Ethics and the Conduct of Business Eighth edition Chapter 11 Ethics in Finance Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

Modules Introduction: Ethics in Finance 11.1: Financial Services 11.2: Financial Markets 11.3: Insider Trading 11.4: Hostile Takeovers Conclusion: Ethics in Finance Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

Learning Objectives (1 of 2) 11.1: Explain the three basic forms of ethical misconduct when selling financial products and services, and the responsibilities brokers have to their clients 11.2: Assess the significance of the three main elements of fairness in financial markets and the ethical issues introduced by new financial instruments and practices 11.3: Summarize the two main arguments against insider trading and the challenges in applying these theories to its prevention and prosecution Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

Learning Objectives (2 of 2) 11.4: Analyze the ethical issues raised by various hostile takeover tactics and what they suggest about the rights and fiduciary duties of officers and directors Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

Introduction: Ethics in Finance Case: Goldman Sachs Creating the deal Expert analysis Collapse of the deal Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

Figure 11.1: Objectionable Sales Practices for Financial Products Deception Churning Suitability Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

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 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 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 Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

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 Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

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 Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

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 Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

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? Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

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 Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

11.3 Insider Trading (1 of 2) 11.3.1: Theories of Insider Trading 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 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 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 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 Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

11.3 Insider Trading (2 of 2) 11.3.3: Recent Insider Trading Cases 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 Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

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 Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

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 Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

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 Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

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 Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved