Some Background

Robert T. Stafford Student Loan Program

Stafford loans are fixed-rate student loans guaranteed by the full faith of the US government. The government guarantee should mean lower interest rates for students compared to other private loans. Students can get two types of loans: Direct Unsubsidized Loans and Direct Subsidized Loans.

1. Direct Unsubsidized Loans

This category of student loans is available to undergraduates, graduates and professional students. The interest rates for loans given between July 1, 2012, and June 30, 2013 is 6.8%.

2. Direct Subsidized Loans

Direct subsidized loans are available to undergraduate students with financial need. As of July 1, 2012, graduate and professional students are no long eligible for direct subsidized loans. For subsidized loans given between July 1, 2012, and June 30, 2013, undergraduate students pay 3.4% in interest. Subsidized loans therefore, have a lower interest rate.

In 2012, interest rates of Direct Subsidized Stafford Loans were due to double from 3.4% to 6.8%. However, Congress intervened to prevent this increase from taking place (in anticipation of November elections perhaps) and forestalled the increase for another full year.

On July 1^st, 2013 the temporary halt to rates doubling will cease. Rates will go up from 3.4% to 6.8%. Congress is likely to vote on another temporary stay on the interest rate increase.

The Bank on Students Loan Fairness Act

However, Senator Warren wants to do more than just delay a seemingly inevitable rise in student loan rates. Warren’s Bank on Students Loan Fairness Act allows students to borrow at interest rates that are equivalent to the interest rates at which the Federal Reserve System provides to banks through the Fed’s discount window overnight rate as banks or 0.75%. The low rate will be in place for one year.

Warren wants students to be charged a rate equal to the rates banks are getting from the government. Her bill applies only to Direct Subsidized Stafford Loans. The loans will be funded through the Federal Reserve and be administered by the Department of Education.

Warren is probably eyeing the Fed’s profits from its operations. The Federal Reserve sent $88.9 billion in profit to the Treasury Department in 2012, a record. Over the last five years the Fed has bought $2.7 trillion in Treasury securities and mortgage-backed securities. The interest payments on those securities are the primary source of the Fed’s profits. The Fed has transferred a total of $335 billion to the Treasury since 2009. However, because the Fed holds mostly Treasuries, its profits are largely payments from — the government.

The Ethics of Senator Warren’s Bill

According to Senator Warren her bill seeks to obtain fairness. She wants those without the power of position and money to have direct access to the low interest rates offered to banks by the Federal Reserve System.

The Fed argues that Quantitative Easing which, entails the policy of keeping interest rates low, is necessary to give a boost to economic and job growth. Senator Warren’s response is that the burden of student debt is hindering economic recovery because borrowers are not spending. Thus, lowering rates for student loans will also be ultimately good for the economy. If it is fair to lower rates for banks to attain economic growth, then it is just as fair to lower rates for student loans for the same objective.

In addition, the Federal government and its agencies bailed out banks when they seemed to be in danger of failing during the financial crisis in 2008. So in fairness, if student loan borrowers appear to be danger of falling into a debt crisis, the government also should go to their aid, with as much alacrity as it did with the banks.

Senator Warren launched a petition on MoveOn.org. So far the petition has 319,516 signatures.

What do you think? Is Senator Warren’s bill a way to obtain some fairness?

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Las promesas deben cumplirse. No hay mucho desacuerdo acerca de esta afirmación. Si estuviera permitido incumplir ciertas promesas, la práctica misma de prometer—diría Kant—perdería su significado y tendería a desaparecer, pues ya no se podría confiar en nadie. En rigor, ni siquiera los utilitaristas disputarían este punto. Para ellos, un mundo con reglas confiables es mejor que un mundo sin ellas.

Pues bien, estoy de acuerdo en que cumplir las promesas es una práctica valiosa y necesaria. Sin embargo, también creo que no todas las promesas deben cumplirse. El tipo de promesas que tengo en mente involucra transacciones financieras y ocurren regularmente en los mercados financieros internacionales.

Más en concreto, creo que a pesar de haber tomado en préstamo fondos de la comunidad internacional y de haber prometido pagar esas deudas, hay muchos países que no están bajo ninguna obligación moral de cumplir con tales promesas. Estas transacciones involucran miles de millones de dólares y, por ello, merecen una atención especial.

Con el fin de mostrar cómo esto es posible, voy a empezar con un ejemplo sencillo. Supongamos que un cliente de cierto banco, Pedro, toma prestado dinero de ese banco en nombre de su amigo, Juan. Pedro utilizar el dinero para comprarle a su hija un regalo de cumpleaños, pero le pasa a Juan la cuenta por el regalo. A pesar de estar al tanto de la situación, el banco obliga a Juan a pagar el préstamo. En este caso, hay una promesa en juego: la promesa de pagar el préstamo. Sin embargo, sería extraño decir que Juan debe cumplir con esta promesa. Después de todo, no pidió el préstamo y ni siquiera se benefició de él. Había una promesa en juego, ciertamente, pero no una promesa realizada por Juan. Por el contrario, se trata de una promesa que otra persona hizo en su nombre, sin la debida autorización. ¿Por qué debería Juan estar obligado moralmente a pagar la deuda? Nadie pensaría normalmente que Juan tiene una obligación en este caso.

Podemos imaginar un tipo de injusticia análoga en el plano internacional, con transacciones entre prestamistas y países. Supongamos que un funcionario público de un país africano toma prestado dinero de un banco internacional en nombre de las personas que supuestamente representa. Supongamos, además, que este funcionario público utiliza el dinero para comprarle a su hija un regio palacio, y que decide pasarle al Estado la factura por esta compra. A pesar de estar al tanto de la situación, el banco internacional obliga al Estado africano, los regímenes sucesores y las generaciones futuras a pagar la deuda.

Al igual que en el caso del cliente que pide prestado en nombre de su amigo, hay aquí una promesa en juego: la promesa de pagar el préstamo. Pero también en este caso hay algo intuitivamente incorrecto en obligar al Estado a pagar el préstamo que se pidió en su nombre. De hecho, la población del Estado no pidió el préstamo y ni siquiera se benefició de él. Por otra parte, el préstamo fue utilizado para fines para los cuales el funcionario no estaba autorizado. ¿Por qué, entonces, debe la población asumir la responsabilidad de pagar las deudas personales del funcionario corrupto que pidió prestado en su nombre?

La injusticia es clara, y tiene nombre. De acuerdo con una antigua doctrina jurídica desarrollado en 1927 por el académico ruso Nahum Sack, este tipo de deudas debería llamarse odiosa.

Los ejemplos hasta aquí discutidos son imaginarios. Sin embargo, los casos de deudas odiosas ocurren regularmente en el mundo real, y la cantidad de dinero en juego es enorme. A pesar de ello, el derecho internacional, los medios de comunicación y el público en general considera que los Estados deberían pagar todas sus deudas, y apoyan la aplicación de mecanismos que obliguen a los gobiernos a cumplir con este supuesto deber moral.

Tomemos, por ejemplo, el caso del ex dictador de Zaire, Mobutu Sese Seko. Mientras estuvo en el poder, las instancias de corrupción relacionadas con el uso de los fondos públicos eran moneda corriente. En 1982, viajó a Disney World e invitó a 100 de sus amigos más cercanos para que disfruten con él las maravillas del conocido parque de diversiones. El viaje le costó a Mobotu alrededor de dos millones de dólares. O tomemos, por ejemplo, su decisión de pasar las vacaciones en un lujoso piso de París, una finca de 32 habitaciones en Suiza y un castillo español del siglo XVI. O, sin ir más lejos, su salario como presidente, que llegó a superar el gasto total nacional en todos los servicios sociales. Este tipo de comportamiento muestra que para el dictador la frontera entre los gastos públicos y privados es muy confusa.

Este no es, desde luego, un ejemplo aislado. Hay muchos casos que podrían citarse. Consideremos, por ejemplo, el caso de Haití. La dictadura violenta de Haití asoló al país por casi treinta años, entre 1957 y 1986. Durante ese período, la deuda externa se multiplicó 17 veces y media. Al momento en que el dictador Duvalier abandonó el gobierno, la deuda era de alrededor de 750 millones de dólares, pero aumentó, por los intereses y las multas, a mil ochocientos millones de dólares. Lo que prueba que la deuda no fue tomada en beneficio del Estado o de sus ciudadanos es que la riqueza de la familia de Duvalier rondaba los 900 millones de dólares cuando el dictador huyó del país, y no hay ninguna otra manera por la que habría podido amasar tal fortuna.

Casos como éstos han sido frecuentes en la mayoría de los países de África, América Latina y Asia. Lo que todos tienen en común es que, a pesar de que estos países estaban gobernados por regímenes que muy probablemente fueran a gastar el dinero para fines ilegítimos, y que tenían un historial muy pobre en materia de transparencia, la comunidad internacional continuó prestándoles de manera irrestricta. Por otra parte, incluso después de que los fondos fueron robados o utilizados para fines ilegítimos, los países acreedores siguieron obligando a los Estados (y no a los funcionarios públicos) a pagar los préstamos y las correspondientes las tasas de interés. Estos mecanismos incluyen sanciones comerciales, diplomáticas y políticas: medidas que resultaron en pérdidas de reputación, exclusión de futuros mercados financieros, e incluso la confiscación de bienes y activos en el exterior.

¿Pero cuál es realmente la magnitud de este problema? La conclusión fácil que sería tentador extraer es que las deudas odiosas sólo afectan a unos pocos países regidos por gobiernos autocráticos y corruptos, que utilizan fondos públicos para beneficio personal. Sin embargo, una vez que entendemos el rol que deben tener los funcionarios y las razones por las cuales tienen derecho a pedir dinero prestado en nombre de los ciudadanos, nos daremos cuenta de que el problema de la deuda odiosa es mucho más amplio y generalizado de lo que podría suponerse.

Las doctrinas de filósofos como Hobbes, Kant y otros son útiles para ilustrar este punto. Para estos pensadores, lo que hace que un gobierno sea legítimo es que interpreta y defiende los derechos fundamentales de los ciudadanos. Los derechos fundamentales incluyen, entre otros, el derecho a la seguridad, a la vida, a las libertades básicas y a la igualdad. Se espera de los funcionarios públicos que garanticen estos derechos, porque los propios ciudadanos no pueden hacerlo por sí mismos. Ello se debe a que las personas suelen ser parciales o interesadas en sus juicios, o a que son incapaces de hacerse cargo de los asuntos públicos.

Esta idea, aunque bastante simple, es útil para aclarar la cuestión de las deudas. Los funcionarios públicos pueden pedir prestado en nombre de la ciudadanía cuando estas deudas tienden a promover y defender  los derechos de los ciudadanos. Si esta condición básica no se cumple, los ciudadanos no pueden ser responsabilizados por la deuda.

De lo dicho se siguen dos conclusiones importantes. La primera es que, contrariamente a lo que muchos suponen, el problema de las deudas odiosas afecta no sólo a países sometidos a gobernantes autocráticos, sino también a naciones gobernadas democráticamente. Esto se debe a que ambos tipos de gobierno pueden, en principio, actuar de forma tal que no promueven ni defienden los derechos de los ciudadanos. Un dictador puede, por supuesto, malversar dinero, pero el presidente de un gobierno democrático también puede hacerlo. Lo que hace que una deuda sea odiosa, entonces, no es que el pueblo no haya dado su consentimiento a ser gobernado por el régimen imperante, sino que este gobierno, cualquiera sea su naturaleza, haya actuado de manera contraria a los derechos de los ciudadanos.

La segunda conclusión importante es que las deudas odiosas no sólo son aquellas que involucran dinero malversado por el gobierno, sino también aquellas que implican la violación de los derechos de los ciudadanos. Ejemplos de violación de los derechos de los ciudadanos incluye restringir sus libertades, afectar su seguridad, usar fondos públicos para beneficiar compañías privadas y otros.

