty
or otherwise improving people’s lives. The real innovation in microfinance that
earned Muhammad Yunus and Grameen Bank the Nobel Peace Prize consists
in the means that were discovered by experimentation and keen insights for
achieving these three seemingly incompatible aims.
The first task in this section is to understand how microfinance, as developed at Grameen Bank and elsewhere, works. The keys of microfinance’s
success also raise some difficult ethical questions, including the justification
of the high interest rates that typically prevail and the pressure that is applied
to secure repayments. Some critics find a “dark side” to microfinance.68 The
field of microfinance is also riven by controversy over the conflict between
being self-sustaining and even profitable and achieving the aim of alleviating
poverty. Finally, does microfinance actually work to alleviate poverty? Anecdotes of successful stories are now giving way to hard empirical evidence, and
measuring the impact of microfinance has proved to be complex and elusive.
How microfinance works
The poor have traditionally been unlikely candidates for loans due to a general
lack of creditworthiness. Creditworthiness, in turn, consists of both an ability
Ethics in Investment 157
to pay and a willingness to do so. The ability to make payments requires that
borrowers have the skill and knowledge to use money productively in some
enterprise that generates income. Creditworthy borrowers must also have the
discipline to set aside a portion of this income for loan payments and not
spend it on current consumption (moral hazard). This complex of personal
attributes is difficult, especially for an outsider, to judge (information asymmetry), and less creditworthy borrowers have the opportunity to take advantage of a lender’s lack of knowledge by falsely presenting themselves as reliable
(adverse selection). Fortunately, the willingness to pay depends not only
on one’s character (which is relatively fixed and difficult to judge) but also on
incentives (which can be created and reliably known by outsiders). With
sufficient incentives to repay, the character of the borrower becomes less
relevant.
The poor borrower’s lack of collateral presents a different kind of problem
but one that can also be overcome with incentives. Since collateral in a traditional loan is an asset that can be seized in the event of default to offset the
loss to the lender, it must have some market value. However, any possession
that has value to the borrower—even if it is of little worth in a market—
provides a strong incentive to the borrower to avoid seizure. Microfinance
often involves collateral of this kind, which provides an incentive to repay but
not the kind of offsetting compensation afforded by collateral in a traditional
loan. Moreover, the use of collateral in a traditional loan assumes that a borrower makes a rational calculation that repayment is preferable to the loss of
the asset (again, moral hazard). Typically, the lender’s right to seize collateral
is based on a legally enforceable contract, which fosters a legalistic mindset.
Microfinance seeks to instill a different attitude toward repayment in which
one pays the debt not in order to avoid some legal penalty, such as loss of the
collateral, but out of a sense of moral obligation. The use of collateral can be
eschewed entirely if this kind of attitude is successfully instilled.
The secret of microfinance, which was discovered by trial and error in the
creation of Grameen Bank, is group lending. Potential borrowers present
themselves in groups of five. Two members of a group each receive a small
loan with an initial payment due quickly, followed by a frequent repayment
schedule. If these members make the payments, the next two receive small
loans some time later, followed last of all by a loan to the fifth member (this
is called dynamic incentives). When the first round is complete, members are
eligible for successively larger loans (progressive lending). If any member
defaults on a loan, then all others in the group are denied future credit. In
addition, eight groups are brought together in a public place to make payments that all can witness. Although all transactions are recorded, no contracts are signed; obligations are based instead on social relationships.
158 Ethics in Investment
The quick initial payments and frequent payments thereafter (regular
repayment schedules) enable the lender to discover any lack of ability or willingness to repay at an early stage, and the progressive increases in the amounts
of loans minimize any losses. Staggering the loans among group members,
withdrawing credit from all members if any one defaults, and accepting
unconventional collateral (collateral substitutes) create powerful peer pressure
to make payments. Progressively increasing the size of loans also ensures that
borrowers who are eligible to obtain larger amounts have developed a credit
history. Villagers themselves know better than an outsider who is trustworthy
and who is not, and they will use this knowledge in the formation of groups.
Thus, more trustworthy villagers will likely select each other, and less trustworthy people will be left to form their own groups if, indeed, they are able
to do so at all. The public forum in which payments are made also inspires
trust since any irregularity is exposed for all to witness.
Microfinance thus surmounts the first challenge of achieving a high rate of
repayment—which is typically 95 percent or better—by the method of group
lending, which overcomes the problems of traditional, individual lending,
largely by providing strong incentives for making payments and by utilizing
the knowledge of villagers themselves to monitor and motivate each other.
This result is achieved without the use of conventional collateral or legally
enforceable contracts, by basing the whole system on a high level of trust. The
Grameen Bank has achieved a high repayment rate also by lending almost
exclusively to women, who are considered to be more reliable and enterprising
than men and more likely to use funds for their family’s benefit. Group lending
as a method is supplemented, moreover, with a deeper change in people’s
attitudes about borrowing and their relationships with each other. Borrowing
is not merely a financial transaction but a means of collective self-help and
community development, and, in borrowing, people are engaging in a communal activity that strengthens their bonds with others and promotes prosperity in the whole society.
Ethical issues in microfinance
The success of Grameen Bank in Bangladesh, Banco Solidario in Bolivia,
Bank Rakyat Indonesia, and similar institutions elsewhere seem to indicate
the financial soundness, as well as the social benefit, of microfinance. However,
the controversy over the high profitability of Compartamos in Mexico, which
richly rewarded its founder when it went public in 2007, and the 2010 collapse
of Banex in Nicaragua, the largest microfinance institution to fail, have brought
a new level of scrutiny to this branch of the investment industry. Many critical
Ethics in Investment 159
voices have emerged in recent years to question the movement on many
fronts.69 The Grameen model has been duplicated, cookie-cutter fashion, in
countries where a different approach may be warranted, and the rapid growth
of microfinance may have outstripped the useful employment of loan funds.
Worse, the practice may not even be a very effective instrument for alleviating
poverty in the world.
The ethical criticism of microfinance may be divided into three areas of
inquiry. First are questions about how well microfinance actually addresses
the financial needs of the poor and brings genuine benefits. Group lending,
which constitutes the real innovation in microfinance that makes it possible,
has some possibly deleterious consequences, including intense peer pressure
that may be socially disruptive. Although high interest rates may be justified
by the costs of administration and the risks taken, they still constitute a burden
that reduces the economic return to the intended beneficiaries and perhaps
enriches investors in some for-profit ventures. More serious are concerns that
small loans for business enterprises are not really what the poor need and that,
in any event, many loans are not used for this purpose. Other kinds of financial
products might fit the needs of the poor better, and investment aimed at
reducing poverty might be better directed to larger enterprises that create new
jobs instead of merely helping the self-employed.
Second, there is controversy in the microfinance industry over the question
of whether lending institutions should be not-for-profit and rely mainly on
donors’ contributions for funds or should aim to become self-sustaining and
be operated for profit. Not-for-profit status allows institutions to focus on their
mission of alleviating poverty, and aid funds produce greater benefits if loans
to the poor are, in effect, subsidized by development resources. A great deal
of money is contributed by individuals, governments, and private organizations to alleviate poverty, and if microfinance is an effective means of achieving this end, then these aid funds should be used in this way. However,
dependence on aid funds brings some uncertainty and constraints and, in any
event, such funds are limited, so forgoing for-profit opportunities might
endanger the viability of microfinance institutions and limit their growth. This
split in thought has been called “the microfinance schism.”70
Effectiveness of microfinance
Whether microfinance benefits the poor is a complex of questions, each with
no easy answer. First, does microfinance increase the income of the poor?
Second, in the process of increasing income for some, are other people further
impoverished by crushing debt loads? That is, for every success story that is
160 Ethics in Investment
told about microfinance, is there also a cautionary tale of failure? Third, should
alleviating poverty be defined as merely an increase in income or should a
definition of poverty alleviation include other forms of wealth as well? Fourth,
are small loans for a business enterprise the extent of the financial services
needed by the poor or are some other service needs more urgent and unmet?
And finally, are aid funds best spent on loans for self-employed individuals
who create no new jobs but only improve their own or is poverty alleviation
best achieved by the support of small and medium enterprises that increase
total employment?
Whether microfinance actually increases the income of the poor is seemingly a straightforward empirical question to be answered by careful data
collection and analysis. Despite numerous studies, however, the results to
date are inconclusive and unreliable.71 To quantify any gains with assurance,
it would be necessary to undertake the impossible task of comparing the world
as it is with the world as it would have been without microfinance and attribute
the difference to this one factor. The studies that have been undertaken use
suspect data, apply different statistical methods, make different assumptions,
and attempt to draw unbiased conclusions. One source of bias in these studies
is that microfinance might attract borrowers who are better off to begin with
and would have succeeded even without a loan. The progressive loan system
eliminates those who are poorer credit risks and produces possibly skewed
samples. Less successful borrowers might drop out of the programs and leave
the more successful ones to be counted. If loan programs are established and
expanded in geographical areas where small entrepreneurs are more successful and are provided with other support services, as seems likely, then another
source of bias is introduced. Finally researchers may be drawn to study only
the most successful programs. The consensus, even among supporters of
microfinance, is that microfinance probably alleviates poverty to some extent
but that definitive evidence of its effectiveness is lacking.72
Increased income is not the only or even the major need of the poor. The
poor survive not merely as self-employed entrepreneurs but also as members
of an informal economy built on strong family ties and social networks. Not
only do they rely on financial capital but on social capital as well. Consequently, wealth for the poor, as for all people, consists, in part, of developing
their capabilities and gaining control over certain aspects of their lives.
Amartya Sen argues that this state of realizing capabilities and gaining control,
which he calls freedom, should be the end of development, rather than a mere
increase in income.73 Freedom, for Sen, is not merely the proper end of development, but it is also the best means for achieving it. It follows from this view
that aid funds should be used to increase the freedom, and not just the income,
of the poor.74
Ethics in Investment 161
Given the importance of social capital to the poor, as well as Sen’s concept
of development as freedom, it may be that the group lending method, while
effective in securing repayment, is destructive of social capital. When group
lending is successful, it builds social capital, but the peer pressure that occurs
and the discord that results from nonpayment are likely to break down whatever social bonds have been created. One study finds evidence that social
relationships deteriorate after some members of a group default.75 Little is
gained for the poor if financial capital is increased at the expense of social
capital. Freedom is further enhanced by microfinance, though, insofar as loans
made to women empower them in family and community relationships. This
alleged nonincome benefit is questionable, however, since studies show that
although women are typically the recipients of the loans, men still control the
small businesses that the funds support.76 The potential of microfinance to
change the deeply embedded inferior status of women in traditional societies
by empowering them is definitely limited.
Microfinance assumes that the main financial service needed by the poor
is credit and that the demand for it is largely unlimited and relatively unaffected by high interest rates. The idea that the poor are all budding entrepreneurs who need only a small loan to start or expand a business not only inflates
expectations of what is possible but also ignores other, equally crucial, financial needs. Indeed, studies of how loans are actually used reflect some of these
other needs. Often loan funds are used to meet urgent financial obligations,
such as school fees, medical bills, and house repairs, which cannot be met
from current income due to unforeseen circumstances. Like the wealthy everywhere, the poor use credit to smooth variations between income and
expenses. Given the precariousness of their lives and resources, the financial
services of greatest value to the poor are savings and insurance, rather than
credit.77 Without savings or insurance, credit is more likely to be used as a
substitute for resources rather than for production. This point is not an argument against the effectiveness of microfinance but one for changing its aims
and creating new products in order to be more effective in meeting the financial needs of the poor. Indeed, the Grameen Bank requires enrollment in a
savings program as a requirement for obtaining a loan, and many microfinance institutions offer a broad range of financial services.78
The focus of microfinance on individual enterprises as the key to alleviating
poverty is fundamentally misguided, in the view of many people involved in
economic development. Not only are the poor limited in their ability to start
or expand a business, but the most effective means for raising people’s incomes
is creating employment, which is to say real jobs. Jonathan Morduch writes,
“The best evidence to date suggests that making a real dent in poverty rates
will require increasing overall levels of economic growth and employment
162 Ethics in Investment
generation. Microfinance may be able to help some households take advantage
of these processes, but nothing so far suggests that it will ever drive them.”79
This point has been expressed as the problem of the “missing middle.”
In developed countries, small and medium enterprises (SMEs) account for
around 60 percent of gross domestic product (GDP), while in less-developed
countries the figure for SMEs is 17 percent.80 Graphs of employment in lessdeveloped countries show that employment is clustered at the two ends of the
self-employed and large enterprises, whereas developed economies peak at
the mid-point of small and medium enterprises. The problem of the “missing
middle”—that is, a relative lack of jobs at this mid-point—suggests that the
key to turning less-developed countries into developed ones, and thereby
alleviating poverty, lies with correcting what the graphs show to be missing
and creating more employment in SMEs. Thus, more poverty may be alleviated by loaning $100 000 to build a medium-sized factory that will employ
1000 people than to make 1000 $100 loans.
The microfinance schism
Microfinance is appealing to many supporters not only because it appears
to offer the best results for donors who want to make some contribution to
poverty alleviation, but because it also holds out the prospect of being selfsustaining, and even profitable. This outcome would be a win for both the
poor and those who seek to help them—and it would also attract profitminded investors. Profitable microfinance would be an example of “marketing
to the bottom of the pyramid,” which holds that selling products and services
to the poor provide good business opportunities.81
That microfinance can be done profitably is shown by the few large institutions that have successfully gone public, such as Compartamos in Mexico
and SKS Microfinance in India, which conducted successful IPOs in 2007 and
2011 respectively. In the process, the transformations of these formerly notfor-profit lenders generated huge windfalls for insiders. One question is how
many microfinance institutions could be profitable; by one estimate, the
answer is about 5 percent, with most institutions covering only about 70
percent of their costs.82 The more pertinent question is whether becoming
self-sustaining or working toward this goal is desirable. Many donors willingly
support microfinance as pure philanthropy but still expect or hope that
these institutions will eventually be able to survive without donations.
For these donors, sustainability is at least a goal worth pursuing. Achieving
this goal, however, may also change both the operations and the mission of
microfinance institutions in ways that many would consider undesirable.
In 2011, Muhammad Yunus wrote, in the New York Times, that when he
founded the Grameen Bank, seeking to thwart the loan sharks who preyed on
Ethics in Investment 163
the poor, he never imagined that “one day microcredit would give rise to its
own breed of loan sharks.”83 His opinion that commercialization has been a
“terrible wrong turn” for microfinance is based, in part, on principle: “Poverty
should be eradicated, not seen as a money-making opportunity.” However,
he also cites the practical consequences that for-profit microfinance leads to
higher interest rates, more aggressive loan origination and collection practices,
and a focus on higher-income borrowers. In his view, the inevitable neglect
of the very poor leads to “mission drift.” Furthermore, by obtaining loan funds
from capital markets, for-profit microfinance transfers more of the risk of this
volatile source to borrowers. More crucially, the Grameen Bank model, which
is built on trust rather than contracts, is threatened when borrowers no longer
feel a strong moral obligation to repay. Indeed, Yunus notes, borrowers in
India stopped making payments when they came to believe that lenders were
taking advantage of them. The collapse of Banex in Nicaragua was caused, in
part, by the rise of the “no pago” or “no pay” movement, which was encouraged by the government.
Supporters on the other side of the microfinance schism argue, first, that
profitable lenders can tap world credit markets for funds and thereby increase
the volume of loans for the benefit of the poor. Generating loan funds from
donors, along with interest from borrowers and a bank’s own depositors,
places sharp limits on the amounts available. With greater scale, for-profit
institutions can make a greater impact on poverty. This argument assumes,
however, that the demand for credit is virtually unlimited and is not reduced
by the high rates of interest that may be necessary to lend profitably. Further,
the impact on poverty is limited if the focus shifts away from serving the very
poor. The volume of loans is not a good indicator of their impact if the recipients are not well chosen.
Second, by reducing or eliminating reliance on donors, which includes
governments, for-profit microfinance institutions avoid not only the limited
supply of funds but also the uncertainty of this source of funding and the other
demands that donors make. In particular, government subsidies of loans often
have the result that well-off, politically connected insiders obtain loans instead
of the intended recipients. More broadly, alleviating poverty is a long-term
project that requires enduring, substantial institutions. Self-sustaining institutions are more likely to attain sufficient stability and capability for this difficult
task. However, the experience of the Grameen Bank shows that not-for-profit
institutions can achieve considerable scale and longevity. Moreover, both governments and institutional donors (such as foundations, aid organizations,
and world bodies) can be reliable, long-term partners.
Third, it is argued that for-profit microfinance institutions are better able
to offer the poor savings programs and the other financial services that are
164 Ethics in Investment
crucial to alleviating poverty. The call for microfinance to serve as a platform
for a wide variety of financial products has been largely ignored by smaller
lending institutions with a narrow focus. However, this situation is changing,
and there is no reason why a subsidized lending institution might not find it
feasible to offer, say, savings accounts along with loans. Indeed, deposits from
savings accounts can be a source of loan funds for a microfinance lender.
Although institutions that accept deposits must be more carefully regulated
than mere lenders, the obstacles are not insurmountable.
The schism between subsidized and sustainable microfinance continues to
divide supporters of this movement, and much experience and research will
be needed to resolve it. Although some institutions continue to focus on
financial sustainability while others measure success in terms of social impact,
both kinds bring great benefit to the poor of this world. Moreover, there is
room in the movement for both kinds of institutions, and differences between
countries and constituencies demand that the movement contain great variety.
As many writers stress, the important point is to address this schism and the
other issues in microfinance without damaging the motivating commitment
to alleviate poverty.
Conclusion
Investment is a core financial activity that enables individuals to obtain a
return on funds that are not needed for immediate consumption. These funds
and those of organizations—for example, university endowments or corporate
pension funds—are the raw material for a major industry, the investment
industry, which consists of investment banks, mutual and pension funds,
hedge funds, sovereign wealth funds, and the like. Most investment is a
straightforward search for returns, which are obtained by discovering the
most productive use for the funds under management. As in any industry that
turns raw materials into finished products, ethical issues arise in its operations. Investment banks raise many such issues, which are not considered here
directly; the focus is instead on mutual funds, which have encountered criticism for allowing market timing and personal trading by fund managers, and
on hedge funds and other investment forms that practice relationship investing. In addition, some investment funds seek more than a return; they seek
to do good by promoting corporate social responsibility in the case of SRI
funds or alleviating poverty in the case of microfinance. Although the aims of
these kinds of investment are generally admirable, the actual practices of SRI
investing and microlending and the results obtained need to be carefully
understood and evaluated.
Ethics in Investment 165
Notes
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
Investment Company Institute, 2012 Investment Company Fact Book, 2012.
Paula Dwyer and Amy Borrus, “The Coming Reforms,” BusinessWeek, November
10, 2003.
Testimony of Eric W. Zitzewitz before the United States House of Representatives, Committee on Financial Services, Subcommittee on Capital Markets,
Insurance, and Government-Sponsored Enterprises, November 6, 2003.
Eric W. Zitzewitz, “Who Cares about Shareholders? Arbitrage-Proofing
Mutual Funds,” Journal of Law, Economics, and Organization, 19 (2006),
245–280.
Eric W. Zitzewitz, “How Widespread Was Late Trading in Mutual Funds,” AEA
Papers and Proceedings, May 2006.
Peter Elkind, “The Secrets of Eddie Stern,” Fortune, April 19, 2004.
Elkind, “The Secrets of Eddie Stern.”
Riva D. Atlas, “Fund Executive Accepts Life Ban in Trading Case,” New York
Times, May 21, 2004.
Elkind, “The Secrets of Eddie Stern.”
Andrew Caffrey, “Critics Decry Uneven Use of ‘Fair-Value Pricing’,” Boston
Globe, September 12, 2003.
Michael Lewis, “Fidelities Revisited,” New York Times Magazine, January 21,
1996.
Lewis, “Fidelities Revisited.” See also Robert McGough and Jeffrey Taylor, “SEC
Boosts Its Scrutiny of Magellan Fund,” Wall Street Journal, December 11, 1995;
Jeffrey Taylor, “SEC Has Array of Tools in Magellan Probe,” Wall Street Journal,
December 26, 1995; and Jeffrey Taylor, “SEC Action Is Unlikely on Vinik,” Wall
Street Journal, May 9, 1996.
Personal Investment Activities of Investment Company Personnel, Report of the
Division of Investment Management, United States Securities and Exchange
Commission, September 1994.
Report of the Advisory Group on Personal Investing, Investment Company Institute, May 9, 1994.
Personal Investment Activities of Investment Company Personnel, p. 1.
For convenience, the terms fund manager and access people are used here interchangeably, and apply to portfolio managers, analysts, traders, and all others for
whom personal trading is an issue.
This summary is taken from Report of the Advisory Group on Personal Investing,
p. 10.
These points are developed in Personal Investment Activities of Investment
Company Personnel, p. 4.
Personal Investment Activities of Investment Company Personnel, p. 28.
Report of the Advisory Group on Personal Investing, p. 27.
Robert McGough, “Few Mutual Funds Ban Personal Shorting,” Wall Street
Journal, June 24, 1996.
166 Ethics in Investment
22.
23.
24.
25.
26.
27.
28.
29.
30.
31.
32.
33.
34.
35.
36.
37.
38.
39.
Securities and Exchange Commission, “Prohibition on the Use of Brokerage
Commissions to Finance Distribution,” 17 CFR Part 270, Federal Register, Vol.
69, No. 174, September 9, 2004.
The Securities Act Amendments of 1975, Pub. L. No. 94-29, 89 Stat. 97 (1975).
Remark by Peter Rawlins, then chairman of the London Stock Exchange, Times
Business News, February 29, 1992.
Office of Compliance, Inspections and Examinations, Securities and Exchange
Commission, Inspection Report on the Soft Dollar Practices of Broker-Dealers,
Investment Advisers and Mutual Funds, September 22, 1998.
Association for Investment Management and Research, CFA Institute Soft Dollar
Standards: Guidance for Ethical Practices Involving Client Brokerage, 1998.
D. Bruce Johnsen, “Property Rights to Investment Research: The Agency
Costs of Soft Dollar Brokerage,” Yale Law Journal on Regulation, 11 (1994),
75–113.
Johnsen, “Property Rights to Investment Research.” See also D. Bruce Johnsen,
“Mutual Funds,” in John R. Boatright (ed.), Finance Ethics: Critical Issues in
Theory and Practice (New York: John Wiley & Sons, Inc. 2010).
D. Bruce Johnsen and Stephen M. Horan, The Welfare Effects of Soft Dollar Brokerage: Law and Economics, monograph from the Association for Investment
Management and Research, 2000.
Investment Company Institute, “Request for Rulemaking concerning Soft Dollars
and Directed Brokerage,” Petition No. 4-49, December 16, 2003, Securities and
Exchange Commission.
The Brancato Report on Institutional Investment (Fairfax, VA: The Victoria Group,
1993), 1994.
Matteo Tonello and Stephan Rabimov, The 2010 Institutional Investment Report
(New York: The Conference Board, 2010). Figures are for institutional ownership
of the 1000 largest US corporations.
On the concept of “universal ownership,” see James P. Hawley and Andrew Williams, The Rise of Fiduciary Capitalism: How Institutional Investors Can Make
Corporate American More Democratic (Philadelphia, PA: University of Pennsylvania Press, 2000).
Dale M. Hanson, “Much, Much More than Investors,” Financial Executive,
March–Apri1 1993, pp. 48–51.
The study by Stephen Nesbitt of Wilshire Associates is reported in Ed
McCarthy, “Pension Funds Flex Shareholder Muscle,” Pension Management,
January 1996, pp. 16–19.
Marc Lifsher, “CalPERS to Seek Improved Governance, Stricter Wall Street
Rules,” Los Angeles Times, February 9, 2009.
Quoted in Hanson, “Much, Much More than Investors,” p. 48.
Albert O. Hirschman, Exit, Voice, and Loyalty: Responses to Decline in Firms,
Organizations, and States (Cambridge, MA: Harvard University Press, 1970).
See Nell Minow, “Proxy Reform: The Case for Increased Shareholder Communication,” Journal of Corporation Law, 17 (1991), 149–162.
Ethics in Investment 167
40.
41.
42.
43.
44.
45.
46.
47.
48.
49.
50.
51.
52.
53.
54.
“Indexing Fingered,” The Economist, April 30, 1994.
John Brook, “Corporate Pension Fund Asset Management,” in Abuse on Wall
Street: Conflicts of Interest in the Securities Industry (Westport, CT: Quorum
Books 1980).
“The Politically Correct Pension Fund,” BusinessWeek, March 21, 1994; and
“Clinton Administration Official Advocates Relationship Investing,” Pension
World, July 1994.
Department of Labor Interpretive Bulletin 94-1 on Economically Targeted
Investments, 59 Fed. Reg. 32,606 (June 23, 1994), codified at 29 C.F.R. § 2509.941. See Diane E. Burkley and Shari A. Wynne, “The Clinton Administration Is
Attempting to Persuade Pension Plans to Invest Their Vast Resources in Projects
that Offer Benefits to Low-Income Communities,” National Law Journal, September 5, 1994.
Edward Zalinsky, “ETI, Phone the Department of Labor: Economically Targeted
Investments and the Reincarnation of Industrial Policy,” Berkeley Journal of
Employment and Labor Law, 16 (1995), 333–355.
Zalinsky, “ETI, Phone the Department of Labor,” p. 341. For criticism, see Jayne
Elizabeth Zanglein, “Protecting Retirees While Encouraging Economically
Targeted Investment,” Kansas Journal of Law and Public Policy, 5 (1995–1996),
47–58; and a response, Edward A. Zelinsky, “Economically Targeted Investments: A Critical Analysis,” Kansas Journal of Law and Public Policy, 6 (1996–
1997), 39–48.
Adam Bryant, “Colt’s in Bankruptcy Court Filing,” New York Times, March 20,
1992.
Richard W. Stevenson, “Pension Funds Becoming a Tool for Growth,” New York
Times, March 17, 1992.
Roberta Romano, “Public Pension Fund Activism in Corporate Governance
Reconsidered,” Columbia Law Review, 93 (1993), 795–853. Romano notes that
the alternative is to make up the shortfall by taking tax dollars away from some
other state services.
John Pound, “Beyond Takeovers: Politics Comes to Corporate Control,” Harvard
Business Review, March–April 1992, p. 83.
Quoted in Judith H. Dobrzynski, Business Week, March 15, 1993. Nell Minow
was a founder and principal of Lens, a relational investment firm that operated
between 1992 and 2000.
Pound, “Beyond Takeovers,” p. 88.
Michele Galen, “Sin Does a Number on Saintliness,” BusinessWeek, December
26, 1994; John Rothchild, “Why I Invest with Sinners,” Fortune, May 13, 1996;
and Ann Brocklehurst, “Banking on the Wages of Sin,” New York Times, February
18, 1995.
Ritchie P. Lowry, Good Money: A Guide to Profitable Social Investing in the ‘90s
(New York: W.W. Norton, 1991), p. 19.
For a short history of social investing, see Mayra Alperson, Alice Tepper Marlin,
Jonathan Schorsch, and Rosalyn Will, The Better World Investment Guide (New
168 Ethics in Investment
York: Prentice Hall, 1991). See also Elizabeth Judd, Investing with a Conscience
(New York: Pharos Books, 1990); Peter D. Kinder, Steven D. Lydenberg, and Amy
L. Domini, The Social Investment Almanac: A Comprehensive Guide to Socially
Responsible Investing (New York: Henry Holt, 1992); Jack A. Brill and Alan Reder,
Investing from the Heart (New York: Crown, 1992); and Amy L. Domini, Socially
Responsible Investing: Making a Difference in Making Money (Chicago: Dearborn
Trade, 2001).
55. Céline Louche and Steven Lydenberg, “Responsble Investing,” in John R.
Boatright (ed.), Finance Ethics: Critical Issues in Theory and Practice (New York:
John Wiley & Sons, Inc., 2010).
56. 2012 Report on Sustainable and Responsible Investing Trends in the United States
(Washington, DC: The Forum for Sustainable and Responsible Investment,
2012).
57. Eurosif, European SRI Study 2012.
58. Steven D. Lydenberg, Alice Tepper Marlin, and Sean O’Brien Strub, Rating
America’s Corporate Conscience: A Provocative Guide to the Companies behind
the Products You Buy Everyday (Reading, MA: Addison-Wesley, 1986).
59. Sally Hamilton, Hoje Jo, and Meir Statman, “Doing Well While Doing Good?”
Financial Analysts Journal, November–December 1993, pp. 62–66; J. David Diltz,
“The Private Cost of Socially Responsible Investing,” Applied Financial Economics, 5 (1995), 69–77; and C. Mallin, B. Saadouni, and R. J. Briston, “The Financial
Performance of Ethical Investment Funds,” Journal of Business Finance and
Accounting, 22 (1995), 483–496.
60. D. J. Ashton, “A Problem in the Detection of Superior Investment Performance,”
Journal of Business Finance and Accounting, 17 (1990), 337–350; and John H.
Langbein and Richard A. Posner, “Social Investing and the Law of Trusts,” Michigan Law Review, 79 (1980), 72–112.
61. For a discussion of the implications of finance theory for social investing, see
Larry D. Wall, “Some Lessons from Basic Finance for Effective Socially Responsible Investing,” Economic Review, 8 (1995), 1–12.
62. Maria O’Brien Hylton, “ ‘Socially Responsible’ Investing: Doing Good versus
Doing Well in an Inefficient Market,” American University Law Review, 42 (1992),
1–52.
63. Attempts to measure the relation between social and financial performance have
been marred by problems of definition and measurement, and the results of
the many studies have been contradictory and inconclusive. For an overview
of the available studies, see Joshua Margolis and James P. Walsh, People and
Profits? The Search for a Link between a Company’s Social and Financial Performance (Mahwah, NJ: Lawrence Erlbaum, 2001).
64. Wall, “Some Lessons from Basic Finance for Effective Socially Responsible
Investing,” p. 4.
65. http://www.nobelprize.org/nobel_prizes/peace/laureates/2006/press.html
66. http://www.grameeninfo.org/index.php?option=com_content&task=view&id
=26&Itemid=175
Ethics in Investment 169
67.
68.
69.
70.
71.
72.
73.
74.
75.
76.
77.
78.
79.
For a history of microfinance initiatives, see David Roodman, Due Diligence:
An Impertinent Inquiry into Microfinance (Washington, DC: Center for Global
Development, 2012), Chapter 3.
David Hulme, “Is Microdebt Good for Poor People? A Note on the Dark Side of
Microfinance,” Small Enterprise Development, 11 (2000), 26–28. See also Keith
Epstein and Geri Smith, “The Ugly Side of Microlending,” Newsweek, November
12, 2007.
See, for example, Roodman, Due Diligence; Hugh Sinclair, Confessions of a Microfinance Heretic (San Francisco, CA: Berrett-Koehler, 2012); and Milford Batemen,
Confronting Microfinance: Undermining Sustainable Development (Sterling, VA:
Kumarian Press, 2011).
Jonathan Morduch, “The Microfinance Schism,” World Development, 28 (2000),
617–629.
One of the most often cited studies is Mark M. Pitt and Shahidur Khandker, “The
Impact of Group-Based Credit Programs on Poor Households in Bangladesh:
Does Gender Participation Matter,” Journal of Political Economy, 106 (1998),
958–996. A subsequent analysis of the data by Jonathan Morduch failed to yield
the same positive conclusions. Jonathan Morduch, “The Microfinance Promise,”
Journal of Economic Literature, 37 (1999), 1569–1614. An extended exchange
between these researchers did not produce a decisive conclusion. See also Beatriz
Armendariz and Jonathan Morduch, The Economics of Microfinance (Cambridge,
MA: MIT Press, 2005); and Roodman, Due Diligence, pp. 160–165.
Jonathan Morduch and Barbara Haley, “Analysis of the Effects of Microfinance
on Poverty Reduction,” NYU Wagner Working Papers No. 1014, June 28, 2002;
and Manohar Sharma and Gertrud Buchenrieder, “Impact of Microfinance on
Food Security and Poverty Alleviation: A Review and Synthesis of the Empirical
Evidence,” in Manfred Zeller and Richard L. Meyer (eds), The Triangle of Microfinance: Financial Sustainability, Outreach and Impact (Baltimore, MD: The Johns
Hopkins University Press, 2002).
Amartya Sen, Development as Freedom (New York: Knopf, 1999).
See Roodman, Due Diligence, Chapter 7.
Dean S. Karlan, “Social Connections and Group Banking,” The Economic Journal,
117 (2007), F52–F84. See also Annabel Vanroose, “Is Microfinance an Ethical
Way to Provide Financial Services to the Poor?” Ethics and Economics, 5 (2007),
1–8.
Anne Marie Goetz and Rina Sen Gupta, “Who Takes the Credit? Gender, Power,
and Control over Loan Use in Rural Credit Programs in Bangladesh,” World
Development, 24 (1996), 45–63.
Timothy H. Nourse, “The Missing Parts of Microfinance: Services for Consumption and Insurance,” SAIS Review, 21 (2002), 61–69. See also Hulme, “Is Microdebt Good for Poor People?”
Alex Counts, “Reimagining Microfinance,” Stanford Social Innovation Review, 6
(Summer 2008), 46–53.
Morduch, “The Microfinance Promise,” p. 1610.
170 Ethics in Investment
80.
81.
82.
83.
Meghana Ayyagari, Thorsten Beck, and Asli Demirgüç-Kunt, “Small and Medium
Enterprises across the Globe: A New Database,” World Bank Policy Research
Working Paper 3127, August 2003.
C. K. Prahalad, The Fortune at the Bottom of the Pyramid: Eradicating Poverty
through Profits, 5th edition (Upper Saddle River, NJ: Wharton School Publishing,
2010).
Morduch, “The Microfinance Schism,” p. 618.
Muhammad Yunus, “Sacrificing Microcredit for Megaprofits,” New York Times,
January 14, 2011.
Chapter Five
Ethics in Financial Markets
Anything that can be owned can be traded, and if trading in something is
frequent, a market probably exists for that purpose. This holds true not only
for commodities and valuable objects, such as pork bellies and French Impressionist paintings, but also for financial instruments of all kinds. However,
unlike pork bellies, which can be carved up and packaged only in limited ways,
financial instruments can take a wide variety of forms for trade in many different markets. With puts and calls, swaps and strips, and a host of other
colorfully named instruments, the possibilities for trading in financial markets
are limited only by human inventiveness and the constraints of law—which
may often be gotten around with even more inventiveness.
The broad aim of financial market regulation is to secure “fair and orderly
markets” or “just and equitable principles of trade.” These expressions, which
are standard in securities law and market rules, combine the economic value
of efficiency with an ethical concern for fairness or equity, thereby giving rise
to the familiar equity/efficiency trade-off. When applied to markets, the
concepts of fairness, justice, and equity (which are roughly synonyms) serve
mainly to forbid fraud and manipulation, the violation of certain rights, and
the exploitation of asymmetries in such matters as information and bargaining
power. Prohibitions of unfair market practices are designed to protect both
market participants and the integrity of markets themselves, which cannot
function properly when they lack fairness.
In addition to an examination of what constitutes fairness in markets, this
chapter examines three specific areas where unfairness is often alleged. These
are insider trading, hostile takeovers, and financial engineering. Although
insider trading is illegal and diligently prosecuted, the ethical case against it
Ethics in Finance, Third Edition. John R. Boatright.
