Ethics in Finance

Question 1

Two important features of ethical reasoning?

Answer 1

(1) Seeking out and acting on reasons
(2) Impartial, consistent judgement
- > Regard the interests of everyone (including self) as equally worthy of consideration
- > Same judgement for self as for another person, given the same set of circumstances/facts
- > A good test: would you feel comfortable with others (colleagues/friends/family) knowing about the decision?
- > Decisions based on ethical reasoning with stand (may even invite) openness and scrutiny

Question 2

Important characteristics of a system of ethical reasoning?

Answer 2

(1) Completeness
The system can handle all cases put before it and arrive at a decision
(2) Coherence
You shouldn’t change who you are and what you stand for depending on the context; consistent application of reasoning
(3) Connection to a theory of ethics or beliefs
Which theory or beliefs is a personal matter
(4) Practicability
Can be implemented / carried out; is not impossible

Question 3

Theories of ethical reasoning?

Answer 3

(1) Utilitarianism: An action is morally ‘right’ if it maximises the total utility of the group affected by the action
(2) Deontology: Actions themselves are either morally right/wrong based on a set of principles
(3) Kantian ethics: A form of deontology, therefore focusses on the morality of actions, not their consequences
- > Universality principle: only act on rules that you would be willing for everyone to follow
(4) Virtue ethics: One should cultivate desirable personality traits and then with these traits he/she will make ethical decisions

Question 4

Define (1) Welfare; (2) Duty; (3) Rights; (4) Fairness/justice; (5) Honesty; (6) Integrity

Answer 4

(1) Welfare: “the greatest good for the greatest number” (sum utility across all people)
(2) Duty: Optimally fulfil the obligations of your role without regard for self interest  e.g., fiduciary duty of management = act in the best interests of shareholders
(3) Rights: Entitlements to be treated in a certain way
(4) Fairness/justice: Equal treatment, or different treatment in cases of justified differences
(5) Honesty: Truthfulness; can be regarded as duty
(6) Integrity: Holding a strong set of reasoned values and having the courage to apply them consistently

Question 5

Name the three blocks of CFA Standards of Practice

Answer 5

I. PROFESSIONALISM
A. Knowledge of and compliance with the law
B. Independence and objectivity
C. Honesty in both representation and conduct
II. INTEGRITY OF FINANCIAL MARKETS A. Insider trading
B. Market manipulation
III. DUTIES
A. Loyalty, prudence (caution) and care to clients/employer
B. Disclosure of conflicts of interest to clients/employer
C. Fair and objective dealings with clients
D. Accurate and complete performance presentation
E. Preservation of client confidentiality

Question 6

I. PROFESSIONALISM: Knowledge of and compliance with the law

Answer 6

A. Knowledge of and compliance with the law

- >Know the laws/rules and comply with them. -> Stay informed of developments
- > Do not knowingly assist/associate with violations
- > If you become aware of a violation, disassociate as follows: (i) persuade the perpetrator to cease the illegal activity, and (ii) if unsuccessful, then sever connections and/or resign
- > When operating in multiple jurisdictions, adhere to the stricter law

Question 7

I. PROFESSIONALISM: B. Independence and objectivity

Answer 7

B. Independence and objectivity

• > Must not offer/solicit/accept gifts/benefits/compensation that could compromise their or other’s independence and objectivity (e.g., boozy ‘business’ lunches, sponsorship of events, tickets, travel funding , favours, job referrals)
• > Settings, e.g., selling financial products, securities issuance, credit ratings, analyst research reports

Question 8

I. PROFESSIONALISM: C. Honesty in both representation and conduct

Answer 8

C. Honesty in both representation and conduct

- >Must not knowingly misrepresent analysis/performance/qualifications/abilities
- >Must not engage in dishonesty/fraud/deceit
- >Always quote, except from «recognized financial and statistical reporting services»

Question 9

II. INTEGRITY OF FINANCIAL MARKETS: A. Insider trading

Answer 9

A. Insider trading

 ->Must not act on or cause others to act on material non-public information (must not leak information for someone else to trade on)
-> Illegal in most jurisdictions: Insider trading causes investors to perceive markets as unfair or rigged and deters participation, resulting in welfare losses

“Material” = would cause prices to move if it were announced to the market (i.e., influences value), e.g., earnings, bankruptcy, M&A, changes in firm
Compliance procedures: firewalls, achieve public dissemination, trading blackouts

Question 10

What is Mosaic theory?

