Ethics in Finance: How It Affects Professionals

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The financial industry has given us countless scandals and news stories about professionals who have defrauded investors, employers, and 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 these circumstances should be handled, we can better understand how the industry can not only meet these standards but exceed them.

Key Takeaways

Handling Material Non-Public Information

For many professionals who deal with securities, instances may 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 that 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 this type of trading are far worse than any paper loss you might incur.

Material non-public information can come in a number of different forms for a variety of financial professionals. For instance, a portfolio manager who controls a large stake in a number of small-cap stocks may have a profound effect on short-term stock movement based on any substantial sales or purchases of said stocks. If the manager plans 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, insider trading laws have likely been broken and the parties involved may be prosecuted.

Analysis Using 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 analyst 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.

As analysts compile information on companies and securities to build a clear picture of their fair value, they may gather a great amount of information from a number of sources, any of which may be public, material or non-material. An analyst can 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 their professional research, with the conclusions they reach from that information being considered as "fair game" and attributed to their research — not to insider information.

Reporting Unethical Activities

We 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 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 most important.

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. Additionally, 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.

The Bottom Line

This only scratches the surface of the types of ethical dilemmas and situations that financial professionals may face on any given day. Over the years, financial professionals have been involved in 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 workplace, 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.