Financial Ethics 101: Conflict of Interest
By Londra Ademaj
*A conflict of interest arises when personal or self-serving interests clash with an entity or individual’s professional duties or responsibilities, undermining their reliability. *
Conflict of interest manifests across diverse fields, including finance, and investment advisory services. The ramifications of conflicts of interest span from reputational harm to substantial legal repercussions, underscoring the imperative for adept management and unwavering transparency in addressing these intricate challenges. Expanding the conflict of interest perspective reveals its potential to arise in unforeseen sectors, reaching beyond finance and infiltrating industries like hospitality. This exemplifies the magnitude of the conflict-of-interest conundrum, showcasing its pervasive reach. Imagine a situation where a friendly concierge arranges a taxi service run by their own family member. Now, in this scenario, the concierge might not even realize it, but they could unconsciously lean away from suggesting the most budget-friendly or deluxe option. It’s like a subtle hint of favouritism, where they unintentionally by steering business to the family business.
Conflicts of interest should be avoided particularly in the financial sector, where impartial decision-making stands as a cornerstone of ethical conduct and investor confidence. The 2008 financial crisis spotlighted the conflicting role of credit rating agencies, laying bare their contributions to the inflation of the home mortgage bubble and ensuing market turmoil.
Conflicts of Interest in Financial Institutions: Balancing Rationality, Trust, and Transparency
Within finance, the provision of advisory services and the strategic execution of investments on behalf of clients constitute pivotal endeavours. Professionals within this sector are driven by the overarching objective of optimizing returns while steadfastly adhering to ethical principles.
Beneath the surface of these transactions, recurrent conflicts of interest is driven by factors including incomplete information, the constraint of verifiability, and the absence of a costless contracting mechanism. These elements converge to create a landscape where economic transactions become focal points of contention. Clients often grapple with the challenge of accurately assessing or verifying the intrinsic value of goods and services they intend to procure. Simultaneously, financial institutions wield a level of influence over variables that may remain opaque to clients, thus complicating clients’ ability to logically substantiate or address any potential manipulations.
In the intricate matrix of this landscape, a state of equilibrium is pursued through the lens of rationality. Clients, guided by self-interest and rational thinking, elect to engage in transactions only when the terms and conditions offer commensurate benefits to offset potential conflicts of interest. This equilibrium relies upon the foundational principles of rational decision making, trust, and transparent communication (Mehran and Stulz).
These elements of rational behavior, unwavering trustworthiness, and transparent communication collectively contribute to constructing a resilient and dependable rapport (Mehran and Stulz). The foundation of this rapport is the apt comprehension and adroit management of conflicts of interest. When approached judiciously rationality, trust, and transparency contribute to credibility and the establishment of a stable and mutually advantageous financial environment, serving the interests of all stakeholders involved.
Investment Banking
An investment bank plays a role in a variety of financial transactions, serving as an intermediary that facilitates processes such as initial public offerings (IPOs) for emerging companies and corporate mergers. Given the multifaceted nature of an investment bank’s operations, conflicts of interest often come to the forefront (Hargrave). These conflicts arise from the web of relationships and responsibilities inherent in investment banking. One specific area where these conflicts manifest is between research and underwriting functions within the investment bank. The institution faces must harmonize the competing demands of distinct stakeholders, namely the issuing firms seeking capital infusion and the investors aiming to make well-informed investment decisions (Crockett et al.).
Equitable Balance and the Chinese Wall
In this context, striking an equitable balance becomes a central concern. The concept of an equitable balance refers to finding a just equilibrium that accommodates the interests of various parties. The goal is to ensure fair treatment for all stakeholders, including clients, investors, and the institution itself. This equilibrium maintains the integrity of the investment bank’s operations and upholds its reputation in the financial market.
Investment banking introduces the concept of a “Chinese wall.” This metaphorical barrier is put in place to segregate different divisions within the investment bank, effectively preventing the improper flow of information that could lead to conflicts of interest. Chinese walls safeguard the institution’s credibility and trustworthiness, ensuring decisions and advice provided to clients and investors are free from biases.
Conflict between Research and Underwriting Functions
Within investment banking, a notable conflict of interest often arises between the research and underwriting functions. These two functions, while distinct, are interconnected and can potentially lead to conflicting priorities:
- Research Function: The research department conducts in-depth analysis of companies, their performance, and future prospects. Its primary purpose is to provide impartial and accurate information to guide investors in making well-informed decisions.
