ETHICS IN FINANCE

WHAT DOSE FINANCE MEANS:

Finance means fund or other financial resources; it deals with matter related to money and the

market. The field of finance refers to the concept of time, money and risk and how they are

interrelated. Banks are the main facilitators of funding. Funding means asset in the form of

money. Finance is the set of activities that deals with the management of funds. It helps in

making the decision like how to use the collected fund. It is also art and science of determining if

the funds of an organization are being used in a right manner or not. Through financial analysis,

any company or business can take decision in making financial investments, acquisition of

company, selling of company, to know the financial standing of their business in present, past

and future. It helps to stay competitive with others in making strategic financial decisions.

Finance is the backbone of business; no business can run without finance.

WHAT IS ETHICS

Ethics is the study of human behavior which is right or wrong. In general, ethics means doing

right things to others, being honest to others, being fair and justice to others. Even ethics in

finance is a compartment to general ethics. Ethics are very important to maintain constancy in

social life, where people work together with one another. In the process of social development

we should not be conscious of ourselves but also conscious to take care of others. Ethics in

general is concerned with human behavior that is acceptable or "right" and that is not acceptable

or "wrong" based on conventional morality. General ethical norms encompass truthfulness,

honesty, integrity, respect for others, fairness, and justice. They relate to all aspects of life,

including business and finance. Financial ethics is, therefore, a subset of general ethics.

Ethical norms are essential for maintaining stability and harmony in social life, where people

interact with one another. Recognition of others' needs and aspirations, fairness, and cooperative

efforts to deal with common issues are, for example, aspects of social behavior that contribute to

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social stability. In the process of social evolution, we have developed not only an instinct to care

for ourselves but also a conscience to care for others. There may arise situations in which the

need to care for ourselves runs into conflict with the need to care for others. In such situations,

ethical norms are needed to guide our behavior. As Demsey (1999) puts it: "Ethics represents the

attempt to resolve the conflict between selfishness and selflessness; between our material needs

and our conscience."

Ethical dilemmas and ethical violations in finance can be attributed to an inconsistency in the

conceptual framework of modern financial-economic theory and the widespread use of a

principal-agent model of relationship in financial transactions. The financial-economic theory

that underlies the modern capitalist system is based on the rational-maximizer paradigm, which

holds that individuals are self-seeking (egoistic) and that they behave rationally when they seek

to maximize their own interests. The principal-agent model of relationships refers to an

arrangement whereby one party, acting as an agent for another, carries out certain functions on

behalf of that other. Such arrangements are an integral part of the modern economic and financial

system, and it is difficult to imagine it functioning without them.

The behavioral assumption of the modern financial-economic theory runs counter to the ideas of

trustworthiness, loyalty, fidelity, stewardship, and concern for others that underlie the traditional

principal-agent relationship. The traditional concept of agency is based on moral values. But if

human beings are rational maximizers, then agency on behalf of others in the traditional sense is

impossible. As Duska (1992) explains it: "To do something for another in a system geared to

maximize self-interest is foolish. Such an answer, though, points out an inconsistency at the heart

of the system, for a system that has rules requiring agents to look out for others while

encouraging individuals to look out only for themselves, destroys the practice of looking out for

others" (p. 61).

The ethical dilemma presented by the problem of conflicting interests has been addressed in

some areas of finance, such as corporate governance, by converting the agency relationship into

a purely contractual relationship that uses a carrot-and-stick approach to ensure ethical behavior

by agents. In corporate governance, the problem of conflict between management (agent) and

stockholders (principal) is described as an agency problem. Economists have developed an

agency theory to deal with this problem. The agency theory assumes that both the agent and the

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principal are self-interested and aim to maximize their gain in their relationship. A simple

example would be the case of a store manager acting as an agent for the owner of the store. The

store manager wants as much pay as possible for as little work as possible, and the store owner

wants as much work from the manager for as little pay as possible. This theory is value-free

because it does not pass judgment on whether the maximization behavior is good or bad and is

not concerned with what a just pay for the manager might be. It drops the ideas of honesty and

loyalty from the agency relationship because of their incompatibility with the fundamental

assumption of rational maximization. "The job of agency theory is to help devise techniques for

describing the conflict inherent in the principal-agent relationship and controlling the situations

so that the agent, acting from self-interest, does as little harm as possible to the principal's

interest" (DeGeorge, 1992). The agency theory turns the traditional concept of agency

relationship into a structured (contractual) relationship in which the principal can influence the

actions of agents through incentives, motivations, and punishment schemes. The principal

essentially uses monetary rewards, punishments, and the agency laws to command loyalty from

the agent.

Most of our needs for financial servicesmanagement of retirement savings, stock and bond

investing, and protection against unfore-seen events, to name a fewre such that they are better

entrusted to others because we have neither the ability nor the time to carry them out effectively.

The corporate device of contractualization of the agency relationship is, however, too difficult to

apply to the multitude of financial dealings between individuals and institutions that take place in

the financial market every day. Individuals are not as well organized as stockholders, and they

are often unaware of the agency problem. Lack of information also limits their ability to monitor

an agent's behavior. Therefore, what we have in our complex modern economic system is a

paradoxical situation: the ever-increasing need for getting things done by others on the one hand,

and the description of human nature that emphasizes selfish behavior on the other. This

paradoxical situation, or the inconsistency in the foundation of the modern capitalist system, can

explain most of the ethical problems and declining morality in the modern business and finance

arena.

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WHAT IS ETHICS IN FINANCE MEANS

Ethics in finance is one of the main things which everyone has to follow from the small, medium

and big level company because all most all the country depend up on the financial background of

the country because without financial component no business can run for a long time. The

assumption of modern financial-economic theory runs counter to the ideas of honesty, devotion,

dependability and loyalty. Ethics in finance may vary from different industries to different

industries but everyone is liable to do their work at utmost good faith. Peoples who involved in

finance activity have to serve both their company and their customers at utmost good faith.

ETHICAL VIOLATIONS

The most frequently occurring ethical violations in finance relate to insider trading, stakeholder

interest versus stockholder interest, investment management, and campaign financing. Business

in general and financial markets in particular are replete with examples of violations of trust and

loyalty in both public and private dealings. Fraudulent financial dealings, influence peddling and

corruption in governments, brokers not maintaining proper records of customer trading, cheating

customers of their trading profits, unauthorized transactions, insider trading, misuse of customer

funds for personal gain, mispricing customer trades, and corruption and larceny in banking have

become common occurrences.

Insider trading is perhaps one of the most publicized unethical behaviors by traders. Insider

trading refers to trading in the securities of a company to take advantage of material "inside"

information about the company that is not available to the public. Such a trade is motivated by

the possibility of generating extraordinary gain with the help of nonpublic information

(information not yet made public). It gives the trader an unfair advantage over other traders in

the same security. Insider trading was legal in some European countries until recently. In the

United States, the 1984 Trading Sanctions Act made it illegal to trade in a security while in the

possession of material nonpublic information. The law applies to both the insiders, who have

access to nonpublic information, and the people with whom they share such information.

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Campaign financing in the United States has been a major source of concern to the public

because it raises the issue of conflict of interest for elected officials in relation to the people or

lobbying groups that have financed their campaigns. The United States has a long history of

campaign finance reform. The Federal Election Commission (FEC) administers and enforces the

federal campaign finance statutes enacted by the Congress from time to time. Many states have

also passed lobbying and campaign finance laws and established ethics commissions to enforce

these statutes.

