1. Chapter 16 What Should Be Done About Conflicts of Interest? A Central Issue in Business Ethics

2. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-2 Chapter Preview 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 against J.P. Morgan, Merrill Lynch, and Goldman Sachs.

3. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-3 Chapter Preview Surrounding many of these cases is a central theme of conflicts of interest – a situation where multiple interests have to be served, often the investing public and corporate clients. In this chapter, we examine this problem more closely.

4. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-4 Chapter Preview 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 Are They 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

5. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-5 What Are Conflicts of Interest and Why Are They Important? Financial intermediaries engage in a variety of activities to collect, produce, and distribute information. By providing multiple services, they realize economies of scope. However, these services may be competing with one another, and this creates the potential for a conflict of interest.

6. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-6 What Are Conflicts of Interest and Why Are They Important? The conflicts of interest may arise as the concealment of information to 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.

7. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-7 Ethics and Conflicts of Interest 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.

8. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-8 Types of Conflicts of Interest 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 in credit-rating agencies – Universal banking

9. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-9 Underwriting and Research in Investment Banking Some investment banks both underwrite new securities sold to the public, and provide research (buy/sell recommendations) to the investing public When revenues from underwriting exceed brokerage commissions, favorable research will attract more business, at the expense of unbiased recommendations to the investing public.

10. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-10 Underwriting and Research in Investment Banking In initial public offerings of equity, underwriters direct the new shares as they wish, typically to their best clients or potential new clients. Since most IPOs are underpriced, many of these shares are immediately sold for a profit (called spinning). This immediate “profit” may appear as nothing more than payment for future business.

11. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-11 Auditing and Consulting in Accounting Firms 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 firm’s management and the investing public. By also providing management advisory services (such as systems support), the auditor has an incentive to fudge the audit if the fees from other services are substantial.

12. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-12 Auditing and Consulting in Accounting Firms 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 Andersen’s audit of Enron.

13. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-13 Case: The Enron Implosion Up to 2001, Enron appeared to be a very successful firm engaged in energy trading. It appears, however, that the firm had severe financial problems, but hid many of its problems in complex financial structures that allowed Enron to not report them. Even though Enron regularly filed records with the SEC, the problem was not prevented.

14. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-14 The Enron Implosion Even worse, its auditor Arthur Andersen eventually plead guilty to obstruction of justice charges. With that plea, one of the largest and trusted auditors closed its doors forever.

15. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-15 Credit Assessment and Consulting in Credit-Rating Agencies Bond investors rely on credit-rating agency assessment of firm’s 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.

16. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-16 Credit Assessment and Consulting in Credit-Rating Agencies Rating agencies have also started providing firms with other services, and have the same conflicts as auditors in this regard.

17. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-17 Universal Banking Universal banking refers 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.

18. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-18 Universal Banking Bank managers may push investing products and/or insurance of its affiliates, even if they aren’t in customer’s best interest. E.g., Lehman Brothers mini-bonds in Hong Kong, sold by banks to small investors

19. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-19 Universal Banking 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.

20. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-20 Can the Market Limit Exploitation of Conflicts of Interest? Conflicts of interest are a problem when they lead to a decreased flow of reliable information (increased asymmetric information). However, even with potential conflicts, the incentives (financial gain) may not be present to actually act on them because of reputational concern of financial instituions.

21. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-21 When Are Conflicts of Interest a Serious Problem? Early empirical evidence suggests that rating agency debt ratings are unbiased, despite being paid by the firms. But in the current credit crisis, the rating companies did not function well.

22. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-22 When Are Conflicts of Interest a Serious Problem? Empirical evidence also suggests that the investing public “discounts” recommendations made by the underwriter’s analysts. However, when temporary rewards are too high (such as the late 1990s and 2008-09), “trusted” firms may extract reputational rents from the investing public by seeking short-term gains at the expense of their future reputation.

23. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-23 Case: 1929 Banksters When the market fell in 1929, investors asked why they had been encouraged 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.

24. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-24 What Has Been Done to Remedy Conflicts of Interest? One major policy was implemented following the scandals of the late 1990s and early 2000s. – Sarbanes-Oxley Act of 2002

25. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-25 Sarbanes-Oxley Act of 2002 Passed following the public outcry over corporate scandals. The act, in summary, has the following six major components: 1.Established the Public Company Accounting Oversight Board to supervise accounting firms. 2.Prohibited public accounting firms from engaging in nonaudit services to a client it is also auditing. 3.Members of the board’s audit committee must be independent.

26. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-26 Sarbanes-Oxley Act of 2002 4. It increases SEC’s budget to supervise securities markets 5. Increased the charges for white-collar crimes and obstruction. 6. It requires corporations CEOs and CFOs to certify that periodic financial statements and disclosures of firms

27. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-27 A Framework for Evaluating Policies to Remedy Conflicts of Interest A trade-off between potential conflicts of interest and economies of scale/scope exists. Simply eliminating any potential conflict may not be the best solution: 1.The existence of a conflict of interest does not mean that the conflict will have severe consequences. 2.Even if incentives to exploit conflicts are high, eliminating the conflict may be worse if it reduces the flow of reliable information.

28. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-28 Approaches to Remedying Conflicts of Interest 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.

29. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-29 Approaches to Remedying Conflicts of Interest 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.

30. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 16-30 Approaches to Remedying Conflicts of Interest Socialization of Information Production: look to public funding for information providers, such as credit agencies.