Ethics in finance boatright, john r SRG

Ethics in Finance Foundations of Business Ethics Series editors: W Michael Hoffman and Robert E Frederick Written by an assembly of the most distinguished figures in business ethics, the Foundations of Business Ethics series aims to explain and assess the fundamental issues that motivate interest in each of the main subjects of contemporary research In addition to a general introduction to business ethics, individual volumes cover key ethical issues in management, marketing, finance, accounting, and computing The books, which are complementary yet complete in themselves, allow instructors maximum flexibility in the design and presentation of course materials without sacrificing either depth of coverage or the discipline-based focus of many business courses The volumes can be used separately or in combination with anthologies and case studies, depending on the needs and interests of the instructors and students John R Boatright, Ethics in Finance, third edition Ronald Duska, Brenda Shay Duska, and Julie Ragatz, Accounting Ethics, second edition Richard T De George, The Ethics of Information Technology and Business Patricia H Werhane and Tara J Radin with Norman E Bowie, Employment and Employee Rights Norman E Bowie with Patricia H Werhane, Management Ethics Lisa H Newton, Business Ethics and the Natural Environment Kenneth E Goodpaster, Conscience and Corporate Culture George G Brenkert, Marketing Ethics Al Gini and Ronald M Green, Ten Virtues of Outstanding Leaders: Leadership and Character Forthcoming Denis Arnold, Ethics of Global Business Ethics in Finance THIRD EDITION John R Boatright This edition first published 2014 © 2014 John Wiley & Sons, Inc Registered Office John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, UK Editorial Offices 350 Main Street, Malden, MA 02148-5020, USA 9600 Garsington Road, Oxford, OX4 2DQ, UK The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, UK For details of our global editorial offices, for customer services, and for information about how to apply for permission to reuse the copyright material in this book please see our website at www wiley.com/wiley-blackwell The right of John R Boatright to be identified as the author of this work has been asserted in accordance with the UK Copyright, Designs and Patents Act 1988 All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books Designations used by companies to distinguish their products are often claimed as trademarks All brand names and product names used in this book are trade names, service marks, trademarks or registered 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from the British Library Cover image: © Getty Images / pepifoto Cover design by Cyan Design Set in 10.5/12.5 pt Minion by Toppan Best-set Premedia Limited 1  2014 Contents Preface Acknowledgments Abbreviations vii ix x Finance Ethics: An Overview The Need for Ethics in Finance The Field of Finance Ethics 13 Fundamentals of Finance Ethics A Framework for Ethics Agents, Fiduciaries, and Professionals Conflict of Interest 26 27 40 45 Ethics and the Retail Customer Sales Practices Credit Cards Mortgage Lending Arbitration 63 64 78 96 108 Ethics in Investment Mutual Funds Relationship Investing Socially Responsible Investing Microfinance 120 121 141 148 155 Ethics in Financial Markets Fairness in Markets Insider Trading Hostile Takeovers Financial Engineering 171 172 182 189 201 vi  Contents Ethics in Financial Management The Corporate Objective Risk Management Ethics of Bankruptcy Corporate Governance 223 224 234 243 254 Index 273 Preface Writing a book on ethics in finance poses a special challenge The difficulty does not arise from a lack of subject matter, despite the cynical view that there is no ethics in finance To the contrary, finance is infused with ethics and could not exist without it Financial activity is governed by detailed rules, and a high level of integrity is expected of people who bear great responsibility As a field of study, however, finance ethics is barely formed, and so the first task for a writer in this area is to define the subject, frame the main issues, and identify the relevant ethical principles Whereas most textbooks present standard material, this one is forced by necessity to be original Hopefully, Ethics in Finance, Third Edition, will continue to advance the important task of creating the field of finance ethics Not only is the field of finance ethics still being formed, but it is also highly diverse People trained in finance enter many different lines of work, in which they encounter a variety of ethical situations and issues The situation of a stockbroker is different from that of a mutual fund manager, a market regulator, or a corporate financial officer In addition, finance ethics encompasses broader ethical issues in financial markets, financial services, and financial management, which are addressed by both industry leaders and government regulators A book on finance ethics must also identify the relevant ethical principles for resolving many different kinds of questions Some of these involve dilemmas of individual conduct, but the most perplexing and significant issues are related to the operation of financial services providers and financial markets and institutions Many ethical issues in finance have already