CHAPTER 2 - FE

Fundamentals of Finance Ethics

 CONTENT
1 Overview

2 A Framework for Ethics

3 Agents, Fiduciaries, and Professionals

4 Conflict of Interest
 1. OVERVIEW
▪ Ethics is concerned with conduct-by both
individuals and organizations.
▪ Ethical conduct involves doing what is right
and not doing wrong, fulfilling one’s
duties/obligations, respecting people’s rights,
acting fairly/justly, and treating others with
dignity.
 1. OVERVIEW
▪ Ethics is also about who we are, about our
character and about having integrity or virtue.
▪ Further, ethics deals with the evaluation and
justification of practices, states of affairs,
institutions, and systems.
▪ For example, is insider trading wrong? Is
income inequality fair? Should corporations
aim solely at shareholder wealth? Is
capitalism the best economic system?...
1. OVERVIEW
▪ In approaching finance from an ethical point of
view, it is necessary to have some understanding
not only of the language of ethical discourse but
also of the principles of ethical reasoning. At a
minimum, we need to be able to determine what
is ethical conduct in finance and how financial
activity ought to be conducted → This is a matter
not merely of identifying rules - which are often
contained in law and regulation, as well as in
codes of conduct-but also of understanding the
reasons for these rules, the reasoning behind them.
 2. A FRAMEWORK FOR ETHICS
▪ No framework can possibly provide all that is
needed for ethical understanding, but it is
possible to approach ethics in finance, as
well as ethics generally, with a few key
elements of ethical reasoning.
2. A FRAMEWORK FOR ETHICS
The
elements
of ethics