Las deudas administradas de manera irresponsable e imprudente (tal como lo ha hecho el gobierno griego en los últimos años) no son odiosas, porque la administración irresponsable del dinero no cuenta como una violación de los derechos de los ciudadanos. Sin embargo, muchos otros casos, como el de las deudas contraídas por el gobierno de Sudáfrica para oprimir a una parte de su población durante el Apartheid, claramente cuentan como un caso de deuda odiosa, ya que se trató de deudas contraídas por el régimen, en nombre de la ciudadanía, pero para fines incompatibles con los derechos de los ciudadanos.

Estas dos conclusiones muestran que las deudas odiosas no sólo se generan por los gobernantes autocráticos que malversan fondos para comprar palacios y Ferraris. La injusticia es de una escala mucho mayor, ya que también incluye a muchos países democráticos. Y la cantidad de dinero es mucho mayor también, pues además involucra casos de violación de los derechos de los ciudadanos, que por desgracia han sido muy comunes en la historia reciente.

Posibles objeciones

Es posible, ciertamente, formular objeciones de diverso tipo a lo que he sostenido.  A continuación considero algunas de estas objeciones.

En primer lugar, se podría objetar que por lo general los prestamistas desconocen los fines para los que se va a utilizar el dinero que prestan, por lo que es injusto responsabilizarlos por el uso corrupto de ese dinero. De acuerdo con esta objeción, si el gobierno de un país en regla pide dinero prestado por alguna razón y más tarde decide malversarlo o utilizarlo para fines ilegítimos, los prestamistas deberían tener derecho a  reclamar el dinero al Estado, porque no podrían haber sabido de antemano que el dinero se iba a utilizar de esa manera.

Pero esta objeción es inválida. Las deudas son odiosas cuando existe un cierto grado de conocimiento por parte de los prestamistas. Si el gobierno con el que operan los prestamistas es totalmente corrupto y autocrático, pide prestado para fines sospechosos, o se niega a declarar lo que va a hacer con el dinero, y a pesar de ello los prestamistas deciden prestarle, éstos no podrán luego alegar que ignoraban los posibles usos espurios de los fondos. Dado que la información sobre el grado de corrupción o autoritarismo de los gobiernos está disponible públicamente; siempre se puede mostrar que los prestamistas saben, o deberían haber sabido, el uso que se le iba a dar al dinero que entregaron en préstamo. En otras palabras, estos préstamos no habrían sido de buena fe. Y teniendo en cuenta que no se trata de préstamos de buena fe, parece extraño decir que la población de un Estado debe asumir la responsabilidad de pagarlos. Estas transacciones son transacciones corruptas entre dos partes (el prestamista y el funcionario corrupto), y no puede responsabilizarse  por ese acuerdo a un tercero no involucrado en la transacción.

En segundo lugar, algunos han sostenido que si los Estados tienen un derecho moral a negarse a reconocer sus deudas, los mercados internacionales se desplomarían y ya nadie estaría dispuesto a prestar dinero. Ello sería así porque los prestamistas tendrían miedo de no recuperar el dinero que otorgan en préstamo.

Sin embargo, este temor es infundado. Como he dicho antes, las deudas son odiosas sólo cuando los prestamistas saben, o deberían saber, que el dinero podría ser utilizado para fines ilegítimos. Así que los prestamistas pueden evitar la pérdida de sus inversiones prestando exclusivamente a gobiernos que no muestran ningún indicio de malversación o utilización corrupta de fondos, o que son capaces de demostrar que los fondos serán utilizados para fines de interés público (tales como la construcción de infraestructura, escuelas, hospitales, etc.). Si obran de ese modo, las instituciones financieras podrían seguir operando normalmente.

Una solución al problema de la deuda odiosa, aplicado correctamente, tampoco daría lugar a tasas de interés más altas. Es un hecho bien conocido que el aumento de las tasas de interés está asociado a mayores niveles de riesgo. El riesgo asociado al problema de las deudas odiosas, sin embargo, no es que el prestatario incumpla sus deudas. El riesgo es simplemente que el prestatario sea corrupto. De modo que si los prestamistas aplican salvaguardias adecuadas para asegurarse de que el prestatario está actuando dentro de su mandato legítimo, la posibilidad de que alguna de esas deudas sean declaradas odiosas no debería necesariamente tener como consecuencia un alza en las tasas de interés. Sin duda, hacen falta más estudios sobre cómo reformar las instituciones financieras internacionales actuales.

Por último, se podría argumentar que es difícil establecer si los fondos prestados se han utilizado ilegítimamente ex post facto, ya que por lo general los fondos de deudas se mezclan con el gasto público normal. A menudo, los gobiernos corruptos piden prestado dinero para algún fin público legítimo, como cubrir un déficit en el presupuesto, pero más tarde malversan los fondos del tesoro nacional. En estos casos, no está claro si el funcionario obtuvo dinero del presupuesto general, del préstamo, o de ambas fuentes.

Sin embargo, este problema no pone en duda seriamente la idea de que algunas deudas son odiosas. En primer lugar, el problema de la deuda odiosa es un problema de justicia, no un problema de rendición de cuentas. En otras palabras, este tipo de deudas son inmorales, independientemente de si son o no fáciles de identificar. En segundo término, parece posible, de todos modos, identificar al menos algunas de esas deudas, como lo demuestra el hecho de que varios gobiernos históricamente han desviado fondos de forma masiva para fines claramente no autorizados.

En suma, las promesas deben cumplirse. Sin embargo, hay excepciones a esta regla general. Las promesas de pagar las deudas no obligan a los Estados (ni, por lo tanto, a sus ciudadanos) si los fondos de estas deudas fueron utilizados para fines para los que los funcionarios públicos no estaban autorizados. Dado que los funcionarios públicos de regímenes tanto democráticos como autocráticos pueden extralimitarse, que hay muchas políticas que pueden violar los derechos de los ciudadanos, y que muchos países en el pasado han pedido dinero prestado para fines no autorizados, debemos concluir que una gran parte de las deudas de los países son deudas odiosas que no corresponde pagar.

Cristian Dimitriu

Nota: Agradezco a Pablo Stafforini por haber traducido este artículo

Referencias bibliográficas

• Ayittey, George, Africa Betrayed, St. Martin’s Press, 1992
• Dimitriu, Cristian. “The practical interpretation of the categorical imperative: a defense”, Ideas y Valores (forthcoming)
• http://cadtm.org/Haiti-Grants-to-repay-an-odious
• Kant, Immanuel. Foundations of Metaphysics of Morals, translated by Lewis White Beck. Library of Liberal Arts, 1959
• Mill, John Stuart. Utilitarianism. Indianapolis: Bobbs-Merril, 1957.
• Nahum Sack, Alexander. Les Effets des Transformations des États sur leurs Dettes Publiques et Autres Obligations Financières. Paris: Recueil Sirey, 1927
• Ndikumana, L. and Boyce, J. Congo’s Odious Debt: External Borrowing and Capital Flight in Zaire. Development and Change, 29: 195–217. doi: 10.1111/1467-7660.00076. 1998
• Richburg, Keith, “Mobutu: A Rich Man in Poor Standing,” The Washington Post, October 3, 1991.
  http://www.highbeam.com/doc/1P2-1087898.html

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In this issue of Moral Cents we focus on pertinent problems, policies, and reactions spawned by the financial crisis: (1) The persistent debt crisis (2) Quantitative easing (3) The flash crash  (4) Regulations (5) Regulations (6) Questioning current economic theory. The articles on each of the six topics have their own particular approach to the corresponding issues.

Cristian Dimitriu writes on odious debt, when states can legitimately repudiate their sovereign debts. Thomas Aden attempts to analyze the outcomes from four years of quantitative easing. Laure Madonna tells us about the ethics of High Frequency Trading after the Flash Crash. Tyler Dumler reviews both the Volker Rule aimed at preventing proprietary trading at banks and the Wheatley Report on LIBOR manipulation. Travis Strawn reviews A History of Homo Economicus: The Nature of Moral in Economic History by William Dixon and David Wilson.

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The Players:

• Bank of America: Bank of America Corporation is a bank holding and financial holding company. Its primary headquarters are located in Charlotte, North Carolina. Brian Moynihan is the current CEO, while Charles Holliday serves as chairman. Bank of America operates in 32 states, the District of Columbia, and more than 30 countries internationally. Bank of America functions through the “banks” in which they provide a variety of banking and non-banking financial services and products. As per 2011 financials, the shareholder’s equity was $232.50 billion.
• Ken Lewis: In 2008, when Bank of America took over, Ken Lewis was Merrill Lynch’s chairman and CEO.
• Merrill Lynch & Co.: Merrill Lynch was founded in 1914; it quickly became successful, specializing particularly in investment banking. The company continued to build its brokerage network and eventually became known as the “Thundering Herd.”
• John Thain: He was chairman and CEO of Merrill Lynch and was in this position for about nine months when he made this weekend deal with Bank of America.
• The Securities and Exchange Commission (SEC): The SEC is a federal agency that acts as the primary enforcer of federal securities laws and regulates the securities industry, the nation’s stock exchanges, and other electronic securities markets in the United States. The SEC has the authority to bring civil enforcement actions against individuals or companies alleged to have violated the securities law.
• Government and Economy of the United States of America: From the government’s point of view, another major collapse of a Wall Street corporation would likely cause an enormous crisis in an already unstable financial climate. The overall economy of the United States was at risk; there were fears that a deep depression could result in untold damage to the citizens of the country. Even without total economic collapse, the taxpayers were certainly at risk in taking on the financial obligations of a failed Merrill Lynch.
• Board of Directors: The Board of Directors of Bank of America and Merrill Lynch were directly affected by the decision of not being transparent to the public and shareholders. Also, the information that the voters did not receive from Ken Lewis and John Thain allowed the acquisition to take place in such economic turmoil.
• Shareholders: Millions of shareholders of Bank of America would be affected by the decision and the consequences of an unfortunate takeover.
• Ben Bernanke: He was the Federal Reserve chairman who, according to Lewis, insisted that he did not back out of the deal.

Instruments:

After 2001, the real estate boom accelerated. To service this market, Wall Street created a number of financial instruments. These instruments were a major cause for the decline of Merrill Lynch.

Collateralized Debt Obligations (CDO): These instruments repackaged a pool of bonds, derivatives, and other instruments such as corporate bonds. The CDO derived its value from converting illiquid assets, such as buildings, into liquid financial instruments. A mortgage CDO bundled thousands of individual mortgages into a single bond, which was supposed to diversify default risk.

Mortgage-backed Securities: These are a subset of CDOs. They were bundles of mortgages that were sold to Fannie Mae, which repackaged them to sell as stock to individual investors. This process enabled banks to take mortgages off their balance sheets.

Credit Default Swaps (CDS): These were an insurance policy against the risk of investors, who bought them like bonds. A premium was paid to underwrite the risk of the various instruments like CDOs. CDSs lowered the cost of taking risks and created confidence in investors.

Events:

Risky Financial Instruments

In 2001, interest rates in the U.S. fell to low levels for several reasons. The environment of “cheap credit” encouraged investors and financial institutions to speculate in the real estate market, which increased property value and enticed household consumers to take additional debt. The Federal Reserve began to raise the interest rate incrementally in late 2004. By 2006, the subprime mortgage market began to appear vulnerable because of the increased interest rate. Holders of adjustable rate mortgages were required to make higher monthly payments than many could meet. The entire mortgage finance system, which was based on the assumption of ever-rising property value, began to unravel. Many rushed to sell their houses, which created further downward pressure on housing prices. This created a series of financial failures as CDOs dropped in value and banks lost their capital in defaults and withdrawals. In June 2007, two hedge funds managed by Bear Sterns suffered substantial losses and required huge capital injections from the bank, frightened investors, and investments bankers. These funds were heavily invested in high-risk, mortgage-backed securities and had been used to borrow more capital from the market.

BoA and Merrill Buy Damaging Assets

Countrywide Financials, which was America’s largest mortgage lender, had huge exposure in the subprime market. The company had approximately 900 offices and $200 billion in assets but was forced to draw down on its entire $11.5 billion credit line because of high exposure in the subprime market. Many regulators blamed Countrywide for helping fuel the housing bubble by offering loans to high-risk borrowers, so the company had very little hope of government help. Ken Lewis saw this as an opportunity to enhance the bank’s role in mortgage banking. Bank of America took a 16 percent stake in the company in August 2007, and there were hopes that this investment would bring some confidence in the market. But Countrywide’s stock collapsed, and Bank of America bought Countrywide with a total investment of $4.1billion.