been addressed by legal regulation, as well by firm and industry self-regulation The role of ethics in such a highly regulated environment is problematic Why is it not sufficient merely to obey the applicable rules? One answer to this question is that ethical principles lie at the heart of much regulation, and issues not yet settled by law or self-regulation are debated, in part, as matters of ethics Much of this book is viii  Preface devoted, therefore, to an examination of existing regulation and proposals for regulatory reform In addition, regulation, whether it is by government or industry, is a rather ineffective, uncertain guide, and so a commitment to high ethical standards, and not merely to legal compliance, is essential Since the publication of the first two editions of this book, much has changed and much has remained the same In particular, the financial crisis that began in 2007 has renewed interest in finance ethics and led to calls for greater attention to the subject However, this crisis, for all of the misconduct involved and damage done, raises few novel issues in finance ethics and presents mostly familiar issues in new guises Still, the third edition of this book devotes considerable space to the ethical aspects of the greatest financial crisis since the Great Depression Readers of the first two editions will find the third one extensively revised and expanded Although the number of chapters remains the same, the material has been substantially reorganized for greater clarity and orderliness Chapter now offers a more explicit framework for approaching ethics, which presents, first, ethics in markets and, second, the ethics of roles and relationships, including those of agents and fiduciaries The remaining material is organized around the areas of financial services, financial markets, and financial management Subjects that are new to this third edition include ethical issues in credit cards, subprime mortgages, microfinance, derivatives, highfrequency trading, and risk management As with the first two editions, I am indebted to W Michael Hoffman and Robert E Frederick of Bentley University, the editors of the series Foundations of Business Ethics, and my editor at Blackwell, Jeffrey Dean The Quinlan School of Business at Loyola University Chicago has provided critical support for the preparation of the third edition I am especially grateful for the resources of the Raymond C Baumhart, S.J., Chair in Business Ethics, which was created to honor a former president of Loyola University Chicago and a pioneer in the field of business ethics To Ray Baumhart I owe a special debt of gratitude I also wish to express my appreciation to Kathleen A Getz, dean of the Quinlan School of Business for her enthusiastic support As always, I am indebted to my wife Claudia, whose affection, patience, and encouragement have been essential for my work John R Boatright 268  Ethics in Financial Management Ultimately, securing a financial system that embodies the highest level of ethics is a joint effort The first step requires that the people who work in finance have the necessary understanding of ethical conduct and a commit­ ment to act accordingly, but good people are not sufficient Attention must also be paid to the organizations and market structures within which people act and especially to the pressures and incentives that operate on them Ethics is also inseparable from financial regulation, which is a main means by which ethical conduct is, first, identified and then made subject to enforceable rules Ethics guides much regulation, but regulation, in turn, gives expression to ethics and provides a means for approaching it Indeed, anyone committed to good ethics in finance must also work for good regulation Just as necessary as good regulation, however, is wise, effective leadership in financial services and financial markets worldwide, which can balance the competing demands of business success and social responsibility Notes   1.  For this distinction, see Charles Handy, “What’s a Business For?” Harvard Business Review, 80 (December 2002), 49–55   2.  See, for example, John Micklethwait and Adrian Woolridge, The Company: A Short History of a Revolutionary Idea (New York: Modern Library, 2003)   3.  See Duane Windsor, “Shareholder Wealth Maximization,” in John R Boatright (ed.), Finance Ethics: Critical Issues in Theory and Practice (New York: John Wiley & Sons, Inc., 2010)   4.  For criticism, see Lynn A Stout, The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public (San Francisco, CA: Berrett-Koehler Publishers, 2012)   5.  James Hawley and Andrew Williams, The Rise of Fiduciary Capitalism: How Institutional Investors Are Making Corporate America More Democratic (Phila­ delphia, PA: University of Pennsylvania Press, 2000)   6.  Franco Modigliani and Merton H Miller, “The Cost of Capital, Corporation Finance, and the Theory of Investment,” American Economic Review, 48 (1958), 261–297; and Merton H Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of Shares,” Journal of Business, 34 (1961), 411–433   7.  Henry T C Hu, “Risk, Time, and Fiduciary Principles in Corporate Investment,” UCLA Law Review, 38 (1990–1992), 277–389   8.  Hu, “Risk, Time, and Fiduciary Principles in Corporate Investment,” p 282   9.  