Why Is It Important To Worry About Ethics In Finance?

• When you think about it, you realize that you put your hard-earned savings in the care of financial firms –

asset managers, banks, insurance, and all kinds of funds – and you trust them to look after the money.

• You want the best return, but there is a balance between risk and reward.

• You need to feel confident that you can trust the finance professionals to act with integrity, in your

interests.

Financial sector in INDIA

REGULATORS

THE   RESERVE BANK OF INDIA  

(RBI) is India's central banking institution, which controls the monetary policy of the Indian

rupee. It was established on 1 April 1935 during the British Raj in accordance with the

provisions of the Reserve Bank of India Act, 1934. The share capital was divided into shares of

10₹ 0 each fully paid, which was entirely owned by private shareholders in the

beginning. Following India's independence in 1947, the RBI was nationalised in the year 1949.

The RBI plays an important part in the development strategy of the Government of India. It is a

member bank of the Asian Clearing Union. The general superintendence and direction of the

RBI is entrusted with the 21-member-strong Central Board of Directors—

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the Governor(currently Duvvuri Subbarao), four Deputy Governors, two Finance

Ministry representative, ten government-nominated directors to represent important elements

from India's economy, and four directors to represent local boards headquartered at Mumbai,

Kolkata, Chennai and New Delhi. Each of these local boards consists of five members who

represent regional interests, as well as the interests of co-operative and indigenous banks.

Securities and Exchange Board of India :  

(frequently abbreviated SEBI) is the regulator for the securities market in India. It was

established on 12 April 1992 through the SEBI Act, 1992.

SEBI has to be responsive to the needs of three groups, which constitute the market:

the issuers of securities

the investors

the market intermediaries.

SEBI has three functions rolled into one body: quasi-legislative, quasi-judicial and quasi-

executive. It drafts regulations in its legislative capacity, it conducts investigation and

enforcement action in its executive function and it passes rulings and orders in its judicial

capacity. Though this makes it very powerful, there is an appeal process to create accountability.

There is a Securities Appellate Tribunal which is a three-member tribunal and is presently

headed by a former Chief Justice of a High court - Mr. Justice NK Sodhi. A second appeal lies

directly to the Supreme Court.

Powers

For the discharge of its functions efficiently, SEBI has been vested with the following powers:

1. to approve by−laws of stock exchanges.

2. to require the stock exchange to amend their by−laws.

3. inspect the books of accounts and call for periodical returns from recognized stock

exchanges.

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4. inspect the books of accounts of a financial intermediaries.

5. compel certain companies to list their shares in one or more stock exchanges.

6. levy fees and other charges on the intermediaries for performing its functions.

7. grant license to any person for the purpose of dealing in certain areas.

8. delegate powers exercisable by it.

9. prosecute and judge directly the violation of certain provisions of the companies Act.

10.power to impose monetry penalties.

Forward Markets Commission (FMC) :

Fmc is the chief regulator of forwards and futures markets in India. As of March 2009, it

regulated Rs52 trillion worth of commodity trades in India. It is headquartered in Mumbai and

unusually for a financial regulatory agency is overseen by theMinistry of Consumer Affairs,

Food and Public Distribution (India). Mr. Bijay Kumar Ramesh Abhishek replaced Mr. B.C.

Khatua as the chairman of the commission in 2011.

The functions of the Forward Markets Commission are as follows:

To advise the Central Government in respect of the recognition or the withdrawal of

recognition from any association or in respect of any other matter arising out of the

administration of the Forward Contracts (Regulation) Act 1952.

To keep forward markets under observation and to take such action in relation to them, as it

may consider necessary, in exercise of the powers assigned to it by or under the Act.

To collect and whenever the Commission thinks it necessary, to publish information

regarding the trading conditions in respect of goods to which any of the provisions of the act

is made applicable, including information regarding supply, demand and prices, and to

submit to the Central Government, periodical reports on the working of forward markets

relating to such goods;

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To make recommendations generally with a view to improving the organization and working

of forward markets;

To undertake the inspection of the accounts and other documents of any recognized

association or registered association or any member of such association whenever it

considers it necessary.

It allows futures trading in 23 Fibers and Manufacturers, 15 spices, 44 edible oils, 6 pulses, 4

energy products, single vegetable, 20 metal futures, 33 others Futures.

The commission appeared in the news in March 2012 for their controversial ban on guar

gum futures trading after it said the price quadrupled due to its use in fracking causing food

inflation.

Insurance Regulatory And Development Authority 

(IRDA) : is an autonomous apex statutory body which regulates and develops

the insuranceindustry in India. It was constituted by a Parliament of India act called Insurance

Regulatory and Development Authority Act, 1999  and duly passed by the Government of

India. [4]

The agency operates its headquarters at Hyderabad, Andhra Pradesh where it shifted

from Delhi in 2001. 

Duties, Powers And Functions

The duties, powers and functions of IRDA are laid down in section 14 of IRDA Act, 1999 as : 

1. Subject to the provisions of this Act and any other law for the time being in force, the

Authority shall have the duty to regulate, promote and ensure orderly growth of the

insurance business and re-insurance business.

2. Without prejudice to the generality of the provisions contained in sub-section (1), the

powers and functions of the Authority shall include, -

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1. issue to the applicant a certificate of registration, renew, modify, withdraw,

suspend or cancel such registration;

2. protection of the interests of the policy holders in matters concerning assigning of

policy, nomination by policy holders, insurable interest, settlement of insurance

claim, surrender value of policy and other terms and conditions of contracts of

insurance;

3. specifying requisite qualifications, code of conduct and practical training for

intermediary or insurance intermediaries and agents

4. specifying the code of conduct for surveyors and loss assessors;

5. promoting efficiency in the conduct of insurance business;

6. promoting and regulating professional organizations connected with the

insurance and re-insurance business;

7. levying fees and other charges for carrying out the purposes of this Act;

8. calling for information from, undertaking inspection of, conducting enquiries and

investigations including audit of the insurers, intermediaries, insurance

intermediaries and other organizations connected with the insurance business;

9. control and regulation of the rates, advantages, terms and conditions that may be

offered by insurers in respect of general insurance business not so controlled and

regulated by the Tariff Advisory Committee under section 64U of the Insurance

Act, 1938 (4 of 1938);

10. specifying the form and manner in which books of account shall be maintained

and statement of accounts shall be rendered by insurers and other insurance

intermediaries;

11. regulating investment of funds by insurance companies;

12. regulating maintenance of margin of solvency;

13. adjudication of disputes between insurers and intermediaries or insurance

intermediaries;

14. supervising the functioning of the Tariff Advisory Committee;

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15. specifying the percentage of premium income of the insurer to finance schemes

for promoting and regulating professional organisations referred to in clause

(2.6);

16. specifying the percentage of life insurance business and general insurance

business to be undertaken by the insurer in the rural or social sector; and

17. exercising such other powers as may be prescribed

MARKETS

Commodities

Equities

Debt

Foreign Exchange

PLAYERS

Brokers, firms, banks, financial institutions, FII ,mutual fund managers, investors, exchanges, depositories,

custodians, registrars.

CODE OF ETHICS IN FINANCE:

1.Act with honesty and integrity, avoiding real or clear conflicts of interest in personal and

professional relationships.