- Underwriting Function: On the other hand, underwriting is responsible for facilitating companies in raising capital through the issuance of securities. This activity involves assessing the company’s financial health, risk profile, and determining the terms of the securities to be issued.
Navigating Conflicting Interests and Incentives for Bias
Conflicting interests arise due to the differing goals of these functions.
- Issuing Firms (Companies): Companies seeking capital infusion through securities offerings naturally prefer positive assessments of their prospects. They lean towards research reports that present an optimistic view of their future performance, as this can attract a larger pool of investors.
- Investors: Conversely, investors require objective, unbiased information to make informed investment choices. They depend on research that offers a neutral evaluation of a company’s strengths and weaknesses.
Furthermore, a critical challenge emerges when the potential revenue generated from underwriting surpasses earnings from brokerage commissions. This financial incentive can create pressure to tailor research information to align with the preferences of issuing firms, potentially compromising the impartiality of the research.
Upholding Integrity and Credibility
To preserve an investment bank’s integrity and credibility, it must maintain an equitable balance between the interests of issuing firms and investors. This equilibrium ensures research remains unbiased and impartial, enabling investors to make informed decisions grounded on accurate information. The implementation of a “Chinese wall” serves as a practical mechanism for achieving this balance, preventing the unauthorized flow of information across departments and mitigating conflicts of interest.
Proprietary Trading vs. Trading for Clients
Another potential source of conflict arises in proprietary trading, where the investment bank participates in trading financial instruments using its own capital instead of client funds. This practice enables the bank to capture profits from trades, extending beyond mere commissions. Nonetheless, the engagement in proprietary trading brings about potential conflicts between the bank’s interests and those of its clients. Individual investors might not derive advantages from this activity, as it doesn’t encompass trades conducted on their behalf (CFI). This situation prompts inquiries into whether the bank could potentially prioritize its own gains above the well-being of its clients.
Mergers and Acquisitions
The role of M&A advisors within investment banks is noteworthy. These advisors facilitate transactions between buyers and sellers, orchestrating corporate mergers or acquisitions. Nonetheless, these advisors often find themselves in potential conflicts of interest.
One notable instance involves M&A advisors representing both the acquiring party and the target company in a transaction. This dual role can present challenges in providing impartial guidance and securing the most advantageous terms for both parties (Rosen Advisory). Another situation arises in M&A. Occasionally, advisors engage in special projects for companies they potentially intend to collaborate with in the future. This dynamic can nudge advisors to guide sellers towards these companies, reflecting a reciprocal arrangement of sorts. Additionally, the urgency to expedite transactions can exert pressure on M&A advisors, prompting them to prioritize speed over thorough evaluation (Rosen Advisory). This inclination is particularly pronounced when their compensation hinges on the successful closure of the deal or when they have other clients awaiting their attention. This prioritization of expediency may not consistently align with the optimal interests of the clients.
Financial Advisors
When it comes to financial advice, conflicts of interest arise when advisors’ goals don’t match their clients’ goals. When advisors and clients start working together, they have detailed conversations about things like how much risk the client is comfortable with and how long they plan to invest. While clients might set some limits on their investments, advisors may have the power to make decisions for them.
One way to determine if there are conflicts is to look at how advisors get paid. There are two main ways they’re paid : fee-only and fee-based. In the fee-only setup, advisors only make money for the advice they give (Houston). They don’t get extra cash for suggesting certain investments or products. This ensures advisors are not tempted to recommend investments just because they’ll earn more transaction fees. Fee-only advisors usually get a percentage of the money they manage for clients, and they might also charge flat fees or hourly rates for specific work. This transarent way of getting paid means advisors’ interests match clients’ interests, as their income goes up when their clients’ investments do well.
With fee-based advisors, things can get more complicated. Advisors also get paid based on assets managed. But advisors also earn money from commissions when they sell financial products like insurance or investments. This mix of payment methods can lead to conflicts, as fee-based advisors may suggest products that give them higher commissions, even if those might not be the best choices for their clients (Houston).
