Practical analysis for investment professionals
11 February 2014

History Shows Ethics, Or Lack of It, Will Shape the Future of Finance

It seems that barely a month goes by without another headline about the ethical failure of an investment professional. Most recently, of course, was SAC Capital’s decision to plead guilty to all five counts of insider trading violations and pay a record $1.2 billion penalty, becoming the first large Wall Street firm in a generation to confess to criminal conduct, according to the New York Times. While these record penalties seem to be broken fairly frequently, one is left wondering: Is there anything new about the nature of the ethical issues involved?

The short answer is: No. Neither the insider trading by SAC Capital nor any of the ethical failures by other financial institutions are new. This conclusion became abundantly clear when I read, “Ethics and Financial Markets: The Role of the Analyst,” an exhaustive literature review of ethical issues spanning more than a century. The literature review was published by the CFA Institute Research Foundation and is written by Marianne M. Jennings, professor emeritus of legal and ethical studies in business at Arizona State University, Tempe.

While there is no magic bullet to make finance professionals behave ethically, learning from history is a necessary step to finding a solution and rebuilding trust.

Here are some of the key excerpts from the review:

History Repeats Itself, Or At Least Rhymes

“Doubts about the ability of the [trust securities] market to keep going lingered, but in September 1929, Charles E. Mitchell, National City Bank chairman, said that there was ‘nothing to worry about in the financial situation of the United States.’ Almost a century later, words from that same bank’s CEO would be eerily similar.

“Mitchell sailed for Europe and could not be reached when the stock market crashed in October 1929. Investors who had bought into the ‘safe’ investment trusts were left with worthless investments. Those who had lent the money to the investment banks were left with worthless collateral and debtors who lacked not only cash but also assets. The Dow dropped every day, to a total of 89%, from the 1929 peak to the 1932 bottom.

“In the summer of 2007, with the mortgage securities market already fraying at the edges, Charles Prince, CEO of Citigroup, offered Mitchell-like reassurance: ‘As long as the music is playing, you’ve got to get up and dance. We’re still dancing.’ A year after Prince’s statement, Citigroup required a government bailout, and by the fall of 2009, the Dow had dropped 54% from its 2007 peak.”

Insider Trading Is an Old Sin

“In 1986, the markets had to cope with the Ivan Boesky insider trading issues and Michael Milken’s junk bond offers. The cases captured the public’s attention because the fictional Gordon Gekko’s mantra of ‘Greed is good’ fueled public backlash about investment markets. The perception of an unfair playing field or asymmetrical dissemination of information perpetuated public unease about the profession.

“Dennis Levine, an investment banker with Drexel Burnham Lambert, was a merger specialist who used day trips to the Bahamas to phone in (from public pay phones) instructions on stock trades in advance of the public disclosure of pending mergers. Levine obtained information from a young associate at a law firm who was working on the merger documents. This young associate passed similar premerger information along to other Wall Street professionals, including Ivan Boesky. Boesky paid $100 million in penalties as a result of the profits he earned from the tips he received from Levine. . . . What was significant in terms of the investment and stock market culture was that Levine was not involved with clients in structuring 35 of these takeovers; his information was coming from other sources at law firms and investment banks who were handling the takeovers. . . . Milken entered a guilty plea to six felonies and paid a $600 million fine. Drexel Burnham Lambert vigorously denied any wrongdoing but eventually pleaded guilty to six counts of fraud and paid a $300 million fine. Within months after the settlement of the criminal charges, Drexel Burnham Lambert declared bankruptcy.”

From Ponzi to Madoff: Fraud Is a Familiar Story

Charles Ponzi (1882–1949) left both his mark and his name in the financial markets. . . . In the 1920s, Ponzi purchased ‘reply coupons’ in Spain for 1 cent but was able to redeem those coupons in the United States for 6 cents. With a net gain of 5 cents per coupon, Ponzi promised his investors a 50% return on their funds — and all within 45 days. Ponzi used his investors’ funds for cash purchases of the 1 cent reply coupons. He bought as many as he could to earn his 5 cents. The golden goose phenomenon kicked in, however; given the small supply of the coupons, there was too much demand. Ponzi solved the mismatch by paying off his early investors with cash generated from the new entrants, after taking the usual cut that goes for the creator.

“In a similar story emerging in the late 1990s, securities broker Bernard Madoff created a fund that would follow the Ponzi pattern with a promise of steady 12% annual returns. Madoff took in investors — from high society and Hollywood stars — by using a feeder network that was skeptical but well compensated. Madoff did pay off the early investors after his creator’s cut to support his residences in Palm Beach and the Hamptons.”

Analysts Have Long Made the Same Errors of Ethical Judgement

“The post-1929 congressional hearings on the market crash examined the activities of the investment firms as well as the analysts who had touted the investment trust instruments as safe. . . . Ferdinand Pecora was Chief Counsel to the United States Senate Committee on Banking and Currency during its investigation after the market crash. . . . The hearings revealed analyst behavior that would reemerge during the dot-com and mortgage securities bubble.

“During the 1920’s market run-up, one analyst for National City Bank, Victor Schoepperle, had made a ‘buy’ recommendation on Peruvian bonds, as a ‘safe’ investment. Pecora had found information in Schoepperle’s files, however, indicating that the government of Peru had a long history of both political instability and defaults. . . . Pecora confronted him with the inconsistency between his own conclusion documented in his files and his public recommendation.

“Schoepperle reconciled his private notes’ negativity with National City’s positive public recommendations as follows: ‘I thought, like a great many others, that I was in a new era. It was an optimistic era in which optimistic interpretations were put on any situation where the pros were about equal to the cons.’ He added that there was a chance for National City to earn underwriting fees through a positive recommendation but no further sales if Schoepperle’s true opinion emerged. The bad credit, the political risk, and the long history of both were not included in the prospectus for National City’s offerings of the Peruvian bonds in 1927. . . . By 1931, these Peruvian bonds were selling at less than 7% of their par value.”

If Regulation Follows Ethical Collapse, Deregulation Leads It

“Beginning in 1980, a pattern of deregulation ran parallel to the evolving scandals of the decade. The passage of the Depository Institutions Deregulation and Monetary Control Act allowed the setup of the next wave of fraud and abuse in a different market segment. The act gave savings and loan (S&L) associations expanded abilities in terms of the nature of their loans and the right to offer savings products beyond the basic deposit account.

“The events that followed this deregulation illustrate how swings from regulation to deregulation remind us of the reasons for the original regulation. Lincoln Savings & Loan became the poster child for the lack of wisdom in the deregulation of the S&Ls. Like its counterparts in the stock market, Lincoln’s ultimate collapse began with advisers steering depositors into noninsured and highly speculative investments. . . . In 1988, the real estate bubble of that era burst, and in 1989, Lincoln Savings and Loan collapsed, at a cost of more than $3 billion to the federal government. Some 23,000 Lincoln bondholders had been defrauded, and many investors lost their life savings.”

Legalism Blinds Us to Ethics

“Why do the missteps recur? . . . One reason documented by this historical review is that we have not learned history’s lessons. Another reason, evident in the examples in this historical review, is that the legalistic focus blinds professionals to higher ethical standards.

“For example, at the Senate hearings on the 2008 market collapse, Senator Susan Collins of Maine posed a question to several Goldman executives: ‘I understand that you do not have a legal fiduciary obligation. But did the firm expect you to act in the best interests of your clients as opposed to acting in the best interests of the firm? Could you give me a yes or no to whether or not you considered yourself to have a duty to act in the best interests of your clients?’

Fabrice Tourre, the young manager who was responsible for one of the collapsed Goldman mortgage funds, responded only with, ‘I believe we have a duty to serve our clients well.’ When Lloyd Blankfein was confronted with the same question, he responded, ‘While we strongly disagree with the SEC’s complaint [a complaint the firm would later settle], I also recognize how such a complicated transaction may look to many people. To them, it is confirmation of how out of control they believe Wall Street has become, no matter how sophisticated the parties or what disclosures were made. We have to do a better job of striking the balance between what an informed client believes is important to his or her investing goals and what the public believes is overly complex and risky.’ . . . The legalistic approach cannot prevent the next clever trick that the financial markets develop to gain at the expense of customers. Each era brought regulation, which took hold only long enough for the next era to be ushered in with its new approaches and the same resulting harm to investors.”

We Can Use These Three Questions to Be Clear on Ethics

“A review of the history of ethics in financial markets and the related literature points to two conclusions: (1) History does repeat itself, and (2) when analysts depart from three simple questions, complex issues are resolved through a thicket of codes, laws, and regulations that encourage further interpretations and exceptions and cloud ethical judgement. The three questions are, Does this violate the law? Is this honest? What if I were on the other side? The last is a question that tends to elicit the simplest summation for ethical missteps: That’s not fair!”

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

About the Author(s)
Usman Hayat, CFA

Usman Hayat writes about sustainable, responsible, and impact investing and Islamic finance. He is the lead author of "Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals," and the literature review, "Islamic Finance: Ethics, Concepts, Practice." He is interested in online learning and has directed three e-courses for CFA Institute: "ESG-100," "Islamic Finance Quiz," and "Residual Income Equity Valuation." The other topics he writes about are macroeconomics and behavioral finance. Previously, he was a content director at CFA Institute. He is a former executive director at the Securities and Exchange Commission of Pakistan (SECP). He has experience working in securities regulation and as an independent consultant. His qualifications include the CFA charter, the FRM designation, an MBA, and an MA in Development Economics. His personal interests are reading and hiking.

6 thoughts on “History Shows Ethics, Or Lack of It, Will Shape the Future of Finance”

  1. Thank you for this article. It is a great reminder to all industry professionals that it is imperative to the future of finance for us to uphold the highest ethical standards.

    1. Kerry Jordan

      Thank you for your kind feedback. I agree with your point.

  2. John Taabavi says:

    This is a wonderful article.I am very interested in Ethics and Responsible Behaviour in Finance : The African Experience. as a research topic. can you give me contact to Proff Emeritus Marianne. Thank you.

    1. John Taabavi

      Thank you for your kind feedback. Professor Jennings has the following website, which has her contact information.

  3. Prajwal Suvarna says:

    This is such a wonderful article.This deals with ethical aspects with regard to our profession. “History does repeat itself”.Probably something which we need to accept.

    1. Prajwal Suvarna

      Thanks for reading the post and sharing your comment.
      Yes, it does seem that history doesn’t just rhyme, but at times, does repeat.



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