Former Merrill Lynch CEO Stan O’Neal said that to generate higher returns, the firm would take on more risks. After entering the mortgage market by repackaging and selling home loans on the debt markets, Merrill Lynch acquired mortgage origination companies so collateral could be readily available. With AIG as its partner, Merrill Lynch became the largest issuer of CDOs. By the end of 2008, Merrill Lynch had issued CDOs worth $136 billion. In 2005, AIG had stopped insuring even the highest-rated CDOs issued by Merrill Lynch because of its aggressive underwriting policies, but Merrill Lynch continued to do what made the highest profits. When the subprime market slowed down, the entire CDO market unraveled. Merrill Lynch, like many others, did not record its position in the market, as the market and credit rating agencies had failed to anticipate the possibility of large-scale collapse in the housing market.

Merrill Lynch Suffers Monstrous Losses

In late 2007, when Merrill Lynch was forced to admit its liabilities of $7.9 billion and write off $9 billion in holdings, O’Neal was forced to resign, and John Thain took over as CEO. O’Neal was still allowed to retain his $30 million in retirement benefits and $129 million in stocks and options. John Thain also failed to understand the extent of Merrill Lynch’s financial condition, which he later acknowledged. But with further losses of $10 billion in CDOs in 2008, the bank was in serious trouble. With the support of the New York Federal Reserve Bank, Thain approached Bank of America CEO Ken Lewis to sell the company. Although Thain initially turned down the offer from Lewis, he sold Merrill Lynch for $50 billion, at $29 per share. The investment firm had more than $1.02 trillion in assets and more than 60,000 employees worldwide. Bank of America became more universal once it acquired Merrill Lynch. The primary concern for Bank of America was the actual worth of Merrill Lynch in 2008, when the market environment fluctuated rapidly. Lewis wanted to buy the company because of Merrill Lynch’s strongest unit, its 16,000 investment advisors, which would fill a hole in Bank of America’s product offering. The entire transaction took place in the panic when Lehman Brothers was about to declare bankruptcy.

BoA Buys Merrill Lynch

Both Treasury Secretary Hank Paulson and New York Federal Reserve President Timothy Geithner had pressured Bank of America to purchase Merrill Lynch. During the weekend of the Sept. 13, 2008, Bank of America auditors performed due diligence for a potential merger, and an agreement was publically announced on Sept. 15. At the beginning of December, information became known to Lewis that Merrill’s losses were going to be far worse than expected. The anticipated losses were in excess of $13 billion. Lewis asked advice from Bank of America’s legal staff and considered cancelling the offer to acquire Merrill Lynch. On Dec. 17, 2008, Ken Lewis met with Federal Reserve Chairman Ben Bernanke and Paulson; they both urged Lewis not to back out of the deal. They said that pulling out of the deal would create systemic risk to the U.S. economy. On Dec. 21, Lewis was also warned that the government would consider replacing the Board of Directors and management if Bank of America backed out of the deal. The officials also suggested that if Bank of America backed out then any further government assistance would be difficult to obtain. The idea behind this was to demonstrate to the market that even though Lehman had failed, the big banks of Wall Street were cooperating to keep the system running.

Over the next four weeks, the government and Bank of America negotiated a deal that included another $20 billion in direct aid. The government also agreed to back an additional $118 billion to cover potentially bad assets held by Merrill Lynch. None of the above-mentioned communications between the government and Lewis were conducted in an official manner. The government did not want public disclosure at the risk of creating systemic issues in the overall financial system. Lewis and the Board of Directors did not disclose the additional losses to the shareholders. According to Lewis, this decision was not his to make; instead, the government had directed Lewis to keep the information private.

Bonuses for Poor Performance

After the acquisition was finalized, without a public announcement, Bank of America allowed Merrill Lynch’s executives to distribute bonuses of approximately $3.6 billion before the deal closed. Perhaps indicating how these bank executives live in an elite bubble of their own making, neither Lewis nor Thain realized that this small amendment to the contract would eventually spark a state investigation. Oddly, Thain did not seem to understand it was wrong to pay bonuses out to poorly performing employees (whose actions led to the damaging losses), while accepting taxpayers’ money to bail out the bank.

At Bank of America’s request, most of the money would be paid out in cash before the deal closed. The early payment would actually reduce expenses for Bank of America in 2009, ­making it easier for the bank to hit its first-­quarter numbers. Thain had also negotiated a new title for himself: President of Global Banking, Securities and Wealth Management. He would be responsible for planning and executing the merger of Merrill Lynch’s banking and trading business with that of Bank of America. With this deal, Merrill Lynch employees would emerge as winners, with thousands of Bank of America staffers laid off and replaced by their Merrill Lynch counterparts.

After word of the acquisition got out and the bonuses were paid, criticism focused on the price and potential risks, both of which were very high. Some argued that regardless of pressure from the U.S. government, Bank of America should have waited for the markets to adjust after the news of Lehman Brothers bankruptcy.

Ethical Issues:

As chairman and CEO of Bank of America, Lewis has a responsibility to inform the shareholders of the adverse conditions that were present in the Merrill Lynch merger. The same applies to CEO John Thain, who misled shareholders by not being transparent about the losses at Merrill Lynch and the bonuses paid. Another issue for both the CEOs is paying out bonuses right before the acquisition.

On the other hand, Lewis was also responsible for the overall wellbeing of the U.S. and global financial system. Another major crisis to the financial system would have had adverse impacts on Bank of America shareholders and customers. Millions of shareholders clearly had a major stake in the decisions facing Lewis. The CEO must also take into account the interests of nearly 200,000 employees and contractors.

Analysis of Ethical Issues:

The short-term consequences are more easily identified. Lewis and Thain had to consider that if the deal fell through, the overall economy would be adversely impacted. On the other hand, if the deal went through, the shareholders would take an economic blow in terms of diluted share value. Lewis estimated that it would take two to three years for the deal to bring economic value to the corporation, so any shareholders on a short-term horizon would suffer.

The long-term impacts are more difficult to predict. One could argue that letting Merrill Lynch fail would result in a total collapse; on the other hand, allowing the market to take its natural path would be in the best interest of the public and the shareholders.

Public disclosure of the bonuses paid and the true health of Merrill Lynch would have had an immediate impact on Lewis, the Board of Directors and both the companies. The government also stated that the Board of Directors and management would be forced out if the deal did not go through. This would have a large impact on the leaders. Lewis and the board members are all in financially secure positions; therefore, losing their jobs would not have a financial impact. But the corporation would suffer from a government-forced change in leadership with no financial help, not to mention if the deal did not go through and Merrill Lynch was declared bankrupt it would have created more panic in the market — and this was after the fall of Lehman Brothers. The real dilemma was deciding whether secrecy or disclosure would result in greater consequences.

Integrity:

“Doing the right thing” can easily be interpreted as disclosing the information to shareholders, but this action could also have a severe impact on the entire country. No matter what Lewis did, people would be impacted by the decision. Ken Lewis and Thain thought they had only two choices: continue with the deal and keep quiet or pull out of the deal and inform the shareholders of the material adverse conditions of the Merrill Lynch acquisition.

Moral Choices:

Ken Lewis faced enormous consequences without an easy way out. No matter what, Lewis would have to choose an action that would impact a large number of people. The best choice is likely the one that minimizes the damages. Lewis would have to make the choice for the greatest good.

Clearly, Lewis and Thain should not have given out the bonuses in light of the poor performance of management that resulted in the near collapse of Merrill Lynch. On this issue, Lewis and Thain acted unethically.

However, having done so, if Thain had disclosed the bonuses before the acquisition, all of his employees might have lost their jobs, as the deal would not have gone through. On the other hand, he also had to think about the shareholders, who would lose money, and the economy as a whole.

Utilitarian Analysis:

From the utilitarian philosophy of ethical decision making, we can break the decision down based on the choices that will have a greater impact. Failing to disclose the information would have a direct financial impact on the shareholders. Publically disclosing the materially adverse conditions would have potential impact upon the entire financial system. This risk would also impact Bank of America shareholders. Even though a lot of people would suffer from a utilitarian aspect, keeping silent appears to be the better choice.

Ethical decision making can also be based on the duties and obligations of the decision maker. In this case, Lewis and Thain have obligations to both the shareholders and the overall wellbeing of the U.S. financial system. Both Lewis and Thain also have a duty to consider the overall wellbeing and greater good of the entire country. This duty does not omit their obligation to the shareholders, but the universal appeal of the good of the community has a stronger pull than the individual shareholders of the corporation. Lewis’ and Thain’s reputations were on the line. Both were faced with failing at their primary responsibilities.

Ultimately, the decision should be based on seeking the greater good – or it might be more accurate to say choosing the lesser evil. Holding back the information would have certain consequences; however, we can draw a certain boundary around these consequences. Yes, the shareholders will be affected in the short term. However, the deal may turn out to be profitable in the long term. Disclosing the information is a much more dangerous choice. The damage would not only impact Bank of America and its shareholders, it could also easily create global effects.

In the best interest of the corporation, shareholders, and U.S. citizens, my thoughts are that although Ken Lewis and John Thain deceived their shareholders, they might have done the right thing for the greater good in the acquisition of Merrill Lynch without publicly disclosing material adverse consequences.

By: Pratik Patel

Editor: Angela Lutz 

Works Cited

1. Linda K. Trevino, Katherine A Nelson, “Managing Business Ethics”, (2010) Fifth Edition
2. Jessica Silver-Greenberg & Susanne Craig, Bank of America Settle Suit Over Merrill for $2.43 Billion, September 2012
3. Shareholders Transparency Demands Rise  http://www.ethicsworld.org/corporategovernance/corporatereputation.php
4. Greg Farrell and Henny Sender, ” The shaming of John Thain”, Financial Times, March 2009.
5. Countrywide Financial Problems http://www.ehow.com/about_5444985_countrywide-financial-problems.html
6. O.C. Ferrell, John Fraedrich, William Ferrell, “Business Ethics, Ethical Decision Making & Cases”, Ninth Edition
7. Bank of America’s Merrill Scandal Reigniteshttp://www.cjr.org/the_audit/bank_of_americas_merrill_scand.php
8. How the Thundering Herd Faltered and Fell http://www.nytimes.com/2008/11/09/business/09magic.html?pagewanted=all

Photo: Flickr by adibs

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Nomura

Nomura Group is one of Japan’s largest financial conglomerates. Nomura was established in 1925, and acquired most of Lehman Brothers Asia, certain of Lehman’s operations in Europe and the Middle East, and the Lehman Brothers’ service platform in India[1] in 2008.  The Nomura Group has a broad range of services and products, such as securities, international and domestic IPO underwriting, asset management, and capital investment. Nomura is considered Japan’s largest and most powerful securities company[2].

An insider trading scandal at Nomura Group shakes the Japanese conglomerate to its core.  In 2010, market participants claim there is suspicious trading in deals Nomura is underwriting.  Inpex (an oil and gas producer), Tokyo Electric Power, and Nippon Sheet Glass report suspicious trading activities prior to the issuance of new shares in their companies.  From these reports, the Japan Securities and Exchange Surveillance Commission (SESC) launches an investigation, which leads to the definitive discovery of insider trading by Nomura sales officers.

Why is Insider Trading Ethically Wrong?

Insider trading occurs when the stock of publically held corporations is traded on (i) material and (ii) non-public information[3].  The individuals charged with insider trading may be insiders within the company in question, or outsiders entrusted with the non-public information (tipper) or they may be those who obtain the information from an insider (tippee).  John R. Boatwright defines the key points for the occurrence of insider trading:

• the trader has violated some legal duty to a corporation
• the source of the information has a binding legal duty and
• the trader knows that the source is violating that duty[4]

In arguments against insider trading, the ethics focuses on property rights and fairness.  When a person takes material information that has not been made public, and makes trades based on that knowledge, that person is stealing from the corporation in question. The corporation with the non-public information is said to own that information. In terms of fairness, trading on information that is not public is unfair to the corporations and to other market investors because those who have the inside information have an unfair advantage[5]. On a systemic level, insider information results in the stock market being an  unlevel playing field. Ultimately, the practice leads to a decline in trust in the markets and a fall in participation, which is deleterious for proper functioning financial markets.

