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«Global TrusT and EThics in FinancE Innovative Ideas from the Robin Cosgrove Prize Carol Cosgrove-Sacks / Paul H. Dembinski Editors Trust and Ethics in ...»

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The real effort should not be focused on regulations or monitoring, if it is actually looking for creating values for the individual and develop decision makers that have integrity, and that are motivated by values not by rules and incentives; and with the courage and conviction to resist temptations. It is true that the learning and improvement of analysis in decision-making will grow gradually, but it will not take place if the first step that requires recognition of the true values of investment is not taken.

Decision: The Space Between 153 In my vision of future corporate practices, I see that MCDA

• is the method most often used for corporate representatives as a methodology of analysis of decisions during strategic planning and budget allocation.

• is a standard on the Boards of Directors and is known among its members as the method “multi-criteria” referring to the way in which directors account for the decisions that have been taken; i.e. the MCDA is the way in which information is shared and reports are given to investors about the reasons behind the evaluations made, the obstacles they face at the time and alternative actions that have been taken into account.

Bibliography Adam/ Shavit American Management Association, AMA, 2006. The Ethical Enterprise, Doing the Right Things in the Right Ways, Today and Tomorrow.

Barma, Hanif, 2010. “Culture Clash: Policies and procedures are useless if your culture is wrong”, in: Internal Auditing 34:11 Bonn, I. and Fisher, J., 2005. “Corporate governance and business ethics: Insights from the strategic planning experience”, in: Corporate Governance: An International Review 13, 730–8

Dominguez L. et al, 2009. “Corporate Governance and Code of Ethics”, in:

Journal of Business Ethics. 90,187-202 Howard, Ronald, 1976. Readings in Decision Analysis, Part III, Decision Analysis Group, Stanford Research Institute, 491-520.

Huse, M., 2005. “Accountability and Creating Accountability: A Framework for Exploring Behavioural Perspectives of Corporate Governance”, in: British Journal of Management. 16, 65-79.

Phillips, Larry, 1984. “A theory of requisite models”, in: Acta Psychologica 561 (3), 29-48 Roberts, J. et al., 2005. Beyond Agency Conceptions of the Work of the NonExecutive Director: Creating Accountability in the Boardroom British Journal of Management. Volume 16. pp:s5-s26 Sanwal, Anand, 2007. “Get Sustained Growth by Savvy Portfolio Management”, The Journal of Corporate Accounting and Finance.

Sterman, John, 1994. “Learning in and about complex systems”, in: Systems Dynamics Review. 10, 291-330 Schwartz M. et al., 2005. “Tone at the Top: An Ethics Code for Directors”, Journal of Business Ethics. 58, 79-100.

van Ees, Hans et al., 2009. “Towards a Behavioural Theory of Boards and Corporate Governance”, in: Corporate Governance: An International Review. 17 (3), 307–319



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Ethics in general deals with human behaviour that is acceptable or right or is not acceptable or wrong according to conventional morality.

General ethical norms encompass truthfulness, honesty, integrity, respect for others, fairness, and justice. They relate to all aspects of life, including business and finance. Financial ethics is, therefore, a subset of general ethics.

Ethical norms are essential for maintaining stability and harmony in social life, where people interact with one another. Recognition of others’ needs and aspirations, fairness, and co-operative efforts to deal with common issues are an example of aspects of social behaviour that contribute to social stability. In the process of social evolution, we have developed not only an instinct to care for ourselves but also a conscience to care for others.

However, situations may arise in which the need to care for ourselves runs into conflict with the need to care for others. Then ethical

norms are needed to guide our behaviour. As Dempsey (1999) puts it:

“Ethics represents the attempt to resolve the conflict between selfishness and selflessness; between our material needs and our conscience”.

156 Trust and Ethics in Finance

An inconsistency at the heart of finance

Ethical dilemmas and ethical violations in finance can be attributed to an inconsistency in the conceptual framework of modern financialeconomic theory, and the widespread use of a principal-agent model of relationship in financial transactions. The financial-economic theory that underlies the modern capitalist system is based on the rationalmaximiser paradigm, which holds that individuals are self-seeking (egoistic) and that they behave rationally when they seek to maximise their own interests. The principal-agent model of relationships refers to an arrangement whereby one party, acting as an agent for another, carries out certain functions on behalf of that other. Such arrangements are an integral part of the modern economic and financial system, and it is difficult to imagine it functioning without them.