© 2014 John Wiley & Sons, Inc. Published 2014 by John Wiley & Sons, Inc.
172 Ethics in Financial Markets
is surprisingly difficult to make, and some economists and legal theorists
object to the legal prohibition against it. Hostile takeovers are generally legal,
though some think them unseemly, but they must still be conducted according
to rules that prevent unfair advantage taking. Tender offers, which are commonly used to mount a takeover, can be coercive if, for example, shareholders
must decide quickly without adequate information. The idea that a change of
ownership can occur in a “market for corporate control” also raises questions
about whose interest ought to be considered in takeovers. Financial engineering is a broad term for many innovations, including derivatives of various
kinds and so-called high-frequency trading. Although the innovative products
from financial engineering have great potential for improving people’s lives,
their destructive potential must be carefully considered.
Fairness in Markets
Financial markets require rules to function well, and much of the necessary
regulatory framework is provided by law. In the United States, the Securities
Act of 1933 and the Securities Exchange Act of 1934, with their many amendments, and the rules set by the Securities and Exchange Commission (SEC)
constitute the main regulatory framework for markets in securities. In addition, financial investment institutions, such as banks, mutual funds, pension
funds, and insurance companies, are governed by industry-specific legislation,
as well as by industry self-regulation, including the rules of organized
exchanges, such as the New York Stock Exchange.
The main aim of financial market regulation is to ensure both fairness and
efficiency. The charge given to the SEC by the 1934 Securities Exchange Act is
“to maintain fair and orderly markets.” Orderliness in markets is commonly
understood as stability, predictability, and ease of operation, as well as efficiency in the economic sense. Despite their differences, fairness and efficiency
are linked. First, fairness is essential to efficiency for the reason that markets
can be efficient only when people have confidence that they will be treated
fairly. Unfair markets tend to drive people away and thereby reduce participation. Consequently, fairness has value as a means to the end of efficiency.
Second, efficiency is itself an ethical value, an end worth pursuing, because
achieving the maximum output with the minimum input—which is a simple
definition of efficiency—provides an abundance of goods and services and
thereby promotes the general welfare. Thus, achieving efficiency is as much of
a moral goal as the achievement of fairness. However, fairness and efficiency
can sometimes conflict, resulting in the unfortunate equity/efficiency trade-off.
Painful choices between efficiency and fairness (or equity), or between eco-
Ethics in Financial Markets 173
nomic and social well-being, are at the heart of many difficult public policy
decisions. However, we should not lose sight of the fact that fairness contributes to efficiency, and also that efficiency is itself of moral value, even when
the two conflict.
Fairness or justice is a very broad term, even when its use is restricted to
financial markets. The first task of this section, therefore, is to develop some
understanding of this important concept in the context of financial markets.
This is followed by a consideration of the different ways in which transactions
in financial markets can be unfair and to discover how this unfairness can be
corrected. The possible ways in which individual investors and the public at
large can be treated unfairly by the operation of financial markets are many,
but the main kinds of unfairness are fraud and manipulation, inequalities in
information and bargaining power, and inefficient pricing.1
What is fairness?
Fairness is a basic moral category of evaluation, roughly synonymous with
justice, which has a wide range of application. Fairness is commonly applied
in the moral appraisal, variously, of individual acts, activities, practices, rules,
procedures, policies, outcomes, and institutions. It is among the more important moral categories, but it is not the whole of morality: welfare, rights,
equality, liberty, and dignity are also significant moral considerations, with
which fairness may sometimes conflict. Fairness is also closely associated with
such moral concepts as impartiality, proportionality, reciprocity, and mutual
benefit.
The core meaning of fairness involves at least two familiar ideas. First, fairness consists of treating people equally in accord with some rule, agreement,
or expectation. Fairness in a grading system, for example, requires that understood rules be applied in the same way to all students, with no favoritism
shown. When this is done, students typically receive different grades, but this
is not necessarily unfair as long as the grades result from following the stated
rules. Indeed, it would be unfair if students who performed differently received
the same grade, because this would show that the rules were not applied consistently. In addition to equality of treatment, fairness may also reflect the
equal conditions in which an activity takes place, as in a “fair deal” or a “fair
game.” This kind of fairness is often characterized as a “level playing field,”
where no one has an unfair advantage.
The second idea at the core of fairness is that outcomes be in accord with
justified rules. Fairness requires not merely that the rules for grading be consistently applied but that they also be the right rules, which achieve the
purpose of the grading system. Otherwise, the outcome of equally applied
174 Ethics in Financial Markets
rules would still be unfair. Insofar as students receive different grades, the
differences between them should also be proportionate in ways that reflect
the grading system’s purpose. It might be unfair, for example, to give significantly lower grades for only minor differences in performance. The combination of these two ideas can be expressed as, “Like cases should be treated alike,
and unlike cases should be treated differently in proportion to the relevant
differences.”
These two ideas are commonly distinguished as procedural and substantive
fairness. Fairness is often relevant when some goods or some benefits and
burdens are to be distributed. Thus, we should aim to distribute the good of
income or the benefits and burdens of taxation fairly. Whatever procedure is
used to make this distribution it should be fairly applied, but the resulting
outcome or distribution may also be judged as fair or unfair as a matter of
substance. A tax code, for example, may be applied fairly (procedural fairness)
but produce an unfair outcome (substantive fairness), or vice versa. What
makes an outcome fair is problematic, but it is often related to people’s welfare
or their rights or their deserts—that is, to what they are owed in some sense.
The meaning of fairness is narrowed when it is applied to financial markets
or to financial activity generally, but it is still rather broad. Fairness in market
exchange requires, first, a certain equality of conditions, a level playing field,
where no one has an unfair advantage. A playing field may be unlevel or tilted
for many reasons, but a certain amount of equality in information, resources,
and the like is morally required. It is for this reason that insider trading on
the basis of nonpublic information is generally thought to be unfair; the inside
trader is thought to have an unfair advantage by competing under different
conditions. Second, fairness also excludes certain practices that may be characterized as unfair competition. Clearly, fraud and manipulation in securities
markets fit this characterization. Any manipulation of the market is an unfair
competitive practice because it departs from standard trading rules. Other
practices, such as program trading, have been questioned on grounds of fairness. Third, some distributive outcomes in markets may be criticized as unfair,
such as high executive compensation. That a chief executive officer (CEO)
should be awarded compensation that is many times the wages of an ordinary
worker strikes some as unfair in itself. This outcome would be unfair, they
argue, even if it were the result of market forces. Others argue that this level
of pay is unfair, but only because the market itself is not functioning properly.2
For these critics, the unfairness occurs in the area of practice rather than
outcome.
Fairness is an important element not only in financial markets but also in
other areas of finance. Financial reporting, for example, should aim at providing a fair presentation of a company’s financial performance, and the company
Ethics in Financial Markets 175
itself should be fair in making disclosures. Corporate governance should
ensure the fair treatment of shareholders and investors generally. Customers
and clients of financial services providers should be treated fairly. Thus, a bank
should be fair in evaluating applicants for loans. Fairness is also involved in
the management of an economy. The level of inflation or public debt affects
groups differently, since the former favors borrowers over savers and the latter
benefits older generations while passing the burden to younger ones. Consequently, fairness should be considered in making decisions about these
matters.
Fraud and manipulation
One of the main purposes of securities regulation is to prevent fraudulent and
manipulative practices in the purchase or sale of securities. However, fraud is
not confined to securities but can occur in any market exchange or, indeed,
in any area of life where decisions are based on information provided by
another party. Consumer fraud, for example, results when a company misrepresents some aspect of a product being sold or the conditions of sale. Submitting a false tax return—as when an individual or a company uses an illegal tax
shelter—constitutes tax fraud. The collapse of Enron and WorldCom was
caused by accounting fraud in which both companies succeeded for a time
in hiding massive debts by the improper accounting treatment of certain
transactions.
The common-law definition of fraud is the willful misrepresentation of a
material fact that causes harm to a person who reasonably relies on the misrepresentation. Section 17(a) of the 1933 Securities Act and Section 10(b) of
the 1934 Securities Exchange Act both prohibit anyone involved in the buying
or selling of securities from making false statements of a material fact, omitting a fact that makes a statement of material facts misleading, or engaging in
any practice or scheme that would serve to defraud.
This definition of fraud involves five elements. The first element is the
making of a false statement or misrepresentation. Something false must be
stated, written, implied, or otherwise conveyed. This false statement or misrepresentation must be, second, about a material fact; that is, it must involve
some factual matter that can be characterized as true or false and that is
important in some way (material) to a decision. Third, the party making the
statement or representation must know that it is false and thereby intend that
others be deceived. Knowledge and intention are mental matters that are
usually necessary to establish guilt for any crime. Fourth, it is necessary in
fraud that the other party actually relies on the false statement or misrepresentation in making a decision. Fifth, that party must suffer some loss or other
176 Ethics in Financial Markets
harm from this reliance. Each of these elements—a material misrepresentation, knowledge or intent, reliance, and harm—must be established in any
court action for fraud, and proving them all is often difficult.
Investors, both as buyers and as sellers, are particularly vulnerable to fraud
because the value of financial instruments depends almost entirely on information that is difficult to verify. The buyer of a house can at least examine the
house itself, but a stockholder buys solely on the basis of information about
the corporation. Much of the important information is in the hands of the
issuing firm, and so antifraud provisions in securities law place an obligation
not only on buyers and sellers of a company’s stock, for example, but also on
the company itself. Thus, a company that fails to report bad news may be
committing fraud, even though the buyer of that company’s stock buys it from
a previous owner who may not be aware of the news. Insider trading is prosecuted as a fraud under Section 10(b) of the Securities Exchange Act on the
grounds that any material nonpublic information ought to be revealed before
trading. However, communicating that information is often not possible in an
impersonal market, and so the only recourse for an insider may be to refrain
from trading.
Manipulation generally involves the buying or selling of securities for the
purpose of creating a false or misleading impression about the direction of
their price so as to induce other investors to buy or sell the securities at prices
that are disadvantageous to them. Like fraud, manipulation is designed to
deceive others, but the effect is achieved by the creation of false or misleading
appearances rather than by false or misleading representations. Manipulation
may occur not only in securities transactions but also in any scheme that serves
to create a misleading impression that disrupts the normal functioning of the
market. For example, in 2012, a number of banks were accused of manipulating a key interest rate LIBOR (the London Interbank Offered Rate). This
manipulation affected the interest rate charged on many different kinds of
loans, which were pegged to LIBOR. The banks engaging in the manipulation
were able to make trades based on changes in this rate, but perhaps the main
reason for submitting false information was to enable the banks to appear
sounder than they were. Admitting that the rate at which they were able to
borrow was rising would indicate that they were becoming less creditworthy.
Fraud and manipulation are addressed by mandatory disclosure regulations as well as by penalties for false and misleading statements in any information released by a firm or for any manipulative schemes engaged in by
investors. Mandatory disclosure regulations are justified, in part, because they
promote market efficiency. Better informed investors, it is thought, will make
more rational investment decisions, and they will do so at lower overall cost.
A further justification for mandatory disclosure is the prevention of fraud and
Ethics in Financial Markets 177
manipulation under the assumption that good information drives out bad.
Simply put, fraud and manipulation are more difficult to commit when investors have easy access to reliable information.
Mandatory disclosure regulations are generally considered to be preferable
to merit regulations, such as state “blue sky” laws that require approval of
offerings from a regulatory agency in order to ensure that the prices of the
securities fairly reflect their value. Although many states have enacted blue
sky laws with provisions for a regulatory approval based on merit, Congress
specifically denied the SEC the authority to pass on the investment merit of
any security, in the belief that disclosure provides better protection for
investors.
Equal information
In all markets, information is a valuable commodity. Those who possess it can
have a great advantage over those who lack it. Parties in an exchange typically
possess not only different amounts of information but also different kinds.
Such inequality is described by economists as information asymmetry. Some
information asymmetry in financial markets may be considered unfair, but
not all. Exactly what fairness requires with regard to information is not easy
to determine. The same arguments that support a free flow of information
may also justify people in taking advantage of superior information. In general,
securities law aims to protect the reasonable investor from unfair advantage
taking by those with superior information, but whether any given instance of
advantage taking is unfair is open to dispute.
Consider, for example, whether a geologist, who concludes after careful
study that a widow’s land contains oil, would be justified in buying the land
without revealing what he knows.3 The geologist would be concealing relevant
information that the widow would benefit from knowing. Without it, she
might make a deal that would not bring her the greatest potential return.
However, it may be argued that without such opportunities, geologists would
not search for oil, and so society as a whole is better off if such advantage
taking is permitted. In addition, the widow herself is better off in a society
that allows some exploitation of superior knowledge. What she would gain in
this transaction by having the information would be offset by living her life
in a poorer society. A difficult task for securities regulation, then, is drawing
a line between fair and unfair advantage taking when people have unequal
information.
Competition between parties with very unequal information is often
regarded as unfair because of the great advantage held by the one with superior information. In such cases, there is scarcely any real competition since
178 Ethics in Financial Markets
the party with inferior information is almost certain to lose in any transaction.
The unfairness of unequal information involves the conditions under which
market transactions occur, rather than procedures or outcomes. However, one
may question whether conditions with unequal information are really unfair.
Why should parties to an exchange have equal information? Perhaps investors
with inferior information should simply not trade.
One answer to the question of why parties to an exchange should have
equal information comes from the economic theory, which holds that markets
can be efficient only in the presence of perfect information—when buyers and
sellers know fully what they are giving up and receiving in return. Exchanges
with imperfect information may not result in gains for both parties, which
economic theory holds to be a major virtue of markets. This answer entails
that all market exchanges should be conducted by parties with full information but leaves open the possibility that some people should not engage in
market exchanges at all. That is, only parties with full information should seek
to trade.
The problem with this answer is that some market activity is unavoidable,
and people should not be deprived of the benefits of markets unnecessarily. It
is acceptable for most people to shun certain markets in which sophisticated
investors have a decided advantage. However, everyone needs to open a
banking account, obtain credit, invest for the future, buy insurance, and the
like. No one should have to engage in markets for essential services with an
informational disadvantage. Alternatively, one should be able to participate
in markets without fear of being taken advantage of by those with superior
information. Furthermore, markets themselves can benefit from wide participation. Although the stock market is dominated by professional investors—
many of which are institutions that manage pensions and mutual funds for
individuals—there is still some benefit for society in enabling investors of
modest resources to trade without a significant disadvantage. That is, the stock
market may be healthier if professional and amateur investors can participate
on roughly equal terms.
A further reason for promoting equal information is one of cost. Information is essential for market efficiency. Indeed, an efficient market is defined as
one in which all available information is reflected in the price of securities.
Obtaining information and utilizing it in a market involves some cost, which
may be considerable. So efficiency is enhanced when this information is
entered into the market at the lowest cost. This point is exemplified by the
requirement that a company issuing stock provide a prospectus, which contains certain critical information. Investors could obtain this information
themselves only at great cost, if at all, but the issuer can make it available for
all investors in one document at relatively little expense. Thus, the many disclosure laws in finance, as well as the rest of the economy, are aimed at improv-
Ethics in Financial Markets 179
ing the operation of markets by providing information for both buyers and
sellers at the lowest possible cost.
Equal information may mean, at least, two different things: that the parties
to a trade actually possess the same information or have equal access to information. That everyone should possess the same information is an unrealizable
ideal, and actual markets are characterized by great information asymmetries.
However, two investors may be equally well informed even though they may
not have exactly the same information, and this difference may lead them to
make different decisions. When one investor buys a stock that the other sells,
they typically hold different views about its worth. Access to information, on
the other hand, refers to information that is potentially available to an investor,
and an investor who does not make an effort to actually possess this information may be blamed for lacking it. Access to information is like the opportunity to succeed: as long as there is no impediment to success, people succeed
based on their own effort.
One problem with defining equal information as having equal access to
information is that the notion of equal access is not absolute but relative.
Any information that one person possesses could be acquired by another with
enough time, effort, and money. An ordinary investor has access to virtually
all of the information that a stock analyst uses to evaluate a company’s prospects. The main difference is that the analyst has faster and easier access to
information because of an investment in resources and skills. Anyone else
could make the same investment and thereby gain the same access—or a
person could simply “buy” the analyst’s skilled services. Therefore, accessibility is not a feature of information itself but a function of the investment that
is required in order to obtain the information.
However, there are good reasons for encouraging people to acquire superior information for use in trade. Consider stock analysts and other savvy
investors who spend considerable time, effort, and money to acquire information. Not only are they ordinarily entitled to use this information for their
own benefit (because it represents a return on an investment), but they perform
a service to everyone by ensuring that stocks are accurately priced. Efficient
pricing reduces information asymmetries because the prices of stocks, bonds,
and other financial instruments are available to all, but this kind of equal
information is possible only if people with superior information are allowed
to trade on it. Thus, information asymmetries are self-correcting, because
people with superior information can reap the benefit only by trading, but this
trading registers that information in the market for all to see.
The possession of unequal information strikes us as unfair mainly when
the information has been illegitimately acquired or when its use violates some
obligation to others. One argument against insider trading, for example, holds
that an insider has not acquired the information legitimately but has stolen
180 Ethics in Financial Markets
(or “misappropriated”) information that rightly belongs to the firm. Another
argument contends that insiders have an obligation or fiduciary duty to a firm
that precludes trading on inside information. In both arguments, the wrongfulness of insider trading consists not in the possession of unequal information, but in violating a moral obligation not to steal or a fiduciary duty to serve
others. Insider trading can also be criticized on the grounds that others do
not have the same access to the information, which leads us to the second
sense of equal information, namely equal access.
Yet another argument against insider trading is that insiders use information that is not merely costly to obtain but that cannot be obtained by an
outsider at any price. In other words, the information is inherently inaccessible. Frank H. Easterbrook and Daniel R. Fischel question this point. They
ask, “If one who is an ‘outsider’ today could have become a manager by devoting the same time and skill as today’s ‘insider’ did, is access to information
equal or unequal?” They conclude that there is “no principled answer to such
questions.”4 Although the dividing line may be blurry, some information is
clearly inaccessible by any reasonable means.
The sense of fairness that is expressed by the concept of a level playing field
does not require that everyone possess the same information or even have
equal access to information in a strong sense. The proper conclusion is, first,
that people should possess certain information that enables them to act in
the market for essential goods so that they can make necessary transactions
without being at a significant informational disadvantage. Anyone should be
able to open a bank account, acquire a credit card, receive a loan, buy a home,
or take out an insurance policy with sufficient information and other consumer protections that prevent advantage taking by better informed financial
services providers.
Second, people should be able to have access to the information that they
need to act in markets according to their own preferences. Not everyone wants
to be a professional investor, nor need they be one. However, if people choose
to operate in securities markets—or any other market, for that matter—they
should have access to all relevant information on equal terms with others. This
is to say that markets should be transparent with abundant information. The
amount of information that companies are required to disclose to the public
serves to make markets both fairer and more efficient by enhancing access.
Still, we hold that some information asymmetries are objectionable for one
reason or another and ought to be corrected. From a utilitarian perspective,
it could be argued that markets are more efficient when information is readily
available and that we should seek to make information available at the lowest
cost. To force people to make costly investments in information, or to suffer
loss from inadequate information, is a deadweight loss to the economy if the
Ethics in Financial Markets 181
same information could be provided at little cost. Thus, the requirement that
the issuance of new securities be accompanied by a detailed prospectus, for
example, is intended not only to prevent fraud through the concealment of
material facts but also to make it easier for buyers to gain certain kinds
of information, which benefits society as a whole. Furthermore, investors, if
forced to choose rules for a securities market, would realize that everyone is
better off with a free flow of information.
Equal bargaining power
Generally, agreements reached by arm’s-length bargaining are considered to
be fair, regardless of the actual outcome. A trader who negotiates a futures
contract that results in a great loss, for example, has only himself or herself to
blame. However, the fairness of bargained agreements assumes that the parties
have relatively equal bargaining power. Agreements can be criticized as unfair,
then, when one party takes undue advantage of a superior bargaining position.
Whether unequal bargaining power, like unequal information, leads to unfairness is, of course, a matter of dispute.
Unequal bargaining power is an unavoidable feature of financial markets
and exploiting such power imbalances is not always unfair. In general, the law
intervenes when exploitation is unconscionable or when the harm is not easily
avoided, even by sophisticated investors. Little concern should be expressed,
perhaps, for investors without the resources or skills for successful trading,
but the success of financial markets depends on reasonably wide participation.
If unequal bargaining power were permitted to drive all but the most powerful
from economic exchange, then the efficiency of financial markets would be
greatly impaired. Unequal bargaining power can result from many sources—
including unequal information, which is discussed above—but other causes
include unequal resources, unequal processing ability, and other vulnerabilities or weaknesses.
In most transactions, wealth is an advantage. The rich are better able than
the poor to negotiate over almost everything. Prices of groceries in lowincome neighborhoods are generally higher than those in affluent areas, for
example, in part because wealthier customers have more options. Similarly,
large investors have greater opportunities because they can be better diversified; they can bear greater risk and thereby obtain higher leverage; they can
gain more from arbitrage through volume trading; and they have access to
investments that are closed to small investors. For example, SEC rules permit
private placements and other exempt transactions in which securities need
not be registered, but these are limited to “accredited investors,” who must
meet certain thresholds with regard to personal income and wealth. These
182 Ethics in Financial Markets
rules are designed to protect small investors from losses they cannot afford, but
they also limit their investment opportunities. The private sale of large blocks
of securities outside of established markets is also an investment opportunity
that is available only to very large investors, which are usually institutions.
The advantages of greater wealth are not usually considered to be unfair,
in part because small investors can pool their resources and obtain the same
benefits by investing in a mutual fund instead of an individual portfolio, for
example. Without such opportunities for small investors, however, markets
that favor the wealthy would probably be regarded as unfair.
With equal access to information and even equal possession, people still
vary enormously in their ability to process information and to make informed
judgments. Unsophisticated investors are ill-advised to play the stock market
and even more so to invest in markets that only professionals understand.
Securities firms and institutional investors overcome the problem of people’s
limited processing ability by employing specialists in different kinds of
markets, and the use of computers in program trading enables these organizations to substitute machine power for gray matter. Program trading, including
high-frequency trading, has been criticized mainly for introducing volatility
into trading that is not warranted by the fundamentals of a market, but
program trading also serves to reduce the number of investors who have any
business in the financial marketplace.
Investors are only human, and human beings have many vulnerabilities or
weaknesses that can be exploited. Some regulation is designed to protect people
from the exploitation of their vulnerabilities. Thus, consumer protection legislation often provides for a “cooling-off ” period during which shoppers can
cancel an impulsive purchase. The requirements that a prospectus accompany
offers of securities and that investors be urged to read the prospectus carefully
serve to curb impulsiveness. Margin requirements and other measures that
discourage speculative investment serve to protect incautious investors from
overextending themselves, as well as to protect the market from excess volatility. The legal duty of brokers and investment advisers to recommend only
suitable investments and to warn adequately of the risks of any investment
instrument provides a further check on people’s greedy impulses.
Insider Trading
Insider trading prosecutions have ensnared many high profile figures as well
as ordinary investors. The convictions in the 1980s of Michael Milken and
Ivan Boesky captured the popular imagination, and, more recently, media
maven Martha Stewart served prison time for offenses related to her questionable sale of stock after receiving a tip. In 2012, the prominent hedge fund
Ethics in Financial Markets 183
manager Raj Rajaratnam was found guilty and sentenced to 11 years in prison
for trades that netted him an alleged $60 million dollars in illicit profits.
The Rajaratnam case is significant not only for the amount of the gain but
also for the extensive use of so-called “expert networks.” His defense was a test
of the “mosaic theory,” that the investment decisions of Galleon, his hedge
fund, were not based on any one piece of inside information but were pieced
together, like a mosaic, from many different sources, no one of which might
be considered significant in itself.5 The investor’s skill is required to put all
this information together. Moreover, the stock transactions also involved a
considerable amount of legitimate research and analysis. Needless to say, this
test of the mosaic theory failed, and the expert network business has been
set back.
It is difficult to determine the frequency of insider trading and the amounts
involved since evidence is available only from the successful convictions.
These convictions, moreover, rise and fall with the zeal of prosecutors and the
investigative tools available. (The prosecution of Rajaratnam was facilitated,
for example, by extensive recordings of telephone conversations and the cooperation of witnesses.) In recent years, though, insider trading enforcement has
been a high priority in the United States and it is gaining strength in Europe
after years of neglect.6
Despite many prosecutions, a definition of insider trading remains elusive.
Insider trading is prosecuted in the US under SEC Rule 10b-5, which merely
prohibits fraud in securities transactions. This vague wording is deliberate in
order to create uncertainty in the minds of investors, but it also raises the legal
vulnerability of the unwary. Some have argued that such a vague definition
with draconian powers is fundamentally unfair to investors.7 A more explicit,
“bright line” definition would ease prosecutions and reduce the risk for investors, but it might also have less deterrent value. So one task for this section is
to develop a definition for insider trading.
In addition to the need to define insider trading is the problem of showing
its wrongness. Although insider trading is generally considered to be wrong,
the basis of this judgment is surprisingly difficult to establish. Further, some
legal scholars have argued that there is nothing wrong with the practice and
that, indeed, it is, on balance, beneficial and should not be legally prohibited.8
Much of this section consists of a discussion of the arguments for and against
the wrongfulness of insider trading.
Insider trading defined
Insider trading is commonly defined as trading in the stock of publicly held
corporations on the basis of material, nonpublic information. In a landmark
1968 decision, executives of Texas Gulf Sulphur Company were found guilty
184 Ethics in Financial Markets
of insider trading for investing heavily in their own company’s stock after
learning of the discovery of rich copper-ore deposits in Canada.9 The principle
established in this case is that insiders must refrain from trading on information that significantly affects their company’s stock price until it becomes
public knowledge. The rule for corporate insiders is: reveal or refrain!
Much of the uncertainty in the law on insider trading revolves around the
relation of the trader to the source of the information. Corporate executives
and directors are definitely “insiders,” but some “outsiders” have also been
charged with insider trading. Among such outsiders have been a printer who
was able to identify the targets of several takeovers from legal documents that
were being prepared; a financial analyst who uncovered a huge fraud at a
high-flying firm and advised his clients to sell; a stockbroker who was tipped
off by a client who was a relative of the president of a company and who
learned about the sale of the business through a chain of family gossip; a
psychiatrist who was treating the wife of a financier who was attempting to
take over a major bank; and a lawyer whose firm was advising a client company
that was planning a hostile takeover.10 The first two traders were eventually
found innocent of insider trading; the latter three were found guilty (although
the stockbroker case was later reversed in part). From these cases a legal definition of insider trading has emerged.
The key points in this legal definition are that a person who trades on material, nonpublic information is engaging in insider trading when: (1) the trader
has violated some legal duty to a corporation and its shareholders or (2) the
source of the information has such a legal duty and the trader knows that
the source is violating that duty. Thus, the printer and the stock analyst had
no relation to the corporations in question and so had no duty to refrain from
using the information that they had acquired. The stockbroker and the psychiatrist, however, knew or should have known that they were obtaining inside
information indirectly from high-level executives who had a duty to keep
information confidential. The corresponding rule for outsiders is: don’t trade
on information that is revealed in violation of a trust! Both rules are imprecise,
however, and leave many cases unresolved.
Debate over insider trading
Three main rationales are used in support of a law against insider trading.
One is based on property rights and holds that those who trade on material,
nonpublic information are essentially stealing property that belongs to the
corporation. The second rationale is based on fairness and holds that traders
who use inside information have an unfair advantage over other investors and
that, as a result, the stock market is not a level playing field. The third rationale
Ethics in Financial Markets 185
contends that an inside trader violates a fiduciary duty to the source of the
information. These three rationales lead to different definitions with different
scopes. On the property rights or “misappropriation” theory, only corporate
insiders or outsiders who bribe, steal, or otherwise wrongfully acquire corporate secrets can be guilty of insider trading. The fiduciary argument applies
only when information is used or disclosed in violation of a fiduciary duty.
The fairness argument is broader and applies to anyone who trades on material, nonpublic information, no matter how it is acquired.
Property rights
One difficulty in using the property rights or misappropriation argument
is determining who owns the information in question. The main basis for
recognizing a property right in trade secrets and confidential business information is the investment that companies make in acquiring information and
the competitive value that some information has. Not all inside information
fits this description, however. Advance knowledge of better-than-expected
earnings would be an example. Such information still has value in stock
trading, even if the corporation does not use it for that purpose. For this
reason, many employers prohibit the personal use of any information that an
employee gains in the course of his or her work. This position is too broad,
however, since an employee is unlikely to be accused of stealing company
property by using knowledge of the next day’s earning report for any purpose
other than stock trading.
A second difficulty with the property rights argument is that if companies
own certain information, then they could give their own employees permission to use it, or they could sell the information to favored investors or even
trade on it themselves to buy back stock. Giving employees permission
to trade on inside information could be an inexpensive form of extra compensation that further encourages employees to develop valuable information
for the firm. Such an arrangement would also have some drawbacks; for
example, investors might be less willing to buy the stock of a company that
allowed insider trading because of the disadvantage to outsiders. What is
morally objectionable about insider trading, according to its critics, though,
is not the misappropriation of a company’s information but the harm done to
the investing public. So the violation of property rights in insider trading
cannot be the sole reason for prohibiting it. Fairness is also an important factor.
Fairness
Fairness in the stock market does not require that all traders have the same
information. Indeed, trades will take place only if the buyers and sellers of a
stock have different information that leads them to different conclusions about
186 Ethics in Financial Markets
the stock’s worth. It is only fair, moreover, that a shrewd investor who has
spent a great deal of resources studying the prospects of a company should be
able to exploit that advantage. Otherwise there would be no incentive to seek
out new information. What is objectionable about using inside information is
that other traders are barred from obtaining it, no matter how diligent they
may be. The information is unavailable not for lack of effort but for lack of
access. Poker also pits card players with unequal skill and knowledge without
being unfair, but a game played with a marked deck gives some players an
unfair advantage over others. By analogy, then, insider trading is like playing
poker with a marked deck.
The analogy may be flawed, however. Perhaps a more appropriate analogy
is the seller of a home who fails to reveal hidden structural damage. One
principle of stock market regulation is that both buyers and sellers of stock
should have sufficient information to make rational choices. Thus, companies
must publish annual reports and disclose important developments in a timely
manner. A CEO who hides bad news from the investing public, for example,
can be sued for fraud. Good news, such as an oil find, need not be announced
until a company has time to buy the drilling rights, and so on; but to trade on
that information before it is public knowledge might also be described as a
kind of fraud by making a purchase without disclosing relevant information
to the seller.
In fraudulent transactions, one party, such as the buyer of the house with
structural damage, is wrongfully harmed for lack of knowledge that the other
party concealed. Similarly, the ignorant parties to insider-trading transactions
are wrongfully harmed when material facts, such as the discovery of copperore deposits in the Texas Gulf Sulphur case, are not revealed.
The main weakness of the fairness argument is determining what information ought to be revealed in a transaction. The reason for requiring a
homeowner to disclose hidden structural damage is that doing so makes for
a more efficient housing market. In the absence of such a requirement, potential home buyers would pay less because they would not be sure of what they
were getting or they would invest in costly home inspections. Similarly, the
argument goes, requiring insiders to reveal before trading makes the stock
market more efficient. This argument appeals not to fairness but to efficiency
and its welfare benefits.
Another problem with this efficiency argument is that some economists
argue that the stock market would be more efficient without a law against
insider trading.11 If insider trading were permitted, they claim, information
would be registered in the market more quickly and at less cost than the
alternative of leaving the task to research by stock analysts. The main beneficiaries of a law against insider trading, critics continue, are not individual
Ethics in Financial Markets 187
investors but market professionals who can pick up news “on the street” and
act on it quickly. A legal prohibition against insider trading denies a benefit
to insiders, who get the information first, but confers the benefit on the second
person to get the information, usually a savvy market professional, which
is of little benefit to the average investor. Some economists argue further
that a law against insider trading preserves the illusion that there is a level
playing field and that individual investors have a chance against market
professionals.
One response to this case for the legalization of insider trading is that it
considers only at the cost of registering information in the market and not at
possible adverse consequences of legalized insider trading, which are many.
Investors who perceive the stock market as an unlevel playing field may be
less inclined to participate or will be forced to adopt costly defensive measures.
In addition, any increase in efficiency from insider trading is apt to be minimal
since the information involved would usually get registered in the market
quickly and at low cost without the aid of insiders. Furthermore, legalized
insider trading would have an effect on the treatment of information in a firm.
Employees whose interest is in information that they can use in the stock
market may be less concerned with information that is useful to the employer.
The company itself might attempt to tailor its release of information for the
maximum benefit to insiders. More importantly, the opportunity to engage in
insider trading might undermine the relation of trust that is essential for business organizations.12 A prohibition on insider trading frees employees of a
corporation to do what they are supposed to be doing—namely, working for
the interests of the shareholders—not seeking ways to advance their own
interests.
Fiduciary duty
The harm that legalized insider trading could do to organizations suggests
that the strongest argument against legalization might be the breach of
fiduciary duty that would result. Virtually everyone who could be called an
insider has a fiduciary duty to serve the interests of the corporation and its
shareholders, and the use of information that is acquired while serving as a
fiduciary for personal gain is a violation of this duty. It would be a breach of
professional ethics for a lawyer or an accountant to benefit personally from
the use of information acquired in confidence from a client, and it is similarly
unethical for a corporate executive to make personal use of confidential business information.
The argument that insider trading constitutes a breach of fiduciary duty
accords with recent court decisions that have limited the prosecution of
insider trading to true insiders who have a fiduciary duty. One drawback
188 Ethics in Financial Markets
of this fiduciary duty argument is that “outsiders” whom federal prosecutors
have sought to convict of insider trading would be free of any restrictions.
A second drawback is that insider trading, on this argument, is no longer an
offense against the market but the violation of a duty to another party, and
the duty not to use information that is acquired while serving as a fiduciary
prohibits more than insider trading. The same duty would be violated by a
fiduciary who buys or sells property or undertakes some other business
dealing on the basis of confidential information. That such breaches of fiduciary duty are wrong is evident, but the authority of the SEC to prosecute them
under a mandate to prevent fraud in the market is less clear.
Resolving the debate
In 1997, the US Supreme Court ended a decade of uncertainty over the legal
definition of insider trading. The SEC has long prosecuted insider trading
using the misappropriation theory, according to which an inside trader
breaches a fiduciary duty by misappropriating confidential information for
personal trading. In 1987, the high court split four-to-four on an insider
trading case involving a reporter for The Wall Street Journal, and thus left
standing a lower-court decision that found the reporter guilty of misappropriating information.13 However, the decision did not create a precedent for
lack of a majority. Subsequently, lower courts rejected the misappropriation
theory in a series of cases in which the alleged inside trader did not have a
fiduciary duty to the corporation whose stock was traded. The principle
applied was that the trading must itself constitute a breach of fiduciary duty.
This principle was rejected in U.S. v. O’Hagan.
James H. O’Hagan was a partner in a Minneapolis law firm that was
advising the British firm Grand Metropolitan in a hostile takeover of the
Minneapolis-based Pillsbury Company. O’Hagan did not work on Grand Met
business but allegedly tricked a fellow partner into revealing the takeover bid.