Answer 10

Mosaic theory – conclusion based on public information together with nonmaterial nonpublic information is not a violation

Question 11

II. INTEGRITY OF FINANCIAL MARKETS: B. Market manipulation

Answer 11

B. Market manipulation

- > Must not engage in practices intended to distort or give a misleading appearance of prices or trading activity
- > Causes investors to perceive markets as unfair or rigged and deters participation, resulting in welfare losses
- > Information-based manipulation: spreading rumours/false information to influence price

Trade-based manipulation: engaging in trades intended to create a misleading price/volume or taking a controlling position in the supply of a financial security

Question 12

III. DUTIES: A. Loyalty, prudence (caution) and care to clients/employer

Answer 12

A. Loyalty, prudence (caution) and care to clients/employer

 - > Loyalty to both clients and employer, putting the client’s interests before those of employer and employer’s before those of self
 - > Judge the suitability of investments in the context of the client’s total portfolio and risk/return objectives, the “suitability test”; investment policy statement updated at least annually; invest to mandate
 - > Professional competence: keep your knowledge up-to-date and at a high level and only act/advise within the bounds of your competence

Question 13

What is Fiduciary and Fiduciary duty?

Answer 13

Fiduciary = person entrusted with the care of another’s property or assets and has responsibility to exercise discretionary judgements in in the other person’s interests
Fiduciary duty = act solely in the interests of the beneficiary
-> e.g., corporate management and shareholders; fund manager and investors
-> Different from contractual obligation, e.g., corporate management and debt-holders

Question 14

III. DUTIES: B. Disclosure of conflicts of interest to clients/employer

Answer 14

B. Disclosure of conflicts of interest to clients/employer

Conflict of interest
-> Inherent in many areas of finance due to: (i) difficulty in defining roles of an agent/fiduciary; and (ii) money and various other forms of direct/indirect compensation floating around

Disclose all matters and compensation that could impair independence and objectivity,
-> e.g., referral fees for recommendation of product/service, own positions in particular assets, structure of compensation from company

Question 15

What is Conflict of interest?

Answer 15

Conflict of interest = when a personal or institutional interest interferes with the ability of an individual or institution to act in the best interests of another party

Question 16

III. DUTIES: C. Fair and objective dealings with clients

Answer 16

C. Fair and objective dealings with clients

Equal treatment (no favouritism)

Question 17

III. DUTIES: D. Accurate and complete performance presentation

Answer 17

D. Accurate and complete performance presentation

Must not falsify information, must not omit relevant information

Question 18

III. DUTIES: E. Preservation of client confidentiality

Answer 18

E. Preservation of client confidentiality

Unless: (i) the information concerns illegal activities; (ii) disclosure is required by law; or (iii) client permits disclosure

Question 19

Is speculation unethical? Why or why not?

Answer 19

(1) Not unethical in general, in fact speculation (when based on perceived mispricings) has an important role in markets, and can increase social welfare:

• > Cause information to be incorporated into prices (increase informational efficiency), which improves allocation of scarce resources to the most productive uses (economic efficiency), which increases GDP growth and aggregate consumption
• > Actions that increase economic efficiency can be viewed as ethical given they can increase aggregate welfare

BUT, there are many forms of speculation that may be unethical, e.g.,
-> Speculation that harms others or markets (e.g., market manipulation, insider trading (? maybe), excessive risk taking with others’ money because your downside is unlimited but upside is unlimited)

Question 20

Is lobbying government/regulators unethical? Why or why not?

Answer 20

Not unethical in general to get an opinion/position conveyed to lawmakers

BUT, may be unethical, if it is done knowing that the proposed outcome will either:

• > Harm others more than it will benefit the beneficiaries;  Is based on deliberate misinformation;
• > Will have a negative impact on fairness and/or rights.

Question 21

Is it unethical for CEOs to earn huge salaries/bonuses? Why or why not?

Answer 21

Large salaries/bonuses are not in themselves unethical:

• > High prices can emerge naturally as a result of supply and demand
• > Top executives may create large sums of additional value through increased efficiency that others may not be able to produce
• > May motivate employees to work hard to advance up the corporate ladder

BUT, large salaries/bonuses may be unethical if

-> CEO is knowingly adding less value to the company/society than he is paid (e.g., leaving ticking time bombs for future CEOs to clean up, being reckless, seeking personal gains at the expense of other stakeholders)

Distributional justice is an issue worth thinking about
-> Aristotle’s principle of distributional justice is that a person’s share of the good (e.g., salary/bonus) must be proportional to their share of some relevant variable (e.g., value added, risk taken)

In the lead up to the crisis, the top hedge fund managers were making 30 times more money than the highest paid CEOs -> if there is something wrong with CEO salaries, there is certainly something wrong with fund manager salaries

Question 22

Is the creation and selling of complex structured securities/derivatives unethical? Why or why not?

Answer 22

These products are not unethical in general:

-> In fact they can increase social welfare by more efficiently redistributing risk and facilitating better diversification, i.e., their use can be highly ethical

BUT, there are many examples of their misuse in the lead up to and during the recent crisis, e.g.,
-> Investment banks deliberately selling structured securities they knew were bad investments based on their expected risk-return characteristics

Question 23

Name some ethics issues/practices in finance

Answer 23

Market manipulation
    -> Information-based, trade-based 
    -> Cornering/squeezing the market
 Insider trading
   -> Chinese walls
    -> Trading bans for investment bankers, corporate managers
Regulatory (government) capture, lobbying  
   -> Bribing government
Ratings agencies conflicts of interest 
   -> Too big to fail