Bradford Cornell and Alan C Shapiro, “Corporate Stakeholders and Corporate Finance,” Financial Management, 16 (1987), 5–14 10.  This point is made explicitly in Unocal Corporation v Mesa Petroleum Co., 493 A.2d 946, 955 (1985), and in Paramount Communications v Time, Inc., 571 A.2d 1140, 1152 (1990) Ethics in Financial Management  269 11.  Robert N Anthony, “The Trouble with Profit Maximization,” Harvard Business Review, 38 (1960), 126–134 12.  That such standards should be part of the objective of business corporations is recommended in the Principles of Corporate Governance drafted by The Ameri­ can Law Institute Section 2.01 states that in addition to “enhancing corporate profit and shareholder gain,” a business corporation “may take into account ethical considerations that are reasonably regarded as appropriate to the respon­ sible conduct of business.” 13.  See David Vogel, The Market for Virtue: The Potential and Limits of Corporate Social Responsibility (Washington, DC: Brookings, 2005); Craig C Smith, “Cor­ porate Social Responsibility: Whether or How?” California Management Review, 45 (2003), 52–76; and David Hess, Nikolai Rogovsky, and Thomas W Dunfee, “The Next Wave of Corporate Community Involvement: Corporate Social Initia­ tives,” California Management Review, 44 (2002), 110–125 14.  Milton Friedman, Capitalism and Freedom (Chicago, IL: University of Chicago Press, 1962), p 133 15.  Milton Friedman, “The Social Responsibility of Business Is to Increase Its Profits,” New York Times Magazine, September 13, 1970, p 33 16.  Keith Davis and Robert L Blomstrom, Business and Society: Environment and Responsibility, 3rd edition (New York: McGraw-Hill, 1975), p 50 17.  See James Post, Lee Preston, and Sybille Sachs, Redefining the Corporation: Stakeholder Management and Organizational Wealth (Palo Alto, CA: Stanford Busi­ ness Books, 2002) 18.  Frank H Easterbrook and Daniel R Fischel, The Economic Structure of Corporate Law (Cambridge, MA: Harvard University Press, 1991), p 38 19.  Easterbrook and Fischel, The Economic Structure of Corporate Law, p 39 20.  Ronald H Coase, “The Problem of Social Cost,” Journal of Law and Economics, (1960), 1–44 21.  Indeed, Ronald Coase, the creator of the Coase Theorem, later claimed that his main message had been misunderstood, because a full assignment of property rights and no transaction costs are seldom present Ronald H Coase, The Firm, the Market, and the Law (Chicago, IL: University of Chicago Press, 1988), p 15 22.  Peter L Bernstein, Against the Gods: The Remarkable Story of Risk (New York: John Wiley & Sons, Inc., 1996) 23.  For the role of government in managing risk, see David A Moss, When All Else Fails: Government as the Ultimate Risk Manager (Cambridge, MA: Harvard Uni­ versity Press, 2002) Bernstein points out that the word “statistics” developed from the use of quantitative facts in the administration of state affairs Bernstein, Against the Gods, p 77 24.  Operational risk has received great attention as a result of the requirement of the Basel II bank regulations that banks include it in their risk management systems The Basel II Accord defines operational risk as “The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.” 270  Ethics in Financial Management 25.  See Ingo Walter, “Reputational Risk,” in John R Boatright (ed.), Finance Ethics: Critical Issues in Theory and Practice (New York: John Wiley & Sons, Inc., 2010) Other types of risk include liquidity risk, which is the risk that assets cannot be sold, and sovereign risk, which is the risk that a sovereign state may default on its national debt 26.  Lisa K Meulbroek, “A Senior Manager’s Guide to Integrated Risk Management,” Journal of Applied Corporate Finance, 14 (2002), 56–70, 56 27.  Peter L Bernstein, “The New Religion of Risk Management,” Harvard Business Review, 74 (1996), 47–51, 47 28.  Niall Ferguson, “Wall Street Lays Another Egg,” Vanity Fair (December 2008) 29.  Meulbroek, “A Senior Manager’s Guide to Integrated Risk Management,” p 65 30.  Jacob S Hacker, The Great Risk Shift: The Assault on American Jobs, Families, Health Care, and Retirement and How You Can Fight Back (New York: Oxford University Press, 2006) 31.  Nassim Taleb, The Black Swan: The Impact of the Highly Improbable (New York: Random House, 2007) 32.  Michael Power, The Risk Management of Everything: Rethinking the Politics of Uncertainty (London: Demos, 2004), p 10 33.  See Ricardo Rebonato, The Plight of the Fortune Tellers: Why We Need to Manage Finance Risk Differently (Princeton, NJ: Princeton University Press, 2007) 34.  Taleb, The Black Swan 35.  Bernstein, “The New Religion of Risk Management,” p 50 36.  Jón Daníelsson, “The Emperor Has No Clothes: Limits to Risk Modelling,” Journal of Banking and Finance, 26 (2002), 1273–1296 37.  Jón Daníelsson, “On the Feasibility of Risk Based Regulation,” Economic Studies, 49 (2003), 157–179 38.  David Einhorn and Aaron Brown, “Private Profits and Socialized Risk,” Global Association of Risk Professionals, June–July 2008, pp 10–26 39.  Richard A Posner, A Failure of Capitalism: The Crisis of ’08 and the Descent into Depression (Cambridge, MA: Harvard University Press, 2009) 40.  Raghuram G Rajan, Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton, NJ: Princeton University Press, 2010), p 144 41.  Joe Nocera, “Risk Management: What Led to the Financial Meltdown,” New York Times, January 4, 2009 42.  