1. Ethics and the Conduct of Business
Eighth edition
Chapter 11
Ethics in Finance
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2. 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
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3. 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
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4. 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
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5. Introduction: Ethics in Finance
Case: Goldman Sachs
Creating the deal
Expert analysis
Collapse of the deal
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6. Figure 11.1: Objectionable Sales Practices for Financial Products
Deception
Churning
Suitability
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7. 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
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8. 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
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9. 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
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10. 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
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11. 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?
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12. 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
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13. 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
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14. 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
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15. 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
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16. 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
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17. 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
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18. 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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