O’Hagan then reaped $4.3 million by trading in Pillsbury stock and stock
options. An appellate court ruled that O’Hagan did not engage in illegal
insider trading because he had no fiduciary duty to Pillsbury, the company in
whose stock he traded. Although O’Hagan misappropriated confidential
information from his own law firm, to which he owed a fiduciary duty, trading
on this information did not constitute a fraud against the law firm or against
Grand Met. Presumably, O’Hagan would have been guilty of insider trading
only if he were an insider of Pillsbury.
In a six-to-three decision, the Supreme Court reinstated the conviction of
Mr O’Hagan and affirmed the misappropriation theory. According to the deci-
Ethics in Financial Markets 189
sion, a person commits securities fraud when he or she “misappropriates
confidential information for securities trading purposes, in breach of a fiduciary duty owed to the source of the information.” Thus, an inside trader need
not be an actual insider (or a temporary insider, like a lawyer) of the corporation whose stock is traded. Being a temporary insider in Grand Met is sufficient in this case to hold that insider trading occurred. The majority opinion
observed that “it makes scant sense” to hold a lawyer like O’Hagan to have
violated the law “if he works for a law firm representing the target of a tender
offer, but not if he works for a law firm representing the bidder.” The crucial
point is that O’Hagan was a fiduciary who misused information that had been
entrusted to him. This decision would also apply to a person who receives
information from an insider and who knows that the insider source is violating a duty of confidentiality. However, a person with no fiduciary ties who
receives information innocently (by overhearing a conversation, for example)
would still be free to trade.
Hostile Takeovers
Since its founding in 1863, Pacific Lumber Company had been a model
employer and a good corporate citizen. As a logger of giant redwoods in
northern California, this family-managed company had long followed a policy
of perpetual sustainable yield. Cutting was limited to selected mature trees,
which were removed without disturbing the forests, so that younger trees
could grow to the same size. Employees—many from families that had worked
at Pacific Lumber for several generations—received generous benefits, including an overfunded company-sponsored pension plan. With strong earnings
and virtually no debt, Pacific Lumber seemed well positioned to survive any
challenge.
However, the company fell prey to a hostile takeover. In 1985, financier
Charles Hurwitz and his Houston-based firm Maxxam, Inc., mounted a successful $900 million leveraged buyout of Pacific Lumber. By offering $40 per
share for stock that had been trading at $29, Hurwitz gained majority control.
The takeover was financed with junk bonds issued by Drexel Burnham
Lambert under the direction of Michael Milken. Hurwitz expected to pare
down the debt by aggressive clear-cutting of the ancient stands of redwoods
that Pacific Lumber had protected and by raiding the company’s overfunded
pension plan.
Using $37.3 million of $97 million that Pacific Lumber had set aside for
its pension obligations, Maxxam purchased annuities for all employees and
190 Ethics in Financial Markets
retirees and applied more than $55 million of the remainder toward reducing
the company’s new debt. The annuities were purchased from First Executive
Corporation, a company that Hurwitz controlled. First Executive was also
Drexel’s biggest junk-bond customer, and the company purchased one-third
of the debt incurred in the takeover of Pacific Lumber. After the collapse of
the junk-bond market, First Executive failed in 1991 and was taken over
by the State of California in a move that halted pension payments to Pacific
Lumber retirees. For many years, Charles Hurwitz and Maxxam were mired
in lawsuits by former stockholders, retirees, environmentalists, and local governments. In 2008, the now-bankrupt Pacific Lumber Company was dissolved,
and its assets were formed into the new Humboldt Redwood Company.
A hostile takeover is an acquisition that is opposed by the management of
the target corporation. It is merely one kind of corporate restructuring along
with friendly mergers and acquisitions, leveraged buyouts, breakups into two
or more corporations, divestitures of whole divisions, sales of assets, and
liquidations. These restructurings raise few ethical problems because the managers and shareholders of the firms in question usually come to a mutual
agreement. Hostile takeovers, by contrast, typically involve sharp disagreements between managers, shareholders, and other corporate constituencies.
In addition, hostile takeovers appear to violate the accepted rules for corporate
change. Peter Drucker observed that the hostile takeover “deeply offends the
sense of justice of a great many Americans.”14 An oil industry CEO charged
that such activity “is in total disregard of those inherent foundations which
are the heart and soul of the American free enterprise system.”15 Many economists defend hostile takeovers on the grounds that they bring about needed
changes that cannot be achieved by the usual means.16
The ethical issues in hostile takeovers are threefold. First, should hostile
takeovers be permitted at all? Insofar as hostile takeovers are conducted in a
market through the buying and selling of stocks, there exists a “market for
corporate control.” So the question can be expressed in the form: Should there
be a market for corporate control? Or should change of control decisions be
made in some other fashion? Second, ethical issues arise in the various tactics
that have been used by raiders in launching attacks, as well as by target corporations in defending themselves. Some of these tactics are criticized on the
grounds that they unfairly favor the raiders or incumbent management, often
at the expense of shareholders, employees, and communities. Third, hostile
takeovers raise important issues about the fiduciary duties of officers and
directors in their responses to takeover bids. In particular, what should directors do when an offer that shareholders want to accept is not in the best
interests of the corporation itself—or of other constituencies? Do they have a
right, indeed, a responsibility, to prevent a change of control.
Ethics in Financial Markets 191
Fairness in takeovers
Defenders of hostile takeovers contend that corporations become takeover
targets when incumbent management is unable or unwilling to take steps that
increase shareholder value. The raiders’ willingness to pay a premium for the
stock reflects a belief that the company is not achieving its full potential under
the current management. “Let us take over,” the raiders say, “and the company
will be worth what we are offering.” Because shareholders often find it difficult
to replace the current managers through traditional proxy contests, hostile
takeovers are an important means for shareholders to realize the full value of
their investment. Although restructurings of all kinds cause some hardships
to employees, communities, and other groups, society as a whole benefits from
the increased wealth and productivity—or so the argument goes.
Just the threat of a takeover serves as an important check on management,
and without this constant spur, defenders argue, managers would have less
incentive to secure full value for the shareholders. With regard to the market
for corporate control, defenders hold that shareholders are, and ought to be,
the ultimate arbiters of who manages the corporation. If the shareholders have
a right to replace the CEO, why should it matter when or how shareholders
bought the stock? A raider who bought the stock yesterday in a tender offer
has the same rights as a shareholder of long standing. Any steps to restrict
hostile takeovers, the defenders argue, would entail an unjustified reduction
of shareholders’ rights.
Critics of hostile takeovers challenge the benefits and emphasize the harms.
Targets of successful raids are sometimes broken up and sold off piecemeal,
or downsized and folded into the acquiring company. In the process, people
are thrown out of work and communities lose their economic base. Takeovers
generally saddle companies with debt loads that limit their options and expose
them to greater risk in the event of a downturn. Critics also charge that companies are forced to defend themselves by managing for immediate results
and adopting costly defensive measures. Although takeovers and the threat
of takeovers may force some beneficial changes on corporations, this flurry of
activity serves primarily to enrich investment bankers and lawyers. The benefit
to the shareholders of the companies involved comes at the expense of other
constituencies. Not all takeovers result from sound financial decision making,
and, in any event, change-of-control decisions are too important to be made
solely on the basis of financial considerations. The market for corporate
control should be broadened to include more than the interests of shareholders, and perhaps government should play some role.
The debate over hostile takeovers revolves largely around the question of
whether they are good or bad for the American economy. This is a question
192 Ethics in Financial Markets
for economic analysis, and the evidence, on the whole, is that takeovers generally increase the value of both the acquired and the acquiring corporation.17
These results must be viewed with some caution, however.
First, not all takeover targets are underperforming businesses with poor
management. Other factors can make a company a takeover target. The “bustup” takeover operates on the premise that a company is worth more sold off
in parts than retained as a whole. Large cash reserves, expensive research
programs, and other sources of savings enable raiders to finance a takeover
with the company’s own assets. The availability of junk-bond financing during
the 1980s permitted highly leveraged buyouts with levels of debt that many
considered to be unhealthy for the economy. Finally, costly commitments to
stakeholder groups can be tapped to finance a takeover. Thus, Pacific Lumber’s
pension plan and cutting policy constituted commitments to employees and
environmentalists respectively. Both commitments were implicit contracts
that had arguably benefited shareholders and communities in the past but that
could now be broken with impunity.
Second, some of the apparent wealth that takeovers create may result from
accounting and tax rules that benefit shareholders but create no new wealth.
For example, the tax code favors debt over equity by allowing a deduction for
interest payments on debt while taxing corporate profits. Rules on depreciation and capital gains may result in tax savings from asset sales following a
takeover. Thus, taxpayers provide an indirect, perhaps unintended, subsidy in
the financing of takeovers. Some takeovers result in direct losses to other
parties. Among the losers in hostile takeovers are often bondholders, whose
formerly secure, investment-grade bonds are sometimes downgraded to speculative, junk-bond status. Hostile takeovers are only one among many ways
in which shareholders can benefit at bondholders’ expense.
Third, there is little evidence that newly merged or acquired firms outperform industry averages in the long run.18 This result counts against the claim
that takeovers are cures for underperforming managers. The immediate boost
to the stock’s price may be due to one-time savings from cost-cutting or from
tax and accounting rules, or it may reflect an upward adjustment by a market
that had previously undervalued a company. The difference between shortterm and long-term stock market performance does not necessarily mean that
the market is imperfect; it may result from financial judgments based on different time horizons. Thus, during a period of high interest rates, the market
may apply a relatively high discount rate to investments, whereas managers
may regard current interest rates as an aberration and apply a lower discount
rate in making investment decisions. The justification of takeovers, then,
depends on whether the economy is strengthened by investment decisions
Ethics in Financial Markets 193
that take a long-term view of discount rates or by decisions that readjust with
each short-term change in capital markets.19
Takeover tactics
In a typical hostile takeover, an insurgent group, often called a “raider,” makes
a tender offer to buy a controlling block of stock in a target corporation from
its present shareholders.20 The offered price generally involves a premium,
which is an amount in excess of the current trading price. If enough shareholders accept the tender offer by indicating their willingness to sell their
shares, the insurgents gain control. In the usual course of events, the raiders
replace the incumbent management team and proceed to make substantial
changes in the company. In some instances, a tender offer is made directly to
the shareholders, but in others the cooperation of management is required in
order to reach the shareholders.
When the cooperation of the target firm is required, its officers and directors have a fiduciary duty to consider a tender offer in good faith. If they
believe that a takeover is not in the best interests of the shareholders, then
they have a right, even a duty, to fight the offer with all available means. Corporations have many resources for defending against hostile takeovers. These
tactics—collectively called “shark repellents”—include poison pills, white
knights, lockups, crown-jewel options, the Pac-Man defense, golden parachutes, and greenmail (see Table 5.1). Some of the defensive measures (such
as poison pills and golden parachutes) are usually adopted in advance of any
takeover bid, while others (white knights and greenmail) are customarily
employed in the course of fighting an unwelcome offer. Many states have
adopted so-called antitakeover statutes that further protect incumbent management against raiders. Because of shark repellents and antitakeover statutes,
a merger or acquisition is virtually impossible to conduct today without the
cooperation of the board of directors of the target corporation.
All takeover tactics raise important ethical issues, but three, in particular,
have elicited great concern. These are unregulated tender offers, golden parachutes, and greenmail.
Tender offers
Ethical concern about the tactics of takeovers has focused primarily on
the defenses of target companies, but unregulated tender offers are also
potentially abusive. Before 1968, takeovers were sometimes attempted by a
so-called “Saturday-night special,” in which a tender offer was made after the
close of the market on Friday and set to expire on Monday morning. The
194 Ethics in Financial Markets
Table 5.1 Takeover defenses
Crown-Jewel Option. A form of lockup in which an option on a target’s most
valuable assets (crown jewels) is offered to a friendly firm in the event of a hostile
takeover. This defense reduces the value of the firm to the acquirer.
Golden Parachute. A part of the employment contract with a top executive that
provides for additional compensation in the event that the executive departs
voluntarily or involuntarily after a takeover. The defense adds to the cost of a
takeover by creating a large expense.
Greenmail. The repurchase by a target of an unwelcome suitor’s stock at a premium
in order to end an attempted hostile takeover. The term is modeled on “blackmail”
so as suggest a form of extortion.
Lockup Option. An option given to a friendly firm to acquire certain assets in the
event of a hostile takeover. Usually, the assets are crucial for the financing of a
takeover and may include a firm’s “crown jewels” (see Crown-Jewel Option).
Pac-Man Defense. A defense (named after a popular video game with creatures that
seek to eat each other) in which the target makes a counteroffer to acquire the
unwelcome suitor.
Poison Pill. A general term for any device that lowers the price of a target’s stock in
the event of a takeover. A common form of poison pill is the issuance of a new class
of preferred stock that shareholders have a right to redeem at a premium after a
takeover.
Shark Repellent. A general term for all takeover defenses.
White Knight. A friendly suitor that makes an offer for a target in order to avoid a
takeover by an unwelcome suitor.
Saturday-night special was considered to be coercive because shareholders
had to decide quickly whether to accept the tender offer with little information.21 Shareholders would generally welcome an opportunity to sell stock
that trades at $10 a share on a Friday afternoon for, say, $15. If, on Monday
morning, however, the stock sells for $20 a share, then the shareholders who
accepted the tender offer over the weekend gained $5 but lost the opportunity
to gain $10. With more information, shareholders might conclude that $15 or
even $20 was an inadequate price and that they would be better off holding
on to their shares, perhaps in anticipation of an even better offer.
Partial offers for only a certain number or percentage of shares and two-tier
offers can also be coercive. In a two-tier offer, one price is offered for, say, 51
percent of the shares and a lower price is offered for the remainder. Both offers
Ethics in Financial Markets 195
force shareholders to make a decision without knowing which price they will
receive for their shares or, indeed, whether their shares will even be purchased
by the raider. Thus, tender offers can be structured in such a way that shareholders are stampeded into tendering quickly, lest they lose the opportunity.
The payment that is offered may include securities—such as shares of the
acquiring corporation or a new merged entity—and the value of these securities may be difficult to determine. Without adequate information, shareholders may not be able to judge whether a $15 per share noncash offer, for
example, is fairly priced.
Congress addressed these problems with tender offers in 1968 with the
passage of the Williams Act. The guiding principle of the Williams Act is
that shareholders have a right to make important investment decisions in an
orderly manner with adequate information. They should not be stampeded
into tendering for fear of losing the opportunity or forced to decide in ignorance. Under Section 14(d) of the Williams Act, a tender offer must be accompanied by a statement detailing the bidder’s identity, the nature of the funding,
and plans for restructuring the takeover target.22 A tender offer must be open
for 20 working days, in order to allow shareholders sufficient time to make a
decision, and accepting shareholders have 15 days in which to change their
minds, thereby permitting them to accept a better offer should one be made.
The Williams Act deals with partial and two-tier offers by requiring proration.
Thus, if more shares are tendered than the bidder has offered to buy, then the
same percentage of each shareholder’s offered stock must be purchased. Proration ensures the equal treatment of shareholders and removes the unfair pressure on shareholders to tender early.
Golden parachutes
At the height of takeover activities in the 1980s, between one-quarter and
one-half of major American corporations provided their top executives with
an unusual form of protection—golden parachutes.23 By 2012, the figure had
risen to more than three-quarters.24 A golden parachute is a provision in a
manager’s employment contract for compensation—usually a cash settlement
equal to several years’ salary—for the loss of a job following a takeover. In
general, golden parachutes are distinct from severance packages because they
become effective only in the event of a change of control and apply to both
voluntary and involuntary termination. Thus, a golden parachute-equipped
executive who is assigned to a lesser position after a takeover may be able to
resign voluntarily and still collect the compensation. Golden parachutes are
usually limited to the CEO and a small number of other officers.25
The most common argument for golden parachutes is that they reduce a
potential conflict of interest. Managers who might lose their jobs in the event
196 Ethics in Financial Markets
of a takeover cannot be expected to evaluate a takeover bid objectively. Michael
C. Jensen observes, “It makes no sense to hire a realtor to sell your house and
then penalize your agent for doing so.”26 A golden parachute protects managers’ futures, no matter the outcome, and thus frees them to consider only the
best interests of the shareholders. In addition, golden parachutes enable corporations to attract and retain desirable executives because they provide protection against events that are largely beyond managers’ control. Without this
protection, a recruit may be reluctant to accept a position at a potential takeover target or in an industry subject to takeovers, or a manager might leave a
vulnerable company in anticipation of a takeover bid. Further, the cost of
exercising golden parachutes may deter takeovers and thus function like a
takeover defense, although whether this counts in favor of golden parachutes
depends on the merits of such defensive measures. Ultimately, the value of
reducing conflicts of interests for managers depends on the returns to
shareholders.
Critics argue, first, that golden parachutes merely entrench incumbent
managers by raising the price that raiders would have to pay. In this respect,
golden parachutes are like poison pills in that they create costly new obligations in the event of a change of control. All such defensive measures are
legitimate if they are approved by the shareholders, but golden parachutes,
critics complain, are often secured by executives from compliant boards of
directors that they control. If golden parachutes are in the shareholders’ interests, then executives should be willing to obtain shareholder approval.27 Otherwise, they appear to be self-serving defensive measures that violate a duty
to serve the shareholders. The view that shareholders are perhaps ill-served
by golden parachutes prompted a change in the tax code in 1996 to discourage
high compensation in them,28 and the 2010 Dodd–Frank Act requires a nonbinding shareholder vote on golden parachutes in certain circumstances.29
Second, some critics object to the idea of providing additional incentives
to do what they are being paid to do anyway.30 Philip L. Cochran and Steven
L. Wartick observe that managers are already paid to maximize shareholder
wealth: “To provide additional compensation in order to get managers to
objectively evaluate takeover offers is tantamount to management extortion
of the shareholders.”31 One experienced director finds it “outrageous” that
executives should be paid after they leave a company. Peter G. Scotese writes:
“Why reward an executive so generously at the moment his or her contribution to the company ceases? The approach flies in the face of the American
work ethic, which is based on raises or increments related to the buildup of
seniority and merit.”32 These arguments suggest that even if golden parachutes
can be justified economically, the perception that executives are abusing their
Ethics in Financial Markets 197
power by obtaining undeserved compensation undermines public confidence
in business and leads to demands for government action.
Third, the arguments in support of golden parachutes cite the sources of
shareholder benefit, but these can be questioned. A 2012 study finds that
shareholders gain some benefit from golden parachutes for the reason that the
companies adopting them are more often acquired with the result that shareholders realize an acquisition premium. However, the premium in these
acquisitions is on average lower than in cases of acquired companies without
golden parachutes. The study further finds, though, that companies with
golden parachutes underperform those without them both before and after
the acquisition. As a result, shareholders benefit from the adoption of golden
parachutes only if the acquisition premium exceeds the reduction in stock
returns. A possible reason for this underperformance is that managers with
golden parachutes may not be incentivized to operate the firm for maximum
returns since they lack the discipline that the market for corporate control
would otherwise provide.33
The justification for all forms of executive compensation lies with the
incentive it provides for acting in the shareholders’ interests. If golden parachutes are too generous, then they entrench management by making the price
of a takeover prohibitive, with the possible result that managers do not exert
full effort. Alternatively, overly generous golden parachutes might motivate
managers to support a takeover against the interests of shareholders. In either
case, the managers enrich themselves at the shareholders’ expense. The key is
to develop a compensation package with just the right incentives, which, as
Michael Jensen notes, will depend on the particular case.34 Jensen recommends that golden parachutes be extended beyond the CEO to those who will
play an important role in the negotiation and implementation of a takeover,
and that the compensation provided by the parachutes should be tied in some
way to the payoff of a takeover for shareholders, which is easier said than done.
Greenmail
Unsuccessful raiders do not always go away empty-handed. Because of the
price rise that follows an announced takeover bid, raiders are often able to sell
their holdings at a tidy profit. Indeed, this possibility provides an important
hedge that reduces the risk of an attempted takeover. In some instances,
though, target corporations have repelled unwelcome assaults by buying back
the raiders’ shares at a premium. After the financier Saul Steinberg accumulated more than 11 percent of Walt Disney Productions stock in 1984, the
Disney board agreed to pay $77.50 per share, a total of $325.3 million, for
stock that Steinberg had purchased at an average price of $63.25. As a reward
198 Ethics in Financial Markets
for ending his run at Disney, Steinberg pocketed nearly $60 million. This
episode and many like it have been widely criticized as greenmail.
The play on the ward “blackmail” suggests that there is something corrupt
about offering or accepting greenmail. A more precise term that avoids this
bias is control repurchase. A control repurchase may be defined as a “privately
negotiated stock repurchase from an outside shareholder at a premium over
the market price, made for the purpose of avoiding a battle for control of the
company making the repurchase.”35 Control repurchases are legal; there is
nothing in US securities law that prohibits such transaction. Congress has
conducted hearings on proposals to ban control repurchases in response to
concerns by the SEC and business groups, but to date no legislation has been
passed. Control repurchases have been challenged in court as a breach of the
management’s fiduciary duty to shareholders, but courts have been reluctant
to intervene unless the managers’ decisions serve to protect only their own
interests. Many people think that there ought to be a law, but we need to ask
first why contral repurchases are considered to be unethical.
There are three main ethical objections to control repurchases.36 First,
control repurchases are negotiated with one set of shareholders, who receive
an offer that is not extended to everyone else. This is a violation, same say, of
the principle that all shareholders should be treated equally. The same offer
should be made to all shareholders—or none. To buy back the stock of raiders,
especially at a premium, is unfair to other shareholders.
This argument is easily dismissed. Managers have an obligation to treat all
shareholders according to their rights under the charter and bylaws of the
corporation and the relevant corporate law. This means one share, one vote at
meetings and the same dividend for each share.37 Otherwise, there is no legal
or ethical obligation for managers to treat shareholders equally. That is, their
right to equal treatment is limited to only a few matters. Moreover, paying a
premium for the repurchase of stock is a use of corporate assets that presumably brings some return to the shareholders, and the job of managers is to put
all corporate assets to their most productive use. If the $60 million that Disney
paid to Saul Steinberg, for example, brings higher returns to the shareholders
than any other investment, then the managers have an obligation to all shareholders to treat this one shareholder differently.
Second, control repurchases are criticized as a breach of the fiduciary duty
of management to serve the shareholders’ interests. One critic of greenmail
makes the case as follows:
Say you owned a small apartment building in a distant city, and you hired a
professional manager to run it for you. This person likes the job, and when
someone—an apartment “raider”—sought to offer you a good price for the
Ethics in Financial Markets 199
building, the manager does everything to prevent you from being able to consider the offer. . . . When all else fails, the manager takes some of your own
money and pays the potential buyer greenmail to look elsewhere.38
If managers use shareholders’ money to pay raiders to go away merely to
save their own jobs, then they have clearly violated their fiduciary duty.
However, this may not be the intent of managers in all cases of greenmail.
Managers of target corporations may judge that an offer is not in the best
interests of shareholders and that the best defensive tactic is a repurchase of
the raiders’ shares. With $60 million, Disney might have made another movie
that would bring a certain return. However, Disney executives might also have
calculated that the costs to the company of continuing to fight Saul Steinberg—
or of allowing him to gain control—would outweigh this return. If so, then
the $60 million that Disney paid in greenmail is shareholder money well spent.
Other defensive tactics cost money as well, and the possibility of managers
spending shareholders’ money to preserve their own jobs exists with any
takeover defense.39 There is, therefore, no reason to believe that greenmail
necessarily involves a breach of fiduciary duty.
Third, some critics object to greenmail or control repurchases on the
grounds that the payments invite pseudobidders who have no intention of
taking control and mount a raid merely for the profit.40 The ethical wrong,
according to this objection, lies with the raiders’ conduct, although management may be complicit in facilitating it. At a minimum, pseudobidders are
engaging in unproductive economic activity, which benefits no one but the
raiders themselves; at their worst, pseudobidders are extorting corporations
by threatening some harm unless the payments are made.
Is pseudobidding for the purpose of getting greenmail a serious problem?
The effectiveness of pseudobidding depends on the credibility of the threatened takeover. No raider can pose a credible threat unless an opportunity
exists to increase the return to shareholders. Therefore, the situations in which
pseudobidders are likely to emerge are quite limited. Even if a pseudobidder
or a genuine raider is paid to go away, that person has pointed out some
problem with the incumbent management and paved the way for change.
Unsuccessful raiders who accept greenmail may still provide a service for
everyone.41 A prohibition on greenmail or control repurchases would increase
the risk of attempting a raid and thereby discourage this potentially beneficial
activity.
If it were possible for raiders to hold America’s corporations hostage, then
something should be done, and prohibiting greenmail would be one solution.
Before taking action, however, more empirical research must be done on
the incidence of pseudobidding, the conditions under which it occurs, and
200 Ethics in Financial Markets
the actual consequences. Moreover, the distinction between a pseudobidder
and a genuine raider is difficult to make, and provable pseudobidding could
be prosecuted as a fraud because of false statements in mandatory SEC filings.
Hence, even if pseudobidding is a problem, a ban on greenmail may not be
the solution.
Role of the board
In 1989, Paramount Communications made a tender offer for all outstanding
stock in Time Incorporated. Many Time shareholders were keen to accept the
all-cash $175 per share bid (later raised to $200 per share), which represented
about a 40 percent premium over the previous trading price of Time stock.
However, the board of directors refused to submit the Paramount offer to the
shareholders. Time and Warner Communications, Inc., had been preparing
to merge, and the Time directors believed that a Time–Warner merger would
produce greater value for the shareholders than an acquisition by Paramount.
Disgruntled Time shareholders joined Paramount in a suit that charged the
directors with a failure to act in the shareholders’ interests.
This case raises two critical issues. First, who has the right to determine
the value of a corporation in a merger or acquisition? Is this a job for the
board of directors and their investment advisers? Both boards and their
advisers have superior information about a company’s current financial status
and future prospects, but they also have a vested interest in preserving the
status quo. Should the task of evaluation be left to the shareholders, whose
interests are the ultimate arbiter but whose knowledge is often lacking? Some
of the shareholders are professional arbitragers, who are looking merely for a
quick buck. Second, does the interest of the shareholders lie with quick, shortterm gain or with the viability of the company in the long run? Acceptance
of the Paramount offer would maximize the immediate stock price for
Time shareholders but upset the long-term strategic plan that the board had
developed.
The Delaware State Supreme Court decision in Paramount Communications, Inc. v. Time Inc. addressed both issues by ruling that the Time board of
directors had a right to take a long-term perspective in evaluating a takeover
bid and had no obligation to submit the Paramount proposal to the shareholders.42 The court recognized that increasing shareholder value in the long run
involves a consideration of interests besides those of current shareholders,
including other corporate constituencies, such as employees, customers, and
local communities.43 One concern of the Time directors was to preserve the
“culture” of Time magazine because of the importance of editorial integrity to
the magazine’s readers and journalistic staff.
Ethics in Financial Markets 201
The Paramount decision is an example of a so-called “other constituency
statute.” A majority of states have now adopted (either by judicial or legislative
action) laws that permit (and, in a few states, require) the board of directors
to consider the impact of a takeover on a broad range of nonshareholder
constituencies.44 Other constituency statutes reflect a judgment by judges and
legislators that legitimate nonshareholder interests are harmed by takeovers,
and that directors faced with a takeover do not owe allegiance solely to the
current shareholders.45 Whether other constituency statutes serve to protect
nonshareholder constituencies or merely increase the power of management
to resist takeovers is an unresolved question. However, they represent a
rethinking of the market for corporate control. As a result of other constituency statutes, decisions about the future of corporations depend more on calm
deliberations in boardrooms and less on the buying and selling of shares in a
noisy marketplace.
Financial Engineering
In recent years, financial markets have become highly quantitative. The image
of a Wall Street banker is no longer the elegant figure in a gray pin-stripe suit
but a young, whiz-kid math geek, known as a quant, who designs complex
financial instruments and devises clever trading strategies. At the heart of this
financial engineering is the computer, with its lightning-fast computational
power and ability to crunch large volumes of data. Equally important, however,
have been advances in finance theory, including the capital asset pricing model
(CAPM) and option pricing theory, which have shown how formerly inexact
pricing decisions could be treated mathematically. From economics, quantitative finance took highly mathematical models, which can be constructed to
answer almost any question about market conditions and outcomes. Financial
engineering, especially in the development of models, has also become the
cornerstone of modern risk management.
Quants have not only transformed financial markets but garnered blame
for much that has gone wrong. The subtitle of a recent book The Quants is
“How a New Breed of Math Whizzes Conquered Wall Street and Nearly
Destroyed It.”46 Many of the financial instruments that were central to the
financial crisis—especially subprime mortgages, collateralized debt obligations, and credit default swaps—are the products of financial engineering.
Moreover, the failure of risk management, which led banks to leverage so highly
and overlook hidden dangers, was due, in part, to financial engineering. This
section considers two prominent outcomes of financial engineering, derivatives and high-frequency trading. One is a financially engineered product, the
202 Ethics in Financial Markets
other is a trading method. Both of these innovations offer great benefits but
also can be dangerous if not handled with care.
Derivatives
A common feature of many financial scandals and crises in the past two
decades has been the presence of derivatives. Whether derivatives have been
a cause of these disasters or merely an incidental element is subject to debate,
but their prominence has occasioned searching criticism. A world survey in
2011 by the Chartered Financial Analyst Institute found that issues surrounding financial derivatives were the top ethical concern of its members.47 Distrust of derivatives was also reflected in Warren Buffett’s characterization of
them as “time bombs” and “financial weapons of mass destruction.”48
Derivatives represent very valuable and creative financial innovations,
which combine technology, finance theory, and highly sophisticated mathematics. These remarkable developments have also been facilitated by less
noticed changes in financial regulation, which have been both applauded and
condemned. Derivatives have had tremendous impacts in all realms of finance,
including how trading is done, how risks are managed, and how banks serve
clients. As with all powerful innovations, possibilities exist for misuse and
miscalculation, especially when high leverage is employed, and so care must
be exercised in using these tools and also in regulating their use.
The tasks of this section are, first, to understand derivatives—what they are
and how they are used—and, second, to examine the ethical challenges that
they pose. In particular, are there ways in which derivatives can be economically destructive, socially undesirable or otherwise ethically objectionable?
Given their presence in recent scandals and crises, have they been among
the causes and, if so, what faults, if any, do their causal roles reveal? Finally,
what can be done to ensure that derivatives are used safely, productively, and
ethically?
Understanding derivatives
The term derivative covers a wide variety of financial instruments, some of
which are not really “derivative” at all, and, worse, indiscriminate use of the
term may allow a blanket indictment of a whole class of instruments that have
little in common—except perhaps for our difficulty in understanding them.
One user jokingly described a derivative as “any financial product that is difficult to understand.”49 The Economist magazine suggests that the word itself
should be banned for its role in promoting a myth that a world without such
modern financial instruments would be much safer.50
Ethics in Financial Markets 203
What are derivatives? In the standard definition, a derivative is a financial
instrument or contract between two parties (a buyer and a seller) in which
the value of the asset bought and sold in the contract is dependent on or
“derived” from the value of some underlying asset (the underlying). The underlying may be what is bought and sold in the contract or it may be the value
of something else, such as the price of another asset, a rate (e.g., LIBOR), or
an index (e.g., the S&P 500). All derivatives involve a contract made at some
point in time with a settlement or delivery date set sometime in the future.
On or before that date (the specifics are in the contract) either one party or
both is committed to an exchange (is obligated to complete it) or else one
party has a right (but not an obligation) to insist that the exchange take place
(this is an option).
The contract in question can be customized to fit the unique situation of
one party and thus be sold “over the counter” (OTC) or it can be a standardized instrument that is sold to many parties and traded on an organized
exchange. Although an action must be taken at a time that is specified in the
contract, the completion can be achieved either by the delivery of the asset
purchased or by a cash settlement that represents the gain or loss of the parties.
(A trader with a profit on buying 10 000 pork bellies might appreciate the
cash.) Since derivatives are essentially contracts that commit the parties to an
exchange in which the only missing variable is the price (which is yet to be
determined), any gain for one party (a higher than expected price for the
seller, for example) must be equal to a loss to the other party (who, in this
example, pays a higher than expected price to buy). Thus, derivatives are zerosum games in which one party gains only to the extent that the other loses.
The exchange has no impact on the wealth of the whole economy—except
insofar as the use of derivatives makes the economy more productive, which
is not an inconsiderable factor.
There are three basic types of derivatives: forward and futures contracts
(they may be considered together), options, and swaps. A forward contract is
simply an agreement with another party to buy and sell an asset or commodity
(e.g., gold or wheat) at a certain price at some time in the future. A futures
contract involves the same kind of future exchange except that it is achieved
not in a bilateral forward contract between a buyer and a seller but on an
organized exchange in which the exchange itself serves as an intermediary,
buying from sellers and selling to buyers. Exchanges for futures contracts solve
the critical problems of finding trading partners (search costs), ensuring settlement (credit risk), and exiting positions (market risk). A forward contract
is settled only on the date specified in the contract and has a value only
on that date, while the value of a futures contract is computed daily based on
204 Ethics in Financial Markets
current prices (marked to market) and may be sold (or exited) at any time
prior to the specified date.
An option is a contract that grants one party the right, but not the obligation, to buy or sell a certain quantity of an asset at a fixed exercise or strike
price some time in the future. The right to sell an asset (e.g., a stock or a bushel
of wheat) is a put option, and the right to buy is a call option. A swap is an
agreement between two parties to exchange a series of cash flows for a certain
period in the future. The most common swaps involve interest rates and currencies. For example, a party with a fixed-rate loan who would like to have
one with a variable rate can arrange with the holder of a variable-rate loan
who would prefer a fixed rate for each to make the other’s payments. A similar
swap can be arranged between two parties, one with receivables in Japanese
yen that will be converted into US dollars and the other with the opposite
situation. One party to a swap may have no interest-rate or currency exposure
but may be willing merely to take the other side of the contract.
Especially prominent in the financial crisis was the credit default swap
(CDS), which is essentially an insurance policy in which one party agrees, for
a payment, to compensate the other party in the event that a borrower defaults
on a loan. Although a CDS enables the holder of, say, corporate bonds to
reduce the risk of default, the buyer need not actually own the bonds being
insured; the swap could be merely a bet on whether default will occur with
the bonds. This controversial feature of CDSs is like being able to obtain fire
insurance on your neighbor’s house.
How derivatives are used. Derivatives involve two kinds of parties: the end
users, who are the buyers and sellers in a contract, and dealers, who devise the
contracts and bring the parties together. Dealers benefit from the compensation they receive for their services, as well as any gains from their own trading
in derivatives. Both sources of income have become increasingly important
for dealers and now dwarf many other activities. The benefits for end users
are fivefold: (1) better management of risks, (2) more flexibility in financial
operations, (3) more diversified and economical access to funding, (4) more
value realized from financial assets, and (5) more opportunities in trading
(and perhaps speculating), especially in arbitrage.
Forward and futures contracts have long been employed to reduce or
hedge the risk of uncertain prices. By these means, farmers are able to secure
a fixed price for wheat or other commodities in advance of the harvest, in
effect forgoing any gain from high prices in order to protect against price
drops. Since the profits of airlines are impacted by the price of fuel, which is
unpredictable, they, too, can avoid this risk with futures contracts, which lock
in a known price. A corporation can also select the lowest cost funding avail-
Ethics in Financial Markets 205
able, without regard for whether it bears a fixed or variable interest rate or is
denominated in a foreign currency, by purchasing interest-rate or currency
swaps to cancel out the undesired features. Also, an investment fund that
wants to increase its holdings of stocks or its mix of long-term and short-term
bonds can purchase derivatives that achieve the desired portfolio profile
without buying and selling the actual securities. Similarly, arbitraging differences between the prices of securities can often be done more quickly and
cheaply with derivatives than by trading directly in the markets, and arbitraging indexes would be impossible without them. The possible uses of derivatives are almost unlimited, as are the benefits.
Everyone benefits when corporations are better able to manage risks of all
kinds, which might otherwise lead to distress and reduced production and
employment. Better risk management also yields rewards when firms are able
to focus on their core businesses (flying passengers, for airlines) and not on
risks beyond their control (fuel costs). The costs of managing risks are also
lowered when the risk exposure is transferred to those best able to handle
them. Improved access to funding from more diverse sources and at lower
costs leads to economic growth and greater international competitiveness.
Investors with mutual funds and pension funds also see their assets increase
in value due to the improvements in the investing technology that derivatives
provide.
Problems with derivatives
Derivatives—which encompass futures, options, and swaps, among other
exotic instruments—have immense potential for improving our financial
system and enhancing human welfare generally. Yet, their reputation is clouded
by scandals and crises, and there is strong pressure to regulate them and
perhaps limit their use. Critics cite not only their undeniable role in the financial crisis but also the trading losses that were sustained from derivatives by
Procter & Gamble, Orange County, California, and Société Générale in France.
Money can be lost in unwise trades using any kind of financial instrument,
and self-serving behavior by financial institutions is not uncommon. Therefore, any ethical criticism of derivatives should focus on the problems that are
distinct from their misuse and the misbehavior surrounding them and that
afflict these financial instruments in some more fundamental way. Airplanes can
crash from faulty design, but we respond by correcting mistakes and building
better ones. However, some argue that nuclear power plants are too dangerous
to operate, even when they are properly designed. The relevant question, then,
is whether derivatives are more like airplanes or nuclear power plants? Are
they fundamentally flawed? Derivatives are criticized on two main grounds:
first, that too often these financial instruments are used for speculation, in ways
206 Ethics in Financial Markets
that pose undue risks that make them socially undesirable; and, second, that
some of the derivatives that have been sold, especially by major banks, have
been unsuitable for relatively unsophisticated clients, of whom the issuers have
allegedly taken unconscionable advantage.
Speculation
Elementary derivatives have existed from early history.51 Aristotle recounts a
tale about the philosopher Thales, who, correctly anticipating an abundant
olive crop, paid owners of olive presses in the region to give him exclusive
right of use during the harvest season so that growers would have to pay him
for access to the presses.52 Forward contracts on agricultural commodities
have long been employed, but a distinction has been made throughout history
between hedging, which is protecting against a risk that at least one party
bears, and speculating, which is a pure bet on commodity prices or some other
value without any interest at stake. In English common law, bets involving
commodities have been regarded as “difference contracts,” which are not
legally enforceable if no real hedging occurred.53
In nineteenth century America, farmers were suspicious of commodity
futures, which they believed were used to manipulate prices, and this suspicion, combined with a widespread sentiment against gambling, prevented
the full legal acceptance of such derivatives.54 At the same time, bucket shops
of uncertain legality operated in many American cities.55 Bucket shops, which
are now illegal, claimed to make stock trades on behalf of small investors but,
in fact, merely booked bets and settled them with offsetting wagers, like a
modern-day bookie. Aside from extracting a commission, the operators of
bucket shops would sometimes disappear with all the money collected and
engage in other sharp practices.
When the Chicago Mercantile Exchange (CME) was founded in 1898 (originally the Chicago Butter and Egg Board), its attempt to trade commodity
futures was stymied by an Illinois law against gambling.56 This law could be
avoided if the commodities were physically delivered, but if a contract could
be settled only with cash, then it constituted an illegal wager. A middle course
was found in which a futures contract was not gambling if the commodity
could be delivered, even if the contract was, in fact, settled with cash. This
fiction about delivery was preserved even if the total value of all contracts
exceeded the supply so that not all of them could be settled with physical
delivery. This problem cropped up again as late as 1982 when the CME sought
to offer a stock index future, in which the underlying (a basket of all stocks
in an index) could not be physically delivered. An act of Congress in that year
removed this barrier.57
Ethics in Financial Markets 207
The reason why the possibility of delivery seems crucial is that it establishes
intent. A farmer with a forward contract aims to sell his wheat at an acceptable
price, which furthers a productive activity. On the other hand, a speculator
who believes that wheat prices will fall and agrees to sell wheat on a future
date at a fixed price intends merely to profit from the difference between the
(hopefully low) price of wheat at the time of delivery and the (hopefully high)
price at which he has contracted to sell it. Having no wheat of his own (except
what he buys in the open market at the time of delivery), he cannot have had
the intent of ensuring a good price for his own (nonexistent) crop. In the late
1800s, the term “wind wheat” was used to describe the fictitious supply that
a speculator had agreed to sell.58 The “wind wheat” that a speculator intends
to sell seems rather different from the real wheat a farmer has grown and is
bringing to market.
A noted definition of speculation from Nicholas Kaldor seizes on the
importance of intent or motive. He defines speculation as “the purchase (or
sale) of goods with a view to re-sale (re-purchase) at a later date, where the
motive behind such action is the expectation of a change in the relevant prices
relative to the ruling price and not a gain accrued through their use, or any
kind of transformation effected in them or their transfer between different
markets.”59 This definition suggests that profiting merely from a successful
prediction of a price change is in itself a nonproductive activity that is parasitic
on the market by taking without making any real contribution. In Biblical
terms, speculation is reaping where one has not sown.
Since derivatives are zero-sum, any gain to a speculator requires a loss by
someone else, and when the costs of derivatives use includes all the resources
expended—what economists call transaction costs—the total losses are increased. Any zero-sum game with transaction costs is actually a negative-sum
game. The costs of derivatives use may be offset, however, by gains to the
whole economy, and even the participants may consider the benefits of using
derivatives to be worth the cost. A genuine hedge, for example, is a cost, like
buying insurance, but this protection is “bought” because it brings some
desired benefit.
Furthermore, speculation is alleged to add further costs to the economy by,
in some cases, driving prices above their fundamental level, which harms
consumers, and, on other occasions, below this level, which harms producers.60 Rising prices for oil or wheat, for example, which hurt the poor, are often
blamed on heartless speculators. Speculation is also held to be responsible
for increases in the volatility of markets and for asset price bubbles, which
sometimes lead to crises. It is further alleged that speculation is often involved
in manipulation in markets, which also affects prices, and in price gouging
208 Ethics in Financial Markets
during times of scarcity, in which the shortage may have been caused, in turn,
by manipulation.
All of these afflictions of markets—distorted prices, volatility, bubbles,
manipulation, and price gouging—impose considerable costs, some of which
are deadweight losses that have no redeeming social benefit. However, these
costs bear on an evaluation of speculation only if, first, speculation actually
has these consequences and, second, speculation can be separated from the
use of derivatives with all its benefits. It has been argued that speculation does
not have these alleged consequences—that speculators actually serve to stabilize prices, reduce volatility, deflate bubbles, and generally facilitate production by enabling enterprises to manage risks better.61 Furthermore, manipulation
and price gouging are market practices that are not confined to speculation
or derivatives, and, in any event, they can be controlled by existing market
regulation without addressing speculation.
The first matter—that speculation afflicts the economy with various ills—is
an empirical question for which the evidence is inconclusive at best. Second,
even if speculation has some undesirable consequences, can the activities in
question be separated from the beneficial uses of derivatives and eliminated
without losing these benefits. Whether derivatives are being used in any given
case for speculation or genuine hedging, for example, is a difficult judgment,
which may require knowledge of a trader’s entire portfolio or a company’s
complete financial structure. Further, the user of derivatives for hedging or
other beneficial purposes must have a trading partner who is willing to take
the other side of a contract. Speculators, therefore, may serve an essential role
by increasing the number of willing trading partners, and this increase in
number may also add liquidity to derivatives markets and also lower the costs
of derivatives trading. Finally, as long as speculators do not harm others—this
is seriously contested—perhaps they should be free to trade as they wish, no
matter how foolish.
Suitability
Warren Buffett’s warning that derivatives may be “time bombs” and “financial
weapons of mass destruction” has been borne out in many well-publicized
cases, of which Orange Country, California, and Procter & Gamble are among
the best known. Jefferson County in Alabama, of which Birmingham is the
county seat, narrowly averted bankruptcy in 2011 when it could no longer
make payments on interest-rate swaps with a notional value of $5.4 billion
that had been sold by J.P. Morgan (now JPMorgan Chase), among other
banks, to cover $3.2 billion in bonds for a troubled new sewer system.62
A portion of these swaps, which at one time numbered 18, converted the
original variable-rate loans into fixed rates, while the rest converted this debt
Ethics in Financial Markets 209
back to variable-rate loans. Not only did the swaps fail to protect against
changing interest rates but the downgrading of two bond insurers triggered
further interest-rate rises. Also included in the interest rates were the massive
fees J.P. Morgan had levied, which were estimated to be double the norm. The
fees were necessary, in part, to cover $8 million in bribes that J.P. Morgan had
paid to secure its role in the deal. Although the country was the victim of
massive corruption in its leadership (21 people were convicted), JPMorgan
Chase was forced eventually to forgive about $1 billion of the debt, lower the
interest rates on the remainder, and pay fines of $25 million to the Securities
and Exchange Commission (SEC) and $50 million to Jefferson County. Separately the bank paid $722 million to the SEC for the $8 million in bribes.
Jefferson County has been described as “a ‘poster child’ for all that can go
wrong when municipalities start playing with unregulated derivatives peddled
by Wall Street sharpies.”63
In the early 2000s, the major banks were pushing derivatives, mainly
interest-rate swaps, throughout the United States and Europe for all kinds of
clients, including, in one case, a nunnery in Cassino, Italy. According to a
television documentary “Money, Power & Wall Street,” the young people
selling these derivatives jokingly referred to themselves as “F9 monkeys,” who
merely entered a few numbers in computer programs and punched F9 on the
keyboard to generate a price for the instruments being sold to clients. John
Cassidy, a writer for the New Yorker, says in the documentary, “They’re called
investment bankers but they’re effectively salesmen. Their job is to go out and
sell the stuff that the bank is creating, just in the same way a pharmaceuticals
company would have a very large sales force, would go around selling their
latest version of whatever the particular drug of the moment is.”
The suitability of a derivative or any financial instrument is a complex
judgment involving, first, its efficacy in achieving a desired aim and, second,
the acceptability of the risks it poses. In short, will the derivative actually do
what is intended, or at least have a reasonable likelihood of doing so? And are
the risks of using this instrument understood and correctly evaluated? Most
cases of unsuitability involve the latter concern because derivatives not only
contain an element of risk—it is one side of a bet, after all—but it also introduces new risks. An interest-rate swap might produce a loss if interest rates
move in a certain direction, for example, but that is the direct risk embedded
in the contract. However, the user faces indirect risks from many other sources.
First, a user may fail to understand adequately how a derivative works and
the factors that can affect its working. For example, the credit default swaps
sold by AIG before the financial crisis allowed users to demand collateral from
the company as the insured securities lost value before any default. AIG executives were apparently unaware of this possibility, and meeting the demands
210 Ethics in Financial Markets
that were made led to a serious shortage of cash. Second, the risks in a derivative may be seriously underestimated and hence mispriced. This possibility is
greatly increased by the complexity of many derivatives and the sophisticated
mathematics that they employ. AIG considered the probability of default in
the securities it insured with CDSs to be so low that it failed to set aside
reserves to cover the potential claims. This failure raised the prospect of
default on the swaps, which would have had repercussions for the holders’
trading partners. Third, derivatives introduce the risk that the counterparties
to the contract may be unable to perform due to their own insolvency or
bankruptcy. More generally, a derivative, like any contract, may become unenforceable for unforeseen reasons, including a natural disaster or a legal barrier,
such as the lack of authority to enter into a contract.
Further, a firm may fail to keep adequate oversight of personnel responsible
for handling derivatives, with the result that the risks are not properly managed.
In particular, inadequately supervised personnel may step over a line from
legitimate hedging to speculation. This occurred not only at AIG, where the
London-based Financial Products unit operated without adequate supervision, but also at JPMorgan Chase in its $6.2 billion dollar loss in oversized
derivatives trading by the so-called London Whale, who was able to hide
information and alter the monitoring system. The collapse of Barings Bank
in 1995 and the 4.9 billion euro loss at Société Générale in 2008 resulted
from the activities of unsupervised rogue derivatives traders. The bets by Nick
Leeson at Barings Bank on the direction of the Japanese stock market were
also undone by a natural disaster, the Kobe earthquake, which caused prices
to fall unexpectedly.
The factors that can make a derivative unsuitable for a user are numerous
and not easily identified, except perhaps in hindsight, and even then it may
be difficult to assign responsibility between the buyer and the seller. Did
Merrill Lynch take unconscionable advantage of Orange County officials, or
Bankers Trust of Procter & Gamble executives, or were these buyers foolishly
trying to speculate? Furthermore, how much care is a seller obligated to take
in dealing with a foolish buyer—or a sophisticated one for that matter? Lloyd
Blankfein defended the conduct of Goldman Sachs before Congress for selling
mortgage-backed securities to German banks that his firm was betting against
by saying, “These are professional investors who want this exposure.”64 The
message was clear: the buyers of these securities knew what they were doing
and should be allowed to make mistakes. Indeed, making money on Wall
Street is done, in part, by exploiting one’s own superior judgment by taking
advantage of other’s mistakes.
However, even to sophisticated investors, some degree of disclosure or
transparency is owed, not only about material information on the securities
Ethics in Financial Markets 211
themselves but also of any conflicts of interest the seller may have. In the
Goldman Sachs’s transaction, it was not disclosed that the mortgage securities
being packaged were chosen by the trader on the other side of the deal or that
the firm was also taking an opposing position. Further, investors vary in their
sophistication and may be reasonably relying on the seller for advice as well
as a product. Orange County and Procter & Gamble are not investment banks
with the sophistication of Merrill Lynch or Bankers Trust, and they no doubt
believed that they were paying for good advice as well as the interest-rate
swaps they were sold. Moreover, any manufacturer has a moral obligation—as
well as a legal duty—to sell products that are free of known defects, and so is
the same not true for financial products?
The 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act
empowers the Securities and Exchange Commission and the Commodities
Futures Trading Commission to create new rules for some derivatives, mostly
swaps. As of May 2013, these rules have not been formally adopted, but they
exist in draft form. Many of the risks from derivatives have been addressed by
seeking to force more transactions into organized exchanges, where contracts
are standardized, prices are known, and payment is assured. Other rules
require Wall Street firms to provide buyers with “material information” about
the composition of derivative products and the risks they pose, as well as any
conflicts of interest, and to confirm that buyers have an adequate capacity to
evaluate the instruments and adequate risk management systems in place.
These regulations address only the supply side of the equation, however, and
steps must also be taken by users of derivatives on the demand side to employ
derivatives for legitimate purposes and not for mere speculation.
High-frequency trading
At 2:42 in the afternoon of May 6, 2010, the New York Stock Exchange experienced a rapid drop in stock prices. Already down 300 points for the day, the
Dow Jones Industrial Average plunged another 600 points for a 9 percent or
$1 trillion loss of value, only to rebound within 30 minutes. During this time,
prices of individual stocks gyrated wildly, with Accenture falling from $40 to
1 penny and Sotheby’s rising from $34 to $99 999.99. Labeled the “flash crash,”
this traumatic event has never been fully explained,65 but a commonly cited
culprit is high-frequency trading (HFT), also known as algorithmic trading.
In HFT, massive computers programed with sophisticated proprietary software execute trades within a fraction of a second and often hold numerous
positions for very short periods of time. Speed, not superior analysis, enables
computers to make money at the expense of their slower, low-tech human
counterparts.
212 Ethics in Financial Markets
Although HFT may be a destabilizing force, especially in already vulnerable
markets, the main criticism of this recent controversial practice is its fairness
to other investors and ultimately its social value. Is HFT merely another way
of making a lot of money, perhaps at other’s expense, or does it really make
a valuable contribution to society? The practice may permit new kinds of
manipulation in trading and confer other unfair advantages on firms that
engage in it, but if HFT has considerable social value, then it may be possible
to regulate the excesses and retain the benefits. However, the social value of
HFT includes more than making markets more efficient; one must also consider the ability of markets to allocate capital and attract investors. If investments are made in milliseconds with a view only to quick gains, then we may
end up with idle factories and unemployed workers. The same result may
occur if substantial amounts of resources—both financial and human capital—
are tied up in essentially unproductive activities. Further, little is gained if
investors shun markets for fears that the game is rigged in favor of big-time
players with expensive equipment and privileged access, which are denied
everyone else. If HFT makes money largely at the expense of slow, low-tech
traders, it must be appreciated that the losing sides to these trades may be the
mutual funds and pension funds of ordinary people. However, high-frequency
trading is already here, with momentous consequences for market operations,
and, as The Economist magazine explains, “Doing nothing is like allowing
Formula 1 drivers onto suburban streets.”66
How HFT works
Stock trading has two parts: identifying a trading opportunity and executing
the trade. Trade execution, which involves finding a trading partner and
agreeing on a price, has been done traditionally in a physical space, an
exchange, such as the New York Stock Exchange. In addition to buyers and
sellers, exchanges need a matching mechanism or matching engine to determine which buyer and seller offers will be brought together to constitute a
transaction. In the past, this function was served by market makers or specialists, who maintained an order book of submitted offers to buy and sell a
particular stock and who stood ready to sell from their own holdings when
there were no sellers, and similarly to buy in the absence of buyers. The assurance that one can quickly buy or sell at market prices is called liquidity. The
compensation for market makers came from opportunities to exploit their
knowledge of the market, including the bid and ask prices of buyers and sellers
respectively. However, market makers were expected to avoid excessive exploitation and seek only reasonable compensation.
Today, maintaining an order book and matching buyers and sellers
are done almost entirely by computers—the ones for the New York Stock
Ethics in Financial Markets 213
Exchange are housed in a nondescript 400 000-square-foot data center in
Mahwah, New Jersey, 30 miles from the iconic Wall Street building. Traders
whose own computers have access to these exchange computers can monitor
order flow and submit their own orders almost immediately, with the times
measured in fractions of a second. The time it takes to execute a trade is called
latency, and so HFT reduces latency. Time is so critical that being in the same
building as an exchange’s matching engine confers a significant advantage—
fiber optic cables from Chicago to New York are too slow—and so exchanges
can also make money by renting space next to their own computers for those
of trading firms in a process known as co-location. As if saving a few milliseconds were not enough, exchanges also permit some traders, for a fee, to have
access to orders from other market participants a few more milliseconds
before anyone else, which permits flash trading.
Quicker access to market information permits those with it to execute
trades before others and so to exploit trading opportunities that may disappear
in the blink of an eye. This capability is of little use, however, unless the
computer programs or algorithms are also able to identify profitable trading
opportunities within a few milliseconds. The programs, in turn, must be based
on some market trend discernible from the data which is not only exploitable
but also innovative, which is to say that it has yet to be discovered by others.
Thus, HFT computer programs are vigilantly protected, as well as shortlived—of use only until others find the secret and begin to act on it. Although
the two-tier market that is created by access to exchange computers, including
co-location and flash trading, raise some ethical concerns, objections to HFT
focus mainly on the use to which quick access is put. Put simply, how does
HFT identify profitable trading opportunities from which to make money?
Uses of HFT
One use of HFT is to execute trades in ways that avoid the loss that occurs
when large volumes are bought and sold in the market. An offer to buy, say,
ten thousand shares of any stock will not only raise the price by exceeding the
number being offered for sale at the current price, but other traders will spot
the demand and buy themselves in anticipation of yet higher prices. This loss
is known as slippage. Execution algorithms attempt to reduce the loss from
slippage by breaking orders into smaller units and distributing them over time
on a flexible schedule determined by market conditions. In addition to merely
avoiding losses, HFT can also make money by acting like a traditional
market maker and posting offers to buy and sell at prices that would, if
accepted, make a small profit on the spread. Unlike a human market maker,
however, a market-making algorithm can update prices continuously and with
fine gradations in response to changing information. Further, HFT can be
214 Ethics in Financial Markets
utilized to engage in standard forms of arbitrage, one of which consists in
identifying slight price discrepancies between the same securities in different
exchanges. More sophisticated arbitrage algorithms spot price fluctuations in
single securities that appear to be temporary abnormalities, such as deviations
from the relatively slow-moving average price of a stock (known as the volume
weighted average price, or VWAP).
These three types of HFT algorithms—execution, market-making, and
arbitrage—differ little from conventional stock trading strategies except in
the speed and precision that highly sophisticated technology makes possible.
However, the possibility exists for traders to engage in market manipulation
using HFT, although the extent of such manipulative practices is unknown.
One example is that in 2010, Trillium Brokerage Services paid $2.26 million
to settle charges brought by the Financial Industry Regulatory Authority
(FINRA) for using HFT to manipulate the market for certain securities.67
Specifically, FINRA charged that Trillium entered and quickly canceled orders
in disproportionate volumes in order to create a false appearance of intense
interest so as to induce others to trade at disadvantageous prices. Although
Trillium used HFT, this kind of manipulation is essentially a classic “pump
and dump” scheme that could be effected in the past by low-tech means.
Four newer, high-tech means of manipulation are spoofing, smoking, stuffing, and algo-sniffing.68 Spoofing, which might describe Trillium’s actions,
consists in placing any order that the perpetrator has no expectation of filling
for the purpose of inducing traders to place other orders that can be exploited.
For example, a trader looking to buy might place a large volume of limit orders
to sell at a high price that is unlikely to be accepted while also placing a limit
order to buy at a low price. Although this kind of multiple-order placement
might be used legitimately to ascertain accurate prices, it can also facilitate
illegitimate market manipulation by inducing some gullible slow traders to
note the large sell order, suspect a price drop, and accept the low buy offer.
Smoking seeks to draw out slow traders with attractive offers that are subsequently revised so that the slow trader’s order is ultimately matched to an offer
with much less generous terms. Stuffing is simply entering and quickly canceling so many orders that slow traders become overwhelmed, resulting in
temporary price discrepancies that faster traders can arbitrage. Finally, algosniffing consists of attempts to discover the strategy of other HFT computer
programs and develop programs that take advantage of any weakness found.
Any gains from algo-sniffing result from some algorithms outsmarting others:
may the best algorithm win!
All of these manipulative practices enable HFT traders to profit at the
expense of the slower, low-tech trading community. However, they are also
generally illegal under existing securities industry regulation for all kinds of
Ethics in Financial Markets 215
trading (algo-sniffing may be an exception), so these opportunities for manipulation are not unique to HFT and need not pose barriers to its acceptance.
The crucial question, then, is the impact of HFT on securities markets. Overall,
is HFT of social value in creating greater efficiency and allocating capital for
greater wealth creation? Or does putting Formula 1 drivers on suburban
streets create unacceptable dangers?
Evaluation of HFT
The arguments in favor of allowing HFT are that it makes markets more efficient by producing greater liquidity (the volume of order ensures that securities can be bought and sold at accurate prices), securing more accurate pricing
(the number and frequency of trades facilitates price discovery and arbitrages
away any price differences), and lowers trading costs (the market-making function reduces the bid-ask spread). These are not inconsiderable benefits, but
they are already present in conventional markets with slow, low-tech traders.
It is not clear how much of these beneficial qualities HFT adds to markets and
how much the market needs the additional benefits. If, indeed, HFT poses
some risks to markets, are gains worth the cost?
First, the liquidity claim is questionable inasmuch as the assurance it provides is critical mainly in times of crisis, such as the flash crash of May 6, 2010,
when even HFT came to a halt. The liquidity provided by HFT might be like
a parachute that works except when a plane goes down. More importantly,
high-frequency traders, unlike traditional market makers, whose service provides liquidity in a crisis, are not obligated to trade when buyers or sellers are
scarce. They can simply pull the plug on their computers, as commonly occurs
in troubled times. The replacement of human market makers with computerized matching engines thus removes an important source of liquidity that HFT
does not fully replace. However, even traditional market makers may not be
adequate in a crisis. The fact that some stocks traded at a penny and others a
penny short of $10 000 in the flash crash is revealing because market makers
with an obligation to quote prices may offer safe stub quotes at the lowest or
highest permitted values, which are sure not to be accepted, simply in order
to comply with regulations.
Second, accurate pricing is generally secured, in part, by traditional arbitrage, which does not require very fast computation and is based, in any event,
on information about market prices rather than order flow. Price discrepancies in a market or between markets will be quickly corrected by traditional
arbitrage, and any seconds (or milliseconds) gained by HFT are probably of
little incremental value. Because of the fragmentation of markets—which
has resulted from relaxed market regulation aimed at developing more
competition—the ability to arbitrage across many different markets is more
216 Ethics in Financial Markets
critical, and for this task HFT is especially effective. However, accurate pricing
is ultimately dependent on good analysis of the fundamentals of a security,
and HFT, which is based solely on market trading information, contributes
virtually nothing to this vital task.
Third, the reduction of bid-ask spreads may wring certain costs out of
trading—which have traditionally been a source of revenue for market
makers—but HFT, especially when combined with flash trading, may raise
costs for traders without high-tech equipment and privileged access. One
benefit of quicker access to order flow is to spot large trades and jump in ahead
of them, which is called frontrunning. Some allege that HFT is simply computerized frontrunning.69 The result of such frontrunning is more slippage in
markets, which drives large institutional investors to use execution algorithms,
which break orders into smaller units that are traded over a period of time.
Such defensive measures produce no added value, and the costs are deadweight losses to the economy. An alternative for institutional investors is to
trade large blocks in private exchanges known as dark pools. These have the
drawback that information about trades and prices is kept from the market,
which results in decreased transparency and hence less market efficiency.
Furthermore, the reduction of bid-ask spreads may be offset by the ability
of HFT to discover the reserve prices of buyers and sellers. As an example,
if a seller asks $40 for a stock but is willing to accept $39.50 (the reserve price
or limit), then a high-frequency buyer can issue rapid bids for a small number
of shares at prices that descend down from $40, all of which will be accepted
by the seller until the reserve price of $39.50 is reached. At that point, a large
order to buy the stock at $39.51 will be entered and accepted. The spread
between $40 and $39.50 represents a range in which a deal can be struck
between two traders (each will consider the trade to produce a gain), but the
executed price will determine the distribution of the gain between them. At
$39.51, the gain goes almost entirely to the high-frequency trader, who has
taken advantage of a capability that HFT makes possible. In this case, was the
seller merely outsmarted, or was the advantage taken by the buyer unfair?
Risks of HFT
The greatest concerns about HFT are the risks it poses for both firms and the
markets. In addition to the flash crash of May 6, 2010, Knight Capital lost
$440 million in less than 45 minutes on August 1, 2012.70 Three months earlier,
in May 2012, the IPO of Facebook was delayed by a computer glitch at
NASDAQ, which caused many computer-driven trading programs to enter
and cancel many faulty orders.71 UBS reportedly lost $350 million in the fiasco
and Knight Capital, $35.4 million.72
HFT algorithms are engineered products that allow little human intervention once a switch is turned on, and, given their complexity, the fast speed,
Ethics in Financial Markets 217
the volume of trades, and their interaction with other computers, the results
can be unanticipated and occasionally disastrous. In addition, markets themselves are fragmented and volatile in the best of times, and so the added
volume of HFT introduces an additional element of uncertainty and the
potential for a complete system breakdown. One study concludes that in 2010,
HFT constituted 56 percent of equity trades in the US and 38 percent in
Europe,73 and other commonly cited estimates are between one-half and
three-quarters of all stock trades. Evidence suggests that the higher volume
of HFT creates dangerous volatility beyond that ordinarily based on other
factors.74 Moreover, other studies indicate that HFT trades tend to be highly
correlated—that is, make the same kind of trades—which may further increase
volatility and, with it, systemic risk.75
The risks of HFT are significant but not unmanageable. Other engineered
products, such as bridges and airplanes, pose risks, especially at early stages,
which subsequently have been handled satisfactorily. Many means are available for both better engineering practice76 and successful market regulation.77
A Federal Reserve report notes that in the past, when securities were traded
in a “physical, paper-based environment,” every step in the trading process
was overseen by a person who could detect any errors. The report concludes,
“High-speed trading requires a similar level of monitoring, but it needs to
happen a lot faster—ideally, there should be automated risk controls at every
step in the life cycle of a trade with human beings overseeing the process.”78
Conclusion
The universally accepted goal of “fair and orderly markets” is difficult not only
to define but also to maintain. Market activity is so diverse that simple definitions of fairness and orderliness scarcely suffice, but the constant innovation
in finance markets makes its maintenance a constant struggle. Since so much
money can be made in markets, participants are continually pushing against
ethical and legal boundaries and engaging in new activities that have yet to
be evaluated and addressed by either ethics or law. This task is further complicated by intervals of deregulatory sentiment and renewed pro-regulatory
reform movements, both punctuated by periodic crises. The only certainty is
that the challenge of ensuring fair and orderly markets will always be with us.
Notes
1.
Parts of this section are derived from Hersh Shefrin and Meir Statman, “Ethics,
Fairness and Efficiency in Financial Markets,” Financial Analysts Journal, 49
(November–December 1993), 21–29; and Eugene Heath, “Fairness in Financial
218 Ethics in Financial Markets
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
Markets,” in John R. Boatright (ed.), Finance Ethics: Critical Issues in Theory and
Practice (New York: John Wiley & Sons, Inc., 2010).
See Lucien Bebchuk and Jesse Fried, Pay without Performance: The Unfulfilled
Promise of Executive Compensation (Cambridge, MA: Harvard University Press,
2004).
The example is taken from Anthony Kronman, “Contract Law and Distributive
Justice,” Yale Law Journal, 89 (1980), 472–479.
Frank H. Easterbrook and Daniel R. Fischel, The Economic Structure of Corporate
Law (Cambridge, MA: Harvard University Press, 1991), p. 254.
Andrew Ross Sorkin, “Just Tidbits, or Material Facts for Insider Trading?” New
York Times, November 29, 2010.
See, for example, Stephen J. Nelson, “European Regulators Ramp Up Insider
Trading Enforcement,” Traders Magazine Online News, April 12, 2010.
Stephen M. Bainbridge, Securities Law: Insider Trading (New York: Foundation
Press, 1999).
The most prominent of these scholars is Henry G. Manne in Insider Trading and
the Stock Market (New York: The Free Press, 1966).
SEC v. Texas Gulf Sulphur, 401 F.2d 19 (1987).
Chiarella v. U.S., 445 U.S. 222 (1980); Dirks v. SEC, 463 U.S. 646 (1983); U.S. v.
Chestman, 903 F.2d 75 (1990); U.S. v. Willis, 737 F. Supp. 269 (1990); and U.S. v.
O’Hagan, 521 U.S. 642 (1997).
Manne, Insider Trading and the Stock Market. See also Henry G. Manne, “In
Defense of Insider Trading,” Harvard Business Review, 44(6) (1966), 113–122.
This point is argued in Jennifer Moore, “What Is Really Unethical about Insider
Trading?” Journal of Business Ethics, 9 (1990), 171–182.
Carpenter et al. v. U.S., 484 U.S. 19 (1987).
Peter Drucker, “To End the Raiding Roulette Game,” Across the Board, April
1986, p. 39.
Michel T. Halbouty, “The Hostile Takeover of Free Enterprise,” Vital Speeches of
the Day, August 1986, p. 613.
See Michael C. Jensen, “The Takeover Controversy,” Vital Speeches of the Day,
May 1987, pp. 426–429; Michael C. Jensen, “Takeovers: Folklore and Science,”
Harvard Business Review, November–December 1984, pp. 109–121.
Jensen, “Takeovers”; Michael C. Jensen and Richard S. Ruback, “The Market for
Corporate Control: The Scientific Evidence,” Journal of Financial Economics, 11
(1983), 5–50; and Douglas H. Ginsburg and John F. Robinson, “The Case against
Federal Intervention in the Market for Corporate Control,” The Brookings Review,
Winter–Spring 1986, pp. 9–14.
F. M. Scherer, “Takeovers: Present and Future Dangers,” The Brookings Review,
Winter–Spring 1986, pp. 15–20.
These points are made in Scherer, “Takeovers,” pp. 19–20.
Hostile takeovers are conducted less frequently by means of a proxy contest. A
friendly merger or acquisition generally results from a proposal to the board of
directors of the target corporation, which is submitted in due course to a vote
Ethics in Financial Markets 219
21.
22.
23.
24.
25.
26.
27.
28.
29.
by the shareholders. Shareholders are not asked to tender their stock, but if the
takeover is approved, their shares are exchanged for some package that typically
includes shares of the acquiring corporation or a newly created corporation.
Even “friendly” takeovers that are approved by the board of directors may involve
heated proxy contests for shareholder votes.
For a discussion of coercion in tender offers see John R. Boatright, “Tender
Offers: An Ethical Perspective,” in W. M. Hoffman, R. Frederick, and E. S. Petry
Jr (eds), The Ethics of Organizational Transformation: Mergers, Takeovers, and
Corporate Restructuring (New York: Quorum Books, 1989).
Section 13(d) requires a similar statement within ten days after any party acquires
more than 5 percent of a corporation’s stock. This statement provides notice of
a possible takeover bid and facilitates an orderly response.
Philip L. Cochran and Steven L. Wartick, “ ‘Golden Parachutes’: A Closer Look,”
California Management Review, 26(4) (1984), 111–125. A 1982 study by Ward
Howell International reported that the number of Fortune 1000 companies with
golden parachutes doubled between 1979 and 1982 to 25 percent. Ward Howell
International, Inc., Survey of Employment Contracts and Golden Parachutes
among the Fortune 1000, company report, 1982. A study by Hewitt Associates in
1987 found that the figure among Fortune 100 industrial companies was 46
percent. Hewitt Associates, Survey of Employment Contracts, Change-in-Control
Agreements and Incentive Plan Provisions, company report, June 1987.
A 2012 study reported that among 2000 of the largest US corporations, the percentage with golden parachutes rose from 50.44 in 1990 to 77.65 in 2006. Lucian
A. Bebchuk, Alma Cohen, and Charles C. Y. Wang, “Golden Parachutes and the
Wealth of Shareholders,” John M. Olin Center for Law, Economics, and Business,
Harvard University, Discussion Paper 683, October 2012.
Protection against job losses following a takeover has been extended by some
companies to all employees in the form of “tin parachutes.” See Diana C. Robertson, “Corporate Restructuring and Employee Interests: The Tin Parachute,”
in Hoffman et al., The Ethics of Organizational Transformation.
Michael C. Jensen, “The Takeover Controversy: Analysis and Evidence,” in John
C. Coffee Jr, Louis Lowenstein, and Susan Rose-Ackerman (eds), Knights, Raiders,
and Targets: The Impact of the Hostile Takeover (New York: Oxford University
Press, 1988), p. 340.
One study reports that the announcement of golden parachutes raises the price
of a company’s shares by 3 percent, although this price rise could be due to the
perception that the company is a takeover target. R. Lambert and D. Larker,
“Golden Parachutes, Executive Decision-Making, and Shareholder Wealth,”
Journal of Accounting and Economics, 7 (1985), 179–204.