2. To provide information which is full, fair, accurate, complete, objective, relevant, timely and

understandable, including in and for reports and documents that the Company files with, or

submits to, the other public communications made by the Company.

3. Act in accordance with all applicable laws, rules and regulations of governments, and other

appropriate private and public regulatory agencies.

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4. Act in good faith, responsibly, with due care, competence and carefulness, without

misrepresenting material facts or allowing my independent judgment to be subordinated.

5. Respect the confidentiality of information acquired in the course of business except when

authorized or otherwise legally obligated to disclose the information. It should not be used for

personal advantage.

6. To promote ethical behavior among our associates.

7 . Adhe re t o and p romote t h i s  Code o f E th i c s .

Approaches to dealing with ethical problems in finance range from establishing ethical codes for

financial professionals to efforts to replace the rational-maximizer (egoistic) paradigm that

underlies the modern capitalist system by one in which individuals are assumed to be altruistic,

honest, and basically virtuous.

It is not uncommon to find established ethical codes and ethical offices in American corporations

and in financial markets. Ethical codes for financial markets are established by the official

regulatory agencies and self-regulating organizations to ensure ethically responsible behavior on

the part of the operatives in the financial markets.

One of the most important and powerful official regulatory agencies for the securities industry in

the United States is the Securities and Exchange Commission (SEC). It is in charge of

implementing federal securities laws, and, as such, it sets up rules and regulations for the proper

conduct of professionals operating within its regulatory jurisdiction. Many professionals play a

role within the securities industry, among the most important of which are accountants, broker-

dealers, investment advisers, and investment companies. Any improper or unethical conduct on

the part of these professionals is of great concern to the SEC, whose primary responsibility is to

protect investor interests and maintain the integrity of the securities market. The SEC can

censure, suspend, or bar professionals who practice within its regulatory domain for lack of

requisite qualifications or unethical and improper conduct. The SEC also oversees self-regulatory

organizations (SROs), which include stock exchanges, the National Association of Security

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Dealers (NASD), the Municipal Securities Rulemaking Board (MSRB), clearing agencies,

transfer agents, and securities information processors. An SRO is a membership organization that

makes and enforces rules for its members based on the federal securities laws. The SEC has the

responsibility of reviewing and approving the rules made by SROs.

Other rule-making agencies include the Federal Reserve System, the Federal Deposit Insurance

Corporation (FDIC), and state finance authorities. Congress has entrusted to the Federal Reserve

Board the responsibility of implementing laws pertaining to a wide range of banking and

financial activities, a task that it carries out through its regulations. One such regulation has to do

with unfair or deceptive acts or practices. The FDIC has its own rules and regulations for the

banking industry, and it also draws its power to regulate from various banking laws passed by

Congress.

In addition to federal and state regulatory agencies, various professional associations set their

own rules of good conduct for their members. The American Institute of Certified Public

Accountants (AICPA), the American Institute of Certified Planners (AICP), the Investment

Company Institute (ICI), the American Society of Chartered Life Underwriters (ASCLU), the

Institute of Chartered Financial Analysts (ICFA), the National Association of Bank Loan and

Credit Officers (also known as Robert Morris Associates), and the Association for Investment

Management and Research (AIMR) are some of the professional associations that have well-

publicized codes of ethics.

ETHICS IN FINANCE IN DIFFERENT FIELDS:

People trained in finance may enter in to different fields and in different line of work in which

they will identify different ethical values followed in different line of work. These eight general

values remain the same but there will be a small variation in ethical dilemmas. The situation of

a stockbroker is different from that of a mutual fund manager, a market regulator or a corporate

financial officer. People in finance involved in lot of activities which depend not only in

handling of financial asset but also involved in using of those asset and taking care of it.

Everyday billions of financial transaction takes place with a high level of integrity. However,

there are several opportunities in finance for some people to gain at others’ expenses. Finance

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simply concern with other people’s money and other people’s money invites misconduct. Some

of the professionals in the financial service whom are bound to serve their clients are as follows

they are stockbrokers, bankers, financial advisers, mutual fund, pension manager and insurance

agents. Financial manager in corporations, government, and other organizations have to take care

of their employers and manage their asset as well.

Characteristics of Management Prone to Fraud

Unduly aggressive financial Target

Pressure to reduce tax liabilities

Non-Financial personnel involved in accounting matters

Aggressive accounting practice to keep stock prices high

Domination by person or group without controls

Major performance related compensation

Ethical issues in Finance

Financial statements

Financial Markets

Insider Trading

Hostile Takeovers

Fraud in Financial Statements

Fictitious Revenues

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Concealed Liabilities and Expenses

Fraudulent Asset Valuations

Improper or Fraudulent Disclosures or Omissions.

Example:

 SATYAM COMPUTER SERVICES   SCANDAL

Ram lingam Raju along with 2 other accused of the scandal, had been granted bail from Supreme

court on 4 November 2011 as the investigation agency CBI failed to file the charge sheet even

after more than 33 months Raju being arrested.

Raju had appointed a task force to address the Maytas situation in the last few days before

revealing the news of the accounting fraud. After the scandal broke, the then-board member’s

elected Ram Mynampati to be Satyam's interim CEO. Mynampati's statement on Satyam's

website said:

"We are obviously shocked by the contents of the letter. The senior leaders of Satyam stand

united in their commitment to customers, associates, suppliers and all shareholders. We have

gathered together at Hyderabad to strategize the way forward in light of this startling revelation."

On 10 January 2009, the Company Law Board decided to bar the current board of Satyam from

functioning and appoint 10 nominal directors. "The current board has failed to do what they are

supposed to do. The credibility of the IT industry should not be allowed to suffer." said

Corporate Affairs Minister Prem Chand Gupta. Chartered accountants regulator ICAI issued

show-cause notice to Satyam's auditor PricewaterhouseCoopers (PwC) on the accounts fudging.

"We have asked PwC to reply within 21 days," ICAI President Ved Jain said.

On the same day, the Crime Investigation Department (CID) team picked up Vadlamani

Srinivas, Satyam's then-CFO, for questioning. He was arrested later and kept in judicial custody.

On 11 January 2009, the government nominated noted banker Deepak Parekh,

former NASSCOM chief Kiran Karnik and former SEBI member C Achuthan to Satyam's board.

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Analysts in India have termed the Satyam scandal India's own Enron scandal. Some social

commentators see it more as a part of a broader problem relating to India's caste-based, family-

owned corporate environment.

Immediately following the news, Merrill Lynch (now a part of Bank of America) and State Farm

Insurance terminated its engagement with the company. Also, Credit Suisse suspended its

coverage of Satyam.It was also reported that Satyam's auditing firm PricewaterhouseCoopers

will be scrutinized for complicity in this scandal. SEBI, the stock market regulator, also said that,

if found guilty, its license to work in India may be revoked. Satyam was the 2008 winner of the

coveted Golden Peacock Award for Corporate Governance under Risk Management and

Compliance Issues,[9] which was stripped from them in the aftermath of the scandal.] The New

York Stock Exchange has halted trading in Satyam stock as of 7 January 2009. ] India's National

Stock Exchange has announced that it will remove Satyam from its S&P CNX Nifty 50-share

index on 12 January. The founder of Satyam was arrested two days after he admitted to

falsifying the firm's accounts. Ramalinga Raju is charged with several offences, including

criminal conspiracy, breach of trust, and forgery.

