In the final analysis, it’s really up to the business community, not government, to restore investor confidence. After all, the problems we’ve seen emanated from the private sector, and should be solved there. More importantly, companies that wait for the government to tell them what they can or can’t do, have only themselves to blame if they don’t like what they’re told.
In that vein, a recent enforcement action raises concerns for the financial services industry. In December, the Securities and Exchange Commission and the National Association of Securities Dealers settled cases with Knight Securities, alleging that Knight defrauded certain of its institutional customers. Instead of dutifully executing every trade order, the SEC and NASD alleged, Knight took advantage of orders from institutional investors to improve the positions in its own proprietary accounts. Upon receipt of large purchase orders, Knight was accused of first ascertaining whether it had a position in those securities and, if it did, waiting to see if the shares it purchased increased in value during the day. If the price went up, the regulators alleged, customers were charged the higher price. If the price decreased, the firm allegedly dumped its stock on the unsuspecting customer. This course of conduct was said to have permitted Knight to trade for its own accounts risk-free.
Even though Knight’s clients were sophisticated institutional investors, they had little way of knowing if Knight was acting in its own interests, not theirs. Knight’s customers could not have known the timing, size and costs of Knight’s positions. Moreover, Knight’s traders were charged with regularly misreporting the timing of client trades, making them appear to have been executed closer in time to market prices. As a result, Knight’s clients would not have been able to monitor effectively Knight’s quality of execution.
Allegations like these should leave all of us in an uncomfortable place. The popular wisdom some business bashers purvey is that businesses are run by insensitive, unthinking, selfish, greedy men and women; allegations like these perpetuate, not end, this stereotype. And, consider that it’s through institutional investors that most individuals find their way to our equity markets; average investors are not going to entrust their money to the business community if they think it’s just being divvied up among insiders.
Just prior to the announcement of the Knight Securities settlements, The Wall Street Journal ran a front-page article headlined, “Client Comes First? On Wall Street, It Isn’t Always So.” In the article, the Journal cited various “open secrets”: real-life examples of brokerage firms putting their own interests ahead of their clients and trading in their own proprietary accounts at the expense of the clients they represent. The examples ranged from trading ahead of client orders and lax oversight of “back books” accounts, to “pre-hedging” or making educated guesses of institutional clients’ next moves. Each incident underscored conflicts of interest facing financial services firms engaging in both proprietary and customer trading. Top management and compliance officers need to patrol against these conflicts.
As agents, broker-dealers have clear responsibility to act in their customers’ best interests. Brokers have a fiduciary responsibility to achieve best execution of their customers’ orders. Best execution derives from the common law agency duties of loyalty and care, obligating an agent to act exclusively in the customer’s best interest. When firms engage in both customer and proprietary trading, as virtually all firms do, the economic inducements to traders and firms create the potential for serious conflicts of interest that can compromise a broker’s delivery of its fiduciary obligation to achieve best execution of its customers’ orders. The Golden Rule, “Treat others as you want to be treated,” applies here.
The integrity of the capital markets depends on financial services firms acting in their clients’ best interests. As the 1963 Report of the Special Study of the Securities Market aptly stated, “The integrity of the industry can be maintained only if [the industry adheres to] the fundamental principle that a customer should at all times get the best available [execution].” Investors are willing to commit their capital to markets only if they have confidence that those markets are fairly and honestly run, are fully transparent, and affirmatively minimize the risk of loss from fraud or manipulation.
The tone for acting in clients’ best interests needs to come from the top of the firm. The starting point for superior client service is the tone set by firm leaders. Take, for example, Thomas Watson; in 1914, he turned a small firm that manufactured meat slicers and time clocks into International Business Machines. He had three simple rules, which he circulated to every employee: “(1) The customer must be respected; (2) The customer must be given the best possible service; and (3) Excellence and superior performance must be pursued.” These values became the foundation for the company’s operation and, under Watson, all actions and policies were influenced by them. Leaders of financial services firms must inculcate their corporate cultures with a client-centric, customer-service-oriented philosophy. After all, the very essence of their product is service, not widgets.