26 USC §280G denies the corporation a tax deduction for compensation above
a certain amount, and 26 USC §4999 imposes a further tax on individuals who
receive this excessive compensation.
Dodd–Frank Wall Street Reform and Consumer Protection Act, Public Law 111203, sec. 951.
220 Ethics in Financial Markets
30.
31.
32.
33.
34.
35.
36.
37.
38.
39.
40.
41.
42.
43.
44.
45.
46.
47.
48.
49.
Peter G. Scotese, “Fold Up Those Golden Parachutes,” Harvard Business Review,
March–April 1985, p. 170.
Cochran and Wartick, “ ‘Golden Parachutes’.” p. 121.
Scotese, “Fold Up Those Golden Parachutes,” p. 168.
Bebchuk, Cohen, and Wang, “Golden Parachutes and the Wealth of
Shareholders.”
Jensen, “The Takeover Controversy,” p. 341.
J. Gregory Dees, “The Ethics of ‘Greenmail’,” in William C. Frederick and Lee E.
Preston (eds), Business Ethics: Research Issues and Empirical Studies (Greenwich,
CT: JAI Press, 1990), p. 254.
These arguments are developed and evaluated in Dees, “The Ethics of
‘Greenmail’.”
Different classes of stock can carry different voting rights and different dividends,
but such differences are known in advance and accepted by all stockholders.
Quoted in Robert W. McGee, “Ethical Issues in Acquisitions and Mergers,” MidAtlantic Journal of Business, 25 (March 1989), 25.
Some argue that managers should never attempt to defend against a takeover
but allow the shareholders to decide. However, management generally has better
information than shareholders and may be in a better position to determine what
is in the shareholders’ interests. See Frank H. Easterbrook and Daniel R. Fischel,
“The Proper Role of a Target’s Management in Responding to a Tender Offer,”
Harvard Law Review, 94 (1981), 1161–1204.
John C. Coffee Jr, “Regulating the Market for Corporate Control: A Critical
Assessment of the Tender Offer’s Role in Corporate Governance,” Columbia Law
Review, 84 (1984), 1145–1296.
Roger J. Dennis, “Two-Tiered Tender Offers and Greenmail: Is New Legislation
Needed?” Georgia Law Review, 19 (1985), 281–341.
Paramount Communications, Inc. v. Time Inc., 571 A.2d 1140 (1990).
In Paramount, the Delaware State Supreme Court cited a previous decision in
which it had held that considering a takeover’s “effect on the corporate enterprise” includes such concerns as “the impact on ‘constituencies’ other than shareholders (i.e. creditors, customers, employees, and perhaps even the community
generally).” Unocal Corporation v. Mesa Petroleum Co., 493 A.2d 946, 955 (1985).
See Eric W. Orts, “Beyond Shareholders: Interpreting Corporate Constituency
Statutes,” George Washington Law Review, 61 (1992), 14–135.
Roberta S. Karmel, “The Duty of Directors to Non-shareholder Constituencies
in Control Transactions—A Comparison of U.S. and U.K. Law,” Wake Forest Law
Review, 25 (1990), 68.
Scott Patterson, The Quants: How a New Breed of Math Whizzes Conquered Wall
Street and Nearly Destroyed It (New York: Crown Business, 2011).
Chartered Financial Analyst Institute, Financial Market Integrity Outlook: 2011,
January 2011.
Berkshire Hathaway Annual Report, 2002.
Saul S. Cohen, “The Challenge of Derivatives,” Fordham Law Review, 63 (1995),
1993–2029, 2000.
Ethics in Financial Markets 221
50.
51.
52.
53.
54.
55.
56.
57.
58.
59.
60.
61.
62.
63.
64.
65.
66.
67.
68.
69.
70.
71.
“A Risky Old World,” Economist, October 1, 1994.
Edward J. Swan, Building the Global Market: A 4000 Year History of Derivatives
(Boston: Kluwer Law International, 2000).
Aristotle, Politics, 1259a.
Lynn A. Stout, “Derivatives and the Legal Origins of the 2008 Credit Crisis,”
Harvard Business Law Review, 1 (2011), 1–38.
Cedric B. Cowing, Populists, Plungers, and Progressives: A Social History of Stock
and Commodity Speculation, 1890–1936 (Princeton, NJ: Princeton University
Press, 1965).
Ann Vincent Fabian, Card Sharps, Dream Books, and Bucket Shops: Gambling in
19th-Century America (Ithaca, NY: Cornell University Press, 1990).
William Cronon, Nature’s Metropolis: Chicago and the Great West (New York:
W.W. Norton, 1991).
Donald MacKenzie, An Engine, Not a Camera: How Financial Models Shape
Markets (Boston, MA: MIT Press, 2006), pp. 145, 172.
James E. Boyle, Speculation and the Chicago Board of Trade (New York: Macmillan, 1920), p. 125.
Nicholas Kaldor, “Speculation and Economic Stability,” Review of Economic
Studies, 7 (1939), 1–27, 1.
James J. Angel and Douglas M. McCabe, “The Ethics of Speculation,” Journal of
Business Ethics, 90 (2009), 277–286.
Angel and McCabe, “The Ethics of Speculation.”
Michael D. Floyd, “A Brief History of the Jefferson County, Alabama, Sewer
Financing Crisis,” Cumberland Law Review, 40 (2009–2010), 691–715.
Joe Nocera, “Sewers, Swaps and Bachus,” New York Times, April 22, 2011.
Andrew Ross Sorkin, “Wall Street Ethos Under Scrutiny at Hearing,” New York
Times, January 13, 2010.
The official account is Findings Regarding the Market Events of May 6, 2010:
Report of the Staffs of the CFTC and SEC to the Joint Advisory Committee of
Emerging Regulatory Issues, September 30, 2010.
Buttonwood, “Not So Fast: The Risks Posed by High-Frequency Trading,”
The Economist, August 6, 2011, 62.
“FINRA Sanctions Trillium Brokerage Services, LLC, Director of Trading, Chief
Compliance Officer, and Nine Traders $2.26 Million for Illicit Equities Trading
Strategy,” FINRA News Release, September 13, 2010.
Bruno Biais and Paul Woolley, “The Flip Side: High Frequency Trading,” Financial World, February 2012, pp. 34–35; Donald MacKenzie, “How to Make Money
in Microseconds,” London Review of Books, 33 (May 2011), 16–18.
Ellen Brown, “Computerized Front-Running,” Counterpunch, April 24, 2010.
Nathaniel Popper, “Knight Capital Says Trading Glitch Cost It $440 Million,” New
York Times, August 2, 2012; Jessica Silver-Greenberg, Nathaniel Popper, and
Michael J. de la Merced, “Trading Program Ran Amok, with No ‘Off ’ Switch,”
New York Times, August 3, 2012.
Hayley Tsukayama, “Glitches Mar Facebook’s Stock Debut,” Washington Post,
May 18, 2012.
222 Ethics in Financial Markets
72.
73.
74.
75.
76.
77.
78.
Jenny Strasburg, Telis Demos, and Jacob Bunge, “Facebook Losses Slice UBS
Profits,” Wall Street Journal, July 31, 2012.
Biais and Woolley, “The Flip Side: High Frequency Trading,” p. 34.
Ilia D. Dichev, Kelly Huang, and Dexin Zhou, “The Dark Side of Trading,” Emory
Law and Economics Research Paper No. 11-95, January 4, 2011.
Alain Chaboud, Eric Hjalmarsson, Clara Vega, and Benjamin Chiquoine, “Rise
of the Machines: Algorithmic Trading in the Foreign Exchange Market,” Federal
Reserve Board International Finance Discussion Paper No. 980, February 20,
2013. This study concludes that high correlation “does not appear to cause a
degradation in market quality.”
Michael Davis, Andrew Kumiega, and Ben Van Vliet, “Ethics, Finance, and
Automation: A Preliminary Survey of Problems in High Frequency Trading,”
Science and Engineering Ethics, 19 (2013), 851–874; Irene Aldridge, High-Frequency
Trading: A Practical Guide to Algorithmic Strategies and Trading System (New
York: John Wiley & Sons, Inc., 2010).
Foresight: The Future of Computer Trading in Financial Markets (2012), Final
Project Report, The Government Office for Science, London.
Carol Clark, “How to Keep Markets Safe in the Era of High-Speed Trading,”
Federal Reserve Bank of Chicago, Chicago Fed Letter No. 303, October 2012.
Chapter Six
Ethics in Financial Management
Financial management is a function within a corporation, usually assigned to
a chief financial officer (CFO) and his or her staff, which is concerned with
raising and deploying capital. In a sense, a CFO makes investment decisions
and manages a portfolio, but these decisions are not about which securities to
hold but about what business opportunities to pursue and especially how they
are to be financed. Every corporation must have a financial structure in which
capital is divided between equity, debt, and other types of obligations. All of
these decisions are usually guided by the objective of maximizing shareholder
wealth. In the United States, the Sarbanes–Oxley Act assigns the CFO a
responsibility to personally attest to the accuracy of financial statements, and
the act also requires that corporations have a code of ethics for its top financial
managers.
The ethical issues in financial management fall into two broad categories: the ethical obligations or duties of financial managers of a corporation
and the ethical justification for organizing a corporation with a certain assignment of control (usually to shareholders) and the designation of an objective
(usually shareholder wealth maximization). The former category of issues
bears on the decisions made by financial managers in fulfilling the finance
functions of a corporation, and involves the fiduciary duties of financial managers to a corporation and its shareholders. The latter category is a matter
largely for government in establishing the laws of corporate governance and
those governing other aspects of corporate financial conduct, such as managing bankruptcy.
One function that falls to a CFO, as well as other top officials, is managing
the risk of a corporation. Indeed, some corporations now have the position of
chief risk officer. How risk is managed in a corporation can have immense
Ethics in Finance, Third Edition. John R. Boatright.
© 2014 John Wiley & Sons, Inc. Published 2014 by John Wiley & Sons, Inc.
224 Ethics in Financial Management
impacts on many different constituencies, including the public. CFOs are typically involved in decisions about bankruptcy and especially about the possible
abuse of the Bankruptcy Code for strategic ends. Sections on corporate governance and the objective of shareholder wealth maximization complete the
chapter.
The Corporate Objective
A fundamental tenet of financial management is that the objective of the
corporation is shareholder wealth maximization (SWM). Pursuing this objective means that all major decisions in a for-profit business firm ought to be
made with the sole aim of increasing the return from its activities to the putative owners, the shareholders. Since this return is commonly in the form of
profits, SWM may also be expressed as maximizing profits—which, in turn,
go to shareholders. Further, the stock markets’ estimates of future profits are
reflected in the share price of a firm, and so SWM can also be expressed, in
practice, as the imperative for maximizing the price of a company’s stock.
The objective of shareholder wealth maximization is seldom justified in
financial management textbooks and is presented, instead, as a basic axiom, like
those of geometry. However, a justification for SWM can be easily constructed
from the argument for shareholder control of a firm—also called the doctrine
of shareholder primacy. This argument is based on the financial theory of the
firm and the resulting system of corporate governance, which are discussed
in another section of this chapter. To anticipate, if shareholders ought to have
control (shareholder primacy), then this right of control includes the power
to decide whose interests should be paramount in corporate decision making.
Assuming that shareholders invest in a firm in order to benefit themselves by
obtaining a maximum return on their investment, then they have the right to
make this the objective of the firm. The justification for shareholder primacy
and, with it, for SWM is not without controversy, but for present purposes it
may be accepted as a fundamental tenet of financial management.
Accepting this objective raises further questions about what constitutes
SWM. The objective of SWM is not as clear as may first appear, and clarifying
it requires some ethical considerations. First, even if SWM is the ultimate
objective of a corporation, it begs many questions about how this objective is
to be achieved. Completing 18 holes with the fewest number of strokes is the
objective in golf, but a golfer’s attention must be focused on each swing.
Reaching the ultimate objective is how we judge the success of a golfer or a
manager, but achieving success depends on setting and reaching more immediate goals or aims. Indeed, focusing exclusively on any ultimate end may be
Ethics in Financial Management
225
counterproductive by neglecting the means necessary for achieving it. Thus,
management advice books often counsel a focus on customers and employees
as the means to success—in order to better serve shareholders in the end.
Furthermore, corporations, in their ordinary course of business, are bound
by many commitments, contracts, and legal restrictions that constrain the
pursuit of SWM. These obligations must be met even if they do not constitute
an objective. It may be argued that an objective that takes priority over profit
making is remaining solvent, which enables a corporation to meet its obligations to a wide range of other constituencies. Thus, meeting the payroll for
employees and paying suppliers must be an objective that takes precedence
over making a profit for shareholders. This point is often overlooked because
the objective of remaining solvent is already achieved when any profit is made,
since profit is the net revenues of a firm that remain after all fixed expenses
are paid. In addition, it is often argued that managers can serve the shareholders only by fulfilling a wide-ranging set of responsibilities to all corporate
constituencies, that is, by exercising corporate social responsibility.
Second, the objective of a corporation is not necessarily the same as the
purpose of a business firm.1 Why should corporations exist at all, and what are
we trying to achieve by doing business in the corporate form? Some would
answer, to make a profit! In this case, the objective and the purpose of a corporation are the same. However, people engage in business for many reasons,
including to provide a product or a service, as well as to earn a living through
labor. Corporations are the means we have devised to organize our productive
activity and meet our basic needs. Indeed, corporations would probably not
have arisen, and certainly would not continue to exist, if they were not effective ways of providing for our economic well-being.2 Part of the argument for
shareholder primacy—and hence SWM—is that control by shareholders best
ensures that everyone will benefit from corporate activity. A corollary of this
point is that managers, by pursuing SWM, end up operating a corporation for
maximum social benefit. If managers effectively seek shareholder wealth maximization, the argument goes, then the welfare of society will be the ultimate
outcome.
In sum, the objective of shareholder wealth maximization may be held in
a weak and a strong form.3 In its weak form, this objective is merely a guide
for managers in the operation of a corporation and a means for setting incentives and measuring success. Its scope is limited to managerial decision making,
corporate planning, and performance assessment. The strong form of SWM
expands this objective to the purpose of a corporation and affects not only
how managers should view their task but also how corporations should be
understood by everyone in society. The strong form, because of its greater
implications, is more controversial and difficult to justify than the weak form.4
226 Ethics in Financial Management
What is shareholder wealth?
Before SWM can be accepted as the objective of the firm in either form, we
need to clarify the concept. First, even determining what is a share and who
is consequently a shareholder is complicated by the existence of ordinary and
preferred stock, convertible stock, restricted stock, stock options, and other
financial instruments that may resemble stock. Thus, shareholders are not a
single, undifferentiated group, and so speaking of their interest may not be
entirely clear.
Second, even ordinary shareholders are diverse with different risk preferences and time horizons, and so decisions that raise the value of the firm for
one set of shareholders might lower it for another. Further, the interests
of shareholders are assumed to be identical with that of the firm, and so
perhaps the interest of the firm could be substituted for shareholder interests.
However, the correlation is not perfect and the two interests may diverge.
Thus, well-diversified shareholders might prefer a firm to take risks that
threaten its survival, whereas managers, as well as employees and other constituencies who have a greater stake in the firm as an ongoing entity, are generally more risk-averse. No one group’s interest is necessarily identical to the
interest of the firm itself, and identifying a firm’s interest may be as challenging
as determining the shareholders’ interests.
It has also been observed that institutional shareholders, such as pension
funds and endowments, are “universal shareholders,” whose interests are
affected less by the performance of individual companies than by the condition of the whole economy.5 Such “universal shareholders” may be concerned
more than individuals with social and political issues that affect the broader
economy. For example, a decision to pollute or downsize, which may benefit
individual shareholders, may be opposed by institutional investors, whose
total portfolio may be adversely affected by the social cost of such corporate
actions. Institutional shareholders may also hold bonds as well, and sometimes decisions that benefit shareholders harm bondholders, which may leave
“universal shareholders” worse off on balance.
Given that the interests of shareholders are often diverse and may not be
identical with that of the firm, what precisely does it mean to pursue SWM?
One answer, provided by finance theory, is that this does not matter. Differences between shareholders with regard to their risk preferences and time
horizons ought to be ignored by management. The irrelevance theorem,
advanced by Franco Modigliani and Merton Miller, holds that decisions about
financial policy, such as capital structure and dividends, do not affect firm
valuation because investors can make changes in their own portfolios to
achieve any desired outcome.6 Thus, an investor who would prefer that a cor-
Ethics in Financial Management
227
poration have a different debt-to-equity ratio or a different level of dividends
can make other investments that offset the financial policies of the corporation
in question. Therefore, managers should concentrate on other nonfinancial
decisions that affect share price.
However, this conclusion overlooks the fact that shareholders are not
always able to invest on the same terms as corporations, and hence they may
incur greater costs in satisfying their own risk and return preferences. Moreover, a corporation may change its financial policies suddenly before investors
have the opportunity to make changes in their portfolios. If these considerations are relevant, then the problem of the meaning of SWM remains in the
choice of financial policies.
Possible measures of shareholder wealth are accounting profits (earnings
per share), cash flows, and share price. Accounting profits, which are the net
revenues of a corporation after all costs of doing business are subtracted from
gross revenues, is an unsatisfactory measure since it is based on the accounting
for revenue and expenses, which may be manipulated to some extent within
generally accepted accounting principles (GAAP). Reported profits may also
be inflated by outright fraud in violation of GAAP, as occurred at Enron and
WorldCom, among other notable failures. Profits also do not take account of
the risk that is taken. A smaller return with less risk may represent greater
wealth for an investor on a risk-adjusted basis if a higher return is not commensurate with the greater risk.
Further, profits do not take account of the cost of capital, and so a company
could make profits and still be losing money if the cost of capital is not
covered. A remedy for this problem is use of the concept of economic value
added (EVA), which measures only profit in excess of capital costs. Free cash
flow, which is the actual cash generated minus capital expenditures, is not only
a good measure of the return on investment so far but also a fair predictor of
the future earnings that free cash flows make possible. In addition, this
measure is less subject to manipulation than is net revenue or profit.
The most common measure of shareholder wealth is share price, the price
of a company’s stock. In practice, SWM often means, simply, the focus on
raising the price of the company’s stock. However, share price is influenced by
many nonfundamental factors, including investor psychology, economic
trends, and market irrationality, all of which are beyond management’s control.
Furthermore, share price may be affected by the strategies of short-term investors who have little stake in the long-term prospects of a firm. Thus, a costly
investment in research and development may not be valued by investors in
the current market. In such a case, how can it be determined what is in the
shareholders’ interest and whose judgment of shareholder interests should
prevail. Is the current share price really accurate and should the measure be
228 Ethics in Financial Management
the current price or one expected in the future? For all these reasons, managing to maximize stock price may not be an adequate guide for pursuing SWM.
To meet these problems, Henry Hu proposes the “blissful-shareholder”
model.7 In this model, the managers of large publicly held companies with
actively traded stock and well-diversified shareholders should seek to maximize “what the share price would be in a stock market that is completely
omniscient and fully efficient.”8 Management would thus have a fiduciary duty
to pursue what in their judgment are worthwhile projects, even if doing so
results in a reduction in the price of a company’s stock because of market
mispricing. The hazard in this model is that it elevates the judgment of
management over that of shareholders and the investment community, which
creates the potential for self-serving management entrenchment. In such
cases, the board of directors must play a critical role in evaluating the judgment of management and providing a voice for shareholders.
Bradford Cornell and Alan C. Shapiro propose that the objective of the firm
be measured by an “extended balance sheet,” which includes, in addition
to the usual assets and liabilities, the value to the firm of implicit claims to
various constituencies and the costs to the firm of honoring these claims.9
These constitute “organizational capital” and “organizational liabilities” respectively, and the difference between them is “net organizational capital,” which
represents a form of wealth that is not recorded by traditional financial
accounting practices. This proposal reflects the view that the value of a firm
consists not merely in its financial state but also in its organizational abilities
(and the failure of some financially restructured firms to perform lends credence to this view).
The “blissful shareholder” model and the “extended balance sheet” model
each addresses the fact that maximizing wealth for shareholders is not a clear
objective for managers. Deciding which shareholders to favor and resolving
differences between shareholders and the firm both involve some value judgment about the worth of the respective claims. Short-term profits benefit
well-diversified shareholders with a strong preference for risk and a short time
horizon. By contrast, a decision to promote the long-term prospects of the
firm considers the interests of risk-averse shareholders as well as the various
constituencies with a stake in the survival of the firm.
For example, Hu considers other constituency statutes to embody a “blissful shareholder” view because they permit directors to choose long-term value
over short-term shareholder gain in responding to a takeover bid. The longterm value of a firm has been understood by the courts in some cases to
include its value to employees, consumers, and society in general.10 Moreover,
SWM is subject to differing interpretations, and the choice between these
interpretations requires the use of value judgments. If the value of a firm is
Ethics in Financial Management
229
taken to be its value as an ongoing entity that is capable of creating wealth for
society indefinitely into the future, then managers cannot consider the interests of individual shareholders or current stock price, but must take into
account the interests of all of the groups that make up the corporation.
Do firms seek to maximize?
It is no secret that most business firms do not seek to maximize shareholder
wealth. If all corporations did, there would be no extravagant headquarters or
fleets of corporate jets; prices would be the highest possible and costs the
lowest, so that neither could be changed if the need arose to improve profitability, and every legal stratagem would be employed, no matter how unconscionable, in order to extract the full return from every dollar invested. Some
regard this failure to maximize shareholder wealth as a regrettable shortcoming of a system in which managers are able to consume perquisites, collude
with employees and customers against the interests of investors, and salve
their consciences and gain public approval with good works. Others hold
that SWM is a theoretical ideal that cannot and should not be realized in
practice.
In a 1960 article in the Harvard Business Review, Robert N. Anthony contended that most large, publicly held corporations do not attempt to maximize
profits but seek only a satisfactory level of profit—and that this is a good
thing!11 First, profit maximization is an impractical goal that, if pursued
single-mindedly, would have counterproductive consequences. Pricing, for
example, is not done by comparing demand and costs at all volumes—which
is a formidable task that is seldom attempted outside economics classrooms;
rather pricing is done by developing a “normal” price based on a conventional
cost-accounting system.
Similarly, capital budgeting does not commonly consist of comparing every
investment opportunity in order to select the one with the greatest return over
the marginal cost of capital. Typically, promising projects are selected if they
exceed a minimum expected return. Although decisions are often made by
inexact means that still aim at profits, ethics also plays a role in these decisions.
Business people have learned, for example, that pricing is only one aspect of
marketing and that higher prices can be charged if there is a high degree
of consumer trust. Some opportunities are pursued and others rejected for
reasons of a corporation’s social responsibility.
The main implication for ethics if firms deliberately seek only a satisfactory
return is that a surplus remains to be distributed. Whether managers divert
the surplus to themselves, as many maintain they do, or confer it upon employees, customers, suppliers, or other groups is immaterial to the point that a
230 Ethics in Financial Management
distribution is being made by some criteria other than SWM. These distributions are often justified on the grounds that they ultimately benefit shareholders, but such claims are partially true at best. (It is unfortunate that corporate
managers feel compelled to justify decent treatment of employees—offering
generous severance packages to those laid off, for example—as indirectly
benefiting shareholders when, in truth, they believe that this is the compassionate thing to do.) These criteria for distribution are varied, but some include
ethical standards that are considered a part of responsible business conduct.12
SWM and social responsibility
A major concern about SWM as the objective of a corporations is its possible
implications for practicing corporate social responsibility (CSR). Although the
responsibility of a business firm to serve social ends is much debated, corporations typically devote some resources to philanthropy and other worthwhile
social initiatives.13 However, the objective of shareholder wealth maximization
might seem to be incompatible with the pursuit of corporate social responsibility. CSR also includes addressing the social costs of production, also known
as externalities. Social costs or externalities are costs of production, such as
pollution, that are not internalized (factored into the price of a product) but
externalized (passed on to society). Given the SWM objective, what should
firms do with regard to CSR, including social costs or externalities?
Friedman’s argument
The economist Milton Friedman, who holds a strong version of the SWM
objective, has argued against the idea of corporate social responsibility by
saying:
This view shows a fundamental misconception of the character and nature of a
free economy. In such an economy, there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase
its profits so long as it stays within the rules of the game, which is to say, engages
in open and free competition without deception or fraud.14
Friedman’s argument proceeds mainly from the premise that when managers
make decisions in their capacity as agents of the corporation and not as private
citizens, they have an obligation to serve the interests of the corporation alone.
Otherwise, they are taking on the role of public officials with the power to tax,
and as such they ought to be elected through the political process and not by
the shareholders of private business firms.
Ethics in Financial Management
231
He writes further:
What does it mean to say that the corporate executive has a “social responsibility” in his capacity as businessman? If this statement is not pure rhetoric, it must
mean that he is to act in some way that is not in the interest of his employers.
For example, that he is to refrain from increasing the price of the product in
order to contribute to the social objective of preventing inflation, even though
a price increase would be in the best interests of the corporation. Or that he is
to make expenditures on reducing pollution beyond the amount that is in the
best interests of the corporation or that is required by law in order to contribute
to the social objective of improving the environment. . . . In each of these cases,
the corporate executive would be spending someone else’s money for a general
social interest. Insofar as his actions in accord with his “social responsibility”
reduce returns to stockholders, he is spending their money. Insofar as his actions
raise the price to customers, he is spending the customers’ money. Insofar as
his actions lower the wages of some employees, he is spending their money.15
In presenting this argument, Friedman acknowledges that there are “rules
of the game,” and these rules may impose more obligations on corporations
than he realizes. The operation of a free market requires an extensive set of
rules that we often overlook. These include common understandings, background institutions, the legal system, and government regulations. In addition, corporations, like government and other institutions in society, gain the
legitimacy needed for survival by meeting people’s legitimate expectations.
This point has been expressed as the Iron Law of Responsibility: “In the long
run, those who do not use power in a manner which society considers responsible will tend to lose it.”16 Friedman accepts the need to consider matters of
social responsibility in order to serve the ultimate interests of the corporation,
but he appears to underestimate the attention to such matters that this longterm perspective requires.
Friedman charges that acts of social responsibility, such as spending money
to prevent pollution beyond the amount that is in the corporation’s best interest, takes money away from shareholders, employees, and other groups. To
be sure, acting in a socially responsible manner involves trade-offs between
the interests of different constituencies, and managers must be careful not to
exceed their authority and assume the powers of elected officials. However,
managing trade-offs is a task that is inherent in management decision making.
Thus, spending money on pollution might be described not as spending other
people’s money without authority but as bargaining with environmentalists
who have the power to affect the corporation as consumers (who can boycott
the company’s products), as citizens (who can lobby for government regulation), and even as employees and shareholders, who favor environmental
232 Ethics in Financial Management
protection and are willing to accept less in wages or dividends in order to
achieve this goal.
Friedman would not object to spending money to prevent pollution as long
as the expenditure is in the best interest of the corporation. However, the best
interest of the corporation is not merely what the shareholders of the moment
prefer, because managers deal with all constituencies on whose cooperation
the corporation depends. Corporations organize production involving many
input providers, and a major task of management is securing commitments
from these diverse constituencies.17 Short-term shareholders might complain
that managers are spending their money in preventing pollution, and they
might respond by driving the price of the stock down. However, we have
already noted that stock price is not always a reliable indicator of shareholder
value. Acting in the best interest of the corporation may require a long-term
perspective, such as the “blissful shareholder” model, and taking such a perspective leads to more socially responsible behavior than Friedman’s argument
suggests.
Problem of social costs
Social costs or externalities pose a particular challenge to shareholder wealth
maximization since the pursuit of this objective would seem to counsel,
even demand, that managers externalize costs at every opportunity. Every cost
passed on to society is one that shareholders do not have to bear. In some
instances, internalizing costs is a matter of being a socially responsible corporation and so the problem of social costs or externalities may be addressed,
in part, as a matter of CSR. That is, to the extent that SWM is compatible with
CSR, it may not entail the externalization of all costs. One way of ensuring
this compatibility is government regulation to require internalization, for
example, by laws limiting pollution. In this way, internalizing costs become
part of the “rules of the game” that Friedman cites as a constraint on the
pursuit of SWM.
Another response to the challenge posed by social costs or externalities
is the argument that pursuing the objective of SWM indirectly solves this
problem. Managing a corporation so as to maximize shareholder wealth, the
argument goes, results, in the end, in greater wealth for society that enables it
to pay the social costs generated by business. In particular, managing for SWM
leads to more efficient production, which in turn has social benefits. Frank
Easterbrook and Daniel Fischel make the point in the following way:
A successful firm provides jobs for workers and goods and services for consumers. The more appealing the goods to consumers, the more profit (and jobs).
Prosperity for stockholders, workers, and communities goes hand in glove with
Ethics in Financial Management
233
better products for consumers. Other objectives, too, come with profit. Wealthy
firms provide better working conditions and clean up their outfalls; high profits
produce social wealth that strengthens the demand for cleanliness. . . . [W]ealthy
societies purchase much cleaner and healthier environments than do poorer
nations—in part because well-to-do citizens want cleaner air and water, and in
part because they can afford to pay for it.18
Thus, a wealthier society is better able to afford the cost of pollution, for
example, because it has both the desire and the resources to clean up the
environment.
However, this response does not address the question of who pays. The
wealth created by pursuing the objective of SWM would seem to be the same
regardless of whether corporations internalize or externalize costs. (One relevant factor is which party can clean up pollution, for example, at the lowest
cost?) So the problem remains: Should corporations bear the costs of production by internalizing them? Or is it permissible for corporations to externalize
these costs by passing them on to society? Easterbrook and Fischel propose a
market solution that is compatible with SWM. They write:
The task is to establish property rights so that the firm treats the social costs
as private ones, and so that its reactions, as managers try to maximize profits
given these new costs, duplicate what all of the parties (downstream users and
customers alike) would have agreed to were bargaining among all possible
without cost.19
The crucial point in this argument is that a clear assignment of property
rights would force firms to internalize what would otherwise be external costs.
For example, if third-party victims of pollution could demand compensation
for damage to their property caused by the pollution in the stream, then firms
would be forced to include this compensation in their cost calculations,
thereby internalizing the cost of pollution. This cost could be paid by a
company either by cleaning up the discharge into the stream or by paying
compensation, whichever is cheaper.
This argument exemplifies the Coase Theorem, which holds that externalities do not cause a misallocation of resources provided that there are defined
and enforceable property rights and no transaction costs—that is, that the
affected parties could form contracts at no cost.20 A flaw in the argument,
however, is the absence, in many cases of externalities, of both property rights
and zero transaction costs.21 Although steps can be taken to remedy both of
these factors, they are likely to remain insurmountable obstacles to the solution that Easterbrook and Fischel propose.
234 Ethics in Financial Management
The conclusion to be drawn, then, is that SWM is likely to remain an obstacle to addressing the problem of social costs or externalities. If corporations
are to be socially responsible in addressing this problem, then there must be
either some relaxation of the SWM objective to admit socially responsible
conduct or else more extensive government regulation.
Risk Management
Managing risk is a large part of finance. Risk is of great concern to individual
investors and the managers of investment funds, and, indeed, any firm involved
in financial markets or financial services deals with risk in some way. This task
also belongs to the financial managers of any business enterprise, whether in
finance or some other area, since all financial decisions in business involve
some attention to risk. However, risk has many sources and can be addressed
by different means, and so risk management must be the responsibility
of people throughout any organization. Viewed broadly, the category of
risk encompasses all the bad things that could happen, and managing for
their potential occurrence is obviously a large part of engaging in business
activity.
The management of risk has a long history. In his book Against the Gods:
The Remarkable Story of Risk, Peter L. Bernstein locates the dividing line
between modern times and the centuries of human existence preceding it in
the mastery of risk, which occurred, during the Renaissance, with the discovery of the mathematics of probability.22 This development showed that the
misfortune that occurs in life could be subject to active human control rather
than being endured passively as the whims of the gods. For centuries following, managing risk for the benefit of society was the main function of the
insurance and banking industries, which employed actuaries and statisticians
to calculate the probabilities of untoward events. Governments have also long
played a role in managing risk for its citizens.23
Modern risk management developed in the 1970s in financial institutions
as they took greater risks in making business loans, trading securities for their
own account, and creating new financial instruments. Theoretical discoveries
during this period, such as modern portfolio theory, the capital asset pricing
model, and option pricing theory, led to a vast expansion in the use of derivatives of various kinds. This very profitable activity required highly accurate
calculations of the downside risk as well as the upside return. Finance theory
stresses the ideas that risk represents an opportunity as well as a hazard and
that the aim of business should not be merely to avoid or reduce risk but to
seek the optimal return at an acceptable level of risk.
Ethics in Financial Management
235
What is risk management?
Risk is central to finance. First, risk and return are inextricably linked since
without risk there would ordinarily be no return on an investment. Any return
is compensation for the risk taken and, typically, the greater the return sought,
the greater the risk that will have to be taken. An investor must seek to ensure
that the expected return is commensurate with the risk and that the level of
risk is acceptable. Second, risk is not always a readily known quantity, and
much financial activity is devoted to determining the amount of risk being
taken—along with the return, of course. In making a loan, for example, a bank
must calculate the risk of default in order to determine the appropriate interest
rate. Similarly, the price of a security or the premium for an insurance policy
depends on complex calculations of risk. Means must be found to calculate
risk, and in recent years this has been done using highly sophisticated mathematical measures and models.
Risk in investment is confined mainly to individual financial instruments
and whole portfolios of such instruments. However, a business firm, whether
it be in finance or some other area, must consider a wider range of risks.
The main types of risk have been commonly classified as credit risk and
market risk. Thus, creditors to whom debts are owed run the credit risk
that these debts may not be paid, and decreasing market demand for a company’s products is an example of market risk. The holder of a bond, for
example, needs to be concerned, first, with the possibility of default by the
issuer (credit risk) and, second, with potential changes in interest rates (market
risk); both kinds of risk can significantly impact the value of a bond. More
recently, the field of risk management has come to include the category of
operational risk, which results from events that affect a company’s operations,
such as a storm that prevents delivery by a supplier.24 Reputational risk, which
involves damage to a company’s brand or franchise, has also become widely
recognized.25
In the past few decades, risk management has extended beyond finance to
virtually all businesses to become what is called enterprise risk management
(ERM). This large and important function is described by one writer as involving “the identification and assessment of the collective risks that affect firm
value and the implementation of a firm-wide strategy to manage those risks.”26
For financial and nonfinancial firms alike, the goal of ERM is to maximize the
value of the enterprise by shaping the firm’s risk profile. This consists of identifying all of the risks faced by the firm, including their likelihood and potential costs, targeting an acceptable level of risk, developing a plan to keep risks
within the preferred limits, and carefully monitoring the implementation of
this plan.
236 Ethics in Financial Management
One feature of ERM is its comprehensive nature: virtually all adverse conditions that could affect a company’s performance have come to be labeled risks
and made into a subject for risk management. Second, ERM recognizes that
risks do not occur in silos but interact with each other in a complex dynamic
process. Therefore, the management of all risk cannot be undertaken in isolation or in a piecemeal manner but must be considered together in an integrated fashion. Third, ERM is no longer a specialized function of low-level
risk managers but a task for the C-level officers and the directors of a corporation. Indeed, many companies have created the office of chief risk officer to
aid the CEO, CFO, and the board in placing risk management at the center of
corporate decision making. Thus, ERM is different from traditional risk management in that it treats risk in a comprehensive and integrated manner at the
highest levels of decision making.