Satyam's shares fell to 11.50 rupees on 10 January 2009, their lowest level since March 1998,

compared to a high of 544 rupees in 2008. In New York Stock Exchange Satyam shares peaked

in 2008 at US$ 29.10; by March 2009 they were trading around US $1.80.

The Indian Government has stated that it may provide temporary direct or indirect liquidity

support to the company. However, whether employment will continue at pre-crisis levels,

particularly for new recruits, is questionable .

On 14 January 2009, Price Waterhouse, the Indian division of PricewaterhouseCoopers,

announced that its reliance on potentially false information provided by the management of

Satyam may have rendered its audit reports "inaccurate and unreliable". Such reply was

disappointment for the general public at large as The Chartered Accountants Act, 1949 clearly

states that an auditor is responsible towards the information provided to him by the management

and shall be grossly negligent on affairs.

On 22 January 2009, CID told in court that the actual number of employees is only 40,000 and

not 53,000 as reported earlier and that Mr. Raju had been allegedly withdrawing  20 crore (US$4

million) every month for paying these 13,000 non-existent employees.

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Duties of an Auditor

To give an accurate statement to the members about the state of affairs of a company.

To meet the objectives of the Companies Act 1956 and also the Articles of Association.

To be reasonably skillful and careful in identifying the true nature of the accounts.

Ethical Audit

An audit that assess a business’s structures, procedures, systems and policies.

It measures the extent to which the activities of a business comply with the standards it

has publicly declared to its external customers

It measures business conduct against varied moral standards of the community.

Objectives of Ethical Audit

To provide a critical assessment of functioning of business

To investigate into acquisition or restructuring operations

To determine the type of training necessary for employees

To establish ethical conduct of business

To enhance, measure and promote the quality that increases business performance by

assessing them against the ethical business objective

To improve the quality of governance by evaluating the performance and ensuring that

financial information is both available and reliable

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Ethical Issues in Financial Markets

Deception: act of misrepresenting relevant information

Churning: Excessive or inappropriate trading for clients account by a broker who has

control over the account with intent to generate commissions rather than to benefit client

Unsuitability

Unfairness in Markets

HARSHAD MEHTA SCAM

Harshad Shantilal Mehta was an Indian stock broker.On April 23, 1992,

journalist Sucheta Dalal exposed Mehta's illegal methods in a column in The Times of

India. Mehta was dipping illegally into the banking system to finance his buying. In this

scam Mehta needed banks which issued fake BRs (Not backed by any government

securities). “Two small and little known banks - the Bank of Karad (BOK) and the

Metropolitan Co-operative Bank (MCB) - came in handy for this purpose. These banks

were willing to issue BRs as and when required, for a fee, once these fake BRs were

issued, they were passed on to other banks and the banks in turn gave money to Mehta,

assuming that they were lending against government securities when this was not really

the case. This money was used to drive up the prices of stocks in the stock market. When

time came to return the money, the shares were sold for a profit and the BR was retired.

The money due to the bank was returned.

This went on as long as the stock prices kept going up, and no one had a clue about

Mehta’s operations. Once the scam was exposed, though, a lot of banks were left holding

BRs which did not have any value - the banking system had been swindled of

rs. 4,000 crore (US$728 million). When the scam was revealed, the Chairman of

the Vijaya Bank committed suicide by jumping from the office roof.He knew that he

would be accused if people came to know about his involvement in issuing checks to

Mehta. 

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INTRODUCTION INSIDER TRADING

Insider trading essentially denotes dealing in a company’s securities on the basis of confidential

information relating to the company which is not published or not known to the public used to

make profit or loss. It is fairly a breach of fiduciary duties of officers of a company or

“connected” persons as defined under the SEBI regulations,1992, towards the shareholders.

Insider terms actually includes both legal and illegal conduct.

The legal version is when corporate insider officer, directors , and employees buy and sell

stock in their own companies. when corporate insiders trade in their own securities , they

must report their trades to SEBI.

Illegal insider trading refers generally to buying or selling a security , in breach of

fiduciary duty or other relationship of trust and confidence, while in possession of

material , non public information about the security.

Who are insider traders?

Corporate officers, directors , and employees who traded the corporations securities after

learning of significant , confidential corporate developments.

Friends , business associates, family members , and other types of such officers , directors

, and employees, who traded the securities after receiving such information.

Employees of law, banking , brokerage and printing firms who were given such

information to provide services to the corporation whose securities they traded.

Govt employees who learned of such information because of their employment by the

Govt .

Other persons who misappropriated ,and took advantage of, confidential information

from their employers.

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Only 14 cases taken up by SEBI for insider trading in 2003-04 , which went down to only

7 in 2004-05.

In terms of cases completed, the no was only 9 and 5 respectively.

So does India has fewer incidence of insider trading or our systems/laws not geared

enough to detect such cases?

Insider Trading Refers to trading on price sensitive information by company employees

or individuals closely connected with the firm This information has not been disclosed to

other market participants

Ethics & Insider Trading

It violates equality of opportunity

Does not give a level playing field between insiders and outsiders

Might harm exchange as a whole because investors might not be willing to trade on

exchange that does not give shareholders their rights.

RAJAT GUPTA SCAM

Rajat Kumar Gupt born 2 December 1948 is an Indian American philanthropist and

businessman who was the managing director (chief executive) of management

consultancy McKinsey & Company from 1994 to 2003 and a business leader in India and the

United States. He was convicted in June 2012 on insider trading charges stemming from the Raj

Rajaratnam-led Galleon Group case on four criminal felony counts of conspiracy and securities

fraud. He was sentenced in October 2012 to two years in prison, an additional year on supervised

release and ordered to pay $5 million in fines.

In his capacity at McKinsey, Gupta was recognized as the first Indian-born CEO of a global

Western company. After becoming a senior partner emeritus at McKinsey, Gupta served as

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corporate chairman, board director or strategic advisor to a variety of large and notable

organizations: corporations including Goldman Sachs, Procter and Gamble and American

Airlines, and non-profits including The Gates Foundation, The Global Fundand the International

Chamber of Commerce.

Rajat Gupta is additionally the co-founder of four different organizations: the Indian School of

Business with Anil Kumar, the American India Foundationwith Victor Menezes and Lata

Krishnan, New Silk Route with Parag Saxena and Victor Menezes, and Scandent with Ramesh

Vangal. On March 1, 2011, the SEC filed an administrative civil complaint against Gupta for

insider trading with billionaire and Galleon Group hedge fund founder Raj Rajaratnam.

Coverage of the event noted that Anil Kumar — who, like Gupta, had graduated from IIT, was a

highly regarded senior partner at McKinsey, and had also co-founded the Indian School of

Business — had already pleaded guilty to charges in the same case. Gupta, Kumar, and

Rajaratnam were all close friends and business partners. Gupta countersued and both sides

eventually dropped charges.

On October 26, 2011 the United States Attorney's Office filed criminal charges against Gupta.

He was arrested in New York City by the FBIand pleaded not guilty. He was released on $10

million bail on the same day. Gupta's lawyer wrote, “Any allegation that Rajat Gupta engaged in

any unlawful conduct is totally baseless .... He did not trade in any securities, did not tip Mr.