The problem is that the behavioural assumption of the modern financial-economic theory runs counter to the ideas of trustworthiness, loyalty, fidelity, stewardship, and concern for others that underline the traditional principal-agent relationship. The traditional concept of agency is based on moral values. But if human beings are rational maximisers, then agency on behalf of others in the traditional sense is impossible. As Duska (1992) explains it: “To do something for another in a system geared to maximise self-interest is foolish. Such an answer, though, points out an inconsistency at the heart of the system, for a system that has rules requiring agents to look out for others while encouraging individuals to look out only for themselves, destroys the practice of looking out for others.” The ethical dilemma presented by the problem of conflicting interests has been addressed in some areas of finance, such as corporate governance, by converting the agency relationship into a purely contractual relationship that uses a carrot-and-stick approach to ensure ethical behaviour by agents. In corporate governance, the problem of conflict between management (agent) and stockholders (principal) is described as Ethics: An Essential Prerequisite 157 an agency problem. Economists have developed an agency theory to deal with this problem.

The agency theory: a structured relationship The agency theory assumes that both the agent and the principal are self-interested and aim to maximise their gain in their relationship. A simple example would be the case of a store manager acting as an agent for the owner of the store. The store manager wants as much pay as possible for as little work as possible, and the storeowner wants as much work from the manager for as little pay as possible. This theory is valuefree because it does not pass judgment on whether the maximisation behaviour is good or bad and is not concerned with what might be a fair wage for the manager.

It drops the ideas of honesty and loyalty from the agency relationship because of their incompatibility with the fundamental assumption of rational maximisation. “The job of agency theory is to help devise techniques for describing the conflict inherent in the principal-agent relationship and controlling the situations so that the agent, acting out of self-interest, does as little harm as possible to the principal’s interest” (DeGeorge, 1992).

The agency theory turns the traditional concept of agency relationship into a structured (contractual) relationship in which the principal can influence the actions of agents through incentives, motivations, and punishment schemes. The principal essentially uses monetary rewards, punishments, and the agency laws to command loyalty from the agent.

A paradoxical situation Most of our needs for financial services – management of retirement savings, stock and bond investing, and protection against unforeseen events, to name but a few – are such that they are better entrusted to othTrust and Ethics in Finance ers because we have neither the ability nor the time to carry them out effectively. The corporate device of contractualisation of the agency relationship is, however, too difficult to apply to the multitude of financial dealings between individuals and institutions that take place in the financial market every day.

Individuals are not as well organised as stockholders, and they are often unaware of the agency issue. Lack of information also limits their ability to monitor an agent’s behaviour. Therefore, what we have in our complex modern economic system is a paradoxical situation: the everincreasing need for getting things done by others on the one hand, and the description of human nature that emphasises selfish behaviour on the other. This paradoxical situation, or the inconsistency in the foundation of the modern capitalist system, can explain most of the ethical problems and declining morality in the arena of modern business and finance.

Ethical violations…

The most frequently occurring ethical violations in finance relate to insider trading, stakeholder interest versus stockholder interest, investment management, and campaign financing. Business in general and financial markets in particular are replete with examples of violations of trust and loyalty in both public and private dealings. Fraudulent financial dealings, influence peddling and corruption in governments, brokers not maintaining proper records of customer trading, cheating customers of their trading profits, unauthorised transactions, insider trading, misuse of customer funds for personal gain, mispricing customer trades, and corruption and larceny in banking have become common occurrences.

Insider trading is perhaps one of the most publicised unethical behaviours by traders. Insider trading refers to trading in the securities of a company to take advantage of material inside information about the company that is not available to the public. Such a trade is motivated by Ethics: An Essential Prerequisite 159 the possibility of generating extraordinary gain with the help of nonpublic information (information not yet made public).

It gives the trader an unfair advantage over other traders in the same security. Insider trading was legal in some European countries until recently. In the United States, the 1984 Trading Sanctions Act made it illegal to trade in a security while in the possession of material non-public information. The law applies to both insiders who have access to nonpublic information and those with whom they share such information.

