The Chinese Wall Protects Against Conflicts Of Interest

By Lisa Smith AAA

The Great Wall of China was constructed to protect the people of China from invaders. That Chinese wall concept of separation also came into investing in 1929, when the separation of investment banking from brokerage operations was embraced by the securities industry regulators. This was spurred by the stock market crash that occurred the same year, and eventually served as a catalyst for the creation of new legislation.

Rather than forcing companies to participate in either the business of providing research or providing investment banking services, the Chinese wall attempted to create an environment in which a single company could engage in both endeavors. This wall was not a physical boundary, but rather an ethical one that financial institutions were expected to observe. The effort went unquestioned for decades until the scandal-plagued '90s brought it back into the spotlight. In this article, we'll take you through some historic examples to show why a Chinese wall is needed and why legislation was created to keep it in place.

Conflicts of Interest
The deregulation of brokerage commissions in 1975 served as a catalyst for the increased concern about conflicts of interest. This change abolished the fixed-rate minimum commission on security trades, causing profits to plummet at brokerage operations. This became a major problem for sell-side analysts, who conduct securities research and make the information available to the public. Buy-side analysts, on the other hand, work for mutual fund companies and other organizations. Their research is used to guide investment decisions made by the firms that employ them.

Once the pricing changed on brokerage commissions, sell-side analysts were encouraged to craft reports that helped sell stocks, and were given financial incentives when their reports promoted their firm's initial public offerings (IPOs). Large year-end bonuses were based on such successes. This created the potential for a conflict of interest.

The Bustling Dotcom Boom
The Chinese wall model also came to the public's attention during the heyday of the dotcom era, when superstar analysts such as Morgan Stanley's Mark Meeker and Salomon Smith Barney's Jack Grubman became household names for their avid promotion of specific securities and lavish paychecks. Investors followed the advice that these analysts provided, believing that they were receiving unbiased advice. At this time, a few words from a top analyst could literally cause a stock's price to soar or plummet as investors bought and sold based on the "recommendations" of the analysts.

(To read more on behavioral finance, see Taking A Chance On Behavioral Finance, Understanding Investor Behavior and Mad Money ... Mad Market?)

The collapse of the dotcom era shed some light on the flaws in this system. Regulators took notice when it was discovered that big-name analysts were privately selling personal holdings of the stocks they were promoting and had been pressured into providing good ratings (despite personal opinions and research that indicated the stocks were not good buys). Regulators also discovered that many of these analysts personally owned pre-IPO shares of the securities and stood to earn massive personal profits if they were successful, gave "hot" tips to institutional clients and favored certain clients, enabling them to make enormous profits off of unsuspecting members of the public.

Investors who were buying securities on the advice of their favorite analysts lost significant amounts of money, while the analysts and their cronies were selling those very same securities. This is very similar to your average pump-and-dump scheme. (To learn more about investment scams, see The Short And Distort - Stock Manipulation In A Bear Market, Spotting Sharks Among Penny Stocks and Online Investment Scams Tutorial.)

Policing the Industry
Regulatory investigations into the practice of sell-side analysts and their employers revealed some interesting issues. While many analysts owned pre-IPO stocks and relied on the success of the IPO for personal gain, there were no laws against such practices. Weak disclosure requirements enabled the practice to flourish. Likewise, it was discovered that few analysts ever put a "sell" rating on any of the companies they covered. Encouraging investors to sell a specific security didn't sit well the investment bankers because such a rating would discourage the poorly-rated company from doing business with the bank.

The United States Congress (who created the Securities And Exchange Commission (SEC), the overarching regulator of the securities market), the National Association of Securities Dealers (NASD) and the New York Stock Exchange (NYSE) all became involved in the effort to craft new regulations for the industry. Today, there are additional protections in place, such as prohibitions on linking analyst compensation to the success of a particular IPO, restrictions on providing information to some clients and not others, rules against analysts conducting personal trades in securities that they cover, and additional disclosure requirements designed to protect investors. (To find out more about current regulations, read Fee-Based Brokerage: The Latest Target For Regulators, Policing The Securities Market: An Overview Of The SEC and Reg AC: What Does It Mean To Investors?)

Where do we go from here?
While the new legal protections are a good start, smart investors should look beyond the laws and learn a few lessons from the past. Beyond the legalities, the rise and fall of the dotcom era and the accompanying scandals revealed some ugly truths about ethics and greed that no amount of legislation can rectify or erase. The firms and their analysts were vilified for promoting companies that had no profits and no prospects, and they were certainly guilty as charged, but the investors themselves were also guilty of failings of their own.

Rather than taking the time and effort to conduct a bit of research on their own, they used their money to chase "hot" stocks, guided by greed instead of common sense. Naysayers, such as Warren Buffett, were dismissed as being out of touch with the economic realities of the "new" economy. Tried-and-true investment practices such as the principles of valuation and profitability were cast aside for a chance to irrationally join a hunt as stock prices were chased upward by a blind influx of money. In the end, the greater fool theory held true. It's a sobering lesson and one that just might save your fortune the next time market madness prevails.

To read more on this subject, see How To Work Around A Market Maker's Tricks and Brokers and Online Trading.

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