Rajaratnam so he could trade, and did not share in any profits as part of any quid pro quo.”  The

SEC alleged, "The tips generated 'illicit profits and loss avoidance' of more than $23 million."

Manhattan U.S. Attorney Preet Bharara said, "Rajat Gupta was entrusted by some of the premier

institutions of American business to sit inside their boardrooms, among

their executives and directors, and receive their confidential information so that he could give

advice and counsel."

Details of wiretap recordings and trading activity related to the charges were analyzed at length

in the media, assessing the strengths and weaknesses of the prosecution's and defense's cases.

The current case is focusing on the relationship between Raj Rajaratnam, Anil Kumar and Gupta.

Gupta, Rajaratnam, and Kumar were all involved to varying degrees as founding partners of

private-equity firms Taj Capital and New Silk Route, though Rajaratnam and Kumar left before

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they began operation. Gupta remained as chairman of New Silk Route, and Rajaratnam

eventually invested $50 million in the fund.

Rajat Gupta's trial began on May 22, 2012. On June 15, 2012, Gupta was found guilty on three

counts of securities fraud and one count of conspiracy. He was found not guilty on two other

securities fraud charges. At the time, his lawyer told reporters, "We will be moving to set aside

the verdict and will, if necessary, appeal the conviction." Sentencing is scheduled for October

2012. The maximum sentence for securities fraud is 20 years and the maximum sentence for

conspiracy is five years. In arguments in mid-October, prosecutors favored prison time of up to

10 years while defense attorneys favored probation and community service. As one service

option, the latter suggested Gupta "work on health care and agriculture in rural Rwanda".

Prosecutors based their recommendation in part on $11.2 million profits, or losses avoided, by

Rajaratnam based on the tips. The defense argued Gupta "never profited on the alleged trading"

per one news account.

On October 24, 2012, Gupta was sentenced to two years in prison by Judge Rakoff of the  United

States District Court in Manhattan for leaking boardroom secrets to former hedge fund manager

Raj Rajaratnam.

Hostile Takeovers

A hostile takeover is an acquisition in which the company being purchased doesn’t want to be

purchased, or doesn’t want to be purchased by the particular buyer that is making a bid. How can

someone buy something that’s not for sale? Hostile takeovers only work with publicly traded

companies. That is, they have issued stock that can be bought and sold on public stock markets.

Corporate legal professionals, as you may have previously discovered, don’t necessarily get a

great deal of excitement in their professional career. Negotiating deals and working out tax

beneficial strategies may be exciting to some - but not to many. However, when it comes to legal

excitement, it is only the rare courtroom drama that can compare with the thrill of a hostile

takeover transaction. 

The hostile takeover is not a unique type of business combination. It will either take on one of

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the business combinations that we have studied previously in this chapter or it will be a simple

stock transaction, which we will discuss more in the following chapter. Regardless of the form of

the transaction, the thing that adds special flavor to a hostile takeover is the fact that, as the name

implies, it is hostile. In other words, a hostile takeover is the result of a situation where the

incumbent board of the company, and some percentage of its shareholders, are refusing to sell

the company to a would-be buyer. The existing board works to maintain its control over the

company, while the hostile bidder positions itself to accomplish its goal of acquiring control over

the company.

Setting the Scene- The Recent History of the Hostile Takeover

EXAMPLE: Imagine the setting. The directors of Happy Co. are busily operating its business

when they discover that a single individual or company has acquired a significant percentage of

the company’s stock. Happy Co.’s board had failed to notice the sizable acquisition right up until

the point when the SEC informed them that Acquire Co., a known “corporate raider”, had filed

its "13-D," a form that Acquire Co. is required to file with the SEC once its holding reaches

greater than 5% of Happy’s outstanding stock.

As a member of Happy Co.’s board, how do you respond?

The scenario described above, which we will follow to its conclusion below, was fairly typical

throughout the 1980’s. Essentially, an environment of relatively cheap and available capital

created a situation where small organizations – often styling themselves as Leveraged Buyout

(LBO) Firms or alternatively, “vulture investors” – would raise large pools of capital that they

would subsequently use as a means of acquiring various operating companies. 

In such an environment, two opinions generally emerged during the process of a takeover bid.

Many investors in the target companies joined the various investment firms that were financing

these corporate takeovers. From these investors’ perspectives, their corporations' management

had been acting too conservatively and failing to work aggressively to make the company more

profitable. From this point of view, investors felt that corporate raiding was a good thing that

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took companies and assets out of the hands of poor managers and placed them in the hands of

aggressive, talented managers who were prepared to work hard to make companies realize their

full potential. 

From the perspective of incumbent management and often the corporate employees as well,

hostile takeovers simply represented greed run rampant. As these investors acquired their target

companies, they typically would cut the firm’s operating expenses aggressively – slashing

overhead and cutting jobs in the process. Moreover, the transactions structured by these investors

in acquiring the companies often included adding a great deal of debt to the acquired company’s

balance sheet in order to finance the transaction of acquiring the company. 

Ultimately, the likely result was that all parties involved – management, the employees, and the

interceding investors – had varying opinions as to how to manage the company and often led to

chaos within the ranks of the corporation. Time has shown that such transactions rarely netted

investors huge profits, but they often did have the effect of streamlining management and

trimming corporate “fat” from the target companies. There is no question that some of the

transactions structured during the “takeover craze” of the 1980’s were financially unsound and

more about short-term gain than for the long-term growth of the companies and the economy.

However, not nearly as many jobs were lost as had been feared would result from these

transactions, and many employees found themselves working for much more capable

management than they worked for before the takeovers.

EXAMPLE: Happy Co’s board initially responds with a media blitz describing the solid nature

of the firm and its management. The Board cites the company’s long tradition of treating

employees with respect and it points to the accolades that management has received.

Concurrently, Acquire Co. has begun lining up other investors and speaking with financial

experts to determine the nature and amount of any bid it should make for Happy.

The reason why we are studying hostile takeovers, despite the fact that hostile takeovers are no

longer as common, is that such transactions continue to occur. While excessive leverage is no

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longer common in such deals, it continues to be the case that hostile transactions do occur and it

is important to understand both the lingo and options that will be discussed in such a situation.

Management’s Reaction

Faced with a hostile bidder, management has a handful of options at its disposal to consider as

possible responses to the hostile offer. The list that follows provides brief summaries of those

responses. Keep in mind, however, that a creative management team may develop means of its

own to respond to a bid, or combine any or all of the methods below as a method of stopping or

stalling the hostile suitor.

1. Propose a Management Plan

When putting forth a hostile bid, the incoming bidders typically will disclose – either of their

own free will or because they are required to do so by the SEC – their plan for reforming the

firm. However, even if the buyer does not disclose its plans, management may themselves

propose a slate of changes that they feel will win the approval of shareholders and provide the

same beneficial changes as those suggested by the hostile bidder.

Depending on the perspective of the shareholders and the price that is offered by the buyer,

management’s proposing its own plan may be greeted in any of a number of ways. In a situation

where the proposing buyer is viewed as not only hostile, but potentially destructive of corporate

value (such as when the buyer has a track record of dissolving companies quickly for its own

benefit), then management’s plan may be welcomed by the shareholders and the employees of

the company. On the other hand, it’s also possible that management’s plan may be viewed with

disdain by the shareholders. Such a response is usually combined with the observation that

management is offering “too little, too late.” If management could have put the plan forward

before, why did they fail to do so? Was it because they were protecting their jobs? Finally, and

most likely, shareholders often view management presenting its own plan as simply a negotiating

tactic that calls for the hostile suitor to raise its bid in response. 