… And ethical codes Approaches to dealing with ethical problems in finance range from establishing ethical codes for financial professionals to efforts to replace the rational-maximiser (egoistic) paradigm that underlies the modern capitalist system by one in which individuals are assumed to be altruistic, honest, and basically virtuous.

It is not uncommon to find established ethical codes and ethical offices in American corporations and in financial markets. Ethical codes for financial markets are established by the official regulatory agencies and self-regulating organisations to ensure ethically responsible behaviour on the part of the operatives in the financial markets.

One of the most important and powerful official regulatory agencies for the securities industry in the United States is the Securities and Exchange Commission (SEC). It is in charge of implementing Federal securities’ laws, and, as such, it sets up rules and regulations for the proper conduct of professionals operating within its regulatory jurisdiction.

Many professionals play a role within the securities industry. The most important of these are accountants, broker-dealers, investment advisers, and investment companies.

Any improper or unethical conduct on the part of these professionals is of great concern to the SEC, whose primary responsibility is to protect investor interests and maintain the integrity of the securities’ market.

160 Trust and Ethics in Finance The SEC can censure, suspend, or bar professionals who practice within its regulatory domain for lack of requisite qualifications or unethical and improper conduct.

The SEC also oversees self-regulatory organisations (SROs), which include stock exchanges, the National Association of Security Dealers (NASD), the Municipal Securities Rulemaking Board (MSRB), clearing agencies, transfer agents, and securities information processors. An SRO is a membership organisation that makes and enforces rules for its members based on the Federal securities’ laws. The SEC has the responsibility of reviewing and approving the rules made by SROs.

Other rule-making agencies include the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), and state finance authorities. Congress has entrusted to the Federal Reserve Board the responsibility of implementing laws pertaining to a wide range of banking and financial activities, a task that it carries out through its regulations.

One such regulation has to do with unfair or deceptive acts or practices.

The FDIC has its own rules and regulations for the banking industry, and it also draws its power to regulate from various banking laws passed by Congress.

Professional codes of good conduct

In addition to federal and state regulatory agencies, various professional associations set their own rules of good conduct for their members. The American Institute of Certified Public Accountants (AICPA), the American Institute of Certified Planners (AICP), the Investment Company Institute (ICI), the American Society of Chartered Life Underwriters (ASCLU), the Institute of Chartered Financial Analysts (ICFA), the National Association of Bank Loan and Credit Officers (also known as Robert Morris Associates), and the Association for Investment Management and Research (AIMR) are some of the professional associations that have well-publicised codes of ethics.

Ethics: An Essential Prerequisite 161 By joining their professional organisations, people who work in the field of accounting agree to uphold the high ethical standards of their profession. Each of the major professional associations for accountants has a code of ethics. The Code of Professional Conduct of the American Institute of CPAs (AICPA), the national professional association for CPAs, sets forth ethical principles and rules of conduct for its members.

The principles are positively stated and provide general guidelines that CPAs (or any professionals, for that matter) should strive to follow.

The rules of conduct are much more explicit as to specific actions that should or should not be taken. The Institute of Management Accountants (IMA) Standards of Ethical Conduct applies to practitioners of management accounting and financial management, and the Institute of Internal Auditors (IIA) Code of Ethics applies to its members and to Certified Internal Auditors (CIAs).

Towards a paradigm shift?

The other approach to address the ethical problems in business and finance consist in re-examining the conceptual foundation of the modern capitalist system and changing it to one that is consistent with the traditional model of agency relationship. The proponents of a paradigm shift question the rational-maximiser assumption that underlines the modern financial-economic theory and reject the idea that all human actions are motivated by self-interest.

They embrace an alternative assumption – that human beings are to some degree ethical and altruistic – and emphasise the role of the traditional principal-agent relationship based on honesty, loyalty, and trust.

Duska (1992) argues: “Clearly, there is an extent to which [Adam] Smith and the economists are right. Human beings are self-interested and will not always look out for the interest of others. But there are times they will set aside their interests to act on behalf of others. Agency situations were presumably set up to guarantee those times.” 162 Trust and Ethics in Finance The idea that human beings can be honest and altruistic is an empirically valid assumption; it is not hard to find examples of honesty and altruism in both private and public dealings. There is no reason this idea

should not be embraced and nurtured. As Bowie (1991) points out:

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