Ethics and the Conduct of Business

Eighth edition

Chapter 11

Ethics in Finance

Modules

Learning Objectives (1 of 2)

Learning Objectives (2 of 2)

Introduction: Ethics in Finance

Case: Goldman Sachs

Creating the deal

Expert analysis

Collapse of the deal

Figure 11.1: Objectionable Sales Practices for Financial Products

Objectionable sales practices for financial products

Deception

Churning

Suitability

11.1: Financial Services (1 of 2)

Objective: Explain the three basic forms of ethical misconduct when selling financial products and services, and the responsibilities brokers have to their clients

11.1.1: Deception

Overview

Information that should be disclosed

11.1.2: Churning

Overview

Legal definition of churning

Issues in defining excessive trading

Best practices to avoid churning

11.1.1: Deception

Point 1- Overview

Matter of interpretation

Occurs when essential information not revealed

Point 2- Information that should be disclosed

All material information

Most financial products provide prospectus

Two cases of broker misconduct

11.1.2: Churning

Point 1- Overview

Excessive trading for a client’s account to generate commissions

Reverse churning occurs when investors are placed in accounts with less activity

Occurs only when client turns over control of an account to a broker

Concept is difficult to define

Point 2- Legal definition of churning

Broker controls the account

Trading is excessive for the character of the account

Broker acted with intent

Point 3- Issues in defining excessive trading

Whether trading is excessive depends on the character of the account

Pointless trading is also considered churning

Pattern of trading

Point 3- Best practices to avoid churning

Ending payment of higher commissions

Prohibiting sales contests

Tying a portion of compensation to the client’s account

11.1: Financial Services (2 of 2)

Objective: Explain the three basic forms of ethical misconduct when selling financial products and services, and the responsibilities brokers have to their clients

11.1.3: Suitability

Meaning

Common causes of unsuitability

Ethical principles

11.1.3: Suitability

Point 1- Meaning

Difficult to define precisely

Salespeople have a responsibility of recommending suitable products to clients

Point 2- Common causes of unsuitability

Unsuitable types of securities

Unsuitable grades of securities

Unsuitable diversification

Unsuitable trading techniques

Unsuitable liquidity

Point 3- Ethical principles

Disclosure

Fairness

Figure 11.2: The Equity/Efficiency Trade-Off

Unethical conduct in financial markets generally identified with a lack of equity

Efficiency and equity are often conflicting goals

11.2: Financial Markets (1 of 2)

Objective: Assess the significance of the three main elements of fairness in financial markets and the ethical issues introduced by new financial instruments and practices

11.2.1: Fairness in Markets

Overview

Regulation of financial market protects everyone

Fraud and manipulation

Unequal information

Unequal bargaining power

11.2.1: Financial Markets

Point 1- Overview

Fairness is not preventing losses

Only to ensure the game is fair

Point 2- Regulation of financial market protects everyone

Protects investors and public

If financial markets do not fulfill their purpose, everyone is harmed

Point 3- Fraud and manipulation

Fraud is misrepresentation of facts

Buyers and sellers are vulnerable to fraud

Manipulation is creating misleading appearance

Both can be prevented by providing investors easy access to reliable information

Point 4- Unequal information

Information asymmetry

When information is illegitimately acquired

When use of information violates obligation to others

Equal access to information is not absolute but relative

Information asymmetries reduce efficiency

Point 5- Unequal bargaining power

Resources

Processing ability

Vulnerabilities

Table 11.1: Fraud and Manipulation in Financial Markets

What is fraud?	Willful misrepresentation of a material fact that causes harm to a person who reasonably relies on the misrepresentation
Who is a fraud?	Anyone involved in the buying or selling of securities who makes a false or misleading statement or engages in any practice or scheme designed to defraud
Who is vulnerable?	Investors (buyers and sellers) are particularly vulnerable because the value of financial instruments often depends on information that is difficult to obtain or verify.
How is manipulation different?	Manipulation involves buying or selling securities to create a false or misleading impression about future prices, rather than just misrepresenting facts.
How can both be prevented?	Fraud and manipulation can be prevented by providing investors with easy access to reliable information.

What is fraud?

Who is a fraud?

Who is vulnerable?

How is manipulation different?