Japanese Law on Insider Trading

In the United States, insider trading is prosecuted under SEC Rule 10b-5.  While the punishment for insider trading varies depending upon what occurred and the severity of the actions committed, it is clear that actions of insider trading, if detected, will be punished, regardless of whether financial benefit was received.  Insider trading is punishable (may be subject to criminal prosecution) by either jail time or fines.

In Japan, there also are laws against insider trading. While the Japan SESC has recently begun to crack down on insider trading, due partly to the recent spate of insider trading, the agency does not aggressively prosecute or punish insider trading offenders.  The criticism about light punishments challenges the current structure and is prompting the Japanese SESC to consider harsher punishments.

Facts of the Case

In 2010, Nomura participated in several underwriting deals, in which suspicious trading activity was reported prior to the issuance of new shares for the companies involved.  On October 31^st, 2012, the Japanese Stock Exchange fined Nomura Securities Company 200 million Yen ($2.5 million) for the insider trading scandal[6].  Additionally, Nomura CEO Kenichi Watanabe and other executives resign due to insider trading within Nomura. The scandal severely hinders Nomura Group from becoming a serious rival to Wall Street giants in the banking industry[7].  The revelation of insider trading at Nomura, the fall in its stock price, deal revocation of underwriting projects, and leadership turnover demonstrate the consequences of insider trading on a corporation.

As early as 2010, sales representatives share certain information with hedge fund managers and bankers outside the Nomura.  The information pertains public offerings in which Nomura is an underwriter. These deals take place primarily in Japan.  Departing Nomura executives in July 2012 acknowledge that employees leaked information on at least three public offerings in 2010 to favored fund managers, who then profited from short-selling ahead of the expected drop in the share price[8].

Participants in the Japanese market complain for some time that non-public information is leaked prior to the issuance of new shares in a secondary offering.  Additionally, the leaked information often results in the shorting of stock of the issuing company, and a buy back after the new shares are released[9].  Issuing new shares dilute the outstanding shares and thereby reduce the share price.  On this information, shorting the shares likely actualizes a profit when the share price had drops.

On reports of insider trading, the Japan Securities and Exchange Surveillance Commission launched an investigation.  It discovers that investment bankers at Nomura, responsible for selling securities to investors outside of the bank, have in fact shared non-public information with hedge funds, foreign fund managers, and others regarding the issuance of new shares.  The accusations of insider trading have led some experts to believe that the problem began in 2008, when Nomura acquired a large stake of the Lehman Brother’s foreign operations.  The desire to achieve larger scale and bigger profits may have been factors that diverted Nomura’s attention away from compliance, even at a time when banks were facing more scrutiny than ever[10].

Additionally, the desire of Nomura employees to meet sales targets also appears to have been a factor in the events that led to insider trading.  Insiders report that employees “would be willing to do almost anything to meet sales targets”[11].

On each of the insider trading cases in 2010, Nomura employees reportedly gave tips to fund managers regarding the three public offerings that were affected.  The fund managers, one located at Chuo Mitsui Asset Trust (who received information on the Mizuho and Inpex new share offering) and another located at First New York Securities (who received information for Tokyo Electric), were ones that took the information and made trades accordingly.  In each case, the insider at Nomura did not make the trades themselves or profit from the information[12].

Due to the scandal, Nomura lost the underwriting deals in Japan, and faces further pressure on its balance sheet. Insider trading is known as a common occurrence in Japan. Foreigners often criticize the Japanese practice of hyping up the market prior to the release of shares. Nomura employees did not appear to benefit directly from trading in insider information. However, they probably received promises of more business from fund managers, which would result in higher bonuses.

Since the revelation of insider trading at Nomura, there have been severe consequences.  The architect of Nomura Groups extensive expansion through the acquisition of Lehman Brothers foreign operations in 2008, Kenichi Watanabe, as well as a chief lieutenant Takumi Shibata, resigned in July 2012[13].   These officers that took a 50% pay cut in June 2012 while the investigation was being conducted.  Additionally, Nomura’s net profit fell to Y1.98 billion ($25 million) to close the second quarter, which was a 90% decrease from the Y17.7 billion reported in the second quarter of 2011.   Japanese regulators widened their investigation to include other banks and brokers, such as Nikko SMBC Securities and a Tokyo Hedge fund Asuka Asset Management.  Nomura was dropped from a list of companies chosen to underwrite new deals, such as those for Japan Tobacco (a deal worth about $6 billion), Japan Housing Finance Agency, and Resona Holdings[14].  Additionally, in October 2012, the Tokyo Stock Exchange fined Nomura Y200 million ($2.5 million) for the insider trading scandal[15].

Ethics of the Players

The main players in this scandal are Nomura (executives, employees, and shareholders), other banks and brokers (Mizuho Securities, Goldman Sachs, JPMorgan, etc.), the corporations that enlisted Nomura and other brokers to underwrite new share issuances (Tokyo Electric Power, Inpex, Nippon Sheet Glass, etc.), the Japan Securities and Exchange Surveillance Commission, and the Japanese stock market.

The conduct of Nomura (its directors, employees, and executives) was negatively affected by lax internal controls and excessive pursuit of profits[16].  As a global financial institution Nomura has the duty of care to ensure its clients, shareholders, and the market are treated equitably.

The employees of Nomura, specifically those in charge of the sale of newly issued shares, broke their ethical duty to their clients and the market by allowing the desire to achieve sales goals and profit to distract them from their responsibilities as fiduciaries.  The sales employees have an ethical responsibility to protect the sensitive, material, non-public information entrusted to them by their clients. Without their care to act in an ethical manner, the markets would not be fair, as some are privy to non-public information before others have access to the same information.  As John R. Boatwright notes, the information that is used in insider trading is unavailable to the general public not for lack of effort on the public’s part to obtain new market information, but is rather unavailable due to lack of access[17].  The information that is material and non-public is kept that way for a reason.

The reason can be as simple as the process of a merger taking place, or the issuance of new shares, as in this case.  The bottom line however, is that non-public information cannot be given due to the unfairness and the loss of trust that it can cause.  In this case, the Japan SESC was concerned about the potential of scaring investors away from the Japanese markets.  The conduct of the sales employees at Nomura who gave inside information to hedge fund managers and other parties violated the trust bestowed to them by clients in particular and the market as a whole.

An interesting point is the employees at Nomura were not prosecuted for their actions.  Some of them received disciplinary actions, and others were fired, yet none of them were prosecuted by the Japan SESC.  Under Japanese law, a person can only be punished for insider trading if she directly profited financially from the trade.  In this case, none of the Nomura employees in investment banking, underwriting, or sales were prosecuted, as none profited.  Rather, their primary reason for insider trading was to pass information to short sellers who then created demand for shares during the public offerings.

The executives and directors at Nomura have a similar, but slightly different, duty.  While they did not personally commit insider trading, the executives are responsible for ensuring business is administered with proper care, both in ensuring compliance and in meeting clients’ needs.  After the acquisition of Lehman Brothers, the culture at Nomura changed.  In an effort to become a global banking competitor, Nomura sacrificed compliance for  profits.

The executives at Nomura, namely CEO Kenichi Watanabe and his chief lieutenant Takumi Shibata, failed ethically. Insider trading occurred on their watch because these two top executives allowed a culture of blatant non-compliance and lax controls to develop.  Nomura appears to have thrown compliance out the window, for the sake of ensuring that demand for new share issuances was high.  Many companies never have to deal with insider trading, but for a company to be charged with a minimum of three cases of insider trading in one year is outrageous.  The number of cases of insider trading at Nomura in 2010 reflects poorly management’s oversight and controls on their investment bankers.  The executives at Nomura owe their clients and the market a fiduciary duty, to ensure that their business is done with the highest ethics in order to ensure that the Japanese market is a fair place to trade.

The other financial institutions in this case are also blameworthy, whether they were Nomura’s competitors competing for deals, foreign banks, or hedge funds that received the inside information. The foreign banks that received the inside information also acted unethically.  To act on inside information is a clear violation of ethical conduct.  It is surprising how willing and quickly the other banks took the information from Nomura and shorted shares.  Based on the fairness argument, the actions of hedge fund managers and other banks were a violation of the fairness principle.

Japan’s Light Punishment for Insider Trading

Insider trading in the United States receives harsher penalties, such as fines, jail time, or both, for any individual that knowingly participates in the exchange of non-public information.  In Japan, insider trading has become a near epidemic problem, as the punishments for insider trading are not yet serious enough to deter individuals from committing insider trading.  Part of the banking culture in Japan, as exhibited in this case, appears to expects the exchange of non-public information as the order of business.  While the Japan SESC investigates and punishes insider trading, it is unable to curb the near epidemic volume at this time.

The Japan SESC is taking stronger steps to combat and deter insider trading.  In the past year, the Japan SESC has sought fines against three investment firms in a total of four cases of insider trading uncovered[18].  First New York Securities, which is one of the recipients of inside information (from which they made a profitable short sale), was fined $185,000 by the Japan SESC.  Remarkably, this is actually one of the harshest fines levied by Japan SESC[19].

Despite increased fines against foreign and domestic banks that commit insider trading, the Japan SESC has been surprisingly lax in the monitoring, control, and regulation of insider trading.  Critics, in light of the scandal at Nomura, are calling for harsher punishments for insider trading.  The general criticism of the Japan SESC is that the punishments are too light and do not deter individuals or entities from insider trading.

A reason why insider trading is “business as usual” in Japan is because insider trading does not normally warrant criminal charges.  Rather than the threat of prosecution, an inside trader  needs only to worry about any fines she may receive from the Japan SESC, which tend to be extraordinarily light.  Some cases are prosecuted, however these constitute only a handful of the most egregious cases. Criminal prosecution involves a high burden of proof and requires coordination with public prosecutors[20].

The United States has a recent record of prosecuting individuals who leak inside information.  In the United States, Nomura employees who shared inside information would be prosecuted for their roles in the release of the information[21].  In contrast, in Japan, not one individual in the Nomura insider trading scandal has been sanctioned or prosecuted.  Rather, Nomura was simply ordered to implement preventive measures, including ethics training and stricter monitoring of communication with clients[22].

Given the information discussed above, the penalties are not sufficient punishment for the insider trading that took place at Nomura.  The absence of criminal prosecution, heavy fines, and punishment for all parties (not just those that profited from the information) argues for the case that the Japan SESC is not currently doing enough to deter and reduce insider trading.  Regardless of whether individuals in Japan face social consequences for actions such as insider trading (e.g. stunted career prospects, lost jobs, etc.), there still must be strong and enforceable ramifications for those who violate the fairness of the market through insider trading. Yet, Japan is likely to persist in its practice of not placing tougher penalties to deter offenders.

Following this scandal, Nomura, like other international banks who acted badly, is still recovering and hoping to move on as lightly scathed as possible, from its insider trading scandal.  However, while the clients the company lost may eventually return, the damaged reputation and credibility could have a lasting impact.  Nomura’s ethical lapse may prove to be a costly mistake.
By: David Barnes

Citations

Boatright, John Raymond. Ethics in Finance. 2nd ed. Malden, MA: Blackwell Pub., 2008. Print

Emoto, Emi, and Nathan Layne. “Nomura CEO Quits as Insider Trading Scandal Widens.” Reuters. Thomson Reuters, 26 July 2012. Web. 19 Nov. 2012. <http://www.reuters.com/article/2012/07/26/us-nomura-ceo-idUSBRE86P03S20120726>.

Hyuga, Takahiko, and Russell Ward. “Japan’s Insider-Trading Carousel.” Business Week. Bloomberg Business Week, 09 Aug. 2012. Web. 19 Nov. 2012. <http://www.businessweek.com/articles/2012-08-09/japans-insider-trading-carousel>.