Credit Rating Agencies
A credit rating is a vital assessment to determine the creditworthiness of a company or government entity, gauging their capability to fulfil financial obligations and repay debts. This evaluation holds immense significance for both investors and lenders, aiding them in evaluating the level of risk tied to investing in or extending financial assistance to a specific entity, spanning from businesses to government bodies at various levels (Kagan). A higher credit rating signifies the rating agency’s confidence that the borrower will easily meet their debt repayment commitments. Conversely, a lower credit rating signals potential difficulties in maintaining payments or even the possibility of default.
In the midst of the 2008 global financial crisis, the actions of rating agencies came into sharp focus, drawing attention from experts such as Joseph Stiglitz who underscored their substantial contribution to the crisis (Neate). These agencies had multifaceted roles, participating in various capacities that significantly shaped the crisis.
Imagine rating agencies as evaluators responsible for assessing the risk associated with financial securities. However, their role during the crisis took a pivotal yet contentious turn. They upgraded the ratings of securities, even those with underlying assets of questionable quality. This recalibration of risk ratings had far-reaching consequences, misleading investors and fostering an unwarranted sense of security. As a result, these agencies inadvertently played a role in enabling and exacerbating questionable financial practices, exacerbating the crisis.
At the core of the turmoil lay the inflation of the home mortgage bubble, and this is where rating agencies actively played their part. They assigned high ratings to mortgage-backed securities tied to subprime mortgages, effectively encouraging investments in these high-risk loans. These elevated ratings created a sense of assurance among investors, driving the unsustainable expansion of this market segment.
Of particular significance was the dual role of rating agencies – both as evaluators and participants. While entrusted with impartially assessing the risk of financial products, they also engaged in endorsing and promoting investments linked to subprime mortgages. This inherent conflict of interest cast a shadow on the integrity of their evaluations, raising concerns about their objectivity and accuracy.
In essence, rating agencies contributed to the financial crisis through their multiple roles. By upgrading securities, they indirectly facilitated questionable financial practices and played a role in distorting perceptions of risk. Additionally, their role in inflating the mortgage bubble by assigning high ratings to subprime-linked securities significantly compounded the crisis. The intricacies of their dual role, straddling evaluation and participation, underscore their influence and prompt discussions about the depth of their impact on the crisis.
Further revelations by William Harrington, a former senior executive at Moody’s, shed light on potential conflicts of interest within rating agencies (Neate). Harrington disclosed instances of senior management interfering with analysts’ independent assessments, casting doubt on the objectivity of credit ratings. This conflict arises because rating agencies receive payment from the very banks and companies they are entrusted to impartially evaluate.
Another significant development occurred in the 1970s when rating agencies shifted from the “investor pays” model to the “issuer pays” model (White). Under the latter model, entities issuing bonds pay the rating firms for their evaluations. This change introduced the potential for conflicts of interest, as rating agencies may be incentivized to provide overly positive ratings to appease issuers and retain their business.
Skreta and Veldkamp’s model delves into the implications of issuers having the option to select from various rating agencies (Skreta and Veldkamp). Even if these agencies genuinely strive to assess creditworthiness, issuers often choose the most optimistic rating, leading to overly positive evaluations. This phenomenon arises from issuers being able to pick the rater aligning with their desired outcome, thus introducing a conflict of interest that can undermine the credibility of credit ratings.
The Damage from Conflict of Interest
Conflicts of interest carry significant implications, encompassing reputational and legal risks. When individuals or entities face competing interests that could compromise their impartiality, it raises concerns. Disclosure of such conflicts by sources like whistleblowers or journalists can have reputational ramifications. This includes a potential erosion of public trust and a compromised perception of ethical integrity. Furthermore, conflicts of interest that contravene established regulatory frameworks can result in notable legal consequences. Regulatory bodies possess the authority to impose fines, sanctions, or other punitive measures on entities found in violation. In severe instances, individuals involved in conflicts breaching ethical or legal standards may encounter disbarment or substantial constraints on their professional pursuits. Thus, conflicts of interest extend lead to tangible harms, underscoring the necessity of transparent management and adherence to regulations to mitigate potential adverse effects.
Case Study: PWC
In the year 2000, PwC, the world’s largest accounting firm, found itself in a critical situation prompted by a stern advisory from the Securities and Exchange Commission (Davis and Stark). The commission strongly recommended an external investigation to assess PwC’s adherence to conflict-of-interest rules. Responding swiftly, PwC engaged an independent investigator to thoroughly examine the matter.
