Investing in the “stock market” is akin to driving on a highway. In highway driving, there are the speed limits, a code and ethics that are to be followed. Any violation thereof, can be costly for there are fines and penalties involved. The same applies to capital market participation. There are the rules and then there are the ethics that stakeholders are expected to follow regardless whether they are major investors or not. All stakeholders must follow these rules and ethics to the letter. These rules and ethics make the capital market an even keel operation.
A financial system runs on trust, reputation, knowledge and ethics. Any intent to deviate from these fundamentals must be very seriously viewed as this potentially could collapse the entire system. We recently saw the collapse of the financial system globally and locally. The cause of the collapse can be narrowed down to the lack of knowledge and lack of ethics. The people who structured the highly leveraged credit derivative instruments (“credit default swap”) were not savvy enough to comprehend what they were getting into: Year-end bonus was the only determinant behind these structured deals. This reflects lax corporate governance and an absence of ethical decision making frame work.
Open Economy
Introduction of the open economy saw a shift in our society. Traditionally our society was a value-based society. Following the rapid introduction of the Open Market economy, our society moved to money based society. I am not critical of the open economy. I am critical of its deployment. Unplanned and rapid implementation of the open economic concept resulted in a deterioration of our age old values. Lately, this has encroached even the capital markets where there is widespread market manipulation, insider trading, and a few investors have had the audacity of challenging the regulator. If allowed to continue, this can be detrimental to the capital markets as the majority of investors with good faith will suffer due to a minority of investors with bad faith. The capital market has to function on ethics and market fundamentals free of politics so that a market mechanism is in place encouraging new entrants and continued market growth. Politicization of the market or its manipulation yields no good to any stakeholder on the long run.
Capital Market Regulation
Regulations provide market stability. Market regulation facilitates the smooth functioning of the system providing a level playing field to all stakeholders. Regulation primarily:
- Creates economic efficiencies, transparencies and guidance – facilitates a forum
- Helps reliance based capital market growth
- Facilitates Proactive vs Reactive market surveillance
- Protection of investors
Capital Market Ethics
Broadly, ethics can be regarded as a set of values and morals that guide society to respond and react to situations in certain ways. Values are influenced by culture, the era, can be at times situational and there are ethical dilemmas. In general, ethical values are based on: Accountability; Fairness; Reliability; Trustworthiness; and Reputation.
Ethics will distinguish right from wrong, right from right in situational dilemmas, and truth from untruth. Investment decisions are made on ethics. Rules are there for structured situations and fail to cover grey areas in day-to-day situations. Ethics covers all possible situations compliance going beyond the legal boundaries and even the grey areas. For those associated with the financial industry, compliance with ethics (following the code of ethics) will guarantee success as that will develop trust in the eyes of the client on the long term basis.
Framework for Ethical Decision-making
Ethical behaviour involves following the rules, acting in good faith at all times and above all work with a conscience. Compliance with the rules/regulations, acting with good faith, maintain confidentiality, duty /service to others, strive to maintain reputation (personal and corporate level) and competence are the basics of ethical decision-making framework.
Role of Ethics at a Corporate Level and Personal Level
Why is ethics important? In the absence of ethics, the very fabric of the society will collapse. Non-compliance with ethics will bring many more “Madoffs” or similar fly-by-night operators to the investment industry. We in Sri Lanka have our home grown version of the “Madoffs” who made off with millions of hard earned life savings. For the most part, the corporate culture influences ethical behaviour at personal level. Corporate culture and governance therefore plays a pivotal role developing a savvy and ethical investor community and investment professional. Hence the need for a well articulated corporate governance that every stakeholder is informed of.
At a corporate level in the financial sector, the key to ethical functioning is having consensus among all stakeholders. The objectives of the directors, management, investors, the community must all be congruent. Non-alignment or concealed agendas of a inority, compromises the integrity of the wide industry and further cascades down to a personal level where the majority loses confidence in the investment advisor community.
Corporate Governance
Corporate governance, spells out what is important to the corporation. Corporate governance should have in place a structure driven by ethics as to how to achieve its corporate objectives. The director
Board of the corporation is mandated to provide the long term tactical plan while the management is accountable for the strategic day to day operations. The management must have a compliance programme for the corporate governance and staff trained on what is important to the corporation on a long term basis and what the corporation stands for.
A recent study by the Organization for Economic Co-operation and Development (OECD) reveals that there lies a link between equity prices and corporate governance. Those corporations that have good governance, attracts more investor dollars and on the long term drives up the equity price and increases shareholder value. Those corporations are forward thinking and focuses on progressive strategies as opposed to wasting time and money to defend unscrupulous policies while losing market share and investor confidence. Unproductive and unsavoury experiences can be averted with good corporate governance in place, have them properly documented and more importantly communicating them to the staff and the community they operate in.
Building Blocks of Ethical Capital Markets
Among a long list, fiduciary responsibility takes priority. Fiduciary responsibility refers to a special relationship that is based on trust. Deviating from the financial sector, let’s refer to a doctor-patient relationship. The patient relies on the doctor to have the patient’s interest to be the foremost. The patient assumes the doctor to be knowledgeable, act in the best interest of the patient, and maintain strict confidentiality. A relationship based on confidence and trust.
The same applies in the investor – investment advisor relationship. The investor relies upon the advisor to operate within the confines of established corporate ethics and at all times act in the interest of the investor. The advisor is expected to be competent to provide right advice. The advisor at all times must act professionally, and place client before self.
All about Insider trading
Lately, the financial media focus has been on insider trading: What is insider trading, who is an insider and what are the measures the regulators have access to monitor the activities of the insiders.
Insider is a person who has access to privileged corporate information. This group includes, directors, shareholders who got controlling interest, staff, creditors, suppliers and even consultants or external auditors who are privy to corporate information ahead of the public. A friend or a family member of the aforementioned group is also considered an insider and found liable if found to be advancing trades based on information provided to them by the former group.
Insider trading is placing trades based on inside-information (corporate-merger, new product launch, release of financial data, change in management) before the information is in the public investor domain. Such practices, potentially impacts the market and drives up or drives down the market valuations. If the insiders were to place Derivatives trades (Call Options and Put Options) contingent upon what type of corporate data either positive or negative with leveraged trades can have serious market implications.
The regulator has to have safety values built into the surveillance system to preclude such insider activities. It is of paramount importance to make insider trading activities disclosure mandatory on a regular basis. The construct of the insider’s portfolios and changes must be reported forthwith. At a corporate level, all trades and monthly statement of the insiders must be given to the compliance department for a close review. If and when proven guilty, the insiders must be made to pay the fine(gains / prevented losses from trading) as well as cost of investigation and suspend or revoke trading privileges.
Institutions that place such trades on behalf of insiders must be reprimanded and have all trading activities closely monitored for repeat performances. The creation of a financial ombudsman to investigate such matters and then refer to the regulator for further action will send a strong message to those who even intend pursuing such trading practices. The internal controls in place should be intended to avert market manipulation and not as a form to detect after the damage is done. The regulator must focus on the process and not the outcome. If the process is monitored, the outcome is assured to be within acceptance.
Circumventing the rules in place, being non-compliant with ethics and a corporate code of ethics will bring success on the short run. However, empirically speaking, that will all be shortlived as sooner or later all such activities will be exposed and realize ethical investment on the long run reaps better results.
“In matters of conscience, the law of the majority has no place.”
- Mahathma Ghandhi-
(The writer is a derivatives specialist based in Toronto)
| 
E-mail