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EXAMPLE: With its media campaign underway, the Board of Happy Co. now begins to look

for other options. Having received a copy of Acquire’s “13-D” filing and having some insight as

to what the buyer’s plans for the firm are, Happy’s board now begins to formulate its own

strategy for revamping the firm. Their plan includes a major reorganization, the sale of some

non-core assets, and the curtailing of many executive perks. The plan is viewed by shareholders

and the general market with mixed emotions. While the sale of assets and the cuts on executives’

perks are well received, the media is calling into question why the assets were purchased in the

first place and how management was allowed to accumulate so many benefits. Moreover, if these

changes were in the best interest of the company, ask Happy’s shareholders, why were they not

instituted before?

2. Find a White Knight

Management may also respond to a hostile suitor by finding an alternative bidder that it finds to

be less threatening. Typically, when faced with a hostile bidder, management will look to other

potential buyers – including other major shareholders, other investment funds, or even

competitors in the industry – that management would prefer to see assume control of the

company, rather than the hostile bidder. 

In a situation involving a new bidder – the so-called “white knight” – management is taking

some risks. By involving multiple bidders, the company is inviting itself into a situation where it

may be required to either auction the company to the highest bidder, or to enter into a scenario

where a host of additional bidders might enter the fray, since, by soliciting bids, the company has

placed itself, at least in the public’s mind, “in-play.”

EXAMPLE: Management’s next step is to begin searching for another buyer. In the process,

they speak to Compete Co., a competitor of Happy’s that had, in the past, indicated an interest in

acquiring Happy. Management offers Compete favorable deal terms in return for adopting a

portion of management’s plan and retaining the current executives. Compete takes the offer into

consideration, but voices a concern that it does not want to enter an “auction” scenario where the

price of Happy is bid on by multiple suitors until the company is sold to the highest bidder – not

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necessarily the bidder best equipped to run the firm.

3. Stagger the Board

We already discussed the staggered board before. A "staggered" board provides that only a

certain percentage of the board of directors is elected during each year. A staggered board creates

a situation where an incoming buyer who is attempting to take over the company by way of a

proxy solicitation leading to election of their own slate of directors, will require several years to

complete the acquisition.

EXAMPLE: Happy’s board also quickly produces a board initiative to require that the board be

staggered. The new board, which is to consist of nine members rather than the current 5, is to be

staggered over three years, with three directors elected per year.

4. Adopt a Poison Pill

In the final section of this chapter, we will discuss the “poison pill” as a tool used by companies

to protect themselves from hostile buyers. For now, keep in mind that a poison pill serves to

discourage a hostile takeover attempt and/or to help insure that management has additional

leverage in negotiating with the incoming bidder.

The Buyer’s Perspective

Like the incumbent management, the bidder also has a certain set of options for initiating and

completing the takeover bid. The list that follows is a sample listing of such maneuvers.

1. Buy 

The easiest way that an acquirer can gain control of a target company is to simply acquire a large

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percentage of the company and thus secure actual control of the firm. While this is the easiest

method in form, it is often the hardest to put into practice. The SEC has some very specific limits

as to the acquisition of shares by a bidder after initiating a bid. See 15 USCS § 78n(d). In most

cases, such a buyer is not allowed to purchase shares except through the bid itself, and cannot

circumvent the process for any reason. [As an aside, you may notice that the statutory citations in

this area are federal, not state. It is federal regulation, not state law, that deals with the takeover

process. The Supreme Court has ruled that the states may not promulgate rules that restrict or

regulate takeovers because that would be too great an infringement on interstate commerce,

which is the federal government’s job to regulate and control. See Edgar v. MITE Corp., 457

U.S. 624 (1982).] Additionally, the sheer cost of acquiring a control position in a large company

may be difficult or impossible for a single bidder to raise sufficient funds to accomplish the

takeover.

EXAMPLE: Acquire, anticipating Happy’s move, has assembled a “syndicate” – a group of

investors in addition to itself, who are willing to help finance Acquire’s plan – to complete the

deal. However, as the price of Happy’s shares continues to climb because of speculation as to the

possibility of the takeover bid, it is not clear if the syndicate will be able to raise sufficient funds

to finance the transaction.

2. Proxy Contest

As we discussed previously, a proxy contest is where an incoming bidder offers its own slate of

directors at the annual election and solicits proxies from other shareholders to get that slate

elected. This can be an efficient way of effecting a takeover. The problem with such a plan is that

it is inherently unstable, as voters can switch sides without notice and can be lost quickly. 

3. “Bear Hug”

Another technique, employed less frequently but effective when executed properly, is for the

incoming bidder to offer a price that is simply too good for the target company to pass up. Such a

scenario is generally only used in small acquisitions where a large firm is acquiring a small firm,

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typically because it wishes to acquire an asset or customer from the small firm. In a “bear hug,”

the buyer offers a price that is so high that no other buyer is likely to match the offer. The Board,

based on the desire of the shareholders to maximize their investment return, is, in essence,

"forced" to accept the bid. 

EXAMPLE: Having added several new investors to the syndicate, and before any other bidder –

including Compete Co – is able to make an offer, Acquire substantially raises its offer. The new

level of the offer, in addition to the fact that the syndicate is quite large and has involved most of

the major funding banks for such transactions, makes Happy’s board face the fact that their

options are limited, and it may be time to consider maximizing shareholder value, rather than

protecting their own jobs. Therefore, the option of accepting Acquire’s bid becomes the best, and

perhaps only realistic, option.

The Outcome

Once a hostile takeover, or any change of control transaction, has begun, there is usually no way

to reverse it. After a company has been placed on the market, the inevitable outcome is such that

it will ultimately be either acquired by another firm or be forced to markedly change its

operations and management. The problem with such situations is that they are inherently

unpredictable as buyers enter and leave the fray based on the prospects of the deal closing in

their favor. Such transactions represent the best “show” in the corporate legal practice and

provide ample opportunity for any legal professional to learn how businesses are bought, sold,

and changed.

Examples hostile takeover

Microsoft vs Yahoo – Hostile take over explained

I am sure most of us have been following this recent event of Microsoft planning to purchase

Yahoo. News is all over that Microsoft may go hostile against Yahoo. In this case the company

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or more specifically its board of directors doesn’t want to be purchased but buyer company can

do it. I will explain as to what exactly is hostile take over and how does it work.

What is hostile take over?

Take over is a corporate action where an acquiring company makes a bid for an acquiree.A

hostile takeover is an acquisition in which the company being purchased doesn’t want to be

purchased, or doesn’t want to be purchased by the particular buyer that is making a bid. How can

someone buy something that’s not for sale? Hostile takeovers only work with publicly traded

companies. That is, they have issued stock that can be bought and sold on public stock markets.

Can Microsoft legally take over Yahoo?

Yes of course. Because Yahoo is a publicly traded company i.e. its shares are being listed at

stock exchange, any body can buy it by purchasing majority number of shares.

How does it work?

Most large companies do not own a majority share of their own stock as in case of Yahoo. To see

how Yahoo stock has been divided among individuals and companies click here.

Let’s say, Yahoo owns 30% of their stock with the other 70% being owned by individuals or

companies, where each entity only owns 1% or less.