The investigator’s findings were troubling, revealing that a significant majority of PwC’s partners, including thirty-one of the top forty-three, had not diligently separated their personal finances. Shockingly, these partners maintained financial interests in businesses that PwC audited, with a few even owning stock in companies for which they directly handled auditing responsibilities. PwC took decisive action, imposing disciplinary measures on several partners and requesting the departure of others from the firm (Davis and Stark).
Fast forward to 2023, PwC once again faced a challenging situation, this time stemming from allegations of confidential information misuse by its employees. The breach at hand revolves around a situation where confidential tax policy information was shared in an attempt to attract business. Responding promptly, the head of the treasury took assertive action by involving the police and subsequently suspending the staff members involved. In recognition of the gravity of the situation, PwC agreed to adhere to the directive and proceeded to suspend the implicated employees. Simultaneously, the company initiated an internal assessment under the guidance of Ziggy Switkowski, aiming to meticulously examine and refine its operational procedures in light of the breach.
The severity of the breach prompted the Australian Federal Police (AFP) to launch a thorough investigation into the unauthorized utilization and disclosure of confidential information. Compounding the situation, AFP’s existing contracts with PwC raised valid concerns regarding potential conflicts of interest.
The government, displaying a proactive approach, is taking steps to enhance accountability and address vulnerabilities that may lead to breaches of this nature. The breach’s repercussions have been substantial, with the resignation of PwC’s CEO and a broader examination of the firm’s governance structure. This incident has catalyzed discussions surrounding the reduction of reliance on consultancy services, highlighting the paramount importance of rebuilding trust between the government and private sector entities (Karp and Press).
Public response to PwC’s actions has been swift, with key government departments taking significant measures. The head of treasury has referred the matter to the police, and the finance department has suspended staff directly involved in or aware of the breach. Notably, PwC has been directed to suspend relevant employees from all current and future contracts under the management advisory services panel (Karp and Press).
Another breach emerged in 2018, distinctly separate from the 2013 reputation crisis involving confidential tax policy information. This breach pertains to a PwC staff member who engaged in an exclusivity agreement with a client without proper authorization from the firm’s conflict of interest’s team. Unlike the prior situation, this breach unfolded in 2018 and stands apart from the reputation crisis that prompted the divestment of PwC’s government services division due to the misuse of confidential tax policy information. (Belot).
Handling Conflicts of Interest
When faced with a conflict of interest, several established methods can be theoretically employed to address the issue. These approaches include (Coleman):
- Declaring the conflict of interest: This straightforwardly involves communicating the presence of a conflict to the relevant parties.
- Removing the conflict of interest: This approach requires eliminating the conflicting interest or interests that may compromise one’s professional or public role.
- Avoiding the conflict of interest: This strategy involves distancing oneself from the situation that gives rise to the conflict.
However, as demonstrated by the case of PwC spanning from 2000 to the present day, the actual management of conflict of interest within the context of large financial institutions is anything but straightforward. The persistent nature of conflicts of interest becomes apparent when observing the extensive efforts that PwC undertook to address these challenges.
From the initial scrutiny prompted by the Securities and Exchange Commission in 2000, it is evident that detecting and effectively managing conflicts of interest is a complex and ongoing endeavour (Davis and Stark). Despite theoretical approaches, such as disclosure or removal, the real-life application of these methods is fraught with difficulties. The revelation that numerous partners at PwC had intertwined their personal finances with audited businesses demonstrates pervasiveness of these issues. Moreover, as time progressed, instances of alleged misconduct and potential conflicts of interest resurfaced, underscoring the continuous struggle to identify and mitigate such concerns within major financial institutions.
These recurring challenges, encompassing aspects like confidential information misuse and unauthorized agreements, highlight the stark reality that despite well-defined theoretical methods, controlling conflicts of interest remains a formidable and ever-evolving challenge. This complexity necessitates unwavering vigilance and an unyielding commitment to maintaining ethical conduct and compliance in the financial sector.
Instances like the PwC breaches underscore the difficulty in preventing conflicts of interest practices. While theoretical approaches like declaration, removal, or avoidance are established, their practical implementation remains a challenge but one worth the effort.
Works Cited
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