A large percentage of all financial activities are constituted by market transactions. Many of these market transactions are trades that happen in organized exchanges, such as, currency market, stock market, options markets, and the like. Looking at market transactions, the key ethical problems affecting them arise from unfair trading practices, such as, transactions involving fraud and manipulation, unequal playing field that happens due to unequal information and other inequalities. Furthermore, financial activities also involve contractual relations that are of long term in which individuals and organizations become fiduciaries and agents.
When we look at every organization, it is obvious that business ethics related problems are common in them. Finance on the other hand, is concerned with specific ethical issues that require differentiated treatment. Financial activities are usually closely regulated and therefore issues of ethics are usually dealt with as matters of law rather than ethics. For instance, in 1993 a federal grand jury charged senior officials involved in the massive financial scandal at Phar-Mor Inc. The officials were charged with several counts of fraud, money laundering, and other crimes. They were indicted for having conspired for three years to conceal increasing losses and overstating the values of company stocks for almost a billion dollars from July 1989 to June 1992. The actions of company officials overstated the net worth of Phar-Mor and thereby misleading all other stakeholders such as, investment banks, creditors, insurance companies, and other financial backers. These had been led them to invest over $1.1 billion in Phar-Mor inc. in three years on the basis of fraudulent information. Furthermore, the investigations revealed that the company actually lost between $20 million and $40 million, but the books of accounts were written in a way that duped investors to think the company had $80 million in profit. Therefore, it is vital to note that the reason of regulation in finance involves some important ethical issues such as fairness in financial markets and duties of fiduciaries (Spencer, p. 30).
Financial ethics is wide as it is concerned with not only individual conduct but also with the activities of financial markets and financial institutions. It can be categorized under three major areas such as; one, financial markets that are susceptible to trading practices which are unfair such as fraud and manipulation, trading conditions that are not fair such as uneven playing field, and contractual difficulties such as forming, interpreting, and enforcing contracts. In the U.S, federal securities laws and self regulation exchanges are expressed in market terms that are fair and orderly. They are also expressed in a manner that reflects the requirements in financial markets to balance the aims of fairness and efficiency. This is well elaborated in the case study of the Fannie and Mae financial scandal. In this company, the corporate culture gave senior management authority control over financial reporting, risk management, internal control, and corporate governance. When Mr. Raines took over as chairman and Chief Executive Officer in 1999, he made amendments in the company’s compensation programs which increased incentives to management for the achievement of announced targets. This led the company’s senior management to tolerate a wide variety of unsound practices which included, financial incentives tied to a measure of profits that management could manipulate, disinterest in following standards of prudent business operations, and even the company’s vast resources. Furthermore the company’s board failed to act as an oversight over the company’s operations. Accordingly, this made Securities and Exchange Commission (SEC) to direct Fannie Mae to restate its financial results for 2002 to 2004 periods. The company was also required to explain the departure of Raines the CEO and Timothy Howard Chief Financial Officer, losses billions in market capitalization for the company’s shareholders, and others. Through these investigations, Securities and Exchange Commission revealed the extent of the problems in the company’s accounting policies, reporting, internal control, and corporate governance (Weiss et al., p. 3). The second major category is the financial services. The finance service industry affects ordinary citizens directly. As an industry, financial services have a duty to make products that meet people’s needs and to market them in a responsible way avoiding, for instance, coercive sales tactics. Additionally, organizations that give financial services deal with individuals and clients. In this case, therefore, a reputation of for ethical behavior is critical in earning the confidence of clients. More importantly, a firm owes certain duties to clients for example; a stockbroker is more than an order taker in a buyer-seller environment. This individual is offering to deploy his special skills and expertise to work for the benefit of others. By doing this, they become fiduciaries or agents who have a duty to subordinate their own interests to those of clients. Financial services can be provided by individuals or institutions on behalf of others. They act as financial agents because they make decisions on behalf of principals in an agency relation. These agents and fiduciaries have an obligation to act expressly in the interest of other parties and, especially to avoid conflict of interests. The financial service providers are required to avoid deceptive and abusive sales practices despite of them merely being sellers in a buyer-seller relation. Thirdly, financial management is another important topic. It should be understood that business firms are structured legally as the financial instruments of owners, and directors are agents of firms. The executives as agents have a fiduciary duty to lead firms with the objective of maximizing shareholder wealth. Ethics in financial management concern the actions that violate the obligations of financial managers and the discretion of financial directors to serve the interest of stakeholders. An example is a case study involving Tyco International. The financial scandal that happened in this company involved its former C.E.O Dennis Kozlowski. Investigations done in 2002 revealed financial scams under Mr. Kozlowski. The company had failed to disclose multi-billion dollars, low interest loans the senior managers took from the company. They were also accused of selling company shares valued at millions of dollars without them disclosing their self dealings. The actions of Kozlowski and other managers violated the obligations of management to serve the interests of stakeholders. This paper examines the importance of ethics to financial markets, fairness as a key ethical requirement in financial market, unfair trading practices, fair conditions in the financial market, and financial contracting in the financial market.