Microsoft can attempt a hostile take over by buying stock from all the individuals until they own

more than the 30% of Yahoo stock.

What are different methods of hostile take over?

The two primary methods of conducting a hostile takeover are the tender offerand the proxy

fight.

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A tender offer is a public bid for a large chunk of the target’s stock at a fixed price, usually

higher than the current market value of the stock. The purchaser uses a premium price to

encourage the shareholders to sell their shares. The offer has a time limit, and it may have other

provisions that the target company must abide by if shareholders accept the offer. This method is

currently employed by Microsoft as they offered $44.6 billion which Yahoo hasn’t accepted. The

dead line has already passed.

In a proxy fight, the buyer doesn’t attempt to buy stock. Instead, they try to convince the

shareholders to vote out current management or the current board of directors in favor of a team

that will approve the takeover. The term “proxy” refers to the shareholders’ ability to let

someone else make their vote for them — the buyer votes for the new board by proxy. This is

what Microsoft has said they will do in the coming days. Hostile take over through proxy can

turn ugly trust me!

What options does Yahoo have?

Yahoo can prevent Microsoft from hostile take over by buying back their own stock from

individual holders to increase their majority shares. Ideally owning 51% would ensure that no

one could succeed in a hostile take over attempt.

“The Golden Parachute” is also an option. It’s a provision in a CEO’s contract .which states that

he will get a large bonus in cash or stock if the company is acquired. This makes the acquisition

more expensive, and less attractive.

Another option is staggered board of directors drags out the takeover process by preventing the

entire board from being replaced at the same time. The terms are staggered, so that some

members are elected every two years, while others are elected every four.

And last but not least Yahoo can issue “Dual-class stock” will allow them to hold onto voting

stock, while the company issues stock with little or no voting rights to the public. That way

investors can purchase stocks, but they can’t purchase control of the company.

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What options does Microsoft have?

The best Microsoft can do is to keep this in news and publicize this merger as much as possible.

This will put up pressure which will ultimately result in buying majority shares from individuals.

It has to convince individual share holders that selling their shares to Microsoft will result in

benefit for all. This is a proxy war and any thing goes. If Microsoft is able to buy 51% shares

then it’s game over for Yahoo!

PeopleSoft, Inc. was a company that provided Human Resource Management Systems (HRMS),

Financial Management Solutions (FMS), Supply Chain Management (SCM) and customer

relationship management (CRM), Enterprise Performance Management software (EPM), as well

as software solutions for manufacturing, enterprise performance management, and student

administration to large corporations, governments, and organizations. It existed as an

independent corporation until its acquisition by Oracle Corporation in 2005. The PeopleSoft

name and product line are now marketed by Oracle. Beginning in 2003, Oracle began to

maneuver for control of the PeopleSoft company. In June 2003, Oracle made a $13 billion bid in

a hostile corporate takeover attempt. In February 2004, Oracle decreased their bid to

approximately $9.4 billion; this offer was also rejected by PeopleSoft's board of directors. Later

that month, the U.S. Department of Justice filed suit to block Oracle, on the grounds that the

acquisition would break anti-trust laws. In September 2004, the suit was rejected by

a U.S. Federal judge, who found that the Justice Department had not proven its anti-trust case. In

October, the same decision was handed down by the European Commission. Though Oracle had

reduced its offer to $7.7 billion in May, it again raised its bid in November to $9.4 billion.

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In December 2004, Oracle announced that it had signed a definitive merger agreement to acquire

PeopleSoft for approximately $10.3 billion. A month after the acquisition of PeopleSoft, Oracle

cut over half of PeopleSoft's workforce, laying off 6,000 of PeopleSoft's 11,000 employees.

Oracle moved to capitalize on the perceived strong brand loyalty within the JD Edwards user

community by rebranding former JD Edwards products. Thus PeopleSoft

EnterpriseOne became JD Edwards EnterpriseOne and PeopleSoft World became JD Edwards

World. Oracle has announced that a new product, Fusion Applications, is to be released in the

near future. Oracle says Fusion will take the best aspects of the PeopleSoft, JD Edwards and

Oracle Applications and merge them into a new product suite.

Oracle is committed to ongoing maintenance and enhancements to the PeopleSoft application

suite with its Application Unlimited program, recently releasing PeopleTools 8.52.

Anti-takeover defense measures

Poison Pills

Green mail

Buy back

People Pill

Poison Pills

A strategy used by corporations to discourage hostile takeovers. With a poison pill, the target

company attempts to make its stock less attractive to the acquirer. There are two types of poison

pills: 

1. A "flip-in" allows existing shareholders (except the acquirer) to buy more shares at a

discount. 

2. A "flip-over" allows stockholders to buy the acquirer's shares at a discounted price after the

merger.

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Example : Netflix the video-streaming and DVD rental company adopted a shareholder

rights plan commonly known as a poison pill, to fend off the activist investor Carl C.

Icahn to keep things exciting and place a shareholder-friendly spin on the event.

Greenmail

Like blackmail, greenmail is money that is paid to an entity to make it stop an aggressive

behavior. In mergers and acquisitions, it is an antitakeover measure where the target

company pays a premium, known as greenmail, to purchase its own stock shares back (at

inflated prices) from a corporate raider.

Once the raider accepts the greenmail payment, generally it agrees to stop pursuing the

takeover and not to purchase any more shares for a specified number of years. The term

"greenmail" stems from a combination of blackmail and greenbacks (dollars). The great

number of corporate mergers that occurred during the 1980s led to a wave of

greenmailing. During that time, it was suspected that some corporate raiders initiated

takeover bids to make money through greenmail, which no intention of following through

on the takeover.

Example

The St. Regis Paper Company provides an example of greenmail. When an investor

group led by Sir James Goldsmith acquired 8.6% stake in St. Regis and expressed interest

in taking over the paper concern, the company agreed to repurchase the shares at a

premium. Goldsmith's group acquired the shares for an average price of $35.50 per share,

a total of $109 million. It sold its stake at $52 per share, netting a profit of $51 million. 

Buy Back

A buyback allows companies to invest in themselves. By reducing the number of shares

outstanding on the market, buybacks increase the proportion of shares a company

owns. Buybacks can be carried out in two ways:

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1. Shareholders may be presented with a tender offer whereby they have the option to

submit (or tender) a portion or all of their shares within a certain time frame and at a

premium to the current market price. This premium compensates investors for tendering

their shares rather than holding on to them.

2. Companies buy back shares on the open market over an extended period of time.

People Pill

A defensive strategy to ward off a hostile takeover. The target company's management

team threatens that, in the event of a takeover, the entire team will resign. The purpose of

a people pill is to discourage the acquiring company from completing the takeover, by

introducing the possibility of having to put together an entirely new management team.

This strategy is only effective if the acquiring company wants to keep the existing

management.

The first use of the people pill anti-takeover strategy is attributed to a food company

called the Borden Corporation. In 1989, the company's board of directors approved a

people pill that Borden could use to demand that an acquiring company pay a fair value

for the company's shares and that it not fire or demote any of Borden's existing managers.

The people pill strategy is a variation of the poison pill defense.

Ethical Issues In The Financial Services Industry

Ethical issues in the financial services industry affect everyone, because even if you don’t work

in the field, you’re a consumer of the services. That was the message of Ronald F. Duska and

James A. Mitchell in their presentation at a recent meeting of the Business and Organizational

Ethics Partnership.