Layne, Nathan. “Japan Calls for Tougher Insider Trading Rules.” Reuters. Thomson Reuters, 11 June 2012. Web. 19 Nov. 2012. <http://www.reuters.com/article/2012/06/11/us-japan-insider-regulations-idUSBRE85A01Y20120611>.

Nakamoto, Michiyo. “Nomura Admits Insider Trading Mistakes.” Financial Times. Financial Times, 29 June 2012. Web. 26 July 2012. <http://www.ft.com/intl/cms/s/0/da348c24-c1d7-11e1-8e7c-00144feabdc0.html>.

Nakamoto, Michiyo. “Nomura States Its Regret after Insider Trading.” Financial Times. Financial Times, 21 Mar. 2012. Web. 26 July 2012. <http://www.ft.com/intl/cms/s/0/58b68af8-7353-11e1-aab3-00144feab49a.html>.

“Nomura Holdings | History.” Www.nomuraholdings.com. Nomura Holdings, n.d. Web. 18 Nov. 2012. <http://www.nomuraholdings.com/company/group/holdings/history.html>.

“Nomura Slapped With Fine in Insider Trading Case.” Business Week. Ed. AP NEWS. Bloomberg Business Week, 31 Oct. 2012. Web. 18 Nov. 2012. <http://www.businessweek.com/ap/2012-10-31/nomura-slapped-with-fine-in-insider-trading-case>.

Tabuchi, Hiroko. “Nomura Chief Resigns Over Insider Trading Scandal.” Nomura Chief Resigns Over Insider Trading Scandal Comments. New York Times, 26 July 2012. Web. 19 Nov. 2012. <http://dealbook.nytimes.com/2012/07/26/nomura-chief-resigns-amid-insider-trading-scandal/>.

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What Do Private Equity Funds Do?

Private equity funds seek to meet the funding needs of companies that are either unable to or not willing to go public.  These funds pool investment dollars to provide funding for capital investment and growth for privately held companies.  They typically have a lifespan of 10 years, often with annual extensions available thereafter.  Initial funding is accomplished by seeking investors to pledge large sums of money at the inception of the fund, which will then be drawn on over the life of the fund.  The fund is typically structured in a way that creates a limited partnership between investors and fund managers, with oversight and decision making reserved for the fund managers.  With the potential of high returns, as much as 30% or more for highly successful funds, private equity funds are an attractive option to expand the portfolios of ambitious investors.

The fund managers earn revenue through management fees, performance bonuses, and capital gains.  Management fees are typically 1% to 2% of the total committed capital, regardless of fund performance.  If the fund performs well, managers can earn performance incentives up to 20% or more of profits, providing the hurdle rate is achieved.  The hurdle rate is a predetermined measure of performance that investors are expecting, such as an annual return of 8%-12%.  If this is met, a performance bonus is earned based on profits of the portfolio companies, with the remaining profits being paid out to investors in the fund.

While investment styles can vary from fund to fund, they generally have the same characteristics.  The fund seeks out investments to fund the growth and expansion of portfolio companies, that is, a collection of different companies, often from various industries.  This approach is done to diversify the fund and mitigate the risk involved; the more companies in a funds portfolio, the greater the diversification, and the lower the overall risk of default or loss.  The fund is financed from either capital investments from individuals and companies, or through leverage.  Leverage in private equity funding is typically obtained from commercial and investment banks, and to a lesser extent, hedge funds, by taking on liability.  Due to this leverage, some private equity funding is considered a leverage buy-out, or LBO.  It is this side of the business that has come under great scrutiny during the past few years, given the condition it has left funds, companies, and investment banks in.

The objectives of these funds are fairly straightforward.  As stated, private equity funds are formed to provide funding to private companies, while offering attractive returns to investors.  This funding is intended to help firms grow and prosper, which is then returned in part to investors and fund managers.  These relationships are not intended to be a permanent source of funding, with most relationships ended after a 10 year period.

In short, the objective once a fund is formed is to make money, cash out their position, and repeat with another portfolio of companies.

Common exit strategies include a sell off or spin off of the fund’s equity position in the company, or an initial public offering of the company, with the goal of a positive return for the fund.  Profits realized upon exit, along with fees and bonuses collected during the life of the fund is how managers ultimately measure the success of a fund.

Who Invests in Private Equity Funds?

The investors in private equity funds typically consist of two classes: wealthy individuals, and institutional investors, such as insurance companies, pension plans, public universities, and endowments.  With the typical capital commitment being $1MM or more, the average investor is priced out of these investment instruments, and the often lucrative returns associated with the funds.

Returns are expected to be high, and are demanded by investors to offset the risks that they are taking.  Liquidity of investment dollars is very low.  Large amounts of capital are committed over a long period of time.  Sometimes the commitments are not fully funded i.e. invested in companies, presenting opportunity cost risk to investors.  In addition, investors take a passive role, as decisions and daily fund transactions are left to the managers of the fund.  As most investments go, there is no guarantee of return, or even that the fund will be successful.  Investors in these funds stand to lose everything they invest, and potentially more if they are highly leveraged.

What are Some Ethical Considerations of Private Equity Funds?

While there are several aspects of private equity funds, such as fee structures, fund objectives, and investor motives, to analyze from an ethical viewpoint, we focus on one aspect: the consequences of high leveraged buyout funding.  The issue to be addressed is, what are the risks, ethical implications, and ethical questions when banks become involved in high leveraged buyouts?  Who ends up paying the most when these highly leveraged funds fail?  Are high risks being passed on to investors for the sake of fund revenue, or are large amounts of debt being pushed into funds for the sake of investment profits?

First, the parties involved include, but are not necessarily limited to the investors, the individuals represented by the investors in the case of investing firms, the management companies and their employees, investment banks and their employees and clients, and portfolio companies and their employees and clients.  The funds have the potential of impacting a significant number of people from different groups.

The inherent risk, and potential ethical pitfalls arise from actions driven by the non-virtue of greed.  The bank providing funding can see the lucrative nature of a deal, and may cross ethical lines to provide the amount of funding requested beyond what is prudent.  Overlooking certain aspects of the fund during underwriting, creatively packaging the debt to improve the look of their balance sheet, or having self-interests in the portfolio companies are also issues that a bank may face.  If these were to occur, the systemic risk to the credit market through interdependencies could be greatly increased.  Consider this hypothetical:

Suppose JP Morgan Chase stretched its underwriting guidelines to provide significant funding to a private equity firm with a limited number of companies in its portfolio.  Within this portfolio is a large cap firm that has deposit relationships and a guaranteed line of credit with JP Morgan that is very profitable to the bank.  It is under this consideration that JP Morgan was willing to “bend the rules” during the underwriting process to indirectly benefit this high value client.  Fast forward a few years and the economy has taken a turn for the worse.  Some of the companies that are in the equity fund’s portfolio are performing poorly, and a few have gone under.  As a result, the remaining companies, that also are struggling, are not able to service the debt obligation of the equity fund’s liability to JP Morgan.  Soon the fund becomes insolvent and the large cap firm that was part of the portfolio loses key funding during an already difficult economic time.  What might the results of this situation be?

Due to the overly leveraged position that JP Morgan created, they are now facing a very large loss that will impact their shareholders as the stock takes a hit.  The large client that originally benefited from the additional funding of the private equity firm is now without a major source of funding, and is struggling to stay solvent.  Meanwhile, JP Morgan has called its line with the client to help offset the losses it suffered from the failure of the equity fund.  The problem is the client who owes on the equity line has no means to pay.  JP Morgan is now facing another large loss as the client defaults on the line of credit, and goes under.  Due to a failure to follow strict underwriting guidelines and overleveraging the fund while ignoring key interdependencies and obvious conflicts of interest, the bank has taken huge losses, a private equity fund is now insolvent, and a portfolio of companies is in financial trouble.  These issues reach out into the market, demolishing consumer confidence and driving down stock prices. While this is a purely hypothetical example and perhaps slightly sensationalized, it illustrates the complexity of these deals and the far reaching impact that a lapse in moral judgment can cause.

The Good of Private Equity Funds

While that was one example of what might potentially happen, there are other considerations before writing off private equity funds altogether.  These funds have the potential to offer positive benefits for those involved as well.  The companies that become part of the portfolio receive funding for capital investments without going through the expense and time of a public offering, and are able to limit the ownership stakes in their companies to those with whom they choose to work.  This infusion of cash helps a company grow, which can in turn creates a positive impact on: (1) the economy, (2) individuals working for and with the company, (3) increased tax revenue for the government, which can help society and people that have no direct relationship with the fund or the portfolio companies.  In addition, the investors and fund managers benefit financially which may be good for the economy.

When working under moral and ethical considerations, private equity funds can benefit those involved and society as a whole.  These funds serve an important role in the financing of new and growing companies, offering opportunities that may not otherwise exist.  However, when financial decisions and actions are principally driven by greed, ethical issues take on little importance.

Greed and Christian Deontological Considerations

It is worth examining the idea of greed under an ethical/moral framework.  To this end, we attempt to apply Christian moral philosophy to the idea of wealth and greed by examining what the tradition says on the subject.

The question to ask is whether being wealthy is right.  Is it moral to make money?  The answer is yes, if the condition of the heart is right.

Christian ethics proposes that God wants to bless His followers, and that He will always provide for them.  Deuteronomy 7:13 says “…He will bless the fruit of your womb, the crops of your land – your grain, new wine and olive oil – the calves of your herds…”  We do not need to worry about money as God will provide for us according to Matthew, chapter 6, verses 25-33.  The passage details how God has provided more than enough food for the birds, and how beautiful the flowers of the fields are dressed, even though these things will not last. With this mindset, we should not be greedy, as greed is in direct opposition to the trust we are to have.

An important factor to consider is that we are not the ultimate owners of our wealth.   Anything God provides us, whether it is food to eat, clothes to wear, or millions of dollars from a successful private equity fund, is not ours but His.  Psalm 24:1-2 says the following: “The earth is the Lord’s, and everything in it, the world, and all who live in it; for He founded it on the seas and established it on the waters.”  God created it all, and He owns it all.  When one fully grasps this idea and submits to it, one quickly sees how insignificant they and “their” wealth are in comparison to God; they see the foolishness in the greed of possessions and the accumulation of wealth.

According to Christian ethics, it is not enough to simply sit back and let God bless you.  He calls us to action, and commands us to be good stewards of that which He has provided.  Luke 12:48 states “…From everyone who has been given much, much will be demanded; and from the one who has been entrusted with much, much more will be asked”.  This idea of good stewardship and action on our part is clearly set forth in the Parable of the Talents, recorded in the book of Matthew, Chapter 25, verses 14-30.

In this parable, there are three servants, each of whom their master entrusted a portion of his wealth.  Two of the servants, having received the most, invested the money wisely and earned a handsome return on it.  The third servant, given the least, feared that the small amount might be lost, so he hid it in the ground.  When the master returned, he called the servants to see what they had done with the wealth that was entrusted to them.  He was pleased with the two who had trusted and wisely invested the funds, but called the third servant wicked and lazy, as he did not even earn interest on the funds due to his fear and inaction.  Through this parable, we can see the ethos of using what we have been entrusted with wisely to the benefit of those around us.  This idea is in stark contrast to the idea of personal wealth accumulation and greed.  Greed, or hoarding, is not ethical, and those who do so out of personal gain or fear rather than using what they have been given for good will be judged accordingly.

Christian ethics clearly proposes humans are not the ultimate possessors of wealth but must instead be good stewards.  To do otherwise is ethically wrong, whether in the context of talents, time, or financial success in investments.  So what about being greedy?  While the previous ideas should be enough to convince someone not to be filled with greed according to Christian ethics, clearly many struggle to uphold this principle. Matthew 6:24 states: “No one can serve two masters.  Either you will hate the one and love the other, or you will be devoted to the one and despise the other.  You cannot serve both God and money”

Further warning of greed is found in the book of Proverbs:

 “The greedy bring ruin to their households, but the one who hates bribes will live” – Proverbs 15:27

Thus, being wealthy, having success financially, is not unethical in itself.  Our ethical evaluation is determined by how one gets wealth, uses wealth, and approaches wealth. 1 Timothy 6:10 says “For the love of money [not money itself] is the root of all kinds of evil.  Some people, eager for money, have wandered from the faith and pierced themselves with many griefs”.  These words were written two millennia ago, but they still are applicable to evaluating the ethics of how wealth is generated by private equity funds.