John Cassidy, “What’s Wrong with Risk Models?” New Yorker, Blog, April 27, 2010 43.  “The Uses and Abuses of Chapter 11,” The Economist, March 18, 1989, 72; and Paul G Engel, “Bankruptcy: A Refuge for All Reasons,” Industry Week, March 5, 1984, pp 63–68 44.  Anna Cifelli, “Management by Bankruptcy,” Fortune, October 31, 1983; and Harold L Kaplan, “Bankruptcy as a Corporate Management Tool,” ABA Journal, January 1, 1987, pp 64–67 45.  Kevin J Delaney, Strategic Bankruptcy: How Corporations and Creditors Use Chapter 11 to their Advantage (Berkeley and Los Angeles: University of Califor­ nia Press, 1992) Ethics in Financial Management  271 46.  One exception is that a plan may be imposed over the objections of one or more classes of creditors as long it is approved by at least one class of credi­ tors whose claims are reduced and a court finds the plan to be “fair and equitable” for all creditors The imposition of a nonunanimous plan is called a “cramdown.” 47.  See Douglas G Baird and Thomas H Jackson, Cases, Problems, and Materials on Bankruptcy, 2nd edition (Boston, MA: Little, Brown, 1990); and Thomas H Jackson, The Logic and Limits of Bankruptcy Law (Cambridge, MA: Harvard University Press, 1986) 48.  The need to force creditors to act collectively and enhance the total value of a firm’s assets is called the problem of the common pool See Baird and Jackson, Cases, Problems, and Materials on Bankruptcy, pp 39–42 49.  Thomas H Jackson, “Bankruptcy, Non-Bankruptcy Entitlements, and the Credi­ tors’ Bargain,” Yale Law Journal, 91 (1982), 857–907 50.  NLRB v Bildisco, 465 U.S 513 (1984) 51.  Section 1113 of the Bankruptcy Code requires companies to attempt to negotiate with unions in good faith and, if an agreement cannot be reached, to demonstrate that any changes are “necessary to permit the reorganization” or that rejection is justified by a “balancing of equities.” The courts enforced these more stringent standards in Wheeling–Pittsburgh Steel Corporation v United Steelworkers of America, 791 F.2d 1074 (3d Cir 1986) 52.  “A Retailer’s Chapter 11 Has Creditors Enraged,” BusinessWeek, May 9, 1983, pp 71, 74 53.  See Delaney, Strategic Bankruptcy, pp 162–168 54.  Paul Brodeur, Outrageous Misconduct: The Asbestos Industry on Trial (New York: Pantheon Books, 1985), pp 257–258, 268, 270–271 55.  Some asset shifts can be challenged by creditors on the grounds that they con­ stitute “fraudulent conveyance,” which is the transferring of assets in an effort to defraud creditors 56.  Michael Bradley and Michael Rosenzweig, “The Untenable Case for Chapter 11,” Yale Law Journal, 101 (1992), 1043–1095 57.  Bradley and Rosenzweig, “The Untenable Case for Chapter 11,” pp 1049–1050 This conclusion is controversial and has been challenged See Elizabeth Warren, “The Untenable Case for Repeal of Chapter 11,” Yale Law Journal, 102 (1992), 437–479 58.  Jackson, The Logic and Limits of Bankruptcy Law, pp 21–27 59.  Chapter 11 contains some mechanisms to counter these management rights and limit possible abuses Thus, at any time during bankruptcy proceedings, creditors can file a petition for immediate liquidation, which permits a bankruptcy court to judge whether managers are “playing games” with the creditors Because credi­ tors can always hold out for liquidation or the opportunity to submit their own plan, and because management’s plan must be approved by each creditor group, managers are forced to propose a plan that is reasonably fair and equitable In the event of a “cramdown,” a court must determine that the reorganization plan is fair and equitable for all parties 272  Ethics in Financial Management 60.  In such cases, abuse of bankruptcy could be addressed by fraud statutes rather than by provisions of the Bankruptcy Code 61.  Joseph McCafferty, “Is Bankruptcy an Unfair Advantage?” CFO, June 1995, p 28; and Stephen Neish, “Is the Revised Chapter 11 Any Improvement?” Corporate Finance, March 1995, pp 37–40 62.  See Teresa Sullivan, Elizabeth Warren, and Jay Lawrence Westbrook, The Fragile Middle Class: Americans in Debt (New Haven, CT: Yale University Press, 2000); and Elizabeth Warren, “The Bankruptcy Crisis,” Indiana Law Journal, 73 (1997– 1998), 1079–1110 63.  Todd J Zywicki, “An Economic Analysis of the Consumer Banking Crisis,” Northwestern University Law Review, 99 (2005), 1463–1541 64.  Adolf A Berle Jr and Gardiner C Means, The Modern Corporation and Private Property (New York: Macmillan, 1932) 65.  Adolf A Berle Jr, “For Whom Corporate Managers Are Trustees: A Note,” Harvard Law Review, 45 (1931–1932), 1365–1372 66.  