M17_MISH1520_06_PPW_C16.ppt

1. Chapter 16 What ShouldBe DoneAbout Conflictsof Interest?A Central Issue in Business Ethics

In the last several years, the U.S. stock market has been jolted by many corporate scandals.One of the biggest auditors, Arthur Andersen, was indicted on obstruction charges.Criminal charges have been filed again J.P. Morgan, Merrill Lynch, and Goldman Sachs.

Surrounding many of these cases is a central theme ofconflicts of interest a situation where multiple interest have to be served, often the investing public and corporate clients.In this chapter, we examine this problem more closely.

We examine recent equity market scandals and the consequences on the investing public.We pose a broad question: what can be done to resolve these problems?Topics include:

What Are Conflicts of Interest and Why AreThey Important?

Ethics and Conflicts of Interest

Can the Market Limit Exploitation of Conflicts of Interest?

What has been done to Remedy Conflicts of Interest?

A Framework for Evaluating Policies to Remedy Conflicts of Interest

Financial intermediaries engage in a variety of activities to collect, produce, and distribute information.By providing multiple services, they realizeeconomiesof scope .

However, these services may be competing with one another, and this creates the potential for a conflict of interest.

The conflicts of interest may arise as the concealment of information for the dissemination of misleading information.

We care about these conflicts of interest because a reduction in the quality of information increases the presence of asymmetric information.The problems therein were just discussed in the previous chapter.

Conflicts of interest generate incentives to provide false or misleading information.This behavior is considered unethical.

One way to limit these conflicts is to make workers aware of the ethics issues at stake, so that they are less likely to engage in unethical behavior.

We will discuss, in turn, four areas of financial service activities that harbor the greatest potential for generating conflicts of interest.These are:

Underwriting and research in investment banking

Auditing and consulting in accounting firms

Credit assessment and consulting incredit-rating agencies

Universal banking

Some investment banks bothunderwritenew securities sold the public, and provideresearch(buy/sell recommendations) to the investing public

When revenues from underwriting exceed brokerage commissions,favorableresearch will attract more business, at the expense of unbiased recommendations to the investing public.

Ininitial public offeringsof equity, underwriters direct the new shares as they wish, typically to their best clients orpotential new clients .

Since most IPOs are underpriced, many of these shares are immediately sold for a profit (calledspinning ).This immediate profit may appear as nothing more than payment for future business.

Several recent cases highlight the conflicts that IPOs can create.Lets look at two of these: The King, Queen, and Jack of the Internet and Frank Quattrone and Spinning

The title refers to three influential technology analysts during the internet boom:

Henry Blodgett (ML)

Jack Grubman (SSB)

Mary Meeker (MS)

Conflicts of interest may have influenced recommendations they made.

Henry Blodgett (ML)

Publically hyped internet stocks while derailing them privately.Changed recommendations when ML didnt get underwriting business.

Jack Grubman (SSB)

Similar to Henry, recommendations were strong, but private comments suggested otherwise.

Mary Meeker (MS)

Unlike Henry and Jack, Mary did have strong buy recommendations, but didnt derail them privately.Indeed, she did have poor recommendations for firms with poor prospects.She was never subject to criminal charges.

Frank worked for Credit Suisse First Boston underwriting new internet stock issues.

NASD filed a complaint in 1993 that he pressured analysts to provide favorable coverage.

Friends of Frank account used for spinning was also alleged shares sold vary quickly for profit to friends.

To return to our discussion of Types of Conflicts, we now look at the role of auditors in public firms.They provide an unbiased view of the financial reports to reduce asymmetric information between the firms management and the investing public.

By also providingmanagement advisory services(such as systems support), the auditor has an incentive to fudge the audit if the fees from other services are substantial.

Auditors also have a conflict of interest since they are paid by the firm they audit.If the auditor gives an unfavorable audit report, the auditor may lose the auditing business as well.

A well known case of the failure of auditors to provide unbiased reports was Arthur Andersens audit of Enron.

Bond investors rely on credit-rating agency assessment of firms debt (debt ratings).

However, ratings are only provided when the firm pays the agency.Agencies, then, have an incentive provide better ratings to attract business.

Rating agencies have also started providing firms with other services, and have the same conflicts as auditors inthis regard.

Lets look at this further in our mini-case.

In the 1970s, rating agencies earned revenue by providing information about securities (ratings).However, this changed to where the agencies now charge the issuer to have its debt rated.Why the switch?

Free-riders explains this.Few actually paid for the research.One would pay, and then make copies for everyone else.The agencies started losing revenue.Its unfortunate that the solution (charging issuers) created a conflict.Was there a better solution?

Universal bankingrefers to institutions that provide some combination of commercial banking, investment banking, and insurance services.

Glass-Steagall prohibited this in the U.S. as of 1933.However, in 1999, Congress repealed this act, allowing for some form of universal banks in the U.S.

Issuers that use the underwriting services of a bank will also benefit from sale of its products to the banks other (retail) customers.Customers should expect unbiased advice, but may not get it.