BY: THOMAS ADEN

SOURCES CITED

Thomas More Griffin | “Effect of the recession on private equity and leveraged buy-outs (LBOS): Burned, but the phoenix is rising from the ashes” | March 2010 | Web, accessed 11-20-12

[http://www.wcl.american.edu/blr/documents/effects_recession.pdf]

Wikipedia | “Private Equity Fund” | November 2012 | Web, accessed 11-20-12

[http://en.wikipedia.org/wiki/Private_equity_fund]

Bible Gateway | Zondervan Corporation, LLC, ©1995-2010 | Web, accessed 11-20-12

[http://www.biblegateway.com/]

Daniel Sweet | “Parable of the Talents: True Meaning Explained” | God’s Word First | Web, accessed 11-20-12

[http://www.gods-word-first.org/bible-study/parable-of-talents-explained.html]

Photo: Courtesy of Flickr: Peter Elman Photos

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A Short Introduction to Virtue Ethics                                   

Virtue ethics is an agent-based approach to ethics. This approach focuses on the fundamental character and motivations of the individual moral agent. Moral behavior is not limited or attached to a rule or any guidelines, but rather involves the individual rationally pursuing moral excellence as a goal in and of itself. According to Aristotelian virtue ethics, virtue is defined as a desirable character trait, such as courage, that lies between two extremes, rashness and cowardice. The virtuous agent is involved in a continual quest to find balance in ethical decision-making. Such an agent does not apply any specific ‘rules’ in making ethical decisions, but rather attempts to make decisions that are consistent with the pursuit of a particular kind of excellence that entails exercising sound moral judgment guided by virtues like courage, wisdom, temperance, fairness, integrity and consistency.

Virtue ethics is currently one of three major approaches in normative ethics. It may, initially, be identified as the one that emphasizes the virtues, or moral character, in contrast to the approach that emphasizes duties or rules (deontology) or that which emphasizes the consequences of actions (consequentialism).

Suppose it is obvious that someone in need should be helped. A utilitarian will point to the fact that the consequences of doing so maximizes happiness of those affected by the act of helping. A deontologist points to the fact that, in helping the one in need, the agent is acting in accordance with a moral rule such as “Do unto others as you would be done by”. A virtue ethicist points to the fact that helping the person is exercising the character trait of benevolence. All the three moral theories will agree that helping the person in need is ethically correct.

Aristotle is an early developer of virtue ethics. Aristotle writes, “The virtue of man also will be the state of character which makes a man good and which makes him do his own work well“. The aim is to perform the right action, with the right person, to the right extent, at the right time, and in the right way. Although this is the objective, Aristotle considers achieving this goodness as rare, laudable, and noble

Aristotle believes people are naturally suited to do the right thing, but do not automatically develop such inclinations to do “good”. He strongly believes you are what you do, so in that respect the ideal virtuous person does the right thing because she desires to be virtuous. One cannot be accidentally or coincidentally virtuous.

The virtue ethics approach focuses on the “integrity” of the moral actor. The goal with this approach is to be a good person. In virtue ethics, one’s character emerges from a “relevant moral community”.  Therefore, it is important to account for the moral agent’s community or communities within which she operates. This approach is particularly useful for individuals who work within a professional community that has developed high standards of ethical conduct for community members

Moral Virtue is a Habit

Aristotle’s criteria for the virtuous person is as follows: You must have knowledge, consciously choose the acts and choose them for their own sake, and the choice must come from a firm character, in accordance to who you are. You must consistently choose to do good acts deliberately for the right reasons. You cannot be considered virtuous for catching a ball before it hits a child in a baseball game thus saving that child, if you simply wanted to catch the ball and take it home with you as a trophy to show to your friends. You should have saved the child from the incoming ball out of genuine virtue and care towards the child.

To achieve the ability to be moral requires developing the proper character. To develop the proper character requires developing virtues. To develop virtues requires developing moral habits. Aristotle said, “By abstaining from pleasures we become temperate, and it is when we have become so that we are most able to abstain from them“. What begins as a great effort to give up, in time and with effort and practice becomes quite normal and is no effort at all. Aristotle also believes we learn virtue by doing the right things constantly until we are habituated. We learn by doing as children and character is the result of habits, which in turn, are developed from repeated actions.

There are 2 types of virtues. Intellectual Virtues are excellences of the mind, for example, the ability to understand, reason, & judge well. Intellectual virtue comes from being taught. Moral Virtues are learned by repetition. For example, by practicing honesty we become honest. To be virtuous requires knowledge, practice & consistent effort for character building. Moral virtue results from developing proper habits. Neither intellectual nor moral virtue arise without active intervention and participation. According to Aristotle, “We first acquire the potentiality and later exhibit the activity“. We develop virtues by practicing them. In a similar vein, we learn the arts and music. We learn virtues by doing them repeatedly and forming the correct habits as a young basketball player learning to shoot the ball.

In personal/life development, virtue ethics transforms the meaning of doing “What is right and wrong?” to “What kind of person you are and does this action fit into what you are?” Virtue ethics in personal development allows a dynamic way of thinking that allows a person to grow and to learn that everything is not black and white.

A virtuous person is not simply one who just does a good or right act once in a while, rather a virtuous person is someone who “consistently” chooses the right acts for the right motives. Being virtuous is a habitual act and you are what you do. If you lie constantly, you are a liar and the act of lying establishes that character trait in you. In business, if you cut corners and practice unethical business tactics you are an unethical businessman.

Virtue Ethics Theory Applied:             

Rajat Gupta and Insider Trading

The Players

Rajat Gupta is an Indian American businessman who was the managing director of management consultancy McKinsey & Company and a business leader in India and the United States. Rajat Gupta also served as corporate chairman, board director or strategic advisor to Goldman Sachs, Procter and Gamble and American Airlines, and non-profits organizations, The Gates Foundation, The Global Fund and the International Chamber of Commerce.

Rajat Gupta was convicted in June 2012 on insider trading charges. He was sentenced in October 2012 to two years in prison, an additional year on supervised release and ordered to pay $5 million in fines. His trial began on May 22, 2012. On June 15, 2012, Gupta was found guilty on three counts of securities fraud and one count of conspiracy.

The primary parties are affected are Rajat Gupta, McKinsley & Company, Goldman Sachs, Raj Rajaratnam, Galleon Group, Warren Buffet, and the U.S. equity markets. Other parties indirectly affected are family and friends of Rajat Gupta, employees at McKinsley & Company and Galleon Group, investors in Goldman Sachs and its creditors, and government and officials involved with the case.

The Transactions

In September 2008 Warren Buffet agrees to pay $5 billion to Goldman Sachs in exchange for preferred shares in the company. This news is likely to raise the share price of Goldman Sachs. The news is not supposed to be announced and made public until the end of day. Less than a minute after the board approved the Buffet purchase, Rajat Gupta calls his longtime friend Raj Rajaratnam, a hedge fund manager and billionaire founder of Galleon Group. Once Rajaratnam gets this information, he immediately buys shares of Goldman Sachs. Next day when the stock market opens, Raj Rajaratnam makes nearly $1.2 million in profits as Goldman Sachs shares rose. The SEC estimates the tip leaked by Rajat Gupta generates profits and avoids losses of more than $23 million.

Ethical Analysis

Would a virtuous person have leaked the information to Raj Rajaratnam? Rajat Gupta showed a failure of character:

Integrity: Integrity is honesty and truthfulness or accuracy of a person’s action. Rajat Gupta does not show integrity to his company Goldman Sachs, where he was a Board of Director. Instead gives away insider information for personal benefits.

Trust: Rajat Gupta broke the trust to other Directors on Goldman’s board and to of other people with whom he has done business. His actions affect the relationship with McKinsley & Company.

Fairness: Rajat Gupta’s actions are not fair for two reasons. First, other investors who do not have the information on Buffett’s deal are at a disadvantage. Second, he uses the information entrusted to him to benefit himself and Rajaratnam.

Honesty: He was not honest with Goldman Sachs and his fellow board members to whom he implicitly promised not to share inside information.

Self-Control: If Rajat Gupta had self-control he would not have leaked inside information to Rajaratnam for personal gain.

Gupta was commended by people who knew him as a person who helped others. He was very active in providing medical and humanitarian relief to the developing countries. Born to humble circumstances, he became a pillar of the consulting community and a trusted advisor to the world’s leading companies and organizations. A word that was used repeatedly in media coverage for Rajat Gupta during his trial was “respected.” In the past, much less so now, we assume people in leadership positions are virtuous. However, instances like the Rajat Gupta insider trading case and other financial scandals remind us that the assumption is not well-founded

As a true professional, the good manager strives to achieve a moral excellence that includes honesty, fairness, prudence, and courage. Various mechanisms are suggested to develop moral character amongst practitioners and avoid ethical lapses as in the Rajat Gupta case. Suggestions include tighter government regulations, better systems and processes in financial institutions, enhanced corporate governance, and increasing the awareness of customers. Yet, a root of the problem is not addressed: not teaching financial ethics in business schools, where moral decision making should be the core lesson. If business schools provide future financial managers with a proper ethical education, there is a chance that situations like “Rajat Gupta and Insider Trading” may occur less frequently.

By: Pratik Patel

Works Cited

1. http://www.innovation.cc/scholarly-style/virtue-ethics-corruption.htm
2. Linda K. Trevino, Katherine A Nelson, “Managing Business Ethics”, (2010) Fifth Edition
3. James Rachel, “The Elements of Moral Philosophy”, (2009) Sixth Edition
4. Raj Gupta: Virtue is never a Given, Retrieved from
5. http://www.forbes.com/sites/johnbaldoni/2012/10/25/raj-gupta-virtue-is-never-a-given/
6. Blame Business Schools, Electronics Resource, Retrieved from http://www.businessweek.com/debateroom/archives/2008/11/us_financial_cr.html
7. http://ejbo.jyu.fi/articles/0901_3.html
8. http://www.innovation.cc/scholarly-style/virtue-ethics-corruption.htm
9. http://edoc.ub.uni-muenchen.de/12156/1/Villa_Jesus_Simeon.pdf
10. John Graafland & Bret Van de Ven, “The Credit Crisis & the Moral Responsibility of Professional in Finance”

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Summary:                          

The Financial Services Authority (FSA) of the United Kingdom, imposed record fines against David Einhorn and his hedge fund Greenlight Capital for market abuse in the form of insider trading. This article describes Einhorn’s actions. It gives reasons the FSA imposed the punitive judgment based on the FSA’s statutory provisions and regulatory guide. The article analyzes the ethics of Einhorn’s actions and concludes the FSA imposed the large fine for two reasons: first, to show there exist laws by which the financial industry and its members must abide and second, to emphasize to and inform practitioners there also are expectations of a standard of ethics financial professionals must achieve. The emphasis on meeting a standard of ethics also bolsters flagging public confidence in regulators and the financial industry.

The Case:

On January 25^th 2012, the U.K. Financial Services Authority (FSA) filed a civil suit against David Einhorn, President of the celebrated hedge fund, Greenlight Capital. The FSA imposed a fine on Einhorn and Greenlight of £7.2 million (US$12.5 million) for insider trading.[i]  According to the FSA, in early June 2009, David Einhorn was given inside information on Punch Taverns (PUB) [ii], a publicly listed company. The information fits the criteria for insider trading i.e., information of a precise nature that:

1.  Is not generally available
2.  Relates, directly or indirectly, to one or more issuers of the qualifying investments or to one of more of the qualifying investments
3. Would, if generally available, be likely to have a significant effect on the price of the qualifying investments.[iii]

Andrew Osborne, a senior corporate broker with Merill Lynch, on a call with Punch Taverns CEO disclosed information to Einhorn that Punch Taverns was at an advanced stage of equity fundraising.[iv] As a result of this disclosure, Einhorn ordered his traders to sell Greenlight’s shares in Punch Taverns.  Greenlight was able to sell over 11 million shares, reducing its ownership of Punch’s equity from 13.3% to 8.89%.  Days later, the Punch CEO publically announced fundraising of £375 million ($582 million) resulting in Punch’s shares falling nearly 30%.  Greenlight capital was able to avoid £5.8 million ($9 million) in losses.[v]

After an investigation the FSA decided Andrew Osborne, David Einhorn, and Greenlight Capital, had committed insider trading and would be fined for market abuse.