How can both be prevented?

11.2: Financial Markets (2 of 2)

Objective: Assess the significance of the three main elements of fairness in financial markets and the ethical issues introduced by new financial instruments and practices

11.2.2: Derivatives and HFT

Derivatives

High-frequency trading

11.2.2: Derivatives and HFT

Point 1- Derivatives

Future contract

Option

Swap

To manage the risks of an uncertain future

Ethical objections

Point 2- High-frequency trading

Algorithmic trading using computers

To gain additional market information

Constitutes one-half to three-quarters of all stock trades

Matching buyers and sellers

Tasks done by HFT

11.3 Insider Trading (1 of 2)

Objective: Summarize the two main arguments against insider trading and the challenges in applying these theories to its prevention and prosecution

11.3.1: Theories of Insider Trading

Fairness theory

Property rights theory

11.3.2: Evaluation of the Two Theories

Fairness theory

Property rights theory

11.3.1: Theories of Insider Trading

Point 1- Fairness theory

Traders who use inside information have an unfair advantage

Rule for insiders is “Reveal or refrain!”

Rule for outsiders is “Don’t trade on information that is disclosed in violation of a trust!”

Point 2- Property rights theory

Misappropriation theory

Stealing inside information

Seriously flawed, astonishingly dysfunctional, a theoretical mess

11.3.2: Evaluation of the Two Theories

Point 1- Fairness theory

Main value of fairness lies in its promotion of efficiency

If insider trading is permitted, information would be registered quickly at less cost

Undermine the relation of trust

Breach of fiduciary duty

Point 2- Property rights theory

Difficult to determine who holds the information

Company would give information to its employees, or sell information to favored investors, or trade using the information to buy back stock

11.3 Insider Trading (2 of 2)

Objective: Summarize the two main arguments against insider trading and the challenges in applying these theories to its prevention and prosecution

11.3.3: Recent Insider Trading Cases

The O’Hagan decision

Galleon and the mosaic theory

11.3.3: Recent Insider Trading Cases

Point 1- The O’Hagan decision

O’Hagan tricked a partner into revealing information of takeover bid

O’Hagan was convicted for breach of fiduciary duty

Validation of the misappropriation theory

Point 2- Galleon and the mosaic theory

Rajaratnam found guilty of securities fraud and conspiracy

Mosaic theory in which information comes in tidbits

The small pieces of information are assembled like thin tiles in a mosaic

Rejection of mosaic theory

Figure 11.3: Causes of Unequal Bargaining Power

Existence of a market for corporate control

Tactics used by raiders and corporations

Fiduciary duties of officers and directors

11.4 Hostile Takeovers (1 of 2)

Objective: Analyze the ethical issues raised by various hostile takeover tactics and what they suggest about the rights and fiduciary duties of officers and directors

11.4.1: Market for Corporate Control

Advantages

Challenges

Review

11.4.2: Takeover Tactics

Takeover process

Defensive measures

Ethical issues

11.4.1: Market for Corporate Control

Point 1- Advantages

Important means to increase investment value

Benefit from increased productivity

Point 2- Challenges

Loss of job

Debt loads

Recession

Adopt costly defensive measures

Point 3- Review

All takeovers are not of underperforming businesses with poor management

Benefits shareholders but does not create new wealth

11.4.2: Takeover Tactics

Point 1- Takeover process

Tender offer by raiders to buy stock

Premium price

Enough shareholders tender their share

Insurgent gains control

Directors and officers have the right to fight the offer

Point 2- Defensive measures

Shark repellents

Antitakeover statutes

Point 3- Ethical issues

Unregulated tender offer

Golden parachutes

Greenmail

11.4 Hostile Takeovers (2 of 2)

Objective: Analyze the ethical issues raised by various hostile takeover tactics and what they suggest about the rights and fiduciary duties of officers and directors

11.4.3: Role of Directors

Board members’ role

11.4.3: Role of Directors

Point 1- Board members’ role

Other constituency statutes

Right to make decisions about the corporation’s future

Conclusion: Ethics in Finance

They bear on our financial well-being

Misconduct has the potential to rob people of their life savings

Should emphasize integrity of financial professionals and ethical leadership

Principles are duty of fiduciary and fairness

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