There are five main responses to risks: a firm may avoid a risk entirely, for
example, by not entering a certain line of business; it may seek to reduce a risk
by taking appropriate action; the risk may be hedged so that a loss-inducing
event is offset by some gain; the risk may be transferred so that it is assumed
by another party, often with compensation as in the case of insurance policies;
or it may be borne. This latter response may be taken either because the risk
cannot be avoided, reduced, hedged, or transferred or else because it represents a business opportunity in which the firm can profitably employ its core
competencies and investment resources. Indeed, the competitive advantage of
any firm lies in its ability to exploit the opportunities created by the right,
carefully selected risks.
The main tools for implementing ERM are financial instruments to hedge
or transfer risks, operational changes that avoid or reduce risks, and capital
reserves to prevent insolvency in cases of loss due to risks. Changes in interest
rates or currency values can be hedged, for example, by swaps or options;
insurance policies transfer risk from a company to the insurer; the risk of loss
from fire can not only be transferred by the purchase of insurance but can be
reduced by investment in prevention; and setting aside reserves to cover losses
can avoid disruption of business from losses. One function of equity capital
in a corporation and bank capital reserves is to enable the business to absorb
losses and continue operation. Since there are usually several tools available
for managing any particular risk, the choice typically depends on the comparative costs.
Risk management played a role in the recent financial crisis, first, by facilitating the construction of collateralized debt obligations (CDOs), which are
securities that bundle together large numbers of loans and divide them into
tranches with different risks and rates of return. More mathematical models
were needed for the construction of other exotic financial instruments, such
Ethics in Financial Management
237
as synthetic CDOs and credit default swaps (CDSs). A second use of risk
management occurred when banks assessed the risk of their portfolios, which
included large volumes of CDOs and similar securities. Although they assumed
very substantial risks by leveraging their capital—in some instances more than
thirty to one—the banks were able to do so with great confidence because they
had measured their risks very precisely by newly developed model-based
techniques. In particular, value at risk (VaR) became a widely adopted tool for
determining the risks posed by a bank’s portfolio. VaR gave users a great sense
of confidence that their firm’s risks were being managed prudently—mistakenly,
as it turned out.
Ethical issues in risk management
It seems only prudent to manage risk. This is certainly true if the only alternative is a return to the superstition and blind acceptance of fate that Bernstein
describes in Against the Gods. The development of sophisticated risk management techniques based on a mathematical treatment of probability has been
a decided boon for mankind. However, important questions can be raised
about the general enterprise of risk management. Bernstein cautions that risk
management could become “a new kind of religion, a creed that is just as
implacable, confining, and arbitrary as the old.”27 An overreliance on numbers
may lead, he says, to errors as serious as those committed by ancient priests
who placed faith in omens and offerings. Risk management may also create
an overconfidence that leads to disaster. As Niall Ferguson has quipped, “those
whom the gods want to destroy they first teach math.”28
There is no question that risk ought to be managed, but it matters immensely
which risks are managed, by whom, with what means, and for whose benefit.
Modern risk management is a distinctive recent development in which certain
kinds of risks are treated in a certain manner by certain actors for certain ends.
As Lisa Meulbroek has written:
Risk management is not only a decision about how much risk the firm should
bear, it is also a decision about much risk the firm’s customers or suppliers are
prepared to bear. As a more general matter, suppliers, customers, community
members, firm shareholders, and employees are all risk bearers for a firm. Managers must determine the optimal level of risk for all parties and consider not
only how each individual risk affects the firm’s total risk exposure, but also
evaluate the optimal way of managing and distributing those risks.29
What specific impacts can a firm’s practice of risk management have on
parties other than the firm? First is the obvious point that a firm generally
238 Ethics in Financial Management
identifies only those risks that create a potential loss for the firm itself and
ignores any impacts that are borne by others. The category of risks is indefinitely elastic as firms succeed in their relentless quest to externalize costs and
to exploit situations of moral hazard. This category also includes systemic risk,
which is not only beyond the power of any one firm to manage but is also a
risk that affects all groups in an economy. Thus, ethics is involved in the identification of risks to be managed.
In the recent financial crisis, the risks of loans, including subprime mortgages and the CDOs that were securitized from them, were of little concern
to banks once these risks were transferred to other parties. The main risks
that were managed were confined to the banks’ own portfolios; the losses that
might result from these “toxic assets” were someone else’s problem. Similarly,
the moral hazard that the implicit government guarantee provided to “toobig-to-fail” institutions and the systemic risk that their activities posed were
opportunities to be exploited, without regard for the consequences to others.
Second, other groups are affected by the means that firms select to manage
risk. Any given means chosen will have impacts on different groups, and the
choices made will distribute these impacts differently. For example, a firm that
avoids certain risks might deny benefits that people would otherwise enjoy, as
when the uncertainties of flood damage lead insurance companies to cease
issuing such policies, thereby forcing homeowners to assume that risk themselves, or else to rely on government. A company that reduces the risk of
workplace injury by making safety improvements does so in a way that benefits workers, but if it chooses instead to transfer that risk by purchasing an
insurance policy, then the benefit to workers is changed. The company has
traded ex ante safety on the job for ex post compensation in the event of an
accident, which may not be the workers’ preference.
However, the transactions in question may occur without full understanding, so that risks are assumed unknowingly and without consent. Thus, in the
financial crisis, much of the risk of subprime mortgages was transferred to
unwitting borrowers, who in some cases lost their life savings, and these risks
were also borne by savers who were unaware that their mutual funds and
pension funds contained securities backed by these same subprime mortgages.
Although banks thought that they had transferred the risk of securities in their
own portfolios by means of credit default swaps, the risk returned to them—
and to taxpayers!—when the issuers of these swaps were unable to pay claims.
The transfer of risk, which often occurs without much awareness or consideration, is a major development in recent history. In The Great Risk Shift,
Jacob Hacker documents how corporations and governments are shedding
many of their traditional responsibilities and putting a greater burden on
ordinary people in such areas as employment, healthcare, education, and
Ethics in Financial Management
239
retirement, with a resulting erosion of economy security.30 Much of this shedding of traditional responsibilities is due to the pursuit of profit, as banks cease
to bear the risk of loans by securitizing them and collecting fees instead, and
many corporations have changed the forms of their pension plans so as to
shift the risk in retirement portfolios to employees. This massive transfer of
risk, whether good or bad, is certainly a matter of ethics.
A third area in which risk management has ethical implications lies in the
choice of an acceptable level of risk. In managing risk, a firm identifies its own
appetite or tolerance for risk and acts accordingly. Because shareholders generally prefer a higher level of risk than other groups, risk management systems,
which generally lessen risks, serve to reduce conflicts between shareholders
and other groups over risk preferences. However, conflicts may remain not
only over the level of risk but also over the types of risk. Individuals can
respond to any chosen level of firm risk and seek to secure their own risk
preferences. For example, workers may change jobs to secure safer working
conditions or may bargain in a union for greater safety. However, the opportunities for such steps are limited, so that workers may still bear some risks
they would prefer to avoid.
Aside from the identification of the risks to be managed, the means for
managing them, and an acceptable level of risk, there is a fourth ethical
concern. Risk management may create a false sense of confidence that leads
firms to assume too much risk. This false sense of confidence may also extend
to the public, leading ordinary people to accept too high a level of risk as
well. The existence of apparently sophisticated risk management systems may
create an illusion that all risks are understood and under control so that even
a high level of risk is deemed acceptable. As Nassim Taleb has observed,
the greater danger comes not from a high level of known risks but from the
unknown risk of low-probability but high-impact events, which are by their
nature unpredictable—and hence unmanageable.31 Therefore risk management systems may themselves be a source of risk by creating a false sense of
confidence that blinds managers and the public to the hazards that they actually face.
This false sense of confidence may extend from risk management tools to
the legitimacy of the whole corporate system. The public demands that risk
be managed, and so the key institutions in society must at least give the impression that this task is being addressed competently, whether it is or not. Risk
from low-probability, high-impact events is especially difficult, if not impossible, to manage, but the legitimacy of business may depend on maintaining
a convenient fiction of competent control. Risk management meets this need
by inspiring public confidence in corporations, countering fear and suspicion
of their activity, and defusing or deflecting blame when things go wrong.
240 Ethics in Financial Management
When such legitimacy is earned, then everyone benefits, but there is also the
danger that risk management serves to deceive the public by erecting a “managerial smokescreen” to maintain “myths of control and manageability.”32
The failure of risk management
Given the role of risk management in the financial crisis, ethical questions
may be raised about the use of risk management measures and models.
However, the prominent role of risk management in the crisis does not necessarily mean that it was at fault in some way. Some risks are worth taking, and
even great risks may be rationally chosen if the returns are sufficiently high.
The task of risk management is to ensure that top management knows
and understands the risks and the potential gains and makes prudent tradeoffs. Moreover, mistaken judgment is not necessarily ethical failure, and so
a question for ethics is how to determine when incompetence becomes
immorality.
Critics identify four theoretical problems with the techniques of risk management. First, in developing measures and models, risk management attempts
to quantify the probability of extremely rare events that occur far out on the
tails of normal distribution curves. Some experts question whether such
assignments of probabilities are even meaningful,33 while others note the
inherent unreliability of decisions based on any such probability measurements.34 This is the problem of “fat tails” or “black swans,” which have either
no known distributions or else distributions too scant to be successfully
modeled. Peter Bernstein asks, “How can we instruct a computer to model
events that have never occurred, that exist beyond the realm of human imagination?”35 Risk management also assumes that the past is a reliable guide to
the future, so that predictions can be made with models that use historical
data. In the case of extremely rare events, however, historical data may be
unavailable or of little predictive value, and data for even more common
events may become unreliable when circumstances change.
Second, models assume a deterministic world that operates according to
physical laws that can be expressed mathematically. Calculations of probabilities are reliable only when events are the result of an underlying causal system
that may be imperfectly understood but is still orderly. Thus, weather predictions may be difficult, but they are still possible since rain occurs according
to fixed laws of physics. However, economic behavior is an extremely complex
phenomenon, with far too many variables to be accommodated in any model,
and, further, human behavior, which is being modeled, does not follow fixed
laws of physics, like those for rain.
Ethics in Financial Management
241
In addition, models assume that a knowledge of probabilities does not
affect the causal system or its outcomes. When people carry an umbrella after
a forecast of rain, their behavior can have no impact on whether it actually
rains. This is not true in risk management models: people following models
can affect the outcome, especially in times of crisis.36 Models assume randomness, but they can lead traders to take similar positions based on the same
information and to take identical actions in crises, so that the market ceases
to be random. (The October 1987 stock market crash is often used as an
example of this phenomenon.) Because of such model-inspired herd behavior,
Daníelsson argues, “The basic statistical properties of market data are not the
same in crisis as they are during stable periods; therefore, most risk models
provide very little guidance during crisis periods.”
Third, in using models, it is difficult to anticipate the interactions among
variables, which can often result in the compounding of consequences from
small changes. This problem, which is known as procyclicality, may result
when small changes in such factors as prices, volatility, and liquidity, which
often occur in crises, lead to vicious feedback loops that produce large, unexpected effects. The nonlinear dependence involved in such large magnitudes
of change may be more of a problem than fat tails or black swans, because it
is harder to detect and model.37
Fourth, a great deal of criticism has been directed toward value at risk as
a measure. VaR utilizes sophisticated mathematical formulas to circumvent
the need to perform an immense number of calculations about each asset in
a portfolio. Its widespread adoption is due to the convenience of a single dollar
figure that represents the maximum amount that a portfolio might lose in
a certain period of time with a specified degree of probability. For example, a
manager might be informed that there is a 99 percent probability that the
maximum amount that a $100 million portfolio could lose in the next seven
days is $10 million, or 10 percent. With a sufficient gain, this risk may be
considered worth taking since the loss is acceptable and has a very small probability of being any worse.
VaR proved to be of limited value in the recent crisis in part because it
leaves the possible losses in extremely rare conditions unspecified. Measures
of VaR with a 95 percent or a 99 percent degree of probability do not even
attempt to estimate the losses that could occur in the realm of the 5 percent
or the 1 percent range, which could be enormous. Moreover, this lack of attention to possible losses from very low-probability events may encourage traders
to seek investments with an overall low level of risk but the potential for
enormous losses in extremely unlikely cases. Such trades may not come to the
attention of a manager using VaR as the only measure of risk.
242 Ethics in Financial Management
Furthermore, VaR assumes normal distributions of even very rare tail
events, but, as critics argue, this underestimates the probability of some
adverse event or other occurring. Although any given low probability may be
unlikely (by definition), it is quite likely at any given time that some improbable event or other will occur. Critics also note that VaR takes little account
of correlation, when events, such as housing foreclosures, are related, as
occurred in the financial crisis. In addition, VaR does not work well in crises
because it assumes that positions can be sold or hedged costlessly, whereas in
times of stress, when liquidity or confidence is lacking, assets may have no
buyers or may be sold only at a deep discount. For this reason, VaR has been
compared to an airbag that always works except in crashes.38
A final criticism is that VaR calculates only the specific risk of a firm’s own
portfolios and not the systemic risk for the whole economy. As Richard Posner
observes:
The essential point is the difference between a 1 percent probability that a firm
will go broke, because of risky lending, and a 1 percent chance of a depression
because the lending financial firms have a correlated 1 percent risk of going
broke. The toleration of the risk is rational for each firm, irrational for society.39
Posner’s observation cites not only the risk of correlation—for example, the
failure of one broker-dealer such as Bear Stearns or Lehman Brothers would
have posed little risk to the economy if every other financial firm had not also
been in perilous condition and thus unable to absorb the loss—but also the
fact that VaR is calculated only by firms with regard to their own specific risk,
not to the systemic risk for the whole economy.
On a more practical level, managers have been criticized for using risk
management tools, including VaR, as justifications for taking even greater
risks in a search for maximum returns without fully understanding the extent
of these risks. Although risk management may provide a plausible cover
for taking extreme risks, prudent managers may use it to draw different
conclusions. Measures and models are only as good as their interpretation
and application. As one writer observes, “Not taking risks one doesn’t understand is often the best form of risk management.”40 The story is told about
how Goldman Sachs bankers decided to rein in their risks after they sought
to discover the cause of declining results from their profit and loss models,
which were still satisfactory but worrisome.41 By drawing a different conclusion than their competitors might have, Goldman Sachs avoided significant
losses. Furthermore, recent indicators before a crisis are generally benign,
even promising, and, as John Cassidy observes, that may be the time to get
worried.42
Ethics in Financial Management
243
The development of risk management, especially by means of sophisticated
mathematical measures and models, is not only a remarkable intellectual
achievement but also a decided practical benefit. However, like all important
innovations, risk management comes with significant ethical challenges that
must be addressed, by both practitioners and regulators. Some failures must
be expected but not ignored.
Ethics of Bankruptcy
Bankruptcy occurs when individuals and corporations that have insufficient
assets to pay their debt obligations are subject to laws that provide some protection from creditors. Personal bankruptcy absolves individuals of many
debts and enables them to secure a “fresh start.” For businesses, bankruptcy
provides temporary relief from the obligation to pay debts while they seek to
reorganize, or else it produces an orderly liquidation of assets in which, ideally,
all creditors are treated fairly, if not made whole.
Bankruptcy of an individual or a firm is commonly thought to constitute
a failure. The only ethical issues, in the minds of many people, are the broken
promises to pay debts and the faulty character involved in accumulating upayable debts. Prior to 1893—the year in which the United States enacted the
first federal bankruptcy code—individual debtors could lose all their worldly
goods and even be sent to prison, and insolvent firms were quickly liquidated
by creditors in a mad scramble for salvageable assets. This harsh treatment
was generally regarded as just punishment for the bankrupt’s profligacy, and
an injustice was thought to occur only when creditors were not made whole.
In finance, by contrast, bankruptcy is typically regarded as a natural event
in an impersonal and unforgiving marketplace. Firms that cannot compete
are eventually forced out of existence. Nothing of value in the economy is lost
as long as the assets of the bankrupt firm are redeployed by others. Individual
creditors may lose money, but that is part of the risk of doing business, for
which there is some offsetting reward. No moral opprobrium is attached to
bankruptcy. In fact, bankruptcies should be welcomed, because this ruthless
Darwinian struggle for survival strengthens the economy. The only moral
consideration in this financial view of bankruptcy is the rightful settling of
claims, which is largely a matter of enforcing, to whatever extent is possible,
the commitments made by a firm before it became insolvent. This rightful
setting of claims should also be accomplished with a view to efficiency.
Thus, the reorganization or liquidation of firms should be done not only fairly
but also at the lowest cost and in a way that puts assets to their most productive use.
244 Ethics in Financial Management
In contrast to both the common view of bankruptcy as a moral failing
and the nonjudgmental view in finance, bankruptcy raises many difficult and
important ethical issues. These issues arise primarily from the use—or some
would say, the abuse—of bankruptcy protection.43 In recent years, solvent
firms have filed for bankruptcy for many reasons: to defer or avoid payments,
renege on contracts, stop litigation, evade legal liability, break unions, and get
rid of pension plans. Instead of being a last resort in a fight for survival, bankruptcy has become, in the view of its critics, just another management strategy
for maximizing profits.44 In the book Strategic Bankruptcy: How Corporations
and Creditors Use Chapter 11 to Their Advantage, Kevin L. Delaney coins the
term “strategic bankruptcy” and argues that bankruptcy is often a choice that
companies make to achieve strategic ends.45
The discussion of bankruptcy that follows is concerned with the ethical
justification of the bankruptcy system and, in particular, with what might
constitute an ethically objectionable abuse of the bankruptcy process in cases
of strategic bankruptcy. The ethical questions are concerned, at bottom, with
the legal framework of the bankruptcy system, and as such they must be
answered primarily by the drafting of bankruptcy legislation. However, the
decisions of managers to engage in strategic bankruptcy can be criticized from
a moral point of view. Indeed, moral concern about these abuses and other
unfair treatments in bankruptcy proceedings has prompted heated debate and
calls for reform.
Ethical basis of bankruptcy
The use of bankruptcy as a management strategy has been facilitated by a
system that enables, indeed encourages, distressed or insolvent firms to reorganize instead of liquidating. The 1893 US Bankruptcy Act required firms
filing for bankruptcy to liquidate, and it was not until 1938, during the Great
Depression, that a law was enacted to protect insolvent firms from their creditors and permit reorganization. A major overhaul of the Federal Bankruptcy
Code in 1978 (with further revisions in 1994) restructured the 1893 Act and
created Chapter 11, under which corporate bankruptcy petitions are now filed.
The 1978 Act eased the conditions for declaring bankruptcy (a company need
not be insolvent, but must demonstrate merely that it faces insolvency without
protection from creditors), and the Code removed the stigma from bankruptcy by eliminating pejorative terms (bankrupts are now called debtors, for
example).
Once a firm files for bankruptcy under Chapter 11, creditors are prevented
from enforcing their claims. The managers of the firm are left in control
(unless a court finds dishonesty, mismanagement, or incompetence), and
Ethics in Financial Management
245
they are allowed a period of time (initially 120 days, with extensions possible)
to develop a reorganization plan. A plan generally reduces the claims of
creditors and specifies how these reduced claims will be met. The plan offered
by management must be accepted by most of the creditors whose claims
are reduced. The plan must be approved by the shareholders as well.46 In the
event that no management plan is accepted within the time allowed, creditors
are permitted to submit their own plans, subject to the same rules for
acceptance.
The financial argument for this system of bankruptcy is that it maximizes
a firm’s assets.47 The underlying assumption is that insolvency often results
from uncontrollable outside forces or from innocent management mistakes.
If insolvent but financially viable firms are given the opportunity to reorganize, then they can return to profitability and repay their creditors. Such an
outcome is preferable, from a financial point of view, if reorganization instead
of liquidation leads to more productive deployment of a firm’s assets. This is
often the case, because assets generally have greater value when they continue
to be held by an ongoing entity than when they are broken up and sold off
piecemeal. However, a bankrupt firm cannot be operated as an ongoing entity
if diverse creditors are allowed to press their conflicting claims. The solution,
which is provided by bankruptcy law, is to force creditors to act collectively
and to create incentives for them to make wealth-maximizing decisions.48 In
short, bankruptcy law forces creditors, who have control during the bankruptcy process, to act like a group of shareholders with responsibility for
enhancing the total value of a firm instead of acting as individual claimants
who are concerned only with getting their due.
The ethical argument follows directly from the financial argument.
Called the “creditors’ bargain,” this argument employs a hypothetical contract
approach and asks what bankruptcy system would all creditors agree to in
advance of any bankruptcy proceedings.49 That is, suppose that creditors, both
secured and unsecured, could write the Bankruptcy Code. What provisions
would the law contain? The answer, it is assumed, is that creditors would favor
a system that maximizes a firm’s assets and hence its ability to repay all creditors, either through liquidation or reorganization. Although individual creditors, especially those with secured claims, might collect more of what they
are owed in particular cases by liquidation, the cost and uncertainty of these
alternatives make them less attractive as a universal system, when, in other
cases, the same creditor may have unsecured claims. In addition, liquidation
eliminates jobs and has an impact on customers, suppliers, communities, and
other stakeholder groups. Thus, easy access to bankruptcy protection not only
deploys assets more productively—which benefits creditors—but also enhances
the welfare of society.
246 Ethics in Financial Management
Use and abuse of bankruptcy
Easy access to bankruptcy protection has resulted in a number of controversial
uses of the law that were not envisioned by Congress in creating the modern
bankruptcy system. Consider the following.
Product liability suits
In August 1982, Manville Corporation, a Fortune 500 company with annual
earnings of $60 million and a net worth in excess of $1 billion, declared bankruptcy. Manville’s business was healthy, but many users of its main product,
asbestos, were not, and the sick and dying were threatening to bury Manville
in a flurry of lawsuits. Manville had already settled 3500 suits at a cost of $50
million, 16 500 were still pending, and new suits were being filed as the rate
of 500 per month. In the bankruptcy petition, the company claimed that future
suits against the company would eventually total between $2 billion and $5
billion dollars. In 1985, A.H. Robins filed for bankruptcy protection after
agreeing to settle the claims of women who suffered injuries from the Dalkon
Shield intrauterine birth-control device, and Dow Corning Corporation
sought bankruptcy protection in 1995 in the face of heavy liability from suits
over silicone breast implants that women blamed for a variety of disorders.
Collective bargaining agreements
In 1983, two solvent companies, Wilson Foods and Continental Airlines, filed
for bankruptcy protection on the grounds that generous labor contracts placed
the companies at a competitive disadvantage that might eventually make them
insolvent. Bankruptcy enabled each company to void collective bargaining
agreements currently in force and to slash wages virtually in half. Continental
also laid off about 65 percent of its workforce and resumed operation as a
low-fare, nonunion carrier. Wilson Foods and Continental were following in
the footsteps of Bildisco, a New Jersey building supply firm, which successfully
broke a labor contract with the Teamsters Union by filing for bankruptcy.
In the 1984 Bildisco decision, the US Supreme Court held that collectivebargaining agreements are no different from any other contracts and can be
unilaterally rewritten or terminated if the long-term solvency of the firm is at
stake.50 Congress has since revised the Bankruptcy Code to limit the ability of
companies to act in this manner.51
Liabilities and obligations
Bankruptcy has enabled many companies to reduce or avoid substantial liabilities and contractual obligations. LTV Steel used Chapter 11 in an attempt
to dump $2.3 billion in underfunded pension liabilities onto the federal
Ethics in Financial Management
247
Pension Benefit Guaranty Corporation, and in the ensuing court fight, thousands of retirees found their pension benefits jeopardized. Texaco was ordered
by a court to pay Pennzoil damages of $10.5 billion for “stealing” Getty Oil
during merger negotiations between Pennzoil and Getty. Despite $35 billion
in assets, Texaco declared bankruptcy and managed to reduce the payment
for damages to $3 billion. The 1983 bankruptcy of HRT Industries, the operator of a chain of discount stores, achieved several ends.52 Despite holding net
assets of $50 million, the company declared bankruptcy because of a “very
recent” cash-flow problem after receiving the bulk of its merchandise for the
Christmas season. Afterwards, HRT closed more than thirty unprofitable
stores. The company’s short sojourn in Chapter 11 thus enabled HRT to get
an interest-free loan on all of its debt and to terminate a number of onerous
long-term leases.
What is wrong with strategic bankruptcy?
The charge that companies such as Manville, Dow Corning, Continental, LTV,
and Texaco are abusing the bankruptcy system suggests some moral wrong,
but it is difficult to identify that wrong precisely. One charge is that these
companies are using the bankruptcy law for purposes other than that for
which it was enacted. However, to use a law for an unintended end is not itself
morally objectionable. Once a law is on the books, its use is limited solely by
the wording of the law, not by the intent of the legislature in passing it. (For
example, the use of SEC Rule 10b-5 to prosecute insider trading represents a
novel application of law beyond its original scope.)
A second charge is that bankruptcy is being used in these instances to avoid
ethical and legal obligations that result from contractual agreements or court
judgments. However, bankruptcy law is designed, in part, to enable a firm to
fulfill its obligations to the maximum extent possible, consistent with fairness
and efficiency, when the firm is unable to fulfill these obligations fully. That
is, Congress, in creating the bankruptcy system, has already taken into account
the fact that a firm seeking bankruptcy protection will be avoiding some
ethical and legal obligations, and Congress has determined that, all things
considered, it is better to permit a firm to fulfill its obligations only in part
and to continue as an ongoing entity than to require an immediate liquidation
in which creditors will still not be made whole.
Furthermore, by seeking bankruptcy protection, firms do not avoid
their obligations entirely but negotiate the terms under which they will be
filled, and in the end, the claimants are often well served. When Manville
emerged from bankruptcy in 1986, the majority of stock was transferred to
two trusts, one to pay claims for health-related injuries and the second to pay
248 Ethics in Financial Management
for property damages. The victims of Manville thus became the owners,
and the ability of these new owners to be compensated depends on the
continued profitability of the company. Similarly, LTV emerged from bankruptcy after seven years of protracted negotiations with the Pension Benefit
Guaranty Corporation and other creditors by agreeing to contribute $1.6
billion to the company’s underfunded pension plans. The success of asbestos
victims and pensioners in securing their claims did not come easily. They had
to fight for their rights, but in the end, these claimants gained more than they
might have done without the opportunity for the company to seek bankruptcy
protection.
A third and more promising objection to the conduct of Manville, Dow
Corning, Continental, LTV, Texaco, and other companies that seek bankruptcy protection is not that claimants do not receive what they are owed but
that claimants who receive their claims under one set of rules are forced to
fight for them again under another set of rules. Victims of defective products
who succeed in court suits for tort damages must now win their case all over
again in bankruptcy proceedings. Workers who negotiate a labor contract in
good faith can find themselves back at the bargaining table, this time before
a bankruptcy judge. Texaco, which was ordered by a judge in a jury trial to
pay Pennzoil $10.5 billion, gained another opportunity to dispute the case in
an entirely different setting. Thus, bankruptcy provides a company with
onerous obligations the opportunity to renegotiate or relitigate them under a
different set of rules.
However, this charge—that bankruptcy provides a second chance under
different rules—carries no weight if companies are genuinely insolvent. No
claimant can seize assets that are not there, and every claim includes provisions for default. Thus, a creditor must expect to go to court if a debtor cannot
or will not pay and commercial law provides the means for resolving such
disputes. The critical question is whether a company that seeks bankruptcy
protection, and thereby changes the rules on claimants, is actually insolvent
or would face insolvency without the protection of bankruptcy law. If an otherwise healthy company with heavy liabilities is able to use bankruptcy law to
force creditors to renegotiate or relitigate their claims under different conditions, then arguably the system has been abused.
Critics of the bankruptcy system argue that bankruptcy is not always a
condition that afflicts companies but is sometimes a deliberate choice that
companies make for strategic ends.53 Virtually any company could make itself
“bankrupt” by amassing unpayable debts, but, short of that step, a company
with massive liabilities can easily arrange the balance sheets, shift assets, or
even induce a crisis event so as to become insolvent. A company is held to be
insolvent when its liabilities exceed its assets, as though liabilities and assets
Ethics in Financial Management
249
were objective, precisely measurable quantities. Not only do assets and liabilities reflect decisions made by a company, but the valuation of assets and liabilities is subject to manipulation. As a result, the bottom line is not a hard
fact that everyone can observe in the same way but an artificial construct
that is created by a firm’s managers—within accepted accounting principles,
of course.
For example, one critic contends that Manville chose not to include its
liabilities for asbestos-related injuries on the company books prior to filing for
bankruptcy.54 Before 1982 the company claimed that it was not legally required
to do so because the liabilities could not be accurately estimated. When Manville decided to “go bankrupt” in 1982, $2 billion in liabilities suddenly
appeared on the company’s balance sheet. Both Continental and Texaco carefully defined the part of the company that was declared to be the “bankrupt
unit,” and Continental, according to some observers, provoked a union strike
rather than negotiate, in order to qualify for bankruptcy. Bankrupt Dow
Corning is owned 50–50 by (solvent) Dow Chemical and (solvent) Corning
Incorporated. Complex ownership structures permit movement of assets from
one unit to another prior to filing a bankruptcy petition.55
Such strategic use of bankruptcy strikes us as unfair because the accepted
rules for conducting business are suddenly changed. Strategic bankruptcy
might be compared to a game of poker in which a dealer with bad cards is
allowed to stop the game, rearrange some of the hands, perhaps take some
money off the table, and resume play with different rules. However, the poker
game just described is not unfair if the dealer’s options are understood at the
beginning of play. Under such conditions, the game is merely one of many
possible forms of poker, albeit with rather complicated rules, and players can
play their hands with the possibility of a rule change in mind. Similarly, a
bankruptcy system that permits companies to seek bankruptcy protection for
strategic reasons is not unfair merely because of the possibility of a change in
the rules. The first few strategic bankruptcies might be considered unfair
because the affected parties, such as the asbestos victims of Manville and the
employees of Continental, had not anticipated this use of the Bankruptcy
Code. After these well-publicized events, however, creditors and other groups
should be aware of this possibility and play their hands accordingly.
Fairness and efficiency of Chapter 11
In order to understand what is really wrong with a bankruptcy system that
permits bankruptcy as a strategic choice, we need to look at the impact of this
system on the functioning of a business system in which considerations of
both fairness and efficiency play a role.
250 Ethics in Financial Management
One argument for the current Chapter 11 is that it is the bankruptcy system
that would be selected by creditors themselves if they were to choose a system
in advance of any bankruptcy filing. According to this argument, which is
called the creditors’ bargain, a bankruptcy system that permits reorganization
rather than forced liquidation is preferable because it will maximize a firm’s
assets through an orderly adjudication of creditors’ claims. However, the creditors’ bargain argument does not provide clear answers to more specific questions. In particular, strategic bankruptcy is greatly facilitated by the 1978
revision of the Bankruptcy Code that gives distressed companies easier access
to bankruptcy protection. If creditors could write the law on bankruptcy, what
conditions would they include for filing for bankruptcy protection? In particular, how easy would they allow the filing for bankruptcy to be?
The answers to these questions are disputable, but some evidence suggests
that creditors, as well as shareholders, have suffered losses from the 1978 revision of the Bankruptcy Code and that the winners are the managers of firms
and the legion of lawyers, accountants, and financial advisers who assist them.
Two researchers who studied 326 firms that filed bankruptcy petitions between
1964 and 1989 found that losses suffered by bondholders after 1978 were 67
percent greater than the losses suffered before the 1978 revision.56 Shareholders have fared even worse. Before 1978, shareholders of bankrupt firms lost
on average slightly more than one-half of the value of their investments,
and after 1978, the losses were almost 100 percent. The researchers concluded: “Chapter 11, in other words, may be seen as a kind of management
defensive tactic against corporate debtholders, which, like certain antitakeover defensive measures, enhances management’s wealth at the expense
of corporate security holders.”57 If this result is correct, the current system of
bankruptcy law would not be much of a bargain for creditors and would not
be justified, therefore, by the creditors’ bargain argument.
If the purpose of the Bankruptcy Code is debt collection—that is, enforcing
the rights of creditors before a firm becomes insolvent—then there is no justification for creating any new rights unless doing so enforces creditors’ preexisting rights.58 Chapter 11 creates some new rights for managers. They are
permitted under current law to control the process of filing the bankruptcy
petition, to remain in their positions during the bankruptcy process, and to
develop the first reorganization plan. The rationale for these rights is the
assumption that creditors will be better served, but this assumption is not
always well founded.
For example, bankruptcy protection allows managers to “play games” at the
creditors’ expense. Both shareholders and managers have little to lose from
continued operation of a troubled firm and might prefer a long-shot, “bet-thefarm” strategy, which would leave creditors with little should the strategy fail.
Ethics in Financial Management
251
(This is an instance of the well-known problem of moral hazard.) Furthermore, if bankruptcy is an acceptable risk, firms may be encouraged to court
bankruptcy, even when they are not in distress, by pursuing exceptionally
risky strategies. This is especially true when shareholders stand to gain the benefit while bondholders and other creditors assume the risk (again, the moral
hazard problem). Thus, bankruptcy law, which is intended to protect creditors
of distressed firms, may have the unintended effect of generating greater risktaking that further endangers creditors.59
Easy access to bankruptcy protection has far-reaching and unpredictable
implications for rights in market transactions and some areas of law. The effect
is to complicate ordinary commercial relations and alter such diverse matters
as labor relations and product safety.
One principle of market ethics is that investors and those who extend credit
should have sufficient information to make reasonable decisions about risk
and return. Thus, suppliers should have some information about the creditworthiness of a retailer who is seeking merchandise on credit in order to
negotiate terms. If the risk of extending credit to a retailer like HRT Industries
includes the possibility of a bankruptcy filing for strategic reasons, then reasonable estimates of risk become more difficult to make. Further, the sources
of risk are expanded from ordinary market conditions (such as the fact the
HRT had a number of unprofitable stores) to include a firm’s strategy (for
example, to seek bankruptcy protection in order to close unprofitable stores).
In addition, if HRT was planning to file a bankruptcy petition at the same
time that it was seeking credit, then, arguably, this is material information that
ought to be disclosed to creditors, since concealment might constitute fraud.60
In any event, easy access to bankruptcy protection complicates such a fundamental matter as the extending of credit in ways that might be better avoided.
Both labor law and product liability law are premised on certain rights:
namely, the right of workers to organize and bargain collectively and the right
of people who are injured by defective products to be compensated. The law
in these areas is carefully constructed to balance the various competing rights
and interests. Insofar as strategic bankruptcy enables firms to renege on labor
contracts or avoid product-liability awards, then important rights may be
denied, and the carefully constructed balance may be upset. At a minimum,
union members and victims of defective products have lost ground as a result
of bankruptcy reform because of the greater risk in collective-bargaining
agreements and product-liability judgments.
In addition, liberal access to bankruptcy protection might encourage business firms and labor unions to bargain differently if they believe that worker
contracts could be easily broken, or it might encourage manufacturers to
design and produce less safe products if it were the case that liability suits
252 Ethics in Financial Management
could be easily evaded. Easy access to bankruptcy also has an impact on strategic planning. Some companies, such as airlines, may operate for years with
bankruptcy protection. As a result, their nonbankrupt competitors, which
must meet all of their current obligations, complain that they are placed at an
unfair competitive disadvantage.61 Even the knowledge that a major competitor could engage in strategic bankruptcy at any time is an unsettling factor in
a company’s own strategic planning.