Bank managers may push investing products of its affiliates, even if they arent in customers best interest.

Lenders with private (bad) information have an incentive to withhold the information during security issuances in order to get paid themselves, at the expenses of the investing public.

Lenders may offer favorable terms to secure future underwriting business.

Banks may use strong-arm tactics to sell its affiliate insurance products.

Conflicts of interest are a problemwhen they lead to a decreased flow of reliable information (increasedasymmetric information).

However, even withpotentialconflicts, the incentives (financial gain) may not be present to actually act on them.

Empirical evidence suggests that rating agency debt ratings are unbiased, despite being paid by the firms.

Underwriting and commercial banking also appeared to be free from exploitations.Many banks in then 1920s spun-off their investment banking activities to separate the functions.

Empirical evidence also suggests that the investing public discounts recommendations made by the underwriters analysts.

However, when temporary rewards to high (such as the late 1990s), trusted firms may extractreputational rentsfrom the investing public by seeking short-term gains at the expense of their future reputation.

When the market fell in 1929, investors asked why they had been encourage to buy securities.The Senate held hearings to investigate this, and several cases of conflicts arose.As a result, Congress passed Glass-Steagall to separate banking and securities.However, this was repealed in 1999 just in time for another collapse.

Two major policies were implemented following the scandals of the late 1990s and early 2000s.These are:

Sarbanes-Oxley Act of 2002

Global Legal Settlement of 2002

Passed following the public outcry over corporate scandals.The act, in summary, has the following six major components:

Established the Public Company Accounting Oversight Board to supervise accounting firms.

Prohibited public accounting firms from engaging in nonaudit services to a client it is also auditing.

Members of the boards audit committee mustbe independent.

Passed following the public outcry over corporate scandals.The act, in summary, has the following six major components:

Required the reporting of off-balance sheet activities.

Appropriated additional funding for the SEC.

Increased the charges for white-collar crimes and obstruction.

This was a settlement reached between the New York Attorney General and several of the largest U.S. investment banks.The key terms of the agreement included:

Firms must severe the link between underwriting and research activities.

Spinning is banned.

Firms must make public analyst recommendations and target prices.

This was a settlement reached between the New York Attorney General and several of the largest U.S. investment banks.The key terms of theagreement included:

Brokerage firms required to obtain third-party, independent research for their clients.

$1.4 billion in fines.

A trade-off between potential conflicts of interest and economies of scale exists.Simply eliminating any potential conflict may not be the best solution:

The existence of a conflict of interest doesnot mean that the conflict will havesevere consequences.

Even if incentives to exploit conflicts are high, eliminating the conflict may be worse if it reduces the flow of reliable information.

Leave It to the Market: an appealing approach that relies on market forces, but has the problem that the market has a short memory for past problems.

Regulate for Transparency: regulate mandatory disclosure, even if it is more costly than the information provided.

Supervisory Oversight: force firms to provide private information to a supervisor, who can act on it as deemed necessary.

Separation of Functions: separate those functions that create conflicts, either within firms or (in extreme cases) by not allowing those functions within the same firm.

Socialization of Information Production: look to public funding for information providers, such as credit agencies.

SOX has done some good, but it is costly.It is estimated that a firm with revenue less than $100 million will spend about $800,000 (1.5% of sales) to comply.Ouch!

However, recent data suggests that these costs are coming down.But thats no surprise the setup costs arent being incurred.

The Global Legal Settlement called for public disclosure of recommendations.However, analysts still have two clients money managers and small investors.Who do you think gets the information first?

Other practices (like spinning) have been banned.And separation of functions is required in reduce conflicts.

But conflicts are still present.And there are unintended outcomes such as fewer analysts and lower research budgets.Solutions are never clear when trying to reduce conflicts of interest!

What Are Conflicts on Interest and Why Are They Important?We discussed the role of information flow that may be affected by conflicts of interest

Ethics and Conflicts on Interest: we discussed how conflicts of interest may lead to unethical behavior and argued for awareness of the potential conflicts

We examine recent equity market scandals and the consequences on the investing public.We pose a broad question: what can be done to resolve these problems?Topics include:

What Are Conflicts of Interest and Why AreThey Important?

Ethics and Conflicts of Interest

Can the Market Limit Exploitation of Conflicts of Interest?

What has been done to Remedy Conflicts of Interest?

A Framework for Evaluating Policies to Remedy Conflicts of Interest

Can the Market Limit Exploitation of Conflicts of Interest? : wereviewed potential conflicts in underwriting, research, auditing, credit assessment, and universal banking, and further examine empirical evidence suggesting that markets do take into account known conflicts of interest

What Has Been Done to Remedy Conflicts of Interest?The implications of the Sarbanes-Oxley Act and the Global Legal Settlement were reviewed

A Framework for Evaluating Policies to Remedy Conflicts of Interest: potential remedies were suggested to address the trade-off between the cost of conflicts and the benefits of economies of scope

M17_MISH1520_06_PPW_C16.ppt

Business

conflicts of interestand

types of conflicts

public firms

investing public

underwriting business

poor recommendations

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