A Markets
Roles and Framework
relationships for Ethics and
firms

Market
ethics
 2.1 The Elements of Ethics
1. Ethics invariably involves some impact on people’s
welfare.
2. Much of ethics consists of having a duty/an obligation
to act in certain ways.
3. The concept of rights is prominent in ethics.
4. The concepts of fairness/justice are often at issue in
matters of ethics.
5. Honesty might be regarded as a duty/obligation but it
is important enough, especially in finance ethics, to be
recognized separately.
6. The concept of dignity expresses the fundamental
moral requirement that all people be treated with
respect as human beings.
2.1 The Elements of Ethics
▪ With these 6 concepts in mind, we can identify and
address the ethical issues in any situation. The key
elements of ethics can be expressed as 6 questions:
1. Welfare: Is anyone being harmed, and if so, can the
harm be justified?
2. Duty: What is my duty or obligation in this situation?
3. Rights: Are anyone’s rights being violated, and if so,
can the violation be justified?
4. Justice: Is everyone being treated fairly or justly?
5. Honesty: Am I being entirely honest in my actions?
6. Dignity: Am I showing respect for all persons
involved?
2.2 Market and Firms
▪ Markets and firms are the two main venues for
financial activity.
✓Market participants make exchanges at arm’s-
length, solely with a view to their own interests.
Although markets often have a win–win outcome,
they can also create large winners and losers.
Markets of all kinds create opportunities for gain
at other’s expense by exploiting any mistakes or
merely by making winning bets.
2.2 Market and Firms
→ The moral justification of markets is based on
the twin considerations of welfare and rights.
o First, the welfare enhancing feature of market
exchanges is assured when not only individuals
but the whole of society benefits from a system of
voluntary transactions → Pareto improvement.
o Second, markets are further justified because they
enhance freedom/liberty.
2.2 Market and Firms
✓A business firm or corporation is an organization
that brings together many different groups-most
notably managers, employees, suppliers,
customers, and, of course, investors-for the
purpose of providing some product or service.
o The nature of the firm/business corporation can be
understood from many different perspectives,
including economics & law.
o In firms, people act not as traders-entering into
exchanges or transactions with a view to
maximizing their own gain - but as role players
with responsibilities, performing their assigned
tasks and submitting to the authority of a superior.
 2.3 Market Ethics
▪ Since all market exchanges occur, at least in theory,
with the voluntary consent of two parties → how it is
possible for one party in a transaction to wrong the
other, or indeed anyone.
▪ It has been argued that a world in which all activity
took place in perfect markets-with everyone
interacting solely by means of mutual consent-would
have no need of morality → “morally free zone.”
Valid or not, this argument rests on the critical
assumption of perfect markets, and so certainly one
role for morality is to provide guidance when markets
are imperfect-as they often are.
2.3.1 Force and fraud
▪ In a perfect market, there is no place for force or
coercion since each party freely consents to
every exchange. Any forced exchange, where a
person is threatened with violence for not making
a trade, is not really a market transaction at all but
a case of theft or expropriation, which is a moral
wrong in any context.
▪ Every market exchange involves the making of a
promise or an agreement or a contract to act in
certain ways → both parties in a transaction have
a duty/obligation to act as promised or agreed.
2.3.1 Force and fraud
✓For a seller, this includes the delivery of the
promised good, while the buyer is committed to
making the agreed-upon payment.
✓Failure to do either is a moral wrong that violates
the common norms “keep your promises” and
“abide by agreements made.” Since every market
exchange can be viewed as a kind of contract,
failure to act as required may be called a breach
of contract, which is also a moral wrong
→ All of these wrongs can be addressed by the
simple moral rule “Keep your promises.”
 2.3.1 Force and fraud
▪ In a perfect market, no party would lie to the
other about what is being given up or offered
in an exchange.
✓Such lying may consist of concealment or a
failure to disclose certain facts that are
relevant to an exchange or, worse,
misrepresenting these facts.
2.3.1 Force and fraud
▪ Lying of this kind in a market transaction is
commonly called fraud, which may be
defined as a material misrepresentation that
is made with an intent to deceive and that
causes harm to a party who reasonably relies
on it.
▪ Closely related to fraud is manipulation. This
occurs most commonly in securities trading
when investors attempt to move the price of a
stock in order to profit from the change.
 2.3.2 Wrongful harms
▪ Market actors are prohibited, both morally
and legally, from harming others in violation
of their rights.
▪ Market participants have many other rights,
including protection from defective
products, hazardous working conditions,
racial and sexual discrimination, invasion of
privacy, and so on. Violations of these other
rights are generally the subject of tort law.
 2.3.2 Wrongful harms
▪ Not all harm is wrongly inflicted; what
makes a harm wrongful is usually the
violation of some right → The moral rule that
is applicable to cases of wrongful harm is
“Respect people’s rights!”
 2.3.3 Market failures
▪ The final area where wrongs can occur in
markets involves market failure. This
encompasses a broad set of factors, much
studied in economics, which prevents markets
from functioning with maximum efficiency.
▪ Because of market failures (asymmetric
information, monopolies and anticompetitive
trading practices…), the ability of markets to
secure welfare and rights may also be
impaired.
2.3.3 Market failures
▪ Another kind of market failure is the well-known
feature of markets to neglect public goods and to
favor private over public consumption → free riders.
▪ A major source of market failure is the presence of
externalities or spillover effects, which are costs to
society that result from economic production.
▪ Finally, market failures occur in cases of collective
choice. In a market system, many choices for the
whole of society result from the aggregation of all
the choices made by individuals in discrete market
exchanges.
2.3.3 Market failures

Q: How can market failures be addressed ?