Financial services firms need to live up to their own advertising. In order to figure out what your firm should be doing, all you really have to do is look at your corporate Web site. Knight Securities’ trademark is “Earning your trust with every trade.” On their Web site, they claim to have the following firmly held beliefs: “We believe that our commitment to the interests of our clients proves our value to them. We believe that marketplace leadership is earned, and not given. We believe that integrity is demonstrated by daily actions and that collaboration is the key to successful, long-term partnerships.” No one can take issue with any of these statements. Don’t let your customers take issue with whether you live up to your professed philosophies. That’s something within your control.
Build Chinese Walls and monitor their strength. Most brokerage firms utilize “Chinese Walls” to prevent the flow of information from their customer trading to their proprietary trading. But not all firms have done so, and not all Chinese Walls prove to be non-porous. Moreover, even if a brokerage firm has an effective Chinese Wall, that doesn’t mean that all potential conflicts have been eradicated. As long as anyone knows valuable proprietary or client information, there’s always a risk that someone may try to use the information personally, or tip someone else who uses the information personally. And, of course, even the existence of a non-porous Chinese Wall does not guarantee immunity from litigation or prosecution.
Disclosure of conflicts of interest is critical, but many firms mishandle the quality of that disclosure. In the January 2005 issue of the University of Chicago’s Journal of Legal Studies, the authors found that a combination of misaligned pay incentives and prominent disclosure led to the most distorted advice. As the report concluded, “For disclosure to be effective, the recipient of advice must understand how the conflict of interest has influenced the advisor and must be able to correct for that biasing influence.”
In identifying potential conflict situations, there are four critical steps that must be taken. Particularly in the financial services arena, after-the-fact disclosures are sometimes impossible (where the beneficiaries are deceased, for example), and almost invariably inadequate. Before a financial services firm takes on a customer, it must (1) determine what potential conflicts could arise, especially out of the multiplicity of businesses in which it is engaged; (2) decide how it will deal with those conflicts should they arise; (3) disclose, in language anyone could understand, the potential conflicts that could arise and the method by which those conflicts will be resolved; and (4) if a conflict does arise, before finalizing any solution, assess whether the pre-conceived methodology produces a fair result for customers likely to be adversely affected by the conflict.
Periodically assess whether existing disclosure of potential conflicts, and how they will be resolved, is satisfactory. Even if a thorough and effective review of potential conflicts is performed, and even if meaningful and comprehensible disclosure is affected, time has a way of changing how conflicts will be assessed. Dealing with conflicts is not a static concept, but an evolving one, and firms must stay on top of their potential conflict situations.
Periodically have an outside review of conflict disclosures and assessment techniques. It isn’t enough for a firm to satisfy itself that it has conceptually identified the universe of potential conflicts, and has devised a methodology for dealing with such conflicts if they should arise. Firms should also make certain that they have brought outside expertise to bear on both of these issues.
If you don’t self-regulate and self-police, then the SEC or Eliot Spitzer—or both—will do it for you. As SEC Division of Enforcement Director Cutler has indicated, these conflict issues are on the SEC’s radar screen; don’t wait for the government to come knocking on your door and ask you what you’re doing about them. It’s infinitely better to take the high road—and the initiative—rather than leave it to the government to dictate professional ethics and standards. Adopt hard-hitting and far-reaching standards for internal controls and codes of conduct.
Whatever the government does or doesn’t do, financial services firms must take the initiative in policing or cleaning up their own acts. There is growing empirical evidence that companies able to demonstrate they are responsible, ethical, and run by individuals with integrity, significantly outperform their core peer competitor groups. Certainly, there’s evidence that financial services firms that are tarred with the taint of scandal under-perform their core peer competitor groups. More than any government regulation or prosecution, this is the factor that must drive the push toward better governance, more accountability, and greater transparency. Investors must be confident that a financial services firm is acting in their best interests. Brokerage firms have a responsibility to their clients to provide superior trade-execution services.
Even innocuous services have the potential to create conflicts. It’s imperative that financial services stay on top of these potential conflicts, and know, before they arise, exactly how they will deal with them.
The column solely reflects the views of its author, and should not be regarded as legal advice. It is for general information and discussion only, and is not a full analysis of the matters presented.
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