Henry Hansmann, The Ownership of Enterprise (Cambridge, MA: Harvard Uni­ versity Press, 1996), pp 13–14 Index “access people”, personal trading,  132, 133, 134, 135, 136–7 accounting fraud,  5, 22, 175 adjustable-rate mortgages (ARMs),  98, 101, 103 Adoboli, Kweku,  Against the Gods (Bernstein),  234, 237 agents,  19, 40–3 aggressive marketing,  85–6 AIG,  209–10 algorithmic trading see high-frequency trading (HFT) algo-sniffing, trading tactic,  214–15 alienability of property,  31 Alliance Capital Management,  124 annualized turnover ratio (ATR),  75 Aquinas, Thomas,  91 arbitration,  108–9 compulsory,  109–11 legal tactics,  111–12 problems with arbitrators,  112–14 punitive damages,  113–14 Arvida partnerships,  65, 66–7 asset-backed securities (ABSs),  99 asymmetric information,  18, 177, 179, 180–1 auction markets,  53 Bankers Trust,  3–4, 210, 211 Bank of America,  4, 91, 123, 124–5 bankruptcy,  243–4 fairness and efficiency,  249–52 ethical basis of,  244–5 personal,  252–4 strategic use of,  247–9 use and abuse of,  246 collective bargaining agreements,  246 liabilities and obligations,  246–7 product liability suits,  246 Bankruptcy Code 1978 revision,  244, 250 2005 overhaul,  253–4 Barings Bank,  4, 210 Berkshire Hathaway,  20 Berle, Adolf A Jr.,  32–3, 257–8 Bernstein, Peter, L.,  234, 237, 240 bid-ask spreads, reduction of,  216 bid-rigging,  3, 10 blackout periods,  137 “blissful shareholder” model,  228 block positioners,  53–4 Blodget, Henry, Merrill Lynch,  blue sky laws,  177 Ethics in Finance, Third Edition John R Boatright © 2014 John Wiley & Sons, Inc Published 2014 by John Wiley & Sons, Inc 274  Index boards of directors, role of,  200–1, 263–4 Boesky, Ivan,  3, 7, 182 breach of contract,  18, 35 brokerage firms,  51–2, 56–7, 73–5 competition and conflict of interest,  56–7 compulsory arbitration,  109–11 punitive damages,  113 soft-dollar brokerage,  138–41 Buffett, Warren,  11, 20, 142, 202, 208 CalPERS (California Public Employees’ Retirement System),  142–3 Canary Capital,  4, 123, 124–6 candor, duty of,  42–3 capping of credit card rates,  91–2 arguments for and against,  92–5 CARD Act (2009),  78, 82, 84, 86, 87, 89 Cardozo, Benjamin,  40–1 care, duty of,  43 Cassidy, John,  209, 242 caveat emptor (“let the buyer beware”),  71 CDOs (collateralized debt obligations),  12, 99–100, 236–7 Chapter 11 bankruptcy,  244–5 abuse of,  246–7 fairness and efficiency,  249–52 check kiting,  Chicago Mercantile Exchange (CME),  206 chief executive officers (CEOs) excessive compensation,  94 role of,  264–5 chief financial officers (CFOs),  5, 22, 23, 223–4 chief risk officers (CROs),  22, 223–4, 236 “Chinese walls”,  48, 59 churning,  54, 72, 73–4 definition of,  74–5 ethical objection to,  74 quantitative measures,  75–6 suitability,  76–7 Citigroup,  3, 5, 13, 21 Citizens Bank,  87 Coase, Ronald H.,  33–4 Coase Theorem,  233 codes of ethics,  15, 23, 44–5, 127–8, 131, 133, 136–7 coercion,  34–5 collateralized debt obligations (CDOs),  12, 99–100, 236–7 collective bargaining agreements,  246 college students, credit card marketing,  81–7 co-location, high-frequency trading,  213 commissions,  66 commodity futures,  206–7 Community Reinvestment Act,  64 competition,  56–7 compulsory arbitration,  109–11 computers,  201, 209 high-frequency trading,  213–14, 216–17 program trading,  182 concealment,  3–4, 5, 35, 42–3 fraudulent transactions,  186 in retail sector,  66–72 mortgage lending,  96, 101–2 confidentiality,  43 conflict of interest,  45–59 agents and fiduciaries,  43 and golden parachutes,  195–6 and short-selling,  138 causes of,  48–9 credit cards,  86 definition of,  46–8 Enron,  examples of,  50–6 from personal trading,  132, 133, 134 incentive problem,  IPOs (initial public offerings),  137 management of,  56–9 competition,  56–7 disclosure,  57–8 rules and policies,  58 structural changes,  58–9 Index  275 Marsh Inc.,  10 mutual funds,  121, 138 summary,  59–60 Consumer Financial Protection Bureau,  16, 36, 64 consumer loan business,  73 consumer protection,  36, 64, 71, 90, 182, 211 Continental Airlines, bankruptcy,  246, 249 contingency commissions,  10 contracting problems, solving,  260–2 contracts of adhesion,  80, 89–90 contractual theory of the firm,  33–4, 258 control repurchase agreements,  198–9 Cooper, Cynthia,  corporate finance,  13, 22–3 corporate governance,  141, 146–8, 254–5 directors and CEOs,  262–5 public policy,  257–9 shareholder contract,  259–62 shareholder primacy,  255–9 the market,  259 corporate law,  31–2, 42, 55, 198, 257 corporate objective,  224–5 corporate social responsibility (CSR),  230–4 Countrywide,  11, 102–3 Credit Card Accountability Responsibility and Disclosure Act (CARD),  78, 82 Credit Card Nation (Manning),  11 credit cards,  78–9 ethical concerns,  79–81 marketing to students,  81–7 pricing strategies,  79 profitability,  78 rates and fees,  87–96 credit default swaps (CDSs),  12, 204, 209–11, 236–7, 238 creditors’ bargain argument,  245, 250 credit risk,  235 creditworthiness,  251 and microfinance,  156–7 and mortgages,  97, 99, 101, 103, 104, 105 college students,  83–5 crown-jewel options,  194 dark pools (private exchanges),  216 dealers,  204 markets for,  53–4 debit cards,  78 contract, readability of,  79–80 fee for possessing,  91 impact on social welfare,  81 overdraft fees,  87, 88 overdraft protection,  87, 89, 90 see also credit cards deception,  66–72 decision making,  254–5, 262–3 default risk,  6, 12, 94, 99–100, 204, 235 Den of Thieves (Stewart),  derivatives,  202–3 definition of,  203 problems with,  205–6 speculation and,  206–8 suitability,  208–11 types of,  203–4 uses of,  204–5 Deutsche Bank,  dignity,  28–9 directed brokerage,  138–9, 140–1 directors, role of,  200–1, 228, 262–4 disclosure adequacy of, contracts of adhesion,  89–90 and conflict of interest,  57–8, 210–11 and information access,  186 and market timing,  129 and the CARD Act,  82, 86 by mortgage lenders,  101–2 fair disclosure rule, SEC,  23 of personal trading,  136–7 of soft-dollar practices,  140 regulations and laws,  23, 