2.4 Roles and Relationships
▪ Financial activity involves individuals and
organizations assuming roles and entering into
relationships in which market ethics still applies
but which entail further duties or obligations
that limit and often preclude self-interest.
▪ These roles and relationships are essential for
finance inasmuch as many goals could not be
achieved solely in markets but require a high
degree of cooperation and coordination.
3. Agents, Fiduciaries & Professionals
▪ An agent is a party that has been engaged to act on
behalf of another, called the principal. Typically, an
agent is engaged by a principal to act in place of
the principal at the principal’s direction.
▪ A fiduciary is a person or organization that has
been entrusted with the care of another’s property
or assets and that has a responsibility to exercise
discretionary judgment in this capacity solely in
this other person’s interest. The other person in a
fiduciary relationship is described as the
beneficiary.
 3. Agents, Fiduciaries & Professionals
▪ The concepts of agent and fiduciary are very
closely related and often overlap. Thus, directors are
often held to be fiduciaries for the corporation and
its shareholder and also their agents. In general, the
duty of an agent to act in the interest of a principal is
not as inclusive as the duty of a fiduciary.
✓For example, the duty of a broker who is acting
merely as an agent in the sale of securities is usually
narrower than that of a broker who is acting as a
fiduciary in managing a client’s portfolio.
 3.1 Need for agents and fiduciaries
▪ Agency relationships arise from the need to rely on
others for specialized knowledge and skills. For
example, selling a house requires considerable
knowledge and skill, as well as time, and so a seller may
engage a real estate agent to act on the seller’s behalf.
▪ Fiduciaries provide a valuable service for individuals
who are unable for some reason to manage their own
property or assets. Thus, a person saving for
retirement might prefer that the assets in a pension
fund be managed by a professional manager, who
assumes the role of fiduciary.
3.2 Duties of agents and fiduciaries
▪ The duty of an agent is to act as directed by
the principal with competence, diligence, and
care. For example, employees as agents of
employers have assigned tasks with a duty to
complete these tasks as directed.
▪ Aside from a positive duty of an agent to act
in the interest of another, there is a negative
duty to avoid advancing personal interests in
the relationship.
3.2 Duties of agents and fiduciaries
▪ A fiduciary relationship has two elements: trust
and confidence. Something is entrusted to the
care of a person with the confidence that proper
care will be taken. A fiduciary relationship can
be created by a contract, as when one person
(trustor) creates a trust and another agrees to be
a trustee who manages the trust. However, a
fiduciary relationship, with its attendant duties,
can be imposed by legislation.
3.2 Duties of agents and fiduciaries
▪ More specifically, the elements of fiduciary
duty are candor, care, and loyalty.
▪ Another important duty of both agents and
fiduciaries is to maintain confidentiality.
▪ Finally, agents and fiduciaries, by virtue of
their commitment to act in the interest of
some other parties, have a duty to avoid
conflict of interest, since a conflicting
interest would interfere with their ability to
serve this other interest.
 3.3 The role of professionals
▪ Not all people in finance are professionals, but
some might rightly claim the professional
status, especially those that provide
specialized services to clients, such as
financial advisers and insurance underwriters.
▪ Before we can determine whether anyone in
finance is a professional, we need to
understand the criteria for a profession.
 3.3 The role of professionals
▪ 3 features of a profession are commonly cited:
1. A specialized body of knowledge. Professionals do
not merely have valuable skills, like those of a
plumber, but they possess a highly developed,
technical body of knowledge that requires years of
training to acquire.
2. A high degree of organization and self-regulation.
Professionals have considerable control over their
own work, and, largely through professional
organizations, they are able to set standards for
practice and to discipline members who violate them.
3.3 The role of professionals
3. A commitment to public service. The
knowledge possessed by professionals serves
some important social need, and
professionals are committed to using their
knowledge for the benefit of all.
→ These three features are closely related and
mutually reinforcing.
3.3 The role of professionals
▪ The standards of a profession include both
technical standards of competence and ethical
standards.
✓Ethical standards are generally presented in a
code of professional ethics, which is not
only a mechanism for the self-regulation of a
profession but also a visible sign of the
profession’s commitment to public service.
✓A code of ethics is not an option for
professionals but something that is required by
the nature of professionalism itself.
3.3 The role of professionals

Q: Is finance a profession?
 4. CONFLICT OF INTEREST
▪ Defining conflict of interest
▪ Why conflicts occur in finance
▪ Examples of conflict of interest
▪ Managing conflict of interest
✓Competition
✓Disclosure
✓Rules and policies
✓Structural changes
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