The FSA fined Osborne £350,000 for market abuse.  The FSA stated that Osborne disclosed inside information to Einhorn without signing a Non-Disclosure Agreement (NDA).   While the nature of Osborne’s offense was not deliberate the FSA reasons action is necessary to ensure the high standard of market integrity and, in turn, facilitate market confidence.  The FSA explains that as Osborne was a senior broker with extensive experience in wall-crossing procedures, Osborne should have taken greater care to avoid disclosing sensitive information, to comply with the regulatory requirements, in the absence of an NDA.[vi]  (To be wall-crossed is to make an investor an insider. Hence, the investor crosses the wall that separates investors from insiders.)

Furthermore, because of Osborne’s familiarity with NDAs, Osborne was at fault for not realizing the disclosure of inside information had occurred and did nothing to present this information to senior Merill Lynch management as a potential concern.

The FSA fined Einhorn and Greenlight capital £3,638,000 ($5.7 million) and £3,650,795 respectively. The FSA stated that while Einhorn’s actions were not deliberate, “investment professionals are expected to handle inside information carefully regardless of whether they have been formally wall-crossed.”

Tracey McDermott, acting director of enforcement and financial crime, explains that because Einhorn is an experienced professional with a high profile in the industry, he is expected to be able to identify inside information when he receives it and should act appropriately. His actions breached the FSA’s expected standards of market conduct.[vii]

Einhorn’s Argument Against the FSA Judgment:

Einhorn maintains he was not involved in insider dealing. Einhorn never intended to receive inside information and refused to sign an NDA. “[Greenlight] had no interest in becoming an insider,” he said recalling he told the company he would be, “…happy to talk to management, but not interested in receiving information to trade stock.”[viii] He believes the FSA’s action is “truly frightening.” [ix]

Why this dramatic statement? First, Einhorn argues he declined to sign an NDA. Secondly he declared his intention to sell his stake. Third, there was no blatant disclosure of inside information.

The phone call between Einhorn, Osborne, and the Punch CEO began with the Punch CEO explaining to Einhorn the company had sold 11 of its pubs that morning. The company was considering strategic options such as raising equity with the purpose of repaying Punch’s convertible bond and creating a cash buffer.  When asked about the share price, the CEO answers the company’s shares were fairly priced.  Einhorn was concerned by the CEO’s pessimism and believed raising equity to be a terrible idea for Greenlight and its shareholders.[x]

Consequently, Greenlight sold some of its shares and avoided large losses.  Einhorn believes this is not a case of insider trading and says that these actions “resemble insider dealing as much as soccer resembles [American] football.” Although Einhorn does not agree with the FSA’s decision he and Greenlight capital will not seek to appeal the fine.

Regulatory Implications:

In analyzing the British FSA’s decision there are a number of variables to which one should look to determine the intention and ultimately the purpose of the statement made by the FSA.  In the actions taken against Osborne and Einhorn, the British FSA is more than penalizing individual decisions and lack of awareness.  The regulator is making a larger statement to the entire finance industry. The first statement notes that there exist laws by which the industry and its members must abide. The second statement emphasizes to and informs practitioners there also are expectations of a standard of ethics that financial professionals must work towards achieving. This second statement is also meant to bolster flagging public confidence in regulators and the financial industry.

Ethical Analysis:

Determining the ethical implications of the FSA decision requires consideration of the role of the FSA. The institution is a financial regulatory body, independent from the UK government. Although independent, the FSA is run by a non-executive board of members appointed by the National Treasury.  The FSA’s main goal is to regulate close to every financial service in the U.K. The FSA Act of 2000 sets out four statutory objectives for the institution:

1. Market confidence – maintaining confidence in the U.K. financial system
2. Financial stability – contributing to the protection and enhancement of stability of the U.K. financial system
3. Consumer protection – securing the appropriate degree of protection for consumers
4. Reduce financial crime – reducing the extent to which it is possible for a regulated business to be used for a purpose connected with financial crime.[xi]

Although the main goal is to protect and regulate the U.K. financial system, the FSA assumes a larger responsibility over international finance. To achieve its goals, the FSA took action against Greenlight and David Einhorn. In the FSA’s opinion, Einhorn was able to act on inside information because of his privileged position at Greenlight.  The FSA’s apparent motivation to fine Osborne and Einhorn was to punish market abuses and to uphold market confidence and stability.

Consider the magnitude of the fine imposed by the FSA.  In November of 2011, the FSA fined Dubai-based investor Rameshkumar Goenka a record $9.6 million for market abuse.  This record fine was exceeded no more than two months later by the $12.5 million in fines levied on David Einhorn and Greenlight Capital.  In a statement Tracey McDermott explains that, “the fine levied against Goenka was high because of his extensive experience as an investor.” McDermott uses a similar reason for the fines against Einhorn. Furthermore, “[Goenka’s] action was pre-planned and intentional, and, because he intended to take the same action in relation to another structured product.”[xii]  In contrast, the FSA publicly said that Einhorn’s actions were not a deliberate exhibit of market abuse.  By setting a new record in fines, the sanctions imposed on Greenlight, however, imply Einhorn’s offense was somehow worse than Goenka’s intentional market abuse.  The FSA’s explanation for the fines seems inconsistent with dollar amounts when comparing similar cases.

The FSA claims Einhorn’s position necessitates better ethical conduct in dealing with information of this type. From Einhorn’s perspective, he was in contact with the Punch CEO and Andrew Osborne in June about the then state and plan for Punch Taverns.  When prompted, Einhorn refused to be wall-crossed and refused to sign an NDA.  This meant that Einhorn refused to receive any inside information regarding the status and management of Punch Taverns.  Any further conversation between the two parties would be on an open basis.  During the call, the Punch CEO and Osborne discussed a potential equity call and plans for upcoming fundraising.  Einhorn expressed his displeasure with the plan saying it would be, “shockingly horrible from my perspective.”  So horrible that Greenlight sold over 11 million shares.  The question to which the FSA vehemently answered affirmatively was, can Einhorn’s subsequent action to the call be considered market abuse?

Einhorn refused an NDA. With the refusal, there was to be no disclosure of inside information. Einhorn could have inferred that a potentially adverse change was coming when asked if he wanted to sign an NDA, as Greenlight capital was one of Punch Taverns largest investors.  At this point Einhorn was smart to refuse being wall-crossed and may have realized that Punch Taverns was in trouble.  On the offer of an NDA alone Einhorn could have decided to sell significant shares in Punch Taverns.  If this had been the case the FSA would have little basis to fine Einhorn for market abuse. Einhorn was merely acting on his deductive reasoning.  However, the talks between the two parties continued on an open-basis.

Andrew Osborne was fined by the FSA for market abuse by disclosing sensitive inside information without an NDA.  The FSA claimed that a man in Osborne’s position and experience should know better. The FSA deemed Osborne’s conduct as being subject to punishment. Should Einhorn have foreseen Osborne’s negligence and refused the open basis phone call with a company in which Greenlight, and Einhorn himself, had a large stake?  Refusal would have been detrimental to Greenlight’s investors.

What seems to have occurred in this instance is that Punch Taverns, after selling 11 of its pubs that morning, was in serious financial need.  In asking Einhorn to be wall-crossed, the hope was that he would agree. Thus, if Einhorn had agreed to be wall-crossed, he could not sell shares in Punch, possibly decreasing confidence in the company.  After Einhorn refused, the conversation continued. Einhorn was made aware of the upcoming fundraising plans for Punch Taverns.   The information meets all three criteria of the FSA’s definition of insider dealing.  Punch Taverns may have intentionally disclosed information as a tactic to force Einhorn to stay on board.

Facing a dilemma, Einhorn acted to the benefit of Greenlight capital and sold shares, avoiding large losses. Einhorn could have planned on selling shares simply on the basis of being asked to sign an NDA.  He could have assumed that things for Punch were going downhill.  Osborne and the Punch CEO broke the law by disclosing inside information to Einhorn when he refused to be wall-crossed.  Einhorn was put in an undesirable position.  Where do his obligations lie – obey the law, or protect his shareholders? In this case, if Einhorn did what the FSA considered right, he would have watched as Greenlight capital and its investors suffered large losses as a result of the equity call. Einhorn merely acted to protect Greenlight’s investments.

The response to the question of Einhorn’s fiduciary duty is clear and indisputable: no one has a fiduciary duty or obligation to act unethically. An agent has a fiduciary duty to act in the best interest of the client – but never if the act is unethical.

Yet, it seems redundant to penalize Einhorn for someone else’s, intentional or unintentional, negligence. Should we blame Einhorn for being given information he openly declined?  Did the FSA over reach its authority in penalizing Einhorn?

The response to whether Einhorn is blameworthy for his act is given by the FSA when it imposed the largest individual fine in FSA history at that time.  Einhorn and all others in a similar position should recognize insider dealing when it occurs and are obligated to inform the advisor (i.e. Merrill Lynch) of a potential concern.

The record setting fines may seem unfair especially considering the circumstances.  The last fine of this magnitude, in the Goenka case, penalized an individual for blatant and pre-meditated market abuse.  The FSA openly stated that Einhorn’s actions were neither planned nor deliberate.  However, the FSA is not required to act on precedent.  The regulator reasoned this kind of abuse had to be prevented.  Accordingly, in punishing Osborne, the FSA points fault at one of the parties of the insider trading.  It was Osborne who failed to uphold Einhorn’s refusal to be wall-crossed.

Einhorn may be considered a victim.  Some believe he only acted to preserve his company’s interests.  Yet, it takes two to tango.  For insider trading to occur there must be a tipper (the one who discloses the insider information) and the tippee (the one who receives the insider information and acts on that information). Einhorn should not have acted on that information. Even though Einhorn maintains no real inside information was disclosed, his professional experience should have served him better.  The information transmitted does fall under the criteria set out by section 118C(2) of annex one of the Relevant Statutory Provisions and Regulatory Guide.  Although Einhorn refused to receive information of this type, the fact is, he did.  From a legal perspective, the law was broken whether deliberately or not, and the FSA has to uphold a standard of ethical conduct.

There may be more debate about the degree to which the FSA punished Einhorn.  Einhorn may be “shocked” by the FSA’s sanctions in light of the Goenka case.  However, the FSA’s actions are a statement to financial professionals everywhere that there is a standard of ethic necessary to promote market confidence and protect the financial industry.  The sanctions levied against Einhorn will hopefully deter future issues of this type.  The FSA displayed a large degree of the autonomy, showing the regulator’s adherence to its four core objectives.  Einhorn may be unsatisfied with the FSA’s decision and may maintain that his actions resemble insider trading as much “as soccer resembles football”. While soccer and football are different in their scoring, speed of the game, even shape of the ball, the two have one crucial factor in common.  Without referees to ensure fairness and rules of the game to give all participants an equal chance of success, games cannot be played and the sports cannot prosper.  The FSA may not be wearing stripes or blowing whistles but imposing the $12 million dollar yellow-card on Einhorn is a statement to all players that the rules are real and must be followed.

BY: EDWARD REED

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Introduction

The term deontology comes from the Greek word deon, meaning duty. The theory of deontology states we are morally obligated to act in accordance with a certain set of principles and rules regardless of outcome. In religious deontology, the principles derive from divine commandment so that under religious laws, we are morally obligated not to steal, lie, or cheat. Thus, deontological theories and duties have existed for many centuries. Immanuel Kant, the theory’s celebrated proponent, formulated the most influential form of a secular deontological moral theory in 1788. Unlike religious deontological theories, the rules (or maxims) in Kant’s deontological theory derive from human reason.

