A Chinese wall is an ethical concept of separation between groups, departments or individuals within the same organization – a virtual barrier that prohibits communications or exchanges of information that could cause conflicts of interest. While the Chinese-wall concept exists in a variety of industries and professions, from journalism to law to insurance, it's most often associated – and originated – with the financial services sector: investment banks, retail banks, and brokerages. U.S. historical milestones illustrate why a Chinese wall was needed in and why legislation was created to keep it in place.
The Chinese Wall and the 1929 Stock Market Crash
Deriving from the Great Wall of China, the ancient impervious structure erected to protect the Chinese from invaders, the term "Chinese wall" came into popular parlance – and the financial world – during the early 1930s. Spurred by the stock market crash of 1929 (partly attributed at the time to price manipulation and trading on inside information), Congress passed the 1933 Glass-Steagall Act (GSA), demanding the separation of commercial and investment banking activities – that is, investment banks, brokerage firms, and retail banks.
Although the act did cause the breakup of some securities and financial monoliths, such as J.P. Morgan & Co. (which had to spin off brokerage operations into a new company, Morgan Stanley), its main intention was to prevent conflicts of interest – like a broker recommending clients buy shares of a new company whose initial public offering (IPO) his investment banking section colleagues just happen to be handling. Rather than forcing companies to participate in either the business of providing research or providing investment banking services, Glass-Steagall attempted to create an environment in which a single company could engage in both endeavors. It simply mandated a division between departments: the Chinese Wall.
This wall was not a physical boundary, but rather an ethical one which financial institutions were expected to observe. Inside or nonpublic information was not allowed to pass between departments or be shared. If the investment banking gang is working on a deal to take a company public, their broker buddies on the floor below are not to know about it – until the rest of the world does.
The Chinese Wall and 1970s Deregulation
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 IPOs. Large year-end bonuses were based on such successes.
This all helped to create the roaring bull market and the go-go, anything-goes era on Wall Street during the 1980s – along with some high-profile insider trading cases and a nasty market correction in 1987. As a result, the Securities And Exchange Commission's (SEC) Division of Market Regulation conducted several reviews of Chinese Wall procedures at six major broker-dealers. And partly as a result of its findings, Congress enacted the Insider Trading Act of 1988, which increased the penalties for insider trading, and also granted the SEC broader rulemaking authority concerning Chinese Walls.
The Chinese Wall and the Dotcom Boom
Chinese Walls returned to the spotlight in the later 1990s, 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. During 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. Also, the Gramm-Leach-Bliley Act (GLBA) of 1999 repealed much of the Glass-Steagall Act that prohibited banks, insurance companies, and financial services companies from acting as a combined firm.
The collapse of the dotcom bubble in 2001 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.
Interestingly, 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 – though often the analysts and their cronies were selling those very same securities.
Investors who were buying securities on the advice of their favorite analysts, believing their counsel was unbiased, lost significant amounts of money.
In the wake of the dotcom crash, Congress, 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. Ten 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 separate their research and investment banking departments. The legislation led to the creation or strengthening 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.
Are Chinese Walls Effective?
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.
But legislators are still grappling with the role of conflicts of interest in the subprime mortgage crisis of 2007, which led to the Great Recession – and wondering to what extent Chinese Walls helped or hindered the practices that led to the collapse. There seem to be indications rules to ensure the separations between product-rating services and their client companies were being flouted. Another issue: One arm of an investment firm would be recommending collateralized mortgage obligations (or other products) to investors, while another arm of the same firm was selling them short – betting against its own recommendation, in other words, at investors' expense.
Beyond the legalities, all these dark events and scandal-ridden eras reveal some ugly truths about ethics, greed and the ability of professionals to police themselves. There have always been those who have doubted Chinese Walls' efficacy; certainly, they test self-regulation to the limit. The moral of the last century, sadly, seems to be that the Chinese Wall concept helped define ethical limits – but it did little to prevent fraud.