How the ethics wall works in investment banking

A “Chinese Wall” is an ethical concept of separation between groups, departments, or individuals within the same organization – a virtual barrier that prohibits communication or information sharing that could lead to conflict of interest. While the concept of the wall exists in a variety of industries and professions, including journalism, law, insurance, computer science, reverse engineering and computer security, it is most often associated with the financial services sector. An offensive and racist term commonly used in investment banksretail banks and brokerage companies. Historical milestones in the United States illustrate why the ethics wall was necessary in the first place and why legislation was created to keep it in place.

The Wall of China and the 1929 stock market crash

Derived from the Great Wall of China, an ancient impenetrable structure built to protect the Chinese from invaders, the term “Chinese wall“It came into common use – and into the financial world – in the early 1930s. Spurred by the 1929 stock market crash (attributed in part at the time to price manipulation and insider trading), Congress passed the 1933 Act. Glass-Steagall Law (GSA), requiring the separation of commercial and investment banking activities, that is, investment banks, brokerage firms and retail banks.

Although this act did lead to the disintegration of some securities and financial monoliths such as JP Morgan & Co. (which had to spin off its brokerage operations into a new company, Morgan Stanley), his primary intent was to avoid conflicts of interest. An example of this would be a broker recommending that clients buy shares in a new company whose initial public offering (IPO) broker’s colleagues in investment banking are doing just that. Rather than forcing companies to participate in either research or investment banking, Glass-Steagall tried to create an environment in which one company could participate in both endeavors. He simply demanded division between departments: the Chinese Wall.

This wall was not a physical, but rather an ethical boundary that financial institutions were required to respect. Internal or proprietary information no movement or sharing between departments was permitted. If an investment banking team is working on a deal to take a company public, their broker buddies downstairs don’t have to know about it—until the rest of the world does.

How linguistics, discrimination and racism

The term is often seen as a culturally insensitive and offensive view of Chinese culture. Unfortunately, it is now widespread in the world market. This was even challenged in court.

It appeared in a concurring opinion in Peat, Marwick, Mitchell and Company v. Supreme Court (1988)in which Judge Haning wrote: “The Chinese Wall” is one such piece of legal garbage that should be decisively abandoned. The term has an ethnic slant that many would consider a subtle form of linguistic discrimination. This term would be insensitive to the ethnicity of many people of Chinese descent. Modern courts should not perpetuate prejudices that permeate language from older and more primitive ways of thinking.”

The alternative suggested by the judge is an “ethical wall.” The American Bar Association’s Code of Conduct suggests using the terms “screening” or “screening” as a way to describe this concept as it relates to the management of conflicts of interest in law firms.

The Chinese Wall and 1970s deregulation

This arrangement has not been questioned for decades. Then, about 40 years later, deregulation brokerage activities commissions in 1975 served as a catalyst for increased concerns about conflicts of interest.

The change eliminated fixed minimum commissions on securities trades, causing brokerage profits to plummet. This has become a serious problem for seller analystswho conduct securities research and make information available to the public. Buyer-side analystson the other hand, they work for mutual fund companies and other organizations. Their research is used to make investment decisions by the companies that hire them.

Once brokerage commission prices changed, sell-side analysts were encouraged to produce reports that helped sell stocks, and they were given financial incentives when their reports promoted their firm’s IPO. For such successes, large bonuses were paid at the end of the year.

All of this contributed to the wild bull market and go-go, anything-goes era on Wall Street in the 1980s, as well as several high-profile insider trading cases and a nasty market correction in 1987. Securities and Exchange CommissionThe SEC conducted several reviews of China’s Wall procedures at six major broker-dealers. And partly as a result of its findings, Congress passed legislation Insider Trading and Securities Fraud Act of 1988.which increased penalties for insider trading and also gave the SEC greater authority to set rules regarding Chinese walls.

The Chinese Wall and the Dotcom Boom

Chinese walls, or walls of ethics, came into the spotlight again in the late 1990s, during the heyday of dotcom erawhen superstar analysts such as Morgan Stanley’s Mary Meeker and Salomon Smith Barney’s Jack Grubman became household names for their vigorous promotion of specific securities. 

During this time, a few words from a leading analyst can literally cause a stock’s price to rise or fall as investors buy and sell based on the analysts’ recommendations. Besides, Gramm-Leach-Bliley Act (GLBA) of 1999 repealed much of the Glass-Steagall Act, which prohibited banks, insurance companies and financial services companies from operating as a consolidated firm.

dotcom bubble crash in 2001 shed some light on the shortcomings of this system. Regulators took notice when it emerged that prominent analysts were privately selling personal stakes in shares they were touting and were being pressured to provide good ratings (despite personal opinions and research showing the stock was not a good stock). purchase). Regulators also discovered that many of these analysts personally owned shares before IPO securities and expected to make huge personal profits if successful, gave “hot” advice to institutional clients and favored certain clients, allowing them to extract huge profits from unsuspecting members of the public.

Interestingly, there were no laws prohibiting this practice. Weak information disclosure requirements allowed the practice to flourish. Likewise, it turns out that few analysts have ever issued a “sell” rating on any of the companies they cover. Encouraging investors to sell a particular security did not sit well with investment bankers because such a rating would discourage a low-rated company from doing business with the bank, even though analysts and their friends were often selling the same securities. Investors who bought securities on the advice of their favorite analysts, believing that their advice was unbiased, lost significant amounts of money.

Consequences of dot-coms

After the dot-com crash, Congress National Association of Securities Dealers (NASD) and New York Stock Exchange (NYSE) all took part in developing new rules for the industry. Ten well-known firms, including Bear Stearns & Co.; Credit Suisse First Boston (C.S.); Goldman Sachs & Co (G.S.); Lehman Brothers; JP Morgan Securities (DPM); Merrill Lynch, Pierce, Fenner & Smith; Morgan Stanley & Co (RS); and Citigroup Global Markets were forced to separate their research and investment banking departments.

Legislation has created or reinforced a division between analysts and insurers. It also included reforms to compensation practices, since previous practices gave analysts a financial incentive to give positive ratings to underwriting clients.

Are ethics walls effective?

Today, there are additional protections, such as prohibitions on tying analyst compensation to the success of a particular IPO, restrictions on providing information to some clients and not others, rules prohibiting analysts from making personal trades in the securities they cover, and additional disclosures. requirements aimed at protecting investors.

But lawmakers are still trying to understand what role conflicts of interest play in subprime mortgage crisis of 2007 that led to the Great Recession, and questions the extent to which ethical walls helped or hindered the practices that preceded the crash. There appear to be signs that the rules that ensure separation between product rating services and their client companies are being broken.

Another problem: one division of the investment company would recommend secured mortgage obligations (or other products) to investors while another division of the same firm was selling them short. In other words, they were betting against their own recommendations at the expense of investors.

Legality aside, all these dark events and scandalous eras reveal some ugly truths about ethics, greed, and the ability of professionals to control themselves. There have always been those who doubted the effectiveness of ethical walls; of course, they test self-regulation to the limit. Unfortunately, the moral of the last century is that the concept of ethical walls has helped define ethical boundaries, but has done little to prevent fraud.