To better understand deontology, compare it to some opposing theories, such as utilitarianism, which says we have an obligation to take the course of action that achieves the most positive outcome or consequence. According the theory of utility, the best consequence is happiness/pleasure, because it is considered the absolute good. Consequentialism tells us we need to take into account the final consequence of our action, even if the act itself is not morally good.

Immanuel Kant

Immanuel Kant was born in 1724 in the Prussian city of Königsberg. He essentially spent his whole adult life at the university and never truly travelled outside of the city. He only stopped working at the university three years before his death. He was a philosopher and scientist specializing in many areas, including mathematics, astrophysics, geography and anthropology. He wrote several dense, difficult-to-read but highly influential texts regarding metaphysics, metaethics and practical morality, science, history and politics. He was the first recorded scholar to suggest that some of the faint nebulae visible with a telescope are actually separate universes in the sky.

As with many scholars of his time, Kant’s new ideas and published works about the nature of reality and free will were widely condemned, but they have remained prominently influential to this day. In terms of ethics, the most significant of his works are Groundwork in the Metaphysics of Morals (1785), Critique of Practical Reason (1788), and Metaphysics of Morals (1798). These texts constitute the foundation of Kant’s own moral philosophy.

A Theory of Duty

Some terminology to consider:

Moral agent: An agent is a person who performs an action; a moral agent is a person with the capacity to act morally.

Maxim: rule or principle

Will: the faculty of deciding, choosing, or acting

Deontological theories differ from utilitarian theories in several key ways. The most notable difference is utilitarianism aims at a goal of greatest happiness (or the best consequence) and justifies any act that achieves that goal. Deontological theories hold that some acts are always wrong, even if the act leads to an admirable outcome. Actions in deontology are always judged independently of their outcome. An act can be morally bad but may unintentionally lead to a favorable outcome.

Kant is responsible for the most prominent and well-known form of deontological ethics. Kant’s moral theory is based on his view of the human being as having the unique capacity for rationality. No other animal possesses such a propensity for reasoned thought and action, and it is exactly this ability that requires human beings to act in accordance with and for the sake of moral law or duty. Kant believes human inclinations, emotions and consequences should play no role in moral action; therefore, the motivation behind an action must be based on obligation and well thought out before the action takes place. Morality should, in theory, provide people with a framework of rational rules that guide and prevent certain actions and are independent of personal intentions and desires.

According to Kant, the moral worth of an action is determined by the human will, which is the only thing in the world that can be considered good without qualification. Good will is exercised by acting according to moral duty/law. Moral law consists of a set of maxims, which are categorical in nature – we are bound by duty to act in accordance with categorical imperatives.

Categorical Imperatives

There are three formulations of Kant’s categorical imperative.

The First Formulation of the Imperative

“Act only according to that maxim whereby you can at the same time will that it should become a universal law without contradiction.” – Immanuel Kant, Groundwork of Metaphysic of Morals

Kant states that a true moral proposition must not be tied to any particular conditions, including the identity of the person making the decision. A moral maxim must be disconnected from the particular physical details surrounding its proposition and should be applicable to any rational being. According to Kant, we first have a perfect duty not to act by maxims that result in logical contradictions.

Second, we have imperfect duties, which are still based on pure reason but allow for interpretation regarding how they are performed. Because these duties depend loosely on the subjective preferences of mankind, they are not as strong as perfect duties but are still morally binding. Unlike perfect duties, people do not attract blame if they do not complete an imperfect duty, but they receive praise if they complete it, for they have gone beyond basic duty and taken responsibility upon themselves. Imperfect duties are circumstantial, meaning that one can not reasonably exist in a constant state of performing that duty. What differentiates perfect and imperfect duties is that imperfect duties are never truly completed.

The first formulation of the categorical imperative appears similar to the Golden Rule: “Do not impose on others what you do not wish for yourself.” Kant’s first categorical imperative sounds like a paraphrase of the Golden Rule. However, the Golden Rule is neither purely formal nor universally binding. It is empirical in the sense that applying it requires context; for example, if you don’t want others to hit you, then don’t hit them. Also, it is a hypothetical imperative in the sense that it can be formulated, and its “if-then” relationship is open for dispute.

The Second Formulation of the Imperative

“Act in such a way that you treat humanity, whether in your own person or in the person of any other, never merely as a means to an end but always at the same time as an end.” – Immanuel Kant, Groundwork of Metaphysic of Morals

This imperative states that every rational action must be considered not only a principle, but also an end. Most ends are subjective in nature because they need only be pursued if they are in line with a hypothetical imperative. (A hypothetical imperative is a demand of reason that is conditional. It tells us how to act to achieve a specific goal e.g. I must drink when I need to slake my thirst.)

For an end to be objective, it would need to be pursued categorically. The free will is the source of all rational action. Because the autonomous will is the one and only source of moral action, it contradicts the first formulation of the categorical imperative to claim that a person is merely a means to some other end instead of an end in him or herself.

Based on this, Kant derives the second formulation from the first. A person has a perfect duty not to use themselves or others merely as a means to some other end. For example, someone who owns slaves would be asserting a moral right to own a slave by asserting their rights over another person. However, this reasoning violates the categorical imperative because it denies the basis for free rational action and disregards the person as an end in themselves. In Kantian ethics, one cannot treat another person as a means to an end. Under the second formulation of the categorical imperative, a person must maintain her moral duty to seek an end that is equal for all people.

The Third Formulation of the Imperative

“Therefore, every rational being must so act as if he were through his maxim always a legislating member in the universal kingdom of ends.” – Immanuel Kant, Groundwork of Metaphysic of Morals

A truly autonomous will is not subjugated to any interest; it is subject to those laws it makes for itself, but the will must also regard those laws as if others are bound by the laws. If the laws are not universal, they are not laws of conduct at all. Kant suggests that people treat themselves and others always as ends and never merely as means. People ought to act only by maxims that harmonize with a possible kingdom of ends. We have a perfect duty not to act by maxims that create incoherent or impossible states of natural affairs when we attempt to universalize them, and we have an imperfect duty not to act by maxims that lead to unstable or greatly undesirable states of affairs for all parties involved.

Using reasoned judgment we can apply this formula to any maxim and discover whether it is morally permissible under deontological ethics. Let’s take, for example, the act of picking flowers from the local park. The flowers are very pretty, and one may want to take some home. Essentially, this requires adopting a maxim that supports doing whatever one wants to do. Using the formula of the universal law (categorical imperative), there are a few irrationalities and contradictions that arise from the adoption of such a maxim as law.  If everyone were to do this, there would be no flowers left in the park, and the act contradicts the original motive for picking the flowers. The better option is to go to a shop and order or plant one’s own flowers.

There are a few acts that are always forbidden, such as lying, which negatively affects trust between people and the meaning of truth. This rule remains the case even when lying has advantageous or even morally admirable consequences. Imagine a psychotic criminal wants to kill your colleague, who fired the psychotic. If you lie about the whereabouts of your colleague, then an innocent life will be saved. It seems moral duty forbids you from lying. However, a higher moral duty trumps the duty not to lie. That is, the obligation not to kill or help others in killing, is a higher moral duty that we should follow.

Alternative Formulation of Categorical Imperative

Kant expressed the categorical imperative in a few different ways. The most important of these is the formula of humanity: “Act in such a way that you treat humanity, whether in your own person or in the person of another, always at the same time as an end and never simply as a means.”

This is a personal perspective on the same moral theory. To fail to do this would be to treat others in a way that contradicts the moral law. For example, if I steal a book from a friend, I am treating him as a means only (to obtain a book). If I ask to have his book, I am respecting his right to say no and am thereby treating him as an end in himself, not as a means to an end. If I only ask for the book in order to appear nice and hope that my friend is likely to do more things for me in the future, then I am still treating him as a means only. It is true that everyone uses people as a means to an end. Bus/taxi-drivers get us where we want to go; factory workers are the means to producing objects and ultimately profit for their employer. But using people only to get what we want and consistently disrespecting their human worth is against moral law. An example of this would be a factory owner providing unsafe working conditions, such as Foxconn in China or factories in countries that impose inhumane working conditions and pay less than minimum wage.

Criticisms

One of the biggest criticisms of Kantian ethics is that it discounts outcome as a valid factor in evaluating the morality of an action. While it is not necessarily wise to rely solely on outcome (as in utilitarianism/consequentialism), it is not a good idea to completely ignore the outcome altogether. Based on Kant’s formula of humanity, human life is sacred and inviolable, meaning one cannot enslave a few people even if it would enable more people to lead better lives. Killing one person to save the lives of millions is impermissible in Kantian ethics.

At times Kantian moral duty seems to contradict our natural inclinations and common sense. If we obey the moral law rather than our intuitions, we are acting morally. Deontological ethics is weaker when it comes to informing us how to live well or developing virtues of character.

By: Ali Shakil

Source

1. Kant, Immanuel. 1785. “First Section: Transition from the Common Rational Knowledge of Morals to the Philosophical”, Groundwork of the Metaphysic of Morals.

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Here is one answer: Bankers work to fulfill the purpose of finance.

The child will ask: what is the purpose of finance?

Here is an answer: the purpose of finance is to help people save, manage, and raise money.

The answer is simple enough, but hardly ever spoken or acknowledged, which is a pity because purpose is the end towards which actions are directed. Purpose guides actions. Aristotle asked about the purpose of everything from medicine to generalship. (In case you are curious, for Aristotle, the end of medicine is health and the end of generalship is victory.) Every action and decision is done for the sake of an end, a purpose. The ancient Greeks, the Stoics, and the Scholastics knew and lived by this idea and even in a postmodern period modern humans still seek purpose. Why else is The Purpose Driven Life by Rick Warren the second most translated book in the world and the best selling hardback non-fiction book in history?

Just as many seek purpose to life, professionals in the broad sense, seek purpose in their work. A profession’s purpose is:

1. A goal
2. A reason for the work we do
3. A guide to decision and action

A noble purpose is probably more likely to engender good acts, although it does not guarantee every act will be good. Most professions have well articulated purposes. For example, as Aristotle will agree, the medical profession’s purpose is to help people be healthy. The legal profession’s purpose is to help people obtain justice. The teaching profession’s purpose is to help people learn. It is therefore, not in the least odd for the finance profession to profess a purpose.

The purpose of finance is to help people save, manage, and raise money.

Finance needs to have its purpose enunciated and accepted. Students in finance should learn it in their business education. Perhaps the purpose should be taught even earlier at the elementary education level. Practitioners should be comfortable with the purpose of finance, knowing it implicitly and speaking it unabashedly. This acceptance and acknowledgement is a first step towards improving the culture of finance.

The improvement comes about through the crucial bit of the statement of purpose that is ethically charged: “To help people”. This phrase instills the notion of the “other” in finance. The idea of the other is where altruism and ethics begins. Secular moral philosophy from theories of justice to utilitarianism, concerns the other. The idea of helping the other also is widespread in religions from the Mosaic to the Eastern traditions. It is a basis of religious ethics. Christians are asked to love their neighbors, Muslims to show mercy to the less fortunate, and Buddhists to have compassion for sentient beings.

Where finance has fallen over the past half century is its gradual abandonment of an acknowledged purpose that entails the notion of helping people. Finance has been quantified for efficiency, made positivistic to escape the perceived quagmire of relativism, but quantification has led to the collective unconscious equating finance almost exclusively with money, neglecting the connecting link, people. So much so, spiritual leaders such as Pope Benedict and the Dalai Lama, feel the need to remind those who are inclined to listen, money (finance) is meant to serve people and people are not meant to serve money (finance).

Articulating the purpose of finance clarifies, for everyone, the role and work of finance professionals.

So instead of having this fuzzy connection in our minds:

Which leads to this mistaken belief:

We should have this much less fuzzy and more correct connection in our minds:

The statement and acceptance of a purpose is not the silver bullet that slays all unethical acts in finance. There is no silver bullet. Ethical progress is incremental more resembling an asymptotic curve. The quest of this Institute is to develop a new theory of finance in which ethics plays an integral role. The first step towards this new theory may be to propose a purpose for finance that is true, acceptable, and yes, noble.

By: Dr. Kara Tan Bhala

Photo: Courtesy of Flickr: Marta Mela

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