Importance of Ethics in Financial Markets
Ethics refer to the situations and decisions in financial markets that address moral values. Many of the financial transactions are done in markets and are governed by certain moral rules and expectations of moral behavior. The basic of these is deterrence against fraud and manipulation. More generally, the rules and expectations for markets require fairness, which often is termed as a level playing field. There are many factors, including unequal information, resources, and bargaining power that make the playing field to be unequal in the financial market. In addition to enabling one-time economic transactions, market players are also involved in financial contracting whereby they engage into long term relations. The contract relationships the market players enter into involve the assumption of fiduciary duties or obligations to engage as agents, and financial markets are subject to unethical behavior because of selfish conduct by fiduciaries and agents. Usually, a market transaction between two parties often has third parties, meaning that they affect others. Therefore, fairness in financial markets involves some consideration of the social impact of financial activity and responsibility of financial managers to balance the interests of various groups in competition (Fredrick, p. 153).
Ethics in financial markets is important for several reasons such as; first, ethics enhances competitiveness in organizations. It is a key element of maintaining competitiveness besides profit making and improvement of service quality. Today, investors both local and international are less tolerant to unethical practices. Before they make their investment decisions, they seek information on market integrity and fairness, a level playing field in competition, and issues of transparency. Therefore, inorder to build trust and confidence of investors and enhance competitive edge of financial markets, all financial practitioners need to observe laws and practice right business ethics. Second, ethics in financial markets is important as it is a requirement of international standards. The global community is well aware of what is wrong or right. They are well informed of ethical business practices in financial market compliance. The financial markets have to comply with international requirements of placing critical emphasis on the markets transparency, accountability, and the business conduct of financial practitioners. Third, ethics is an important component of professionalism. This is because public confidence in financial markets largely depends on the professional ethics of the practitioners in protecting the interests of clients and stakeholders including employers, employees and the investment industry itself. Fourth, it is an ultimate benefit of the profession. Few investors will risk their investment in unethical and corrupt market. The growth of the profession in the financial industry is depended upon an environment regulated by ethics and professional discipline. Adequate enforcement of business ethics in financial markets ultimately benefits all practitioners and vice versa.
Fairness as a key Ethical Require in the Financial Market
Fairness is a fundamental ethic needed in the financial market. Fairness as a financial market requirement can be described either substantively or procedurally. It is described substantively when a share price reflects the actual value, and procedurally defined when buyers are made able to determine the actual share value. The United States has to set of laws that address these descriptions that is; the state securities laws which address substantive fairness by requiring expert valuation of new securities, and the Federal Securities Act of 1933 and the Securities Exchange Act of 1934 which secures fairness procedurally by requiring adequate disclosures. The reason for mandatory disclosure is that shares transactions are more likely to be fair when material information must be disclosed and investors have easy access to information.