In conclusion, the American bankruptcy system is ethically justified, in its
broad outlines, on the grounds of both efficiency and fairness. The creditors’
bargain assumes that because the system serves to maximize the assets of an
insolvent firm—which is a consideration of efficiency—creditors would prefer
such a system. Hence, the current bankruptcy system is also fair since it is
based theoretically on the consent of all affected parties. At bottom, the charge
that strategic bankruptcies are morally wrong rests on the view that one or
another corporate constituency is being treated unfairly, and it may be argued
that easy access to bankruptcy protection encourages forms of strategic bankruptcy that certainly complicate business decision making and may impact
the rights of some constituencies, most notably employees and consumers.
However, an evaluation of this argument depends on a complex analysis
of the actual consequences of strategic bankruptcies, which are not clearly
known.
Personal bankruptcy
The standard justification for personal bankruptcy, which allows individuals
to discharge many of their debts and have a “fresh start,” is based on the twin
considerations of welfare and justice.
At one time, when individuals were unable to pay their debts, they were
cast into prison. Even without the threat of imprisonment, people with heavy
debts might spend a lifetime of economic struggle, with consequences not
only for themselves and their families but also for the whole of society. The
loss of productivity from heavy debt loads alone would make an unforgiving
system inefficient. Moreover, the greater caution that people would exercise—
for example, in starting a business—would further impede productivity.
Indeed, many successful entrepreneurs have endured personal bankruptcy
from prior failures and would not have been able to continue without lenient
legal protection.
Everyone, debtors and creditors alike, are better off in a society that allows
personal bankruptcy, because even creditors might find themselves with debts
they cannot pay. Although there is an obligation to pay one’s debts, the benefit
of fulfilling this obligation may be outweighed by the loss that results for both
Ethics in Financial Management
253
individuals and society when people are unable to live full, productive lives.
Thus, everyone in society is better off and would choose to live under a more
forgiving system that allows some erasure of debt obligations. In addition, it
is unfair for people to suffer crushing debt loads that are caused, in many cases,
by adversities beyond their control. The idea of bankruptcy as a personal
failing is not always correct.
However, a lenient system of personal bankruptcy creates opportunities for
abuse. Easy access to bankruptcy protection with little stigma or inconvenience might lead individuals to be less restrained in incurring debts. When
facing bankruptcy, individuals might incur all the debt they can, knowing that
it will soon be discharged, and seek to shield other assets from creditors by
improper means. (For example, prior to personal bankruptcy, a person might
transfer property to a relative, although such a move can be challenged as a
form of fraudulent conveyance.) In the United States, creditors, most notably
bank lenders and credit card issuers, whom critics accuse of enticing customers into unmanageable debt loads, have protested these abuses and sought
changes in the law to prevent them. The prevention of abuse is of concern not
only to creditors, such as bank lenders and credit card issuers, but also to
consumers, for whom access to credit and the cost of credit is affected by the
personal bankruptcy system.
The main issues in the debate over personal bankruptcy are: (1) Should
individuals above a certain income level be required to repay a certain portion
of their debts instead of having them discharged completely? (2) Should some
critical assets (such as a home or pension savings) be shielded from creditors
during bankruptcy proceedings? (3) Should certain debts be nondischargable,
such as those incurred from luxury goods or large cash advances obtained just
prior to seeking bankruptcy protection?
In 2005, the US Congress passed and the president signed a sweeping
overhaul of the Bankruptcy Code for individuals. The new law, long sought
by the banking industry, utilizes a means test to limit access to a complete
discharge of debts under Chapter 7 and forces more applicants to develop a
five-year partial repayment plan under Chapter 13. In most cases, a debtor
with income above the state median income may not file under Chapter 7.
Other provisions of the new law include mandatory credit counseling and
debtor education and limits on the amount of debt that can be discharged
for purchases of luxury goods (over $500 within 90 days of filing) and cash
advances ($750 within 70 days). In general, pension funds are exempt, as are
assets in a home within limits set by state laws.
Opponents of the more stringent 2005 personal bankruptcy law argue
that abuse is committed by only a small portion of those seeking protection
and that the vast majority of personal bankruptcies are caused by job loss,
254 Ethics in Financial Management
disability, divorce, medical bills, and business failure.62 For such people, a
“fresh start” will often enable them to resume successful lives, whereas requirements to pay off a portion of their debts will mire them in a cycle of indebtedness. Opponents also claim that bankruptcy due to the failure of a business is
more common than is generally recognized and that more stringent laws will
strongly deter individuals from starting new businesses, thus damaging a vital
engine of economic growth.
Supporters of the 2005 law argue, by contrast, that there is a genuine personal bankruptcy “crisis” that needs to be addressed.63 The standard view that
personal bankruptcy is caused mainly by financial distress cannot account for
the rapid rise since 1978 (the date of the previous change in the Bankruptcy
Code) in the number of personal bankruptcies. In addition to financial distress, American consumers have shown an increasing propensity to avail
themselves of personal bankruptcy protection due to decreases in the social
stigma and the economic costs of bankruptcy. As a result, personal bankruptcy
may be merely a rational consumer choice that should be restricted.
Corporate Governance
In its broadest sense, corporate governance includes all the factors that determine how decisions are made in business organizations that are organized
as corporations. The shareholders of publicly held corporations and the directors whom they elect are commonly recognized as having de jure control, but
these shareholders and directors, as well as the managers, who typically exercise de facto control, are subject to the power of many groups which, acting
within their legal rights, strongly influence, and often determine, corporate
decisions.
Most notable among these groups that affect corporate decisions are governments at all levels, which have the legal power to regulate and tax; auditors
and accounting standard setters; securities exchanges, which set rules for the
listing of stocks and other instruments; rating agencies, which rate a company’s securities; banks, which provide funding and exercise close monitoring;
the media, which inform the public of a company’s activities; and all the
markets in which corporations operate—capital markets, labor markets, commodity markets, and consumer markets. In addition, many decisions in business firms are made by employees at all levels as part of their role responsibilities.
These diverse groups provide a multitude of forces that bear on corporate
decision making.
Viewed in this broad sense, corporate decision making is very highly dispersed among many groups, and the ordinarily recognized corporate govern-
Ethics in Financial Management
255
ance actors, namely shareholders, directors, and senior executives or officers,
make comparatively few decisions. However, these decisions are among the
most important ones, and it is these major decisions which are identified with
the ultimate control of business organizations that is the subject of what is
generally considered corporate governance. Corporate governance in this
more common, narrower sense of the term is the set of legal rules which
specify the parties having the right to make the most important decisions that
constitute corporate control, as well as the legal rules which specify the processes and procedures by which these parties exercise this decision-making
power or control.
However, the assignment of control rights, as well as the processes and
procedures for exercising these rights, is of little importance in a corporation
that is owned and managed by a single individual or a small group—which is
to say a corporation without a separation of ownership and control. The legal
rules which comprise corporate governance become critical mainly when
there are a large number of diverse shareholders and a separation of ownership
and control. Under such conditions, conflicts over control arise among the
different parties, and legal rules become necessary to protect the rights and
interests of each group and ensure that decisions serve the proper corporate
objective.
Case for shareholder primacy
In a capitalist economy, large business organizations or firms are legally structured most often as publicly held for-profit corporations. Businesses may also
be organized as sole proprietorships, partnerships, closed corporations, and
the like, and many organizations are not-for-profit. Although these other
forms of organization are subject to governance rules, they do not commonly
involve the significant conflicts over control that characterize publicly
held corporations, and, consequently, they raise few concerns about their
governance.
In a publicly held corporation, the group with control is the shareholders,
which, because this group has control, leads to the maximization of shareholder wealth as the objective of the firm. The main moral question about
corporate governance, then, is why shareholders, morally, ought to have
control and why, morally, their interests ought to be the objective of the firm.
This right of control with its corresponding role for shareholders in a firm’s
objective is often expressed as the doctrine of shareholder primacy. So the main
moral question about corporate governance is the justification of shareholder
primacy. The answers to further questions about the processes and procedures
of corporate governance—for example, the specific rights of shareholders in
256 Ethics in Financial Management
exercising control and the fiduciary duty of officers and directors—follow
largely from the justification of the shareholder primacy doctrine.
In addition to the right to control, shareholders possess another defining
right, namely a claim on the residual revenues or profits of a corporation.
Many groups have a claim on a corporation’s revenues. These include bondholders, who have claims for interest and principal payments; employees, who
have claims on revenues for payment of wages; suppliers, who have claims for
the payment of materials; government, which has a claim for payment of taxes;
and so on. Most of the income that a corporation generates from customers
and other sources is paid out to a variety of groups that have fixed claims on
a firm’s revenue. Fixed claims are debts that a corporation is legally obligated
to satisfy as long as the firm is solvent. A firm that cannot satisfy all fixed
claims or debts is, by definition, insolvent. Whatever income remains after all
fixed claims are satisfied—that is, all bills are paid—constitutes residual
revenue, and the shareholders’ right to residual revenue constitutes residual
claims.
Every claim on a corporation’s revenues is a return for some resource that
is contributed for production. Employees contribute labor, suppliers contribute materials, and bondholders contribute debt capital. (Customers do not
contribute to production, but they provide the necessary element of revenue
when they purchase a product.) Therefore shareholders, who typically finance
a corporation with equity capital—as opposed to the debt capital provided by
bondholders—contribute a necessary and distinctive resource and accept, in
return, the residual revenues or profits of the firm. Shareholders may be
defined, then, as the group that has both the right of control and a claim on
profits.
The justification of shareholder primacy has two sources, which reach the
same conclusion by different routes. One source is public policy, which asks,
in this case, what form of governance best serves the good of society, and the
other source is the market, which reveals the form of governance that would
result from voluntary market transactions. More specifically, corporations
must contract with shareholders for the provision of equity capital. Given that
there is a market for raising such capital, what terms would corporations and
investors find mutually agreeable, consistent with all the other contracts that
a corporation must form? Markets serve as a means for the exercise and
protection of property rights, and so any system of corporate governance that
emerges from markets is a reflection of this important moral concern.
The first of these two sources, namely public policy, reflects the fact that
corporate governance is established in law by government through legislation,
regulation, and adjudication, and that public policy is a major factor guiding
these processes. Public policy is also reflected in public attitudes toward busi-
Ethics in Financial Management
257
ness generally and in each company’s reputation. In creating the body of law
for corporate governance, one of government’s main concerns is to ensure that
business organizations serve the public good, although government action
may also aim to protect property rights, thus leading to the market as the
second source of justification.
Insofar as corporations result from private contracting among individuals
in the exercise of their property rights, then the contracting that forms a corporation may include the assignment of decision-making rights. In this way,
the rules of corporate governance result from individual’s market transactions.
Corporate law, especially in Anglo-American countries, permits business
firms great latitude in choosing the terms of their legal incorporation. In the
United States, where corporate law is a function of individual states, firms may
choose to incorporate in the state with the most advantageous system. Consequently, in Anglo-American countries, the market is a major factor in determining the forms of corporate governance. The law in Europe and Asia allows
less discretion in choosing the terms of corporate governance and is based
more on considerations of public policy.
Public policy
Traditionally, the law on corporate governance has been guided by two conceptions of the corporation: one conception as the private property of the
owners of the enterprise and the other as a right granted or conceded by
the state. (These two conceptions are discussed in Chapter 2.) However, the
idea that shareholders are the owners of the modern publicly held corporations whose claims are based on property rights ended with the separation of
ownership and control that was observed by Adolf A. Berle Jr and Gardiner
C. Means in their famous 1932 book The Modern Corporation and Private
Property.64 There they argued that with the separation of ownership and
control, shareholders, who have ceased to exercise the responsibility associated with property rights, had forfeited their claim to control based traditionally on ownership.
Without property rights as a basis for shareholder primacy, what else could
justify the claim that shareholders ought to have control of a corporation?
Berle argued that without strong shareholder control, corporate management
would be effectively unconstrained and that such power would be dangerous
to the economic order.65 It would be unwise, in Berle’s judgment, for the law
to release managers from a strict accountability to shareholders, not out of
respect for their property rights (for they have none) but as a matter of sound
public policy. In short, shareholder primacy is justified, in Berle’s view, as a
matter of public policy, to constrain and guide management. However, the
258 Ethics in Financial Management
contractual theory of the firm offers a more powerful public policy justification, for the shareholders’ role in corporate governance can be constructed by
determining which group can operate a firm most efficiently for maximum
value or wealth creation.
Efficiency is both an economic and a moral value because operating a business organization efficiently—which means producing the greatest amount of
output for the least input—creates greater prosperity or material well-being
than operating inefficiently. Other things being equal, we should prefer more
rather than fewer material goods from any given resources, and corporations
ought to be governed so as to achieve this end. Therefore, if one group can
exercise ultimate decision-making power with greater efficiency and wealth
creation than any other group, then, on the basis of public policy, that group
ought to have control. Although this group receives some benefit from having
control, its members provide a service that makes everyone in society better
off.
This public policy justification of shareholder primacy is completed by
arguing that, under most conditions, the financiers of a corporation—which
is to say the investors of equity capital—can exercise control in such a way as
to achieve the greatest efficiency and hence create the greatest value or wealth
creation. Under some conditions this can be done best by employees or
by customers or suppliers, and, as a result, some firms are employee-owned,
customer-owned, or supplier-owned. (These latter are called cooperatives, and
Henry Hansmann has suggested that the shareholder-owned firm can be
viewed as a “capital cooperative.”66) However, corporations are more commonly controlled by financiers or investors, and justifiably so.
The main reason for this greater efficiency and wealth-creating power stems
from the shareholders’ role as residual risk bearers. Given that the shareholders’ return on their contribution to production, namely equity capital, is a
claim on residual revenues, only they have an incentive that a firm be maximally profitable as opposed to merely solvent. Any group with fixed claims,
such as employees, customers, or suppliers, has an interest only in a firm being
solvent and thus able to satisfy this group’s fixed claims.
If employees, for instance, had control with only fixed claims for wages,
they would tend to operate the firm with a low level of risk so as to assure
their wages, even though greater risk might lead to greater wealth creation.
Because the greater wealth creation would accrue disproportionately to other
groups, especially shareholders in the form of profits, employees would be
disinclined to take the risks that may be socially desirable. Similarly, bondholders would prefer that a firm be operated at a low level of risk to avoid
jeopardizing their fixed claims for principal and interest payments, since they,
like employees, would derive little benefit from maximal wealth creation.
Ethics in Financial Management
259
Executives, too, would be suboptimally risk averse unless they were given
incentives tied to profits, which is the rationale for compensating executives
with performance-based bonuses and stock options.
From the point of view of public policy, decisions in a business organization
ought to be made by the party or group with two features: the greatest amount
of relevant knowledge and the strongest incentives to operate the firm for
maximum efficiency or wealth creation. Although shareholders lack much of
the knowledge necessary to operate a firm and, consequently, must rely on
more knowledgeable directors to exercise general oversight and competent
managers to exercise day-to-day control, they alone have the right incentives
to operate a firm for maximum profitability.
Moreover, the decisions that shareholders make about selecting a board of
directors and approving major structural changes, such as mergers and acquisitions, are matters about which shareholders are or can become knowledgeable. Perhaps the most important decisions that shareholders make are to buy
and sell stock, thereby setting a price for a company’s shares that constitute
an up-to-the-minute evaluation of a company’s performance and prospects.
In practice, shareholders make very few decisions, but their central role in
corporate governance derives from the knowledge and, more importantly,
the incentives they have in making some of the most critical decisions in the
operation of a corporation.
The market
In their role as financiers or investors, shareholders provide one resource
needed by a business organization, namely capital. In return, they receive a
payment or claim on revenues, specifically the residual revenues or profits
of the firm. In this respect, shareholders are little different from other input
providers, which include bondholders, employees, suppliers, and so on. They
provide some resource and receive a payment in return. All these groups
contract with a firm, so that the firm itself may be viewed as a nexus of all the
contracts so formed. Insofar as the return for the provision of any input is
insecure, a contract is necessary to safeguard the return. On this nexus-ofcontracts view, a firm “buys” capital in the same way it buys labor or materials,
and such a purchase is an economic transaction that takes place in a market,
namely a capital market, in the same way that a firm buys labor in a labor
market and materials in a commodities market.
The shareholder contract
Corporate governance may be understood as the contract that a firm forms
with its shareholders, who finance the firm by providing equity capital. The
260 Ethics in Financial Management
terms of this contract are determined, in large part, in a market through a
process of negotiation by firms seeking capital and investors seeking to deploy
their savings, with each party bargaining to obtain the best deal for itself.
From a moral point of view, any agreement or contract that is formed by
mutual consent between firms and investors is justified in the same way that
the outcome of any market exchange is justified. The crucial task in justifying
the role of shareholders in corporate governance is to understand why shareholder primacy would result from contracting between a firm and its financiers or investors. In particular, why would investors providing equity capital
not only do so in return for residual revenues or profits but also insist on
obtaining control? Or, alternatively, why would a firm seeking capital offer
control rights in addition to a claim on residual revenues?
The answer lies in the role of shareholders as residual risk bearers. Equity
capital is different from debt capital, which is obtained in loans from banks
or in bonds sold to bondholders. First, equity capital is provided for the life
of a firm with no provision for its return, unlike the fixed term of a loan or a
bond. Second, equity capital has no fixed return, such as the specified interest
on a loan or bond; the return is, rather, the profits of a firm, which are variable
and may even be negative. By accepting a return in the form of a claim on
residual revenues, shareholders become residual risk bearers.
Being a residual risk bearer is not only a benefit—the return is the profits
of a firm—but it is also a service that protects the fixed claims of other groups.
Because shareholders do not need to be paid if there are no residual revenues,
a firm can suffer a loss without becoming insolvent and incurring the risk of
being forced into bankruptcy and possibly liquidated. By serving as residual
risk bearers, shareholders thus make the fixed claims of other groups more
secure. Shareholders are compensated for this service by the prospect of
higher returns when a firm is profitable.
Solving a contracting problem
The role of residual risk bearer creates special contracting problems for shareholders. The fixed claims of other groups—of employees for wages, for example,
or suppliers for payments—are relatively easy to express in legally enforceable
contracts. By contrast, the profitability of a firm, upon which the payment to
shareholders depends, cannot be mandated in a contract. In a firm without a
separation of ownership and control—that is, in a firm in which shareholders
operate the business—there is no problem protecting the shareholders’ return.
However, once shareholders leave the task of operating a firm to professional
managers, a problem arises as to how shareholders can be assured that these
managers will operate the firm for maximum profitability.
Ethics in Financial Management
261
The solution to this problem is for shareholders to accept the role of residual risk bearer only on the condition that they also have control. The roles of
residual risk bearer and holder of control rights are conceptually distinct. In
theory, these roles could be held by different groups, and sometimes they are.
In practice, however, few investors would be willing to become residual risk
bearers without having control. Without control rights, an investor would
generally insist on significantly higher returns to compensate for the greater
risk, with the result that the cost of capital for firms would greatly increase.
Alternatively, firms can lower their capital costs by offering control rights as
well as claims on profits when they seek capital from investors. Thus, control
rights can be viewed not only as a demand of investors to secure the return
on their contribution of capital but also as an offer from firms to obtain capital
on favorable terms.
Combining risk bearing and control in the shareholders’ role is not a
complete solution to the contracting problem, however. Shareholders cannot
merely order managers to operate a firm for maximum profit, because what
managers need to do to make a firm maximally profitable is complex and
uncertain. The best shareholders can do is ask managers to exert their best
effort to be profitable. This is commonly done not only by aligning managers’
interests with those of shareholders by means of bonuses and stock options
but also by imposing a fiduciary duty on managers to act in all matters in the
shareholders’ interests.
A fiduciary duty generally is a strong, open-ended obligation to exercise
loyalty, candor, and care in the service of another party whose interests the
fiduciary is pledged to serve. The fiduciary duty of directors and officers is a
major feature of the law of corporate governance that is designed to overcome
the fact that shareholders cannot bind persons by explicit contracts that fully
specify the conduct to be performed. That the fiduciary duty of management
flows mainly to shareholders is often thought to privilege shareholders in some
way, but it should be understood that only shareholders benefit from being
the beneficiary of managers’ fiduciary duty as a solution to their distinctive
contracting problem with a firm. All other groups are better protected by, and
thus prefer, other contractual means.
Efficiency of the solution
This provides a partial explanation of why residual risk bearers would seek
control, as well as the benefit of managers’ fiduciary duty, namely to protect
their at-risk return for providing equity capital. Although assuming residual
risk and the right of control has a cost, the benefit to shareholders for incurring this cost is greater than the benefit for any other group with only fixed
claims, which can protect its claims more effectively and economically by
262 Ethics in Financial Management
other contracting means. In short, control is worth more to residual risk
bearers than any other group, and so they are willing to pay more for it.
A more complete explanation, however, is that shareholders are able to bear
the costs of residual risk bearing more economically than other groups, which
reduces the cost overall. First, shareholders as equity capital providers are
better able than employees, customers, suppliers, or other groups to diversify
their investments in a firm. One reason why employee-owned firms, for
example, are relatively rare is that an employee’s whole wealth becomes tied
up in the company, thus increasing that person’s overall level of risk. Second,
an active market for corporate control assures that if any group can operate a
firm at lower cost or with greater efficiency or wealth creation than the current
shareholders, they will do so. As in any good in a market, corporate control
will be obtained through Pareto-superior transactions by the party to whom
it is worth the most, which will be the party that can operate a corporation
for maximal wealth creation.
In sum, then, corporate governance is the contract between shareholders
and a firm that confers control rights on the shareholders, along with the
benefit of managers’ fiduciary duty, in order to protect the claim to residual
revenues that they receive as a return for providing equity capital to a firm.
Unlike the contract that other input providers form, this contract is unusually
complex due to the special contracting problems in the relationship between
shareholders and the firm. Although the terms of this contract are, to some
extent, specified by law, corporations still have great flexibility to negotiate
with investors in a market, and the law itself reflects the terms that would
result from market negotiations. Thus, the law of corporate governance is
determined both by public policy and the market and is justified on both
grounds—that it best serves society and is the result of voluntary, efficiencypromoting market transactions.
Directors and CEO
Although shareholders may have ultimate control of corporations in accord
with the shareholder model, the main locus of decision making in corporations is in director boardrooms and executive suites. Accordingly, the law of
corporate governance must focus not solely on the role of shareholders but
also on the roles and functions of directors and the chief officers, especially
the chief executive officer (CEO).
Given the scope and complexity of decision making by all the parties
involved and the potential for conflicts among them, corporate governance
must be defined more broadly than merely the contract between shareholders
and the firm to include the relationships among shareholders, directors, and
Ethics in Financial Management
263
officers or senior executives, as well as with various stakeholders. It is also in
these aspects of corporate governance that differences among national systems
are most pronounced. Although the shareholder model of corporate governance may be characteristic of all capitalist firms, they differ from country to
country mainly in the relative authority and power of the many groups
involved in corporate decision making.
Role of boards
In a typical publicly held corporation, the shareholders elect a board of
directors to effectively exercise control with a fiduciary duty on the part
of directors to act in all matters in the interests of shareholders and the corporation. (In theory, the interests of shareholders and the corporation are
identical, but they may diverge in some instances, which create difficult dilemmas for board members.) In a small company with only a few shareholders,
the board may include all shareholders, but in a large corporation with a large
number of shareholders, each with small holdings, this is impractical. Consequently, shareholders delegate the task of operating a business enterprise to
professional directors and managers, who can do the job much better than
they are able to.
The task of professional directors and managers is to operate the firm in
the way the shareholders would themselves, with only a few decisions reserved
for a shareholder vote. Since these three groups possess different information
and have different incentives, a critical question of corporate governance is
what decisions should be allotted to each one. Since the incentives of directors
and managers are never perfectly aligned with those of shareholders or with
each other, a further question is how to ensure that the decisions they make
are in the shareholders’ interest—which is to say, are maximally efficient and
hence wealth maximizing. Although the CEO and some other top officers or
insiders are commonly directors, often with the CEO as the chair (known as
CEO duality), boards also include outside or independent directors who have
no relationship with the corporation other than membership on the board.
Boards of directors and, in particular, the independent members serve five
main functions. First, they exercise control by selecting, monitoring, compensating, and, if necessary, replacing the CEO and the top management team.
Second, they approve the overall strategy and the major policies and procedures of the corporation. Third, they determine how the corporation’s activities are financed. Fourth, they evaluate major restructurings, such as mergers,
acquisitions, and divestitures. Fifth, they make recommendations on these and
other matters that are submitted for a shareholder vote.
In addition, boards of directors provide a service as decision makers with
considerable knowledge and experience who can advise the CEO and make
264 Ethics in Financial Management
independent decisions. Board members, who are often CEOs of other firms
and usually have extended networks, expand the resources available to a corporation. Among these resources may be finance (access to institutions and
markets that can provide funding), technology (access to research that may
be a source of innovation), and regulation (access to legislatures, industry
organizations, and regulatory bodies). Also, boards of directors, which include
many distinguished and trusted individuals, provide the level of confidence
that is necessary to assure all the parties that deal with a corporation. This
confidence-creating or assurance function is especially important insofar as
other groups beside shareholders make firm-specific investments that could
be exploited in the pursuit of the shareholders’ interests.
In most countries, there is a single or unitary corporate board with both
inside and outside directors. Several continental European countries, including Germany, France, Austria, and the Netherlands, have a dual board structure. This structure involves a supervisory board, comprised mostly of
outsiders, which exercises general oversight, and a managerial board of insiders, which oversees day-to-day operations. In Germany, the supervisory board
includes directors selected by shareholders and employee representatives,
whose role is part of the German system of co-determination or Mitbestimmung, in which employees have decision-making power at the shop level and
the board level. Japanese corporations have a unitary board of mostly insiders,
including representatives of other firms in a company’s circle of partners or
keiretsu.
Role of the CEO
Much of corporate governance is intended to ensure that those who effectively
exercise control do so in the shareholders’ interest. Generally, it is the CEO
who makes the most important decisions in a corporation and thus effectively
governs it. CEOs also have considerable influence in the selection and retention of board members so that, to some extent, they are responsible only to
themselves. Also, CEOs typically have the greatest amount of knowledge of
any participant in corporate governance and so properly should make the
most important decisions.
The main problem with CEOs that is addressed by corporate governance
is how to ensure that they and other top executives have the right incentives.
This is achieved by four main means. First, like directors, officers of a corporation have a legally imposed fiduciary duty to act in all matters in the shareholders’ interest. Although this duty is legally enforceable in that officers and
directors can be sued for breaches, both are protected by the business judgment rule that exempts them from lawsuits for good faith business decisions.
Moreover, successful suits for breach of fiduciary duty are generally limited to
Ethics in Financial Management
265
egregious acts of incompetence or self-dealing, so that fiduciary duty provides
a relatively weak incentive for strong performance.
Second, executives’ interests can be effectively aligned with those of shareholders by a substantial ownership interest or performance-based compensation through bonuses and/or stock options. In this way, CEOs act more like
shareholders because they, in fact, become significant shareholders themselves
and not merely hired professional managers. Indeed, managers with an ownership stake may have a greater incentive than shareholders to operate a firm
profitably since their investment is less diversified than that of shareholders.
Third, a competitive labor market for CEOs and other executive positions
places a premium on a manager’s success in his or her current job. Even if it
is relatively rare for an executive to hold multiple CEO positions, a CEO has
a strong incentive to avoid dismissal, and new CEOs are drawn from the ranks
of aspiring executives who have incentives to excel. Thus, the market for CEO
talent perhaps works best at lower levels among potential CEOs, who help
support the current one.
Fourth, an active market for corporate control serves to discipline underperforming or self-serving management by the threat of a takeover. Although
hostile takeovers are relatively rare in Europe and Japan and increasingly more
difficult to wage in the US, greater pressure by institutional investors has been
successful, in many instances, in producing the same kind of change that a
hostile takeover would achieve.
Problems with shareholder primacy
The justification of shareholder primacy and, along with it, the justification of
the roles of shareholders, directors, and executives or officers encounter a
number of critical problems. On the practical level, many corporate scandals,
such as the collapse of Enron, WorldCom, and other companies in the early
2000s, and the financial crisis beginning in 2007 have been blamed on failures
in corporate governance. These events have led to many proposals for reform,
including the passage of the US Sarbanes–Oxley Act in 2002, which mandates,
among other things, some changes in the composition and operation of boards
of directors. Other concerns, such as high executive compensation, have
prompted proposals to increase shareholder voice in the nomination and election procedures for directors.
On the theoretical level, some of the fundamental assumptions of the
shareholder model have been challenged by a transformation in corporations
worldwide. Traditional corporate governance is focused almost exclusively on
the role of the financiers of a corporation. The interests of other groups are
neglected in corporate governance, not because they are not important and
266 Ethics in Financial Management
deserving of protection, but because they are addressed by other means. This
narrow focus of corporate governance is commonly justified by two related
assumptions that have held true until now. However, changes in the strategy
and structure of corporations bring these assumptions into question.
The first of these assumptions is that only shareholders bear residual risk.
All other groups that contract with a firm do so for fixed claims—that is, for
claims of fixed amounts that can be secured by complete, legally enforceable
contracts. Thus, their claims are properly handled by contract law, not the
law of corporate governance, which is uniquely designed to protect residual
risk bearers, who have been, until recently, only shareholders. The second
assumption, which is related to the first, is that only shareholders are affected
by corporate decision making. The returns of all other groups that contract
with a corporation are determined by the market prices for their inputs in the
appropriate market for labor, commodities, products, and so on. These prices
depend on market forces, such as supply and demand, and are unaffected by
corporate decisions. As long as a firm remains solvent, these claims will be
honored, whereas the returns to shareholders, who have residual claims, are
directly affected by corporate decisions, thus justifying their control of the
corporate decision-making process.
Significant changes have occurred in recent years that bring these assumptions into question. The traditional corporation, for which the prevailing
systems of corporate governance have been devised, has sought to employ
large fixed capital assets and realize economies of scale in order to reduce
prices and capture market share. In such a firm, obtaining large amounts of
capital at low cost is critical, and the control over other inputs, including labor,
is secured by vertical integration and hierarchical command structures.
Because of the high demand for capital and the high level of risk involved, it
is necessary for the traditional corporation to seek outside investors and offer
them control in return for their investment.
Since the early 1970s, though, corporations have been forced to change
from such an asset-intensive strategy that exploits economies of scale to strategies that focus on gaining the benefits of innovation, quality improvements,
and globalization. New and better products, made and marketed globally, are
now the keys to success instead of cheaper, more abundant, domestically made
products. As a consequence, the structures of many corporations have changed
from large conglomerates to small, more nimble firms; from rigid hierarchical
companies to looser, flattened ones; and from vertically integrated firms to
more flexible, open forms of collaborative networks.
Corporations have changed their strategies and structures in recent years,
so that fixed tangible assets have become less important than people’s skills
and knowledge. As human capital has become more important than financial
Ethics in Financial Management
267
capital, corporations must focus less on their financiers and more on their
truly productive assets—which are not only their own employees on the inside
but individuals and organizations outside a firm. In the process, relationships
rather than transactions have become the ultimate source of organizational
wealth. Under these conditions, employees and other groups become residual
risk bearers because they must be induced to make firm-specific investments
in order to engage in innovation and make quality improvements, and because
these firm-specific investments could be expropriated by shareholders, these
providers of human capital have a need for more protection from this possibility. These nonshareholder constituencies are also more affected by corporate
decisions since their return is dependent on firm performance and not merely
on the price of their input in the market.
These changes in strategy and structure challenge the three critical assumptions underlying the justification of the shareholder model and, with it, the
current systems of corporate governance. This challenge suggests not only that
the traditional allocation of decision-making rights in corporations needs to
be altered but also that corporate governance itself must expand its focus from
the financiers of corporations to all groups that make investments in a firm
and are responsible for creating wealth. In particular, it should be the task of
corporate governance to provide the conditions in which all groups can make
firm-specific investments with the assurance that they will share equitably in
the wealth created. Although the problems with the shareholder model are
evident, it is not clear what reforms are needed for corporate governance to
fulfill this task. Thus, the systems of corporate governance are still evolving in
ways yet to be realized.
Conclusion
The financial management of corporations is but one area of finance that needs
to be guided by ethics. The field of finance ethics is broad, encompassing as
it does the financial services industry and activity in financial markets, as well
as financial management. The same few basic ethical principles apply in all
areas of finance, but the specific ethical problems and issues are many and
varied and require thoughtful analysis. A study of ethics in finance must recognize the immense changes that have occurred in financial services and
financial markets in the past few decades. These changes have resulted from
advances in finance theory, new technology, globalization, increased regulation, heightened public expectations, and a vastly more competitive environment. The pressures on people in finance today are immense, and the difficulty
of succeeding, combined with the high rewards that are still possible, create
great temptations for unethical, as well as illegal, behavior.
268 Ethics in Financial Management
Ultimately, securing a financial system that embodies the highest level of
ethics is a joint effort. The first step requires that the people who work in
finance have the necessary understanding of ethical conduct and a commitment to act accordingly, but good people are not sufficient. Attention must
also be paid to the organizations and market structures within which people
act and especially to the pressures and incentives that operate on them. Ethics
is also inseparable from financial regulation, which is a main means by which
ethical conduct is, first, identified and then made subject to enforceable rules.
Ethics guides much regulation, but regulation, in turn, gives expression to
ethics and provides a means for approaching it. Indeed, anyone committed
to good ethics in finance must also work for good regulation. Just as necessary
as good regulation, however, is wise, effective leadership in financial services
and financial markets worldwide, which can balance the competing demands
of business success and social responsibility.
Notes
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
For this distinction, see Charles Handy, “What’s a Business For?” Harvard Business Review, 80 (December 2002), 49–55.
See, for example, John Micklethwait and Adrian Woolridge, The Company: A
Short History of a Revolutionary Idea (New York: Modern Library, 2003).
See Duane Windsor, “Shareholder Wealth Maximization,” in John R. Boatright
(ed.), Finance Ethics: Critical Issues in Theory and Practice (New York: John Wiley
& Sons, Inc., 2010).
For criticism, see Lynn A. Stout, The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public (San Francisco, CA:
Berrett-Koehler Publishers, 2012).
James Hawley and Andrew Williams, The Rise of Fiduciary Capitalism: How
Institutional Investors Are Making Corporate America More Democratic (Philadelphia, PA: University of Pennsylvania Press, 2000).
Franco Modigliani and Merton H. Miller, “The Cost of Capital, Corporation
Finance, and the Theory of Investment,” American Economic Review, 48 (1958),
261–297; and Merton H. Miller and Franco Modigliani, “Dividend Policy,
Growth, and the Valuation of Shares,” Journal of Business, 34 (1961), 411–433.
Henry T. C. Hu, “Risk, Time, and Fiduciary Principles in Corporate Investment,”
UCLA Law Review, 38 (1990–1992), 277–389.
Hu, “Risk, Time, and Fiduciary Principles in Corporate Investment,” p. 282.
Bradford Cornell and Alan C. Shapiro, “Corporate Stakeholders and Corporate
Finance,” Financial Management, 16 (1987), 5–14.