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The public seems to have the perception that the financial services sector is more unethical than

other areas of business, Mitchell began. For the past five years, he has been Executive Fellow-

Leadership at the Center for Ethical Business Cultures, which is affiliated with the University of

St. Thomas College of Business. He assists business leaders in developing ethical and profitable

cultures.

This misperception persists for several reasons, Mitchell said. First of all, the industry itself is

quite large. It encompasses banks, securities firms, insurance companies, mutual fund

organizations, investment banks, pensions funds, mortgage lenders—any company doing

business in the financial arena. Because of its vast size, the industry tends to garner lots of

headlines, many of which tout its ethical lapses.

“This business that we’re talking about is really big. It is, to be precise, $50 trillion in assets. It’s

growing 8 percent a year, which is more than twice as fast as the gross domestic product,”

Mitchell said. “It’s also highly profitable. The financial services sector of the S&P 500 represents

20 percent of this index’s market capitalization. These companies are making a lot of money

serving you.”

So, he theorized, with “trillions of dollars of assets, billions of transactions every year—every

day probably—when a small percentage of them is inappropriate, the absolute numbers are still

pretty big.”

The industry is also highly regulated, so it’s likely that a higher percentage of these bad

transactions are identified and reported, perhaps more so than in other less regulated industries.

But ethical lapses do occur, and Duska discussed five reasons why these misdeeds may happen.

He holds the Charles Lamont Post Chair of Ethics and the Professions at The American College.

The Post Chair supports research and studies of the social responsibilities and ethical challenges

facing the financial services industry.

1) Self-interest sometimes morphs into greed and selfishness

which is unchecked self-interest at the expense of someone else. This greed becomes a kind of

accumulation fever. “If you accumulate for the sake of accumulation, accumulation becomes the

end, and if accumulation is the end, there’s no place to stop,” he said. The focus shifts from the

long-term to the short-term, with a big emphasis on profit maximization.

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For example, swaps (where two communication companies agree to exchange the right to use

excess bandwidth on their networks) fall into this category. Each company recognizes the

income generated in the quarter earned and defers the expenses through capitalizing them as an

asset and logging the cost as a recognized expense over time, resulting in an inflated bottom line.

This is what happened at Qwest during the first three quarters of 2001, when the company was

selling $870 million of capacity, while at the same time buying $868 million of capacity. These

swaps appeared to be round-trip transactions, which served no purpose other than to inflate

Qwest’s revenues, Duska said.

“Companies were making money out of their finance department—not from selling products, not

from doing what the company did, not from fulfilling the company’s mission, but from playing

around with its asset mix,” he said.

2) Some people suffer from stunted moral development:

 “I think this happens in three areas: the failure to be taught, the failure to look beyond one’s own

perspective, and the lack of proper mentoring,” Duska said.

Business schools, he said, too often reduce everything to an economic entity. “They do this by

saying the fundamental purpose of a business is to make money, maximize profit, or the really

jazzy words ‘maximize shareholder value,’ or something like that. And it never gets questioned,”

he said. “Now if the fundamental purpose never gets questioned, the ethics never get questioned,

because the fundamental purpose of something gives you the reason for its existence. It tells you

whether you're doing it well or not. It's the ultimate ethical question: What's your purpose?”

3) Some people equate moral behavior with legal behavior

disregarding the fact that even though an action may not be illegal, it still may not be moral.

“You ought to remember that the reason for all laws is that the moral agreement begins to break

down, and the way to get other people in line is to legislate so that we can stipulate

punishments,” Duska said. Yet some people contend that the only requirement is to obey the law.

They tend to ignore the spirit of the law in only following the letter of the law.

For example, IRS regulations repeatedly single out actions with “no legitimate business purpose”

(like swaps.) “If you are doing things with no legitimate business purpose in order to avoid

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taxation, what are you doing? You’re violating the spirit, are you not? You’re staying within the

letter, but there’s no purpose there except to get you around the law,” he said.

4) Professional duty can conflict with company demands 

For example, a faulty reward system can induce unethical behavior. “A purely self-interested

agent would choose that course of action which contains the highest returns to himself or

herself,” he said.

For example, consider the misguided practice of selling indexed annuities to the elderly. If a

company is paying a high commission for that product, say 15 percent, versus a lower

commission for a more appropriate product, say 3 percent, a salesperson may disregard the needs

of the client and/or assume that the company supports this product and its applicability by its

willingness to pay five fold the compensation. “Sooner or later, people are going to give in to

that temptation. The purely self-interested agent is just responding to the reward system that is in

place,” Duska said. “You need to take a look at what you are rewarding.” In general,

organizations get exactly what they reward. They just don’t realize that their rewards structures

are encouraging dysfunctional or counter-productive behavior or turn a blind eye to the outcome

5) Individual responsibility can wither under the demands of the client. 

Sometimes the push to act unethically comes from the client. How many people expect their

accountants to pad their expenses where possible? How many clients expect their insurance

agents to falsify their applications or claims? “That’s the temptation—you like your client,

you’ve gotten to know your client, you really want to help your client out—that’s just another

conflicting loyalty,” Duska said.

Mitchell concluded the presentation with several suggestions for improvements in the industry to

encourage more ethical behavior. “My experience [in the financial services industry] is that

people who do business are, for the most part, highly ethical people trying to do the right thing

most of the time. Most of them are trying to help their clients achieve their financial objectives,”

he said. “But how could this be better, because clearly, even if I’m right, there are still a lot of

issues and problems in the business?”

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First of all, consumers need to be better informed. “It is your responsibility to take control of

your own financial security,” he said, which doesn’t mean you need to know everything about

the product you are buying in advance, but “you should read enough to know what some of the

right questions are to ask.” Ask those insightful questions of an advisor whom you know, trust,

and who has the proper credentials, if applicable.

Other suggestions included:

incentive compensation better aligned with customers’ interests, rather than agents’ 

more industry trade associations supporting ethics initiatives

the Center for Ethics in Financial Services growing in influence and impact

CONCLUSION

No business and company can run without finance. It is lifeblood for all the organization. So if

almost all the field in finance follows ethics in their duty almost all other process will function

very well without any discrepancies. The financial industry is particularly prone to rogue players

who can undermine confidence in the industry and thus the economy. The response to this

several hundred years ago, were the livery companies, clubs and guilds which amongst other

things used ethical standards to restrict market entry. I think there is a role for a modern day

interpretation of the livery clubs, using due process to establish higher standards than we can

expect the law to provide.

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But at the end of the day, corporate ethics officers aside, individuals need to make their own

moral choices. I do not think these can be easily codified into a list of dos and don’t and I do not

try to do so. I do believe however, that people can be helped to arrive at the answers, by asking

them the right questions. There are two I pose.

In any bargain there are those in advantage or not, but have you contrived a situation in which

you have created your advantage? Have you created the financial panic on the part of your

counter-party that allows you to buy cheap? The second question is will your transaction come

under the wide scrutiny of others. If so, and others less intimately involved in the trade can

judge, then their burden of your judgement is, not passed on, but made lighter than if there is no

opportunity for external scrutiny. Be wary of deals that are secret long after they are complete.

Two simple questions to help us all better evaluate our ethical position; I do not begin to expect

the answers to be simple too.

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