The financial services business is a complex enterprise with many moving parts. Finance companies are often multi-faceted organizations engaging in overlapping activities that present opportunities for conflicts of interest. To avoid such conflicts, regulators require what is referred to as a “Chinese wall.” Like the Great Wall of China, which was designed to separate two parties, the Chinese wall in the securities industry serves a similar purpose. For the Chinese, the wall was designed as a barrier between the Ming dynasty and the nomadic invaders known as the Huns. For the financial services industry, the wall is designed to separate underwriters and analysts. It is supposed to eliminate the transfer of information between these parties, but does it actually work?
Underwriters and analysts have separate and distinct roles, and are supposed to operate independently. Underwriters evaluate companies to gain information or get a picture of each firm’s financial health. The information is used for a variety of tasks, including to determine creditworthiness when a company seeks a loan, and to determine value when a company puts itself up for sale. The insight and data that underwriters gain from evaluating companies may include details about financial health, business developments or pending staff changes, which could not be obtained without direct access to information unavailable to the general public or to securities analysts.
Analysts also evaluate companies. They do so to gain information that will help them make investment decisions. Such decisions could include recommending that portfolio managers or investors purchase securities issued by the firms that have been analyzed. To create a level playing field, analysts are tasked with making their recommendations based on the same information that is available to their competitors. In other words, they are banned from using “inside information,” which includes any non-public fact regarding the plans or condition of a publicly traded company that could provide a financial advantage when used to buy or sell shares of the company's stock. Using this information is a crime punishable by fines, jail time and a possible ban from working in a role making security recommendations.
Because underwriters work on one side of the Chinese wall and analysts work on the other side, information gathered by the underwriters is not supposed to be shared with analysts. To keep information transfer from happening, financial services firms (including banks, brokerage firms and similar entities) have training programs, written policies and procedures, risk management processes, compliance review procedures and supervisory personnel.
In reality, the Chinese wall is porous. As noted earlier, the financial services business is a complex enterprise with many moving parts. There are a multitude of ways to cheat the system. These range from corporate-sponsored procedures for sharing information between underwriters and analysts to sloppy internal controls, intentional use of information gained at work to use in personal trading, and scams involving complex repurchase agreement transactions that few investors even understand. All of these criminal activities and more have been discovered since the Chinese wall mandate was implemented in 2003 in the wake of the massive Wall Street scandals. These activities were best characterized by the famous advertisement that Charles Schwab ran in 2002, in which a group of brokers were encouraged to sell a fundamentally unsound stock to unsuspecting investors with the encouraging recommendation to “put some lipstick on this pig.” A variety of studies, including “Do Bank-Affiliated Analysts Benefit from Lending Relationships?” (Ting Chen, Xiumin Martin 2011) and “Are Chinese Walls the Best Solution to the Problems of Insider Trading and Conflicts of Interest at Broker Dealers?” (Christopher M. Gorman 2004), reach the same conclusion. Chinese walls are not a particularly effective barrier.
Scandals and Legislation
While the Chinese wall's failure is a notable chapter in Wall Street’s scandal-plagued history, conflicts of interest are not a new problem. In fact, regulators have a long history of stepping in with a slate of new rules designed to fix the problem after investors have been ripped off by conflicts of interest in the financial services industry:
- Glass-Steagall Act of 1933
The Great Depression, an economic recession that began on Oct. 29, 1929 following the crash of the U.S. stock market, resulted in poverty, hunger, unemployment and political unrest on a global scale. Greed, of course, was to blame. Improper banking activity, or what was considered “overzealous commercial bank involvement in stock market investment” was deemed the main culprit of the Great Depression. The Glass-Steagall Act was passed to separate commercial and investment banking by prohibiting commercial banks from owning securities brokerage firms.
- Gramm–Leach–Bliley Act of 1999
Glass-Steagall was repealed by the Gramm–Leach–Bliley Act of 1999. This resulted in the dotcom-era scandals with big-name analysts publicly promoting securities to investors despite the private negative research results of these securities. The analysts had been pressured into providing good ratings (despite personal opinions and research that indicated the stocks were not good buys) to bolster profits on the investment-banking side of the business.
- Sarbanes-Oxley Act of 2002
Congress passed the Sarbanes-Oxley Act in 2002 following accounting scandals at Enron, WorldCom and Tyco. Auditors and analysts from investment-banking firms had given clean bills of health to insolvent firms to build relationships for investment bankers. The result was a series of the largest bankruptcies in U.S. history.
- Spitzer Settlement/April 2003
In the wake of the dotcom crash, 10 big-name firms, including Bear Stearns & Co., Credit Suisse First Boston (NYSE:CS), Goldman Sachs & Co. (NYSE:GS), Lehman Brothers, J.P. Morgan Securities (NYSE:JPM), Merrill Lynch, Pierce, Fenner & Smith, Morgan Stanley & Co. (NYSE:MS) and Citigroup Global Markets, were forced to “dramatically reform their future practices, including separating the research and investment banking departments at the firms” as a direct result of conflicts of interest. This reform effort resulted from a settlement with both federal and state regulators. It led to the creation of the Chinese wall between analysts and underwriters, as well as a reform in compensation practices, as prior practices provided a financial incentive for analysts to provide favorable evaluations of underwriting clients.
- The Great Recession
The 20-month economic downturn that began in December 2007 was, once again, linked to conflicts of interest. Legislators are still grappling with the aftermath as of 2013, and much of the discussion revolves around the possible reintroduction of Glass-Steagall type separation of brokerage and banking activities.
The Bottom Line
The financial services industry has a long history of conflicts of interest. Despite the best efforts of regulators, the Chinese wall has proven ineffective at thwarting intentional information-sharing between various parts of financial services organizations. Every little niche that can be exploited is exploited (much of it too complex for the average investor to understand). In the end, greed wins as the motivation to make money entices employees and their employers to break the rules in pursuit of profits. If nothing else, the efforts to regulate the industry by using the Chinese wall has demonstrated that as long as firms are permitted to engage in business activities on both sides of the wall, information will pass through from one side to the other.