Standards And Ethics For Financial Professionals

By Investopedia Staff AAA

The financial industry has given us countless scandals and front-page news stories about financial professionals who have defrauded investors, employers and their peers. There is no doubt that greed is a powerful emotion, but sometimes unethical behavior boils down to a lack of education on basic principles of financial standards.
By taking a look at various situations that often come up over the course of a financial professional's career and how one should handle such circumstances, we can strive to not only meet these standards, but exceed them. (For a background, read The Biggest Stock Scams Of All Time.)

See: Ethical Investing

Material Non-Public Information
For many professionals who deal with securities, instances arise where they come into possession of material non-public information. This type of information is defined as anything that might have an impact on the price of a security and has yet to be made publicly available. For example, if your company's CEO were to tell you during a meeting that upcoming earnings results are going to be disappointing, you have just received material non-public information. As a stockholder in your company, you may be tempted to call up your broker and place a sell order to avoid a capital loss; however, this would be classified as insider trading, and the penalties associated with that are far worse than any paper loss you might incur.

Material non-public information can come in a variety of forms, for a variety of financial professionals. For instance, a portfolio manager who holds large holdings in small-cap stocks may have a profound effect on stock movement based on their sales or purchases of said stocks. If the manager has decided to exit a large position in a small-cap stock based on a recommendation from one of their firm's buy-side analysts, it would be unethical for the manager to alert a few "high-value" clients who may hold the stock independently prior to their selling of the shares. Although it may not seem like much, laws have been broken and all parties involved may be prosecuted. (For more, see Eight Ethics Guidelines For Brokers.)

Mosaic Theory
Insider information is not a black and white concept by any means. Quite often, professionals may stumble upon such information unwillingly or overhear conversations in and around the office. The topic becomes even cloudier for analysts who research companies and issue professional recommendations regarding their securities. Directors have been known to give earnings outlooks during analysts meetings prior to public release. Now, while this may or may not qualify as public information once a room full of analysts have received the information, trading on such information during or immediately following the meeting may be classified as insider trading. The appropriate action in such a situation would be to urge the board to disclose the information immediately to the public. Once a sufficient amount of time has passed, trading or making any recommendations on the information is fair game. (For more information, see The Truth About Insider Trading.)

As analysts gather information on companies and securities in order to build a clear picture on their fair value, they gather a great amount of information from various sources, which may be public, material and non-material in nature. It is possible for an analyst to reach conclusions that would be considered inside information had it been communicated to them by a company insider. However, analysts are free to make recommendations based on their findings under the guidelines of the mosaic theory. The mosaic theory states that analysts are free to use public, material and non-material information during the course of their professional research, and any conclusions they reach can be considered "fair game" and can be attributed to their research and not to insider information.

Taking the High Road
I know what you're thinking: "I'm an honest person and I wouldn't put myself in a situation where my ethical standards would be questioned." That may be true, but professional ethics and standards go beyond the individual; ethics is an industry-wide effort. If one of your coworkers or peers is involved in questionable activities, it's not enough to simply disassociate yourself from that individual. By knowingly allowing illegal or unethical activities to continue, you yourself may be included in any punitive actions resulting from these actions. Although nobody likes being in the position to have to blow the whistle on a coworker or friend, ultimately it is your responsibility to ensure fair practice in the financial industry, and standing up for one's ethics should be paramount. (To learn more, see How To Report A Tax Cheat.)

Professionals can also encourage employers to create a workplace that puts less contradictory pressure on employees. For instance, implementing a "Chinese Wall" between different divisions, such as a brokerage and an advisory division, can limit leaks of inside information and keep brokers, advisors, analysts and other professionals from being caught in the middle of a security breach. Also, investment banks may also implement gray lists when any securities are discussed for underwriting or ratings change. Such lists mandate that no employees may knowingly trade any securities that may be affected by the actions of the bank. (To learn more, read The Chinese Wall Protects Against Conflicts Of Interest.)

The Bottom Line
We've only scratched the surface of ethical dilemmas and situations that financial professionals may face on any given day. Over the years, financial professionals have been targeted under countless scandals and allegations of fraud, which have rocked the industry and given financial professionals a black eye. By knowing the guidelines to follow, encouraging safeguards in the work place and holding yourself to the highest of ethical standards, you can take a leading role in ensuring that the financial industry remains fair and transparent for everyone involved. (For more, see our CFA Level I Study Guide: Ethics & Standards.)

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