176–7, 178–9 Ruder Commission report,  110 276  Index Dodd-Frank Wall Street Reform and Consumer Protection Act (2010),  64, 196, 211 Donaldson, William H.,  Dow Corning Corporation,  246, 249 Drexel Burnham Lambert,  3, 189 Drucker, Peter,  190 due diligence,  76–7 duty/duties,  28, 42–3 see also fiduciary duties Duval, Jessica, debit card overdraft,  87 Ebbers, Bernie,  economically targeted investment (ETI),  146 economic rationality,  68 economic value added (EVA),  227 efficient frontier,  77 E.F Hutton,  Employee Retirement Income Security Act (ERISA),  55, 145, 146 end users,  204 Enron,  5, 22, 175, 227, 265 enterprise risk management (ERM),  235–6 equal information,  177–81 equity/efficiency trade-off,  28, 171, 172–3 “excessive trading”, churning,  72–3, 74–5 “extended balance sheet” model,  228 externalities,  19, 37, 141, 230, 232–4 fairness,  28 and insider trading,  185–7 credit/debit cards,  88–91 in markets,  172–5 Fannie Mae,  6, 97, 106 Fastow, Andrew, Enron CEO,  Federal Trade Commission (FTC),  66, 67, 96 “fee-only” investment advisors,  72 Ferber, Mark S.,  45 Fidelity Investments,  123, 129, 130, 138 fiduciaries,  19, 20–1, 40–1 and conflict of interest,  48–9 fiduciary duties,  22, 41–3, 261 and relationship investing (RI),  144–6 chief executive officers,  264–5 fund managers,  131, 139–40, 141 insider traders,  180, 185, 187–8 institutional investors,  143 finance field of finance ethics,  13–23 need for ethics in,  2–13 financial engineering,  201–2 derivatives,  202–11 high-frequency trading (HFT),  211–17 Financial Industry Regulatory Authority (FINRA),  16, 214 financial innovation,  11–13 financial management,  223–4 corporate governance,  254–67 ethics of bankruptcy,  243–54 risk management,  234–43 shareholder wealth maximization (SWM),  224–34 the corporate objective,  224–34 financial markets,  171–2 equal bargaining power,  181–2 equal information,  177–81 fairness and,  172–82 financial engineering,  201–17 fraud and manipulation,  175–7 hostile takeovers,  189–201 insider trading,  182–9 financial planning organizations,  45 financial scandals,  3–7 and derivatives,  202 causes of,  7–13 financial services industry,  20–2 financial theory of the firm,  224 firms,  31–4 profit maximization,  229–30, 260 firm-specific assets,  34 First Alliance,  96, 100 fixed claims,  256, 258–9, 260, 261–2, 266 Index  277 fixed commissions, legislation ending,  73–4, 138–9 flash crash,  6, 211, 215, 216 flash trading,  213, 216 “flipping”,  73, 74, 76, 101 Fool’s Gold (Tett),  12 forward contracts,  203, 204, 206, 207 fraud,  5, 18, 22, 175–7 and lack of knowledge,  186 concealment as,  251 force and,  34–6 in predatory subprime lending,  101 legislation,  66, 183, 184 securities fraud,  188–9 unfair competition,  174 Freddie Mac,  6, 97, 106 Friedman, Milton,  230–2 fund performance,  152–3 fund-tracking firms,  70 futures contracts,  50, 203–4, 205, 206 GAAP (generally accepted accounting principles),  5, 227 Galleon Group,  3, 183 Getty Oil,  247 Global Crossing,  golden parachutes,  194, 195–7 Goldman Sachs,  3, 21, 125, 210–11, 242 government-sponsored enterprise (GSEs),  97 Grameen Bank, Bangladesh,  22, 155–8, 161–3 Gramlich, Edward M.,  102 Grand Metropolitan,  188 Greenberg, Jeffrey W.,  10 greenmail,  197–200 group lending, microfinance,  157, 158, 159, 161 Grubman, Jack B.,  Gutfreund, John,  Hansmann, Henry,  258 Hanson, Dale M.,  143 Harrington, Noreen,  125–6 hedge funds,  20, 48, 124, 182–3 high-frequency trading (HFT),  211–13 evaluation of,  215–16 risks of,  216–17 uses of,  213–15 Hirschman, Albert O.,  144 home ownership see mortgage lending honesty,  28 hostile takeovers,  189–90 fairness in,  191–3 role of the board,  200–1 takeover tactics,  193 golden parachutes,  195–7 greenmail,  197–200 tender offers,  193–5 housing bubble,  6, 100 HRT Industries,  247, 251 Hu, Henry,  228 Hurwitz, Charles,  189–90 impersonal conflict of interest,  47, 48 incentives,  9, 104–6, 157, 259 incorporation,  31–2, 257 inequality,  93–4 information asymmetries,  18, 177, 179, 180–1 initial public offerings (IPOs),  52, 69, 132, 137, 162, 216 innovation,  11–13 insider trading,  3, 182–3 and Chinese walls,  59 and nonpublic/unequal information,  174, 176, 179–80 and personal trading,  134 debate over,  184–8 resolving,  188–9 definition of,  183–4 Securities Exchange Act on,  176 Institutional Shareholder Services (ISS),  145 insurance companies,  70 insurance organizations,  45 interest rates, credit card,  78, 80–1, 88, 89, 90–1 capping of,  91–5 Invesco Funds Group,  124, 130 278  Index investment advisers,  45, 54, 131 Investment Advisers Act,  54 Investment Company Act 1940 (ICA),  55, 57, 66, 128, 130–1, 133 Investment Company Institute (ICI),  131, 136, 137, 141 investment ethics,  120–1 microfinance,  155–64 mutual funds,  121–41 relationship investing (RI),  141–8 socially responsible investing,  148–55 irrelevance theorem,  226–7 Islamic finance,  14–15 ITT Consumer Financial Corporation,  73 Jensen, Michael C.,  196, 197 joint-stock companies,  32 JP Morgan Chase,  12, 124, 208–9, 210 justice,  28 Kaldor, Nicholas,  207 Kaweske case, personal trading,  131–2 Kerviel, Jérôme,  Knight Capital Group,  6, 216 KPMG,  17 Krugman, Paul,  11 late trading,  4, 121–2 law,  15–17 Lazard Fréres investment bank,  45–6 leadership,  10–11 