Unfair Trading Practices
Unfair trading practices in the financial markets such as fraud and manipulation lead to not only to unfair treatment of share transactions but also to a loss of investor confidence in the integrity of the financial market. Speculative activity in the financial market can produce excess volatility. This phenomenon was largely blamed for the financial market crashes of 1929. Fraud and manipulation is clearly legislated in section 17(a) of the 1933 Securities Act and section 10(b) of the 1934 Securities Exchange Act in the United States. These laws bar anyone involved in the exchange or issue of shares from making misleading material facts or engage in practices that are aimed to defraud. Fraud generally involves concealment of information that bears on the value of a share while manipulation involves trading for the aim of creating an impression about a share value which is misleading. An act of fraud is committed obviously by an initial public offering of stock that inflates the assets of the firm or fails to make sufficient disclosure of its liabilities. Insider trading is also considered as an act of fraud on the grounds that non-public material information ought to be disclosed before trading. For instance the stock market was manipulated in the 1920s by traders who bid up the price of stock in order to sell at the peak to unaware investors. Concern has also been raised in recent years about a form of program trading referred to as index arbitrage. In this program, traders are able to create volatility in different markets for the purpose of trading on the resulting price differences.
Fairness in financial markets is expressed by the concept of a level playing field. Investing conditions may not be level due to factors such as inequalities in information, resources, bargaining power, and others. Unequal information may refer either to the fact that the parties to the transaction do not have the same information or do not have access to information. Indeed investors who invest resources in getting superior information are entitled to exploit this opportunity, and they perform a service by making markets more efficient. Unequal possession of information is unfair only when the information has not been legitimately acquired or when its use violates some rights or obligations. Other arguments against insider trading may be that the information has been legitimately acquired but has been misappropriated from the rightful owner, and that an insider who trades on information that has been acquired in a fiduciary relation violates a fiduciary duty. Similarly, inequalities in bargaining power, resources, and processing ability which are pervasive in financial markets are ethically objectionable only when they are used in violation of some right or obligation especially when they are used coercively. The key ethical requirement is that people do not use any advantage unfairly. In the United States of America, stock markets allow relatively unsophisticated investors with modest resources and processing ability to purchase stocks on terms which are fair and some changes such as increased use of program trading or private placements are criticized for increasing the advantages of institutional investors. The growth of mutual funds has served to reduce the adverse effects of inequalities among investors. Financial market vulnerabilities such as impulsiveness or overconfidence create opportunities for exploitation that can be countered by such measures as a cooling off period on purchases and loans, and the warning to request and read a prospectus before investing (Fredrick, p. 153).
Financial instruments such as home mortgages and future options are contracts which commit the parties to a certain course of action, and many financial relations, such as being a trustee or corporate officer, are contractual in nature. In many instances, contracts are often vague, ambiguous or incomplete with the result that disagreements arise about what is ethically and legally required. Beyond the written words of express contract lie innumerable tacit understandings that constitute implied contracts. Financial matters would be impossible if every detail had to be made explicit. However, whatever is left implicit is subject to differing interpretations, and insofar as implied contracts are not legally enforceable, they may be breached with impunity. Apart from financial instruments, relations of organizations with employees, customers or suppliers, and other stakeholders consists of implied contracts. Contracts are sometimes imperfect because of limitations in our cognitive ability, especially incomplete knowledge, and future contingencies. In addition, some situations may be to complicated and uncertain to allow careful planning. As a result contractual parties may fail to negotiate contracts that produce the maximum benefit for them. Disputes in contractual relations also rise over what constitutes a breach of contract and what is an appropriate remedy.
- Boatright, J. Ethics in Finance. Oxford: Blackwell Publishing. 1999.
- Fredrick, R. A companion to Business Ethics. Oxford: Blackwell Publishing. 2002.
- Spencer, M & Sims The Legal, Societal, and Management Issues. :Greenwood Publishing. 1995.
- Weiss, E, Jickling, M, Cristie. Fannie Mae and Freddie Mac: Scandal in U.S. Housing. New York: Nova Publishers. 2007.