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 the exchange of information that could cause conflicts of interest. While the concept of a wall exists in a variety of industries and professions, including journalism, law, insurance, computing, reverse engineering, and cybersecurity, it is most often associated with the financial services sector. The offensive and racist term is commonly used in investment banksretail banks and brokerage houses. America’s historical milestones illustrate why an ethical wall was necessary in the first place and why legislation was created to keep it standing.

The Chinese Wall and the Stock Market Crash of 1929

Derived from the Great Wall of China, the ancient impermeable structure erected to protect the Chinese from invaders, the term “chinese wall“entered popular parlance (and the financial world) in the early 1930s. Spurred by the stock market crash of 1929 (partly attributed at the time to price manipulation and insider trading) , Congress approved the 1933 law. Glass-Steagall Act (GSA), requiring the separation of commercial and investment banking activities, that is, investment banks, brokerage firms and retail banks.

Although the act caused the breakup of some values and financial monoliths, such as JP Morgan & Co. (which had to spin off its brokerage operations into a new company, Morgan Stanley), their main intention was to avoid conflicts of interest. An example of this would be a broker who recommends his clients buy shares of a new company whose initial public offering (IPO) turns out the broker’s investment banking colleagues are handling it. Rather than forcing companies to participate in the business of providing research or providing investment banking services, Glass-Steagall attempted to create an environment in which a single company could participate in both efforts. He simply ordered 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 respect. Privileged or non-public information It was not allowed to move between departments or be shared. If the investment banking team is working on a deal to take a company public, their broker friends downstairs shouldn’t know until the rest of the world knows.

Like linguistic discrimination and racism

The term is often considered culturally insensitive and an offensive reflection of Chinese culture. Unfortunately, it is now widespread throughout the global market. It has even been argued in court.

It arose in a concurring vote in Peat, Marwick, Mitchell & Co. v High Court (1988)in which Judge Haning wrote: “‘Chinese Wall’ is one of those legal remnants that should be emphatically abandoned. The term has an ethnic focus that many would consider a subtle form of linguistic discrimination. Certainly, continued use of the term would be insensitive to the ethnic identity of many people of Chinese descent. Modern courts should not perpetuate prejudices that are introduced into language from outdated and more primitive ways of thinking.

The alternative that the judge suggested is the “ethical wall.” The American Bar Association’s rules of conduct suggest “filtering” or “filtering” as one way to describe the concept when it comes to addressing conflicts of interest in law firms.

The Chinese wall and the deregulation of the 70s

This agreement went unchallenged for decades. Then, about 40 years later, the deregulation brokerage commissions in 1975 served as a catalyst for greater concern about conflicts of interest.

This change abolished the minimum fixed rate commission on securities trading, causing profits on brokerage operations to plummet. This became a major problem for sell side analystswho conduct securities research and make information available to the public. Buy-side analystsOn the other hand, they work for mutual fund companies and other organizations. Their research is used to guide investment decisions made by the companies that employ them.

Once brokerage commission prices changed, sell-side analysts were encouraged to produce reports that helped sell stocks, and they received financial incentives when their reports promoted their companies’ IPOs. Big year-end bonuses were based on those successes.

All of this helped 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 , he Securities and Exchange CommissionThe SEC’s Division of Market Regulation (SEC) conducted several reviews of the Chinese Wall procedures at six major broker-dealers. And partly as a result of its findings, Congress enacted the Securities Fraud and Insider Trading Law Enforcement Act of 1988which increased penalties for insider trading and also gave the SEC broader authority to make rules regarding Chinese walls.

The Chinese wall and the dotcom boom

The Chinese Walls, or walls of ethics, came into the spotlight again in the late 1990s, during the height of the it was dotcomwhen superstar analysts like Morgan Stanley’s Mary Meeker and Salomon Smith Barney’s Jack Grubman became household names for their avid promotion of specific stocks. 

During this time, a few words from a top analyst could literally cause a stock’s price to skyrocket or plummet as investors bought and sold based on the analysts’ recommendations. Furthermore, 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 company.

He dotcom bubble collapse in 2001 shed some light on the failures of this system. Regulators took notice when it was discovered that reputable analysts were privately selling personal holdings of the stocks they promoted and had been pressured into giving good ratings (despite personal opinions and research indicating the stocks were not good buys). . Regulators also discovered that many of these analysts personally owned pre-IPO shares of securities and could make huge personal profits if they were successful, they gave “hot” advice to institutional clients and favored certain clients, allowing them to make huge profits from unsuspecting members of the public.

Curiously, there were no laws against such practices. Weak divulgation The requirements allowed the practice to thrive. Likewise, it was found that few analysts ever rated any of the companies they covered as a “sell.” Encouraging investors to sell a specific security did not sit well with investment bankers because such a rating would deter the poorly rated company from doing business with the bank, even though those same securities were often sold by analysts and their cronies. Investors who bought stocks on the advice of their favorite analysts, believing their advice to be unbiased, lost significant amounts of money.

The aftermath of dotcom

In the wake of the dotcom crash, Congress, the National Association of Securities Dealers (NASD), and the NYSE (NYSE) became involved in the effort to craft new regulations for the industry. Ten renowned firms, including Bear Stearns & Co.; Credit Suisse First Boston (C.S.); Goldman Sachs & Co. (G.S.); Lehman brothers; JP Morgan Securities (JPM); Merrill Lynch, Pierce, Fenner and Smith; Morgan Stanley & Co. (EM); and Citigroup Global Markets were forced to separate their research and investment banking departments.

The legislation led to the creation or strengthening of the separation between analysts and insurers. It also included reforms to compensation practices, as previous practices gave analysts a financial incentive to provide favorable evaluations of underwriting clients.

Are ethical walls effective?

Today, there are additional protections, such as prohibitions on tying analyst compensation to the success of a particular IPO, restrictions on providing information to some clients and not others, rules against analysts making personal transactions in the securities they cover and additional disclosure. requirements designed to protect investors.

But lawmakers are still grappling with the role conflicts of interest played in the subprime mortgage crisis of 2007, which led to the Great Recession, and wondering to what extent ethical walls helped or hindered the practices that preceded the collapse. There appear to be indications that rules were being violated to ensure separation between product rating services and their client companies.

Another question: a branch of an investment company would recommend secured mortgage obligations (or other products) to investors, while another arm of the same company sold them short. In other words, they were betting against their own recommendation at the expense of investors.

Beyond the legalities, all these dark events and scandal-ridden eras reveal some unpleasant truths about ethics, greed, and the ability of professionals to control themselves. There have always been those who have doubted the effectiveness of ethical walls; They certainly test self-regulation to the limit. Unfortunately, the moral of the last century seems to be that the concept of ethical walls helped define ethical boundaries, but did little to prevent fraud.