Leeson, Nick,  4, 210 Lehman Brothers,  96 less developed countries (LDCs), reducing poverty in see microfinance Levitt, Arthur, SEC chairman,  73 Lewis, Michael,  8, 130 liabilities and obligations, bankruptcy,  246–7 Lipper Analytical,  70 liquidation,  243, 245, 247, 250 litigation,  108, 110, 111–12, 113 lockup option,  194 London Interbank Offered Rate (LIBOR),  7, 176 Long-Term Capital Management,  loyalty, duty of,  43 LTV Steel,  246–7, 248 mandatory disclosure regulations,  176–7 manipulative practices,  6–7, 35–6, 85–6, 175–7, 214–15 Manning, Robert,  11, 86 Manville Corporation,  246, 247–8, 249 market failure,  36–8 markets,  30–1 market specialists,  54 market timing,  4, 121–6 objections to,  126–8 remedies,  128–30 Marsh Inc.,  10 Mastrobuono, Antonio C.,  111 matching transactions,  132–3, 137, 138 mathematical models,  201, 235, 236–7, 241, 243 maximal efficiency,  30 Maxxam,  189–90 Means, Gardiner C.,  32–3, 257 M&E (mortality and expense risk) charges,  69, 70 Merrill Lynch & Co.,  3–4, 5, 45, 64–5, 210, 211 MF Global,  microfinance,  22, 155–6 effectiveness of,  159–62 ethical criticism,  158–9 schism,  162–4 workings of,  156–8 Milken, Michael,  3, 182, 189 Miller, Merton,  226 minimum payment option, credit cards,  90–1 misappropriation,  34, 53, 185, 188 modern corporation,  32–3, 41 Modern Corporation and Private Property, The (Berle and Means),  32, 257 Index  279 Modigliani, Franco,  226 moral duties,  18, 36 moral hazard,  157, 238, 251 moral rules,  16, 17–18, 19, 35, 36 Morningstar,  70 mortality and expense risk (M&E) charges,  69, 70 mortgage backed securities (MBSs),  6, 11, 12, 52, 64, 96, 99, 210 mortgage lending,  96–7 origination process,  perverse incentives,  104–6 predatory lending,  100–2 securitization,  98–100 subprime, rise and fall of,  96–8 toxic products,  102–3 mosaic theory, in insider trading,183 Mozilo, Angelo,  11, 102 mutual funds,  121 conflict of interest,  47, 55, 121 deceptive practices in,  67, 69–70 market timing,  121–30 personal trading,  130–8 regulation of,  57 socially responsible investing (SRI) and,  149, 151 soft-dollar brokerage,  138–41 Nader, Ralph,  150 NASDAQ,  23, 53, 128, 216 National Association of Securities Dealers (NASD),  53, 70, 76, 109, 113 negative amortization loans,  11, 103 New York Stock Exchange (NYSE),  16, 23, 53, 128, 138, 172, 211, 212–13 nexus-of-contracts view of the firm,  33, 259 obligation,  28 off-balance-sheet partnerships,  O’Hagan, James H.,  188–9 options,  66, 73, 204 Orange County, California,  3, 205, 210, 211 organizational conflict of interest,  47–8 organizational culture,  originate-to-distribute system, mortgages,  104–6 “other constituency statutes”,  201 overdraft protection, debit cards,  87, 89, 90 Pacific Lumber Company,  189–90, 192 pac-man defense,  194 Paine, Lynn Sharp,  10 Paramount Communications,  200–1 Pareto optimum,  30 Pareto, Vilfredo,  30 paternalism,  71, 93, 94 PDAAs (predispute arbitration agreements),  108, 109–11 Pennzoil,  247, 248 pension fund managers,  42–3, 145, 146 pension funds CalPERS,  142–3 economically targeted investment (ETI),  145–6 regulation,  55, 172 socially responsible investing,  21–2, 149, 150, 151 “universal shareholders”,  226 personal bankruptcy,  252–4 personal finance,  13 personal trading,  130–1 and conflict of interest,  55, 131–3 banning of,  133–5 codes of ethics,  136 disclosure of,  136–7 purchase of IPOs,  137 shorting,  137–8 short-term trading,  137 perverse incentives, subprime mortgages,  104–6 Pillsbury Company,  188 Pimco Advisors,  124 poison pill,  194 pollution,  19, 230–3 Pound, John,  147–8 280  Index predatory borrowers,  106 predatory lending,  100–2 predispute arbitration agreements (PDAAs),  108, 109–11 pressure,  Prince, Charles, Citigroup CEO,  13 principal,  40, 41–2, 47–8, 49, 51, 54, 57 procedural fairness,  174 Procter & Gamble (P&G),  3–4, 205, 208, 210, 211 product liability suits, bankruptcy,  246 professionals,  21, 40 and conflict of interest,  48–9 arbitrators,  112–13 code of ethics,  15, 44 investors,  178 managers,  54, 263 role of,  43–5 profit maximization,  229–30 program trading,  182 progressive lending, microfinance,  157–8 property rights and social costs,  233 corporate governance,  257 insider trading and,  184–5 market exchange,  30–1 theory of,  32–3 protection credit and debit card issuers,  88–90 responsibility of salespeople,  70–2 pseudobidding,  199–200 psychological tactics, card issuers,  90–1 public goods,  37 public policy, corporate governance,  256–9 punitive damages,  110–11, 113–14 Putnam Investments,  4, 124 Quants,  201 Rajaratnam, Raj,  3, 183 rational choice,  68 real estate investment trusts (REITs),  55–6 reasonableness expectation, violation of,  91 reciprocation,  51 “redlining”,  19, 64 reforms, mutual fund industry,  129–30 regulation,  15–16 and conflict of interest,  58 relationship investing (RI),  141–2 and fiduciary duty,  144–6 as an investment strategy,  142–4 improving corporate governance,  146–8 religious groups,  150 reputational risk,  235 residual claims,  256 residual risk bearers,  260–1 control,  261–2 nonshareholders as,  267 shareholders as,  266 retail customers,  63–4 arbitration,  108–14 credit cards,  78–95 mortgage lending,  96–107 sales practices,  64–77 RI see relationship investing rights,  28 violation of,  36 see also