This point is made explicitly in Unocal Corporation v. Mesa Petroleum Co., 493
A.2d 946, 955 (1985), and in Paramount Communications v. Time, Inc., 571 A.2d
1140, 1152 (1990).
Ethics in Financial Management
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.
24.
269
Robert N. Anthony, “The Trouble with Profit Maximization,” Harvard Business
Review, 38 (1960), 126–134.
That such standards should be part of the objective of business corporations is
recommended in the Principles of Corporate Governance drafted by The American Law Institute. Section 2.01 states that in addition to “enhancing corporate
profit and shareholder gain,” a business corporation “may take into account
ethical considerations that are reasonably regarded as appropriate to the responsible conduct of business.”
See David Vogel, The Market for Virtue: The Potential and Limits of Corporate
Social Responsibility (Washington, DC: Brookings, 2005); Craig C. Smith, “Corporate Social Responsibility: Whether or How?” California Management Review,
45 (2003), 52–76; and David Hess, Nikolai Rogovsky, and Thomas W. Dunfee,
“The Next Wave of Corporate Community Involvement: Corporate Social Initiatives,” California Management Review, 44 (2002), 110–125.
Milton Friedman, Capitalism and Freedom (Chicago, IL: University of Chicago
Press, 1962), p. 133.
Milton Friedman, “The Social Responsibility of Business Is to Increase Its
Profits,” New York Times Magazine, September 13, 1970, p. 33.
Keith Davis and Robert L. Blomstrom, Business and Society: Environment and
Responsibility, 3rd edition (New York: McGraw-Hill, 1975), p. 50.
See James Post, Lee Preston, and Sybille Sachs, Redefining the Corporation: Stakeholder Management and Organizational Wealth (Palo Alto, CA: Stanford Business Books, 2002).
Frank H. Easterbrook and Daniel R. Fischel, The Economic Structure of Corporate
Law (Cambridge, MA: Harvard University Press, 1991), p. 38.
Easterbrook and Fischel, The Economic Structure of Corporate Law, p. 39.
Ronald H. Coase, “The Problem of Social Cost,” Journal of Law and Economics,
3 (1960), 1–44.
Indeed, Ronald Coase, the creator of the Coase Theorem, later claimed that his
main message had been misunderstood, because a full assignment of property
rights and no transaction costs are seldom present. Ronald H. Coase, The Firm,
the Market, and the Law (Chicago, IL: University of Chicago Press, 1988), p. 15.
Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk (New York:
John Wiley & Sons, Inc., 1996).
For the role of government in managing risk, see David A. Moss, When All Else
Fails: Government as the Ultimate Risk Manager (Cambridge, MA: Harvard University Press, 2002). Bernstein points out that the word “statistics” developed
from the use of quantitative facts in the administration of state affairs. Bernstein,
Against the Gods, p. 77.
Operational risk has received great attention as a result of the requirement of
the Basel II bank regulations that banks include it in their risk management
systems. The Basel II Accord defines operational risk as “The risk of loss resulting
from inadequate or failed internal processes, people and systems or from external
events.”
270 Ethics in Financial Management
25.
26.
27.
28.
29.
30.
31.
32.
33.
34.
35.
36.
37.
38.
39.
40.
41.
42.
43.
44.
45.
See Ingo Walter, “Reputational Risk,” in John R. Boatright (ed.), Finance Ethics:
Critical Issues in Theory and Practice (New York: John Wiley & Sons, Inc., 2010).
Other types of risk include liquidity risk, which is the risk that assets cannot be
sold, and sovereign risk, which is the risk that a sovereign state may default on
its national debt.
Lisa K. Meulbroek, “A Senior Manager’s Guide to Integrated Risk Management,”
Journal of Applied Corporate Finance, 14 (2002), 56–70, 56.
Peter L. Bernstein, “The New Religion of Risk Management,” Harvard Business
Review, 74 (1996), 47–51, 47.
Niall Ferguson, “Wall Street Lays Another Egg,” Vanity Fair (December 2008).
Meulbroek, “A Senior Manager’s Guide to Integrated Risk Management,” p. 65.
Jacob S. Hacker, The Great Risk Shift: The Assault on American Jobs, Families,
Health Care, and Retirement and How You Can Fight Back (New York: Oxford
University Press, 2006).
Nassim Taleb, The Black Swan: The Impact of the Highly Improbable (New York:
Random House, 2007).
Michael Power, The Risk Management of Everything: Rethinking the Politics of
Uncertainty (London: Demos, 2004), p. 10.
See Ricardo Rebonato, The Plight of the Fortune Tellers: Why We Need to Manage
Finance Risk Differently (Princeton, NJ: Princeton University Press, 2007).
Taleb, The Black Swan.
Bernstein, “The New Religion of Risk Management,” p. 50.
Jón Daníelsson, “The Emperor Has No Clothes: Limits to Risk Modelling,”
Journal of Banking and Finance, 26 (2002), 1273–1296.
Jón Daníelsson, “On the Feasibility of Risk Based Regulation,” Economic Studies,
49 (2003), 157–179.
David Einhorn and Aaron Brown, “Private Profits and Socialized Risk,” Global
Association of Risk Professionals, June–July 2008, pp. 10–26.
Richard A. Posner, A Failure of Capitalism: The Crisis of ’08 and the Descent into
Depression (Cambridge, MA: Harvard University Press, 2009).
Raghuram G. Rajan, Fault Lines: How Hidden Fractures Still Threaten the World
Economy (Princeton, NJ: Princeton University Press, 2010), p. 144.
Joe Nocera, “Risk Management: What Led to the Financial Meltdown,” New York
Times, January 4, 2009.
John Cassidy, “What’s Wrong with Risk Models?” New Yorker, Blog, April 27,
2010.
“The Uses and Abuses of Chapter 11,” The Economist, March 18, 1989, 72; and
Paul G. Engel, “Bankruptcy: A Refuge for All Reasons,” Industry Week, March 5,
1984, pp. 63–68.
Anna Cifelli, “Management by Bankruptcy,” Fortune, October 31, 1983; and
Harold L. Kaplan, “Bankruptcy as a Corporate Management Tool,” ABA Journal,
January 1, 1987, pp. 64–67.
Kevin J. Delaney, Strategic Bankruptcy: How Corporations and Creditors Use
Chapter 11 to their Advantage (Berkeley and Los Angeles: University of California Press, 1992).
Ethics in Financial Management
46.
47.
48.
49.
50.
51.
52.
53.
54.
55.
56.
57.
58.
59.
271
One exception is that a plan may be imposed over the objections of one or
more classes of creditors as long it is approved by at least one class of creditors whose claims are reduced and a court finds the plan to be “fair and
equitable” for all creditors. The imposition of a nonunanimous plan is called a
“cramdown.”
See Douglas G. Baird and Thomas H. Jackson, Cases, Problems, and Materials
on Bankruptcy, 2nd edition (Boston, MA: Little, Brown, 1990); and Thomas H.
Jackson, The Logic and Limits of Bankruptcy Law (Cambridge, MA: Harvard
University Press, 1986).
The need to force creditors to act collectively and enhance the total value of a
firm’s assets is called the problem of the common pool. See Baird and Jackson,
Cases, Problems, and Materials on Bankruptcy, pp. 39–42.
Thomas H. Jackson, “Bankruptcy, Non-Bankruptcy Entitlements, and the Creditors’ Bargain,” Yale Law Journal, 91 (1982), 857–907.
NLRB v. Bildisco, 465 U.S. 513 (1984).
Section 1113 of the Bankruptcy Code requires companies to attempt to negotiate
with unions in good faith and, if an agreement cannot be reached, to demonstrate
that any changes are “necessary to permit the reorganization” or that rejection
is justified by a “balancing of equities.” The courts enforced these more stringent
standards in Wheeling–Pittsburgh Steel Corporation v. United Steelworkers of
America, 791 F.2d 1074 (3d. Cir. 1986).
“A Retailer’s Chapter 11 Has Creditors Enraged,” BusinessWeek, May 9, 1983, pp.
71, 74.
See Delaney, Strategic Bankruptcy, pp. 162–168.
Paul Brodeur, Outrageous Misconduct: The Asbestos Industry on Trial (New York:
Pantheon Books, 1985), pp. 257–258, 268, 270–271.
Some asset shifts can be challenged by creditors on the grounds that they constitute “fraudulent conveyance,” which is the transferring of assets in an effort to
defraud creditors.
Michael Bradley and Michael Rosenzweig, “The Untenable Case for Chapter 11,”
Yale Law Journal, 101 (1992), 1043–1095.
Bradley and Rosenzweig, “The Untenable Case for Chapter 11,” pp. 1049–1050.
This conclusion is controversial and has been challenged. See Elizabeth Warren,
“The Untenable Case for Repeal of Chapter 11,” Yale Law Journal, 102 (1992),
437–479.
Jackson, The Logic and Limits of Bankruptcy Law, pp. 21–27.
Chapter 11 contains some mechanisms to counter these management rights and
limit possible abuses. Thus, at any time during bankruptcy proceedings, creditors
can file a petition for immediate liquidation, which permits a bankruptcy court
to judge whether managers are “playing games” with the creditors. Because creditors can always hold out for liquidation or the opportunity to submit their own
plan, and because management’s plan must be approved by each creditor group,
managers are forced to propose a plan that is reasonably fair and equitable. In
the event of a “cramdown,” a court must determine that the reorganization plan
is fair and equitable for all parties.
272 Ethics in Financial Management
60.
61.
62.
63.
64.
65.
66.
In such cases, abuse of bankruptcy could be addressed by fraud statutes rather
than by provisions of the Bankruptcy Code.
Joseph McCafferty, “Is Bankruptcy an Unfair Advantage?” CFO, June 1995,
p. 28; and Stephen Neish, “Is the Revised Chapter 11 Any Improvement?” Corporate Finance, March 1995, pp. 37–40.
See Teresa Sullivan, Elizabeth Warren, and Jay Lawrence Westbrook, The Fragile
Middle Class: Americans in Debt (New Haven, CT: Yale University Press, 2000);
and Elizabeth Warren, “The Bankruptcy Crisis,” Indiana Law Journal, 73 (1997–
1998), 1079–1110.
Todd J. Zywicki, “An Economic Analysis of the Consumer Banking Crisis,”
Northwestern University Law Review, 99 (2005), 1463–1541.
Adolf A. Berle Jr and Gardiner C. Means, The Modern Corporation and Private
Property (New York: Macmillan, 1932).
Adolf A. Berle Jr, “For Whom Corporate Managers Are Trustees: A Note,”
Harvard Law Review, 45 (1931–1932), 1365–1372.
Henry Hansmann, The Ownership of Enterprise (Cambridge, MA: Harvard University Press, 1996), pp. 13–14.
Index
“access people”, personal trading, 132,
133, 134, 135, 136–7
accounting fraud, 5, 22, 175
adjustable-rate mortgages (ARMs), 98,
101, 103
Adoboli, Kweku, 4
Against the Gods (Bernstein), 234, 237
agents, 19, 40–3
aggressive marketing, 85–6
AIG, 209–10
algorithmic trading see high-frequency
trading (HFT)
algo-sniffing, trading tactic, 214–15
alienability of property, 31
Alliance Capital Management, 124
annualized turnover ratio (ATR), 75
Aquinas, Thomas, 91
arbitration, 108–9
compulsory, 109–11
legal tactics, 111–12
problems with arbitrators, 112–14
punitive damages, 113–14
Arvida partnerships, 65, 66–7
asset-backed securities (ABSs), 99
asymmetric information, 18, 177, 179,
180–1
auction markets, 53
Bankers Trust, 3–4, 210, 211
Bank of America, 4, 91, 123, 124–5
bankruptcy, 243–4
fairness and efficiency, 249–52
ethical basis of, 244–5
personal, 252–4
strategic use of, 247–9
use and abuse of, 246
collective bargaining
agreements, 246
liabilities and obligations,
246–7
product liability suits, 246
Bankruptcy Code
1978 revision, 244, 250
2005 overhaul, 253–4
Barings Bank, 4, 210
Berkshire Hathaway, 20
Berle, Adolf A. Jr., 32–3, 257–8
Bernstein, Peter, L., 234, 237, 240
bid-ask spreads, reduction of, 216
bid-rigging, 3, 10
blackout periods, 137
“blissful shareholder” model, 228
block positioners, 53–4
Blodget, Henry, Merrill Lynch, 5
blue sky laws, 177
Ethics in Finance, Third Edition. John R. Boatright.
© 2014 John Wiley & Sons, Inc. Published 2014 by John Wiley & Sons, Inc.
274 Index
boards of directors, role of, 200–1,
263–4
Boesky, Ivan, 3, 7, 182
breach of contract, 18, 35
brokerage firms, 51–2, 56–7, 73–5
competition and conflict of
interest, 56–7
compulsory arbitration, 109–11
punitive damages, 113
soft-dollar brokerage, 138–41
Buffett, Warren, 11, 20, 142, 202, 208
CalPERS (California Public Employees’
Retirement System), 142–3
Canary Capital, 4, 123, 124–6
candor, duty of, 42–3
capping of credit card rates, 91–2
arguments for and against, 92–5
CARD Act (2009), 78, 82, 84, 86, 87, 89
Cardozo, Benjamin, 40–1
care, duty of, 43
Cassidy, John, 209, 242
caveat emptor (“let the buyer
beware”), 71
CDOs (collateralized debt
obligations), 12, 99–100, 236–7
Chapter 11 bankruptcy, 244–5
abuse of, 246–7
fairness and efficiency, 249–52
check kiting, 9
Chicago Mercantile Exchange
(CME), 206
chief executive officers (CEOs)
excessive compensation, 94
role of, 264–5
chief financial officers (CFOs), 5, 22, 23,
223–4
chief risk officers (CROs), 22, 223–4,
236
“Chinese walls”, 48, 59
churning, 54, 72, 73–4
definition of, 74–5
ethical objection to, 74
quantitative measures, 75–6
suitability, 76–7
Citigroup, 3, 5, 13, 21
Citizens Bank, 87
Coase, Ronald H., 33–4
Coase Theorem, 233
codes of ethics, 15, 23, 44–5, 127–8,
131, 133, 136–7
coercion, 34–5
collateralized debt obligations
(CDOs), 12, 99–100, 236–7
collective bargaining agreements, 246
college students, credit card
marketing, 81–7
co-location, high-frequency
trading, 213
commissions, 66
commodity futures, 206–7
Community Reinvestment Act, 64
competition, 56–7
compulsory arbitration, 109–11
computers, 201, 209
high-frequency trading, 213–14,
216–17
program trading, 182
concealment, 3–4, 5, 35, 42–3
fraudulent transactions, 186
in retail sector, 66–72
mortgage lending, 96, 101–2
confidentiality, 43
conflict of interest, 45–59
agents and fiduciaries, 43
and golden parachutes, 195–6
and short-selling, 138
causes of, 48–9
credit cards, 86
definition of, 46–8
Enron, 5
examples of, 50–6
from personal trading, 132, 133, 134
incentive problem, 9
IPOs (initial public offerings), 137
management of, 56–9
competition, 56–7
disclosure, 57–8
rules and policies, 58
structural changes, 58–9
Index
Marsh Inc., 10
mutual funds, 121, 138
summary, 59–60
Consumer Financial Protection
Bureau, 16, 36, 64
consumer loan business, 73
consumer protection, 36, 64, 71, 90,
182, 211
Continental Airlines, bankruptcy, 246,
249
contingency commissions, 10
contracting problems, solving, 260–2
contracts of adhesion, 80, 89–90
contractual theory of the firm, 33–4,
258
control repurchase agreements,
198–9
Cooper, Cynthia, 5
corporate finance, 13, 22–3
corporate governance, 141, 146–8,
254–5
directors and CEOs, 262–5
public policy, 257–9
shareholder contract, 259–62
shareholder primacy, 255–9
the market, 259
corporate law, 31–2, 42, 55, 198, 257
corporate objective, 224–5
corporate social responsibility
(CSR), 230–4
Countrywide, 11, 102–3
Credit Card Accountability
Responsibility and Disclosure
Act (CARD), 78, 82
Credit Card Nation (Manning), 11
credit cards, 78–9
ethical concerns, 79–81
marketing to students, 81–7
pricing strategies, 79
profitability, 78
rates and fees, 87–96
credit default swaps (CDSs), 12, 204,
209–11, 236–7, 238
creditors’ bargain argument, 245, 250
credit risk, 235
275
creditworthiness, 251
and microfinance, 156–7
and mortgages, 97, 99, 101, 103, 104,
105
college students, 83–5
crown-jewel options, 194
dark pools (private exchanges), 216
dealers, 204
markets for, 53–4
debit cards, 78
contract, readability of, 79–80
fee for possessing, 91
impact on social welfare, 81
overdraft fees, 87, 88
overdraft protection, 87, 89, 90
see also credit cards
deception, 66–72
decision making, 254–5, 262–3
default risk, 6, 12, 94, 99–100, 204, 235
Den of Thieves (Stewart), 3
derivatives, 202–3
definition of, 203
problems with, 205–6
speculation and, 206–8
suitability, 208–11
types of, 203–4
uses of, 204–5
Deutsche Bank, 4
dignity, 28–9
directed brokerage, 138–9, 140–1
directors, role of, 200–1, 228, 262–4
disclosure
adequacy of, contracts of
adhesion, 89–90
and conflict of interest, 57–8, 210–11
and information access, 186
and market timing, 129
and the CARD Act, 82, 86
by mortgage lenders, 101–2
fair disclosure rule, SEC, 23
of personal trading, 136–7
of soft-dollar practices, 140
regulations and laws, 23, 176–7, 178–9
Ruder Commission report, 110
276 Index
Dodd-Frank Wall Street Reform and
Consumer Protection Act
(2010), 64, 196, 211
Donaldson, William H., 5
Dow Corning Corporation, 246, 249
Drexel Burnham Lambert, 3, 189
Drucker, Peter, 190
due diligence, 76–7
duty/duties, 28, 42–3
see also fiduciary duties
Duval, Jessica, debit card overdraft, 87
Ebbers, Bernie, 5
economically targeted investment
(ETI), 146
economic rationality, 68
economic value added (EVA), 227
efficient frontier, 77
E.F. Hutton, 9
Employee Retirement Income Security
Act (ERISA), 55, 145, 146
end users, 204
Enron, 5, 22, 175, 227, 265
enterprise risk management
(ERM), 235–6
equal information, 177–81
equity/efficiency trade-off, 28, 171,
172–3
“excessive trading”, churning, 72–3,
74–5
“extended balance sheet” model, 228
externalities, 19, 37, 141, 230, 232–4
fairness, 28
and insider trading, 185–7
credit/debit cards, 88–91
in markets, 172–5
Fannie Mae, 6, 97, 106
Fastow, Andrew, Enron CEO, 5
Federal Trade Commission (FTC), 66,
67, 96
“fee-only” investment advisors, 72
Ferber, Mark S., 45
Fidelity Investments, 123, 129, 130,
138
fiduciaries, 19, 20–1, 40–1
and conflict of interest, 48–9
fiduciary duties, 22, 41–3, 261
and relationship investing
(RI), 144–6
chief executive officers, 264–5
fund managers, 131, 139–40, 141
insider traders, 180, 185, 187–8
institutional investors, 143
finance
field of finance ethics, 13–23
need for ethics in, 2–13
financial engineering, 201–2
derivatives, 202–11
high-frequency trading
(HFT), 211–17
Financial Industry Regulatory Authority
(FINRA), 16, 214
financial innovation, 11–13
financial management, 223–4
corporate governance, 254–67
ethics of bankruptcy, 243–54
risk management, 234–43
shareholder wealth maximization
(SWM), 224–34
the corporate objective, 224–34
financial markets, 171–2
equal bargaining power, 181–2
equal information, 177–81
fairness and, 172–82
financial engineering, 201–17
fraud and manipulation, 175–7
hostile takeovers, 189–201
insider trading, 182–9
financial planning organizations, 45
financial scandals, 3–7
and derivatives, 202
causes of, 7–13
financial services industry, 20–2
financial theory of the firm, 224
firms, 31–4
profit maximization, 229–30, 260
firm-specific assets, 34
First Alliance, 96, 100
fixed claims, 256, 258–9, 260, 261–2, 266
Index
fixed commissions, legislation
ending, 73–4, 138–9
flash crash, 6, 211, 215, 216
flash trading, 213, 216
“flipping”, 73, 74, 76, 101
Fool’s Gold (Tett), 12
forward contracts, 203, 204, 206, 207
fraud, 5, 18, 22, 175–7
and lack of knowledge, 186
concealment as, 251
force and, 34–6
in predatory subprime lending, 101
legislation, 66, 183, 184
securities fraud, 188–9
unfair competition, 174
Freddie Mac, 6, 97, 106
Friedman, Milton, 230–2
fund performance, 152–3
fund-tracking firms, 70
futures contracts, 50, 203–4, 205, 206
GAAP (generally accepted accounting
principles), 5, 227
Galleon Group, 3, 183
Getty Oil, 247
Global Crossing, 4
golden parachutes, 194, 195–7
Goldman Sachs, 3, 21, 125, 210–11, 242
government-sponsored enterprise
(GSEs), 97
Grameen Bank, Bangladesh, 22, 155–8,
161–3
Gramlich, Edward M., 102
Grand Metropolitan, 188
Greenberg, Jeffrey W., 10
greenmail, 197–200
group lending, microfinance, 157, 158,
159, 161
Grubman, Jack B., 5
Gutfreund, John, 3
Hansmann, Henry, 258
Hanson, Dale M., 143
Harrington, Noreen, 125–6
hedge funds, 20, 48, 124, 182–3
277
high-frequency trading (HFT), 211–13
evaluation of, 215–16
risks of, 216–17
uses of, 213–15
Hirschman, Albert O., 144
home ownership see mortgage lending
honesty, 28
hostile takeovers, 189–90
fairness in, 191–3
role of the board, 200–1
takeover tactics, 193
golden parachutes, 195–7
greenmail, 197–200
tender offers, 193–5
housing bubble, 6, 100
HRT Industries, 247, 251
Hu, Henry, 228
Hurwitz, Charles, 189–90
impersonal conflict of interest, 47, 48
incentives, 9, 104–6, 157, 259
incorporation, 31–2, 257
inequality, 93–4
information asymmetries, 18, 177, 179,
180–1
initial public offerings (IPOs), 52, 69,
132, 137, 162, 216
innovation, 11–13
insider trading, 3, 182–3
and Chinese walls, 59
and nonpublic/unequal
information, 174, 176, 179–80
and personal trading, 134
debate over, 184–8
resolving, 188–9
definition of, 183–4
Securities Exchange Act on, 176
Institutional Shareholder Services
(ISS), 145
insurance companies, 70
insurance organizations, 45
interest rates, credit card, 78, 80–1, 88,
89, 90–1
capping of, 91–5
Invesco Funds Group, 124, 130
278 Index
investment advisers, 45, 54, 131
Investment Advisers Act, 54
Investment Company Act 1940 (ICA),
55, 57, 66, 128, 130–1, 133
Investment Company Institute
(ICI), 131, 136, 137, 141
investment ethics, 120–1
microfinance, 155–64
mutual funds, 121–41
relationship investing (RI), 141–8
socially responsible investing, 148–55
irrelevance theorem, 226–7
Islamic finance, 14–15
ITT Consumer Financial
Corporation, 73
Jensen, Michael C., 196, 197
joint-stock companies, 32
JP Morgan Chase, 12, 124, 208–9, 210
justice, 28
Kaldor, Nicholas, 207
Kaweske case, personal trading, 131–2
Kerviel, Jérôme, 4
Knight Capital Group, 6, 216
KPMG, 17
Krugman, Paul, 11
late trading, 4, 121–2
law, 15–17
Lazard Fréres investment bank, 45–6
leadership, 10–11
Leeson, Nick, 4, 210
Lehman Brothers, 96
less developed countries (LDCs),
reducing poverty in see
microfinance
Levitt, Arthur, SEC chairman, 73
Lewis, Michael, 8, 130
liabilities and obligations,
bankruptcy, 246–7
Lipper Analytical, 70
liquidation, 243, 245, 247, 250
litigation, 108, 110, 111–12, 113
lockup option, 194
London Interbank Offered Rate
(LIBOR), 7, 176
Long-Term Capital Management, 3
loyalty, duty of, 43
LTV Steel, 246–7, 248
mandatory disclosure
regulations, 176–7
manipulative practices, 6–7, 35–6, 85–6,
175–7, 214–15
Manning, Robert, 11, 86
Manville Corporation, 246, 247–8, 249
market failure, 36–8
markets, 30–1
market specialists, 54
market timing, 4, 121–6
objections to, 126–8
remedies, 128–30
Marsh Inc., 10
Mastrobuono, Antonio C., 111
matching transactions, 132–3, 137, 138
mathematical models, 201, 235, 236–7,
241, 243
maximal efficiency, 30
Maxxam, 189–90
Means, Gardiner C., 32–3, 257
M&E (mortality and expense risk)
charges, 69, 70
Merrill Lynch & Co., 3–4, 5, 45, 64–5,
210, 211
MF Global, 6
microfinance, 22, 155–6
effectiveness of, 159–62
ethical criticism, 158–9
schism, 162–4
workings of, 156–8
Milken, Michael, 3, 182, 189
Miller, Merton, 226
minimum payment option, credit cards,
90–1
misappropriation, 34, 53, 185, 188
modern corporation, 32–3, 41
Modern Corporation and Private
Property, The (Berle and
Means), 32, 257
Index
Modigliani, Franco, 226
moral duties, 18, 36
moral hazard, 157, 238, 251
moral rules, 16, 17–18, 19, 35, 36
Morningstar, 70
mortality and expense risk (M&E)
charges, 69, 70
mortgage backed securities (MBSs), 6,
11, 12, 52, 64, 96, 99, 210
mortgage lending, 96–7
origination process, 6
perverse incentives, 104–6
predatory lending, 100–2
securitization, 98–100
subprime, rise and fall of, 96–8
toxic products, 102–3
mosaic theory, in insider trading,183
Mozilo, Angelo, 11, 102
mutual funds, 121
conflict of interest, 47, 55, 121
deceptive practices in, 67, 69–70
market timing, 121–30
personal trading, 130–8
regulation of, 57
socially responsible investing (SRI)
and, 149, 151
soft-dollar brokerage, 138–41
Nader, Ralph, 150
NASDAQ, 23, 53, 128, 216
National Association of Securities Dealers
(NASD), 53, 70, 76, 109, 113
negative amortization loans, 11, 103
New York Stock Exchange (NYSE), 16,
23, 53, 128, 138, 172, 211,
212–13
nexus-of-contracts view of the firm, 33,
259
obligation, 28
off-balance-sheet partnerships, 5
O’Hagan, James H., 188–9
options, 66, 73, 204
Orange County, California, 3, 205, 210,
211
279
organizational conflict of interest, 47–8
organizational culture, 8
originate-to-distribute system,
mortgages, 104–6
“other constituency statutes”, 201
overdraft protection, debit cards, 87, 89,
90
Pacific Lumber Company, 189–90, 192
pac-man defense, 194
Paine, Lynn Sharp, 10
Paramount Communications, 200–1
Pareto optimum, 30
Pareto, Vilfredo, 30
paternalism, 71, 93, 94
PDAAs (predispute arbitration
agreements), 108, 109–11
Pennzoil, 247, 248
pension fund managers, 42–3, 145,
146
pension funds
CalPERS, 142–3
economically targeted investment
(ETI), 145–6
regulation, 55, 172
socially responsible investing, 21–2,
149, 150, 151
“universal shareholders”, 226
personal bankruptcy, 252–4
personal finance, 13
personal trading, 130–1
and conflict of interest, 55, 131–3
banning of, 133–5
codes of ethics, 136
disclosure of, 136–7
purchase of IPOs, 137
shorting, 137–8
short-term trading, 137
perverse incentives, subprime
mortgages, 104–6
Pillsbury Company, 188
Pimco Advisors, 124
poison pill, 194
pollution, 19, 230–3
Pound, John, 147–8
280 Index
predatory borrowers, 106
predatory lending, 100–2
predispute arbitration agreements
(PDAAs), 108, 109–11
pressure, 8
Prince, Charles, Citigroup CEO, 13
principal, 40, 41–2, 47–8, 49, 51, 54, 57
procedural fairness, 174
Procter & Gamble (P&G), 3–4, 205,
208, 210, 211
product liability suits, bankruptcy,
246
professionals, 21, 40
and conflict of interest, 48–9
arbitrators, 112–13
code of ethics, 15, 44
investors, 178
managers, 54, 263
role of, 43–5
profit maximization, 229–30
program trading, 182
progressive lending,
microfinance, 157–8
property rights
and social costs, 233
corporate governance, 257
insider trading and, 184–5
market exchange, 30–1
theory of, 32–3
protection
credit and debit card issuers, 88–90
responsibility of salespeople, 70–2
pseudobidding, 199–200
psychological tactics, card issuers,
90–1
public goods, 37
public policy, corporate
governance, 256–9
punitive damages, 110–11, 113–14
Putnam Investments, 4, 124
Quants, 201
Rajaratnam, Raj, 3, 183
rational choice, 68
real estate investment trusts
(REITs), 55–6
reasonableness expectation, violation
of, 91
reciprocation, 51
“redlining”, 19, 64
reforms, mutual fund industry, 129–30
regulation, 15–16
and conflict of interest, 58
relationship investing (RI), 141–2
and fiduciary duty, 144–6
as an investment strategy, 142–4
improving corporate
governance, 146–8
religious groups, 150
reputational risk, 235
residual claims, 256
residual risk bearers, 260–1
control, 261–2
nonshareholders as, 267
shareholders as, 266
retail customers, 63–4
arbitration, 108–14
credit cards, 78–95
mortgage lending, 96–107
sales practices, 64–77
RI see relationship investing
rights, 28
violation of, 36
see also property rights
risk
high-frequency trading
(HRT), 216–17
in subprime mortgages, 99–100,
102–3
risk management, 234–43
ethical issues, 237–40
failure, 240–3
Ruder Commission, 109
compulsory arbitration, 109–11
hardball legal tactics, 111–12
problems with arbitrators, 112–14
Ruder, David S., 109
Rules 17j and 17j-1, SEC, personal
trading, 133
Index
safe harbor provision, Securities
Act, 139, 140
sales practices, 64–5
deception and concealment, 66–8
examples for analysis, 68–70
responsibility to protect, 70–2
Salomon Brothers, 3, 8, 10–11
Salomon Smith Barney, 5
Santelli, Rick, 107
Sarbanes–Oxley Act (2002), 23, 223,
265
Saturday night special, 193–4
savings versus credit, 161, 163–4
scandals, 3–7
scienter, 74, 76, 77
Scotese, Peter, 196
screened funds, 150, 151, 152
Sears, Roebuck & Co., 73
Securities Act (1933), 52, 57, 172, 175,
176
Section 28(e), safe harbor
provision, 139, 140
Securities and Exchange Commission
(SEC), 23, 52, 65, 139, 172, 211
report on personal trading, 131–2
rules 17j and 17j-1, personal
trading, 133
Securities Exchange Act (1934), 52, 74,
172, 175, 176
securities industry
arbitration, 108–12
manipulative practices, 214–15
punitive damages, 113–14
securitization, 98–100
and perverse incentives, 104–6
self-regulating organizations
(SROs), 109, 110, 128
self-regulation, 16, 17, 44, 172
shareholder contract, 259–62
shareholder model, 228, 262–3, 265–6,
267
shareholder primacy, 224
case for, 255–9
problems with, 265–7
shareholder wealth, 226–9
281
shareholder wealth maximization
(SWM), 224–5
and social responsibility, 230–2
problem of social costs, 232–4
Friedman, Milton, 230–2
profit maximization, 229–30
shareholder wealth, 226–9
shark repellents (takeover
defenses), 193, 194
Shearson Lehmann Hutton, Inc., 111
shingle theory, 72
short-selling, 137–8
Silicon Graphics, 130
sin stocks, 22, 148, 149–50, 153
slippage, 213, 216
SMEs (small and medium
enterprises), 162
Smith, Adam, 120
smoking, trading tactic, 214
social capital, 160–1
social costs, 19, 37, 141, 230, 232–4
socially responsible investing
(SRI), 21–2, 148–9
and fund performance, 152–3
and investment policy, 153–5
definition of, 149–51
social welfare, 81, 88, 120–1, 225
Société Générale, 4, 205, 210
soft-dollar brokerage, 138–41
speculation, derivatives, 206–8
spillover effects (externalities), 37
Spitzer, Eliot, 4, 123
spoofing, trading tactic, 214
standards, ethical, 44–5
“steering”, 102
Stern, Edward “Eddie”, 123–5
Stewart, Martha, insider trading, 3, 182
stock exchanges, US, 23, 53, 172
strategic bankruptcy, 244, 247–9
Strong Capital Management (SCM), 4,
124
code of ethics, 127
involvement with Canary, 125–6
market timing police, 126
Strong, Richard S., 4, 125, 126, 127
282 Index
students, marketing of credit cards
to, 81–7
stuffing, trading tactic, 214
subprime mortgages, 64, 96–8
aftermath, 106–7
and predatory lending, 100–2
collateralized debt obligations
(CDOs), 99–100
default rate, 98
perverse incentives, 104–6
risk involved in, 102–3
substantive fairness, 174
Sullivan, Scott, 5
Sumitomo Corporation, 4
Surowiecki, James, 57
sustainability issues, 22, 149, 150–1,
162–3, 164
swaps, 12, 21, 171, 203, 204, 205,
208–11, 237, 238
Swift, Jonathan, 156
takeovers see hostile takeovers
tax shelters, 17
tender offers, 172, 193–5
Tett, Gillian, 12
Texaco, 247, 248, 249
Texas Gulf Sulphur Company, 183–4
theft, 18, 34, 35, 75
theories of the firm, 31–4
Time–Warner merger, 200
toxic products, 102–3
“toxic waste”, 64
transaction costs, 33–4, 207, 233
transparency, 79, 80, 95, 126, 139
Trillium Brokerage Services, 214
trust accounts, 47, 48, 52, 56, 58
reciprocation practice, 51
twisting
definition of, 72–3
suitability, 76–7
“underwater” homeowners, 64, 100, 107
underwriting standards, relaxation of, 103
unequal bargaining power, 181
unequal information, 179–80
Uniform Commercial Code, 71
United States Congress
arbitration versus litigation, 110
bankruptcy system, 247, 253
control repurchases, 198
disclosure regulations, 177
Investment Company Act (ICA)
amendments, 130–1, 133
passing of CARD Act, 84–5
Williams Act, 195
“universal shareholders”, 226
unsuitability
derivatives, 209, 210
securities, 76, 77
US Consumer Financial Products
Bureau, 80
usury, 88
value at risk (VaR), 237, 241–2
Value Line, 70
Vinik, Jeffrey, 130
volatility, 77, 182, 207–8, 217
Volcker, Paul, 11
Wakefield, Priscilla, 156
Wall Street, 1, 7, 24, 46, 57, 64, 111,
209
welfare, 27, 30
whistle-blowers, 5, 125–6
white knight, 194
Williams Act (1968), 195
Wilson Foods, bankruptcy, 246
World Bank, 19, 155
WorldCom, 4–5, 22, 175, 227, 265
wrongdoing, organizational
factors, 8–11
wrongful harms, 36
young people, exploitation of, 81–7
Yunus, Muhammad, 22, 155–6,
162–3