property rights risk high-frequency trading (HRT),  216–17 in subprime mortgages,  99–100, 102–3 risk management,  234–43 ethical issues,  237–40 failure,  240–3 Ruder Commission,  109 compulsory arbitration,  109–11 hardball legal tactics,  111–12 problems with arbitrators,  112–14 Ruder, David S.,  109 Rules 17j and 17j-1, SEC, personal trading,  133 Index  281 safe harbor provision, Securities Act,  139, 140 sales practices,  64–5 deception and concealment,  66–8 examples for analysis,  68–70 responsibility to protect,  70–2 Salomon Brothers,  3, 8, 10–11 Salomon Smith Barney,  Santelli, Rick,  107 Sarbanes–Oxley Act (2002),  23, 223, 265 Saturday night special,  193–4 savings versus credit,  161, 163–4 scandals,  3–7 scienter,  74, 76, 77 Scotese, Peter,  196 screened funds,  150, 151, 152 Sears, Roebuck & Co.,  73 Securities Act (1933),  52, 57, 172, 175, 176 Section 28(e), safe harbor provision,  139, 140 Securities and Exchange Commission (SEC),  23, 52, 65, 139, 172, 211 report on personal trading,  131–2 rules 17j and 17j-1, personal trading,  133 Securities Exchange Act (1934),  52, 74, 172, 175, 176 securities industry arbitration,  108–12 manipulative practices,  214–15 punitive damages,  113–14 securitization,  98–100 and perverse incentives,  104–6 self-regulating organizations (SROs),  109, 110, 128 self-regulation,  16, 17, 44, 172 shareholder contract,  259–62 shareholder model,  228, 262–3, 265–6, 267 shareholder primacy,  224 case for,  255–9 problems with,  265–7 shareholder wealth,  226–9 shareholder wealth maximization (SWM),  224–5 and social responsibility,  230–2 problem of social costs,  232–4 Friedman, Milton,  230–2 profit maximization,  229–30 shareholder wealth,  226–9 shark repellents (takeover defenses),  193, 194 Shearson Lehmann Hutton, Inc.,  111 shingle theory,  72 short-selling,  137–8 Silicon Graphics,  130 sin stocks,  22, 148, 149–50, 153 slippage,  213, 216 SMEs (small and medium enterprises),  162 Smith, Adam,  120 smoking, trading tactic,  214 social capital,  160–1 social costs,  19, 37, 141, 230, 232–4 socially responsible investing (SRI),  21–2, 148–9 and fund performance,  152–3 and investment policy,  153–5 definition of,  149–51 social welfare,  81, 88, 120–1, 225 Société Générale,  4, 205, 210 soft-dollar brokerage,  138–41 speculation, derivatives,  206–8 spillover effects (externalities),  37 Spitzer, Eliot,  4, 123 spoofing, trading tactic,  214 standards, ethical,  44–5 “steering”,  102 Stern, Edward “Eddie”,  123–5 Stewart, Martha, insider trading,  3, 182 stock exchanges, US,  23, 53, 172 strategic bankruptcy,  244, 247–9 Strong Capital Management (SCM),  4, 124 code of ethics,  127 involvement with Canary,  125–6 market timing police,  126 Strong, Richard S.,  4, 125, 126, 127 282  Index students, marketing of credit cards to,  81–7 stuffing, trading tactic,  214 subprime mortgages,  64, 96–8 aftermath,  106–7 and predatory lending,  100–2 collateralized debt obligations (CDOs),  99–100 default rate,  98 perverse incentives,  104–6 risk involved in,  102–3 substantive fairness,  174 Sullivan, Scott,  Sumitomo Corporation,  Surowiecki, James,  57 sustainability issues,  22, 149, 150–1, 162–3, 164 swaps,  12, 21, 171, 203, 204, 205, 208–11, 237, 238 Swift, Jonathan,  156 takeovers see hostile takeovers tax shelters,  17 tender offers,  172, 193–5 Tett, Gillian,  12 Texaco,  247, 248, 249 Texas Gulf Sulphur Company,  183–4 theft,  18, 34, 35, 75 theories of the firm,  31–4 Time–Warner merger,  200 toxic products,  102–3 “toxic waste”,  64 transaction costs,  33–4, 207, 233 transparency,  79, 80, 95, 126, 139 Trillium Brokerage Services,  214 trust accounts,  47, 48, 52, 56, 58 reciprocation practice,  51 twisting definition of,  72–3 suitability,  76–7 “underwater” homeowners,  64, 100, 107 underwriting standards, relaxation of,  103 unequal bargaining power,  181 unequal information,  179–80 Uniform Commercial Code,  71 United States Congress arbitration versus litigation,  110 bankruptcy system,  247, 253 control repurchases,  198 disclosure regulations,  177 Investment Company Act (ICA) amendments,  130–1, 133 passing of CARD Act,  84–5 Williams Act,  195 “universal shareholders”,  226 unsuitability derivatives,  209, 210 securities,  76, 77 US Consumer Financial Products Bureau,  80 usury,  88 value at risk (VaR),  237, 241–2 Value Line,  70 Vinik, Jeffrey,  130 volatility,  77, 182, 207–8, 217 Volcker, Paul,  11 Wakefield, Priscilla,  156 Wall Street,  1, 7, 24, 46, 57, 64, 111, 209 welfare,  27, 30 whistle-blowers,  5, 125–6 white knight,  194 Williams Act (1968),  195 Wilson Foods, bankruptcy,  246 World Bank,  19, 155 WorldCom,  4–5, 22, 175, 227, 265 wrongdoing, organizational factors,  8–11 wrongful harms,  36 young people, exploitation of,  81–7 Yunus, Muhammad,  22, 155–6, 162–3 ... Brenkert, Marketing Ethics Al Gini and Ronald M Green, Ten Virtues of Outstanding Leaders: Leadership and Character Forthcoming Denis Arnold, Ethics of Global Business Ethics in Finance THIRD EDITION... distinguish their products are often claimed as trademarks All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective... the third edition of Ethics in Finance with permission from the copyright holders John R Boatright, “Financial Services,” in Michael Davis and Andrew